Correspondent banking - an essential service for international banking - has been on the decline in recent years. The trend has strong development impacts for small countries, particularly in the Caribbean.

The Panama Papers may have cast a glaring light on the risky side of international banking, but another trend has been unfolding that also carries potentially grave consequences for global finance and development.

Some of the world's largest financial institutions have been reporting a steep drop in the services and transactions that they process for smaller local and regional banks around the world.

The severing of these ties poses a number of risks to the growth and development of businesses in affected regions - particularly island states in the Caribbean who rely heavily on international banking - and undermines the type of financial inclusion that regional development banks work to promote.

Lifeblood services

The issue is layered with complexities but ultimately centers on a service that is considered vital for global banking.

"Correspondent banking services are essential to enabling companies and individuals to transact internationally and make cross-border payments," according to a World Bank�report. �

The report was referring to the everyday financial services that banks administer for one another to grease the wheels of international trade and finance.

Correspondent banking typically involves two foreign banks in which one -�the correspondent bank -�holds the deposits of another bank and processes payments on its behalf.�Payments can range from settling customer invoices to processing foreign remittances.

For banks from smaller countries that rely heavily on foreign commerce, correspondent accounts in the United States or the European Union are a common way to gain a foothold in larger markets.

But those arrangements have come under increasing threat.

The World Bank and other international financial bodies have noted a growing trend in recent years among large global banks to limit or terminate their correspondent services.

The latter -�the process in which banks cut off correspondent services entirely -�has come to be known in international banking as "de-risking." Effectively, the correspondent bank eliminates all potential risks related to a client bank by cutting ties altogether.

The products and services most affected by de-risking include cash management services, check clearing and settlement, international wire transfers and, for banking authorities and regional banks, trade finance.

The trend is being driven by a number of factors related to compliance and business costs.

In recent years large banks have come under increasing pressure from regulatory bodies to strengthen their oversight and controls for combating financial crimes, or face harsh penalties. The Financial Action Task Force -�an anti-money laundering and financial terrorism watchdog -� for example, requires banks to conduct thorough due diligence of their clients as well as of their correspondent account holders.

The Panama Papers scandal added to that spectre of risk mitigation by demonstrating how difficult it is for large banks to know for certain the origins of the correspondent funds that they process or how they are being used.

Additionally, international banking rules passed after the financial crisis have required banks to hold more assets for every dollar that they hold in correspondent accounts, effectively lowering the amount they can lend out. Correspondent services for smaller countries, meanwhile, often produce marginal profit for large banks.

Combined, the risks of high compliance and due diligence costs for correspondent accounts usually outweigh the returns, leading many banks to cut ties altogether.

Specific incidents and precise bank names are hard to pin down because of reputational concerns. Global banks avoid major de-risking announcements and respondent banks whose accounts are cut off are also hesitant to go public because of the suspicion it could cast on them.

The issue has instead been raised by national banking regulators and research by groups such as the World Bank. A November 2015 report on the issue by the World Bank highlighted several important trends.

The report surveyed 110 national banking authorities, 20 large global banks and 170 smaller local and regional banks on their correspondent banking practices from 2012 to 2015. It found that roughly half the banking authorities and slightly more local banks indicated they were experiencing a decline in correspondent banking relationships. Seventy-five percent of large international banks also said that they were scaling back their correspondent services over that period.

A separate report released around the same time by the Bank of International Settlements cited "increasing indications of an overall cutback in the number of correspondent banking relationships and, for smaller banks in some specific jurisdictions, difficulties seem to exist in establishing new relationships."

Regional imbalance

The trend is global, but the World Bank specifically indicated that the Caribbean is one of the regions that is most severely affected.

The issue took center stage at the annual board of governors meeting of the Caribbean Development Bank�earlier this month - the first such meeting since the World Bank released its report. Devex Impact spoke with a number of conference participants including CDB officials who underscored the severity of the issue facing their region.

Caribbean countries, which are small and export-oriented because of industries such as agriculture, tourism and manufacturing, depend highly on correspondent accounts to serve as conduits for revenues generated from abroad. External trade accounted for roughly 94 percent of the gross domestic products of member countries borrowing from the CDB in 2014, according to the CDB. Remittances are also a significant contributor to the region's balance of payments and a decline in remittance flows could lead to increased external borrowing, the bank projects.

Many Caribbean banks are being hit hard by the curtailment of financial services.

According to a presentation by the Central Bank of Barbados provided to Devex Impact, eight domestic financial institutions in Barbados have had their accounts terminated by Canadian and U.S. correspondent banks, as well as several from the Netherlands, U.K. and Germany.

In Belize, the country's central bank has reported that U.S. banks have terminated correspondent banking relationships with five of the seven banks operating in the country, including the largest bank, Belize Bank.

In Jamaica, the presentation cites "a leading U.S. bank, which, in addition to terminating a relationship with one deposit-taking institution, issued termination notice to two others and has imposed restrictions on four other financial service licensees."

Together they pose a serious threat to development in the region.

"Banks that are being shut out because of financial preclusion or exclusion can no longer do what they want with their deposits," Toussant Boyce, head of integrity, compliance and accountability at the Caribbean Development Bank, told Devex Impact. "Their customer companies can't pay for services or invest in the U.S. which has significant implications for trade or economic development."

Many Caribbean banking officials consider the trend to be unfair. Because of several small-island jurisdictions that have been deemed tax-havens, international banks paint a broad brush stroke of the region as suspicious and risky, they said.

"In fact there is currently no Caribbean territory that is on the non-compliant list of the Financial Action Task Force," Boyce told Devex Impact.

A report by the Financial Stability Board, a financial watchdog for the G20, noted that the decline of correspondent bank relations in the Caribbean could become a systemic issue for the region by driving payment flows underground into the shadow banking sector.

For some businesses this is already happening.

"In the Cayman Islands, our money services business had been forced to resort to the physical transportation of money between islands due to the closure of our bank accounts," Earl Jarrett, general manager of Jamaica National Building Society, a financial services provider, said in a speech at the CDB annual meeting.

De-risking is also taking its toll on the CDB itself whose lending activities are being constrained by the abrupt correspondent account closures. Because many CDB transactions are made in dollars and the reliance of Caribbean banks on the U.S. financial system, CDB funding often utilizes U.S. correspondent accounts.

"If we give development assistance to borrowing member countries but they can't do what they need to do with local procurement, then it's useless," Boyce said. "Our role is to ensure that any dollar of development finance that we provide is used for its intended purpose."

The de-risking dilemma poses for the CDB what Boyce called a "twin problem." How does the bank not only promote growth among its member countries, but deliver development assistance to those countries when faced with a banking hurdle?

An immediate solution is for the CDB to deliver any necessary technical assistance to its client countries through capacity building, for example, or by helping member institutions manage their compliance or regulatory demands, Boyce said.

Longer-term solutions could involve some sort of coordinated regional approach that pools member country deposits into one correspondent account, making it easier to coordinate with U.S. or E.U. banks.

Boyce also suggested as another option, an insurance instrument coordinated by Caribbean banks that pays out a foreign bank if it were to incur any penalties from regulatory bodies. �

"An important thing to remember is that we're not alone in this fight," Boyce noted. "The International Monetary Fund, the World Bank and the Financial Stability Board are all looking into the issue."

Source