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SectionsOctober 1 2012

Correspondent banking under Dodd-Frank, Section 1073: the new normal

The Dodd-Frank Act, Section 1073 is going to alter the practice of retail cross-border payments services – not just for US-based financial institutions but also for their correspondent banking relationships abroad. The deadline is near, but a practical solution to meet the requirements of the rule still seems far off. The Banker looks at some alternatives that have finally started to emerge.
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Correspondent banking under Dodd-Frank, Section 1073: the new normal

Thanks to Section 1073 under the Dodd-Frank Wall Street Reform and Consumer Protection Act, financial institutes in the US are trying to figure out how they are going to comply with regulation that requires so many technical and cultural changes to a business that offering an efficient service becomes commercially impractical.

Section 1073 requires transparency on all potential fees and taxes, foreign exchange (FX) rates, fund delivery times before payments are initiated, and shifts error liability from the consumer to the institution. It also requires the service provider to issue a post-payment receipt disclosing the date that the beneficiary’s account will be credited, as well as cancellation and error resolution rights. Section 1073 also allows 30 minutes for a consumer to request a recall of a payment.

Impractically yours…

Compliance with the rule in this open loop correspondent banking system is therefore proving to be impractical, both physically and technically. Financial institutions will have to change their payment systems and convince their foreign correspondent banks – to whom Dodd-Frank does not apply – to disclose any fees and taxes they impose for routing transfers.

As correspondent banking is a core business for some 3700 banking groups in more than 200 countries, changing such a model is not easy, says Wim Raymaekers, head of banking market at the Society for Worldwide Interbank Financial Telecommunication (Swift).

This complexity is going to have unintended consequences, both analysts and banks warn (see Chart 3 and Chart 4). The cumulative impact of these requirements will affect a bank’s retail and wholesale business, as well as its relationships with both financial institution clients, which may outsource remittance services, and foreign correspondents (see Chart 1).

But alternatives are emerging, such as the model by Earthport, a specialist payment service provider to financial institutions with access to domestic clearing and settlement systems worldwide.

After strong industry lobbying, the Consumer Financial Protection Bureau (CFPB), which oversees consumer financial laws, relaxed some of the Section 1073 rules. But ask a banker or an analyst, and the general answer is, as Gareth Lodge, senior payments analyst at Celent, puts it: “There are all sorts of complications and nuances in the rule that the CFPB has not thought through.”

Correspondent banking under Dodd-Frank GRAPHS

Problems remain

While the banking industry does not dispute the consumer’s right for more transparency, financial institutions need to address the end-to-end cross-border payments process to provide this transparency, says Roy DeCicco, a managing director and an industry issues executive with the treasury and securities services, global markets infrastructure team at JPMorgan.

“If there are privacy laws or FX control constraints that prevent foreign correspondents from providing that information, the remittance transfer provider needs to know and look at alternatives. One potential solution is inclusion of some markets on a safe harbour list, which the CFPB will publish soon,” says Mr DeCicco.

A definite publication date is yet to be set, so those financial institutions that do want to stay in the remittance business are working “around the clock” to meet the February 2013 deadline on Section 1073, says Cary Whaley, vice-president, payments and technology policy, at the Independent Community Bankers of America. 

But a focus on particular corridors will create region-specific services, says William Sullivan, senior director and group manager, government and industry relations, for the National Automated Clearing House Association (Nacha). 

“There are solutions that should easily be in place by the deadline for Mexico, but not parts of eastern Europe or Africa before February, for instance,” says Mr Sullivan.

For example, a fund transfer may not arrive on the date the sending bank states on the pre-payment disclosure because a correspondent may have money laundering or terrorist financing concerns and hold up the transfer. In these cases, the sending bank is still liable for ‘error’ resolution, says Michael Edwards, chief counsel and vice-president for advocacy and government affairs at the World Council of Credit Unions.

Soft centre

Another difficult, if not impossible, requirement to comply with is the disclosure of possible taxes that a foreign correspondent may impose on payments. Nancy Atkinson, senior analyst for wholesale banking at Aite Group, says there is no central source collecting and maintaining fee and tax information for global cross-border payments. If, for instance, a beneficiary receives a lesser amount than the one stated on the disclosure for the sender, the sending consumer becomes a victim of an error, and is so entitled to a refund or the difference between the amount disclosed and the amount received.

As someone whose industry is caught in this gridlock, Mr Whaley says none of the remittance service providers he has spoken to determined how to calculate national, district and local taxes for the country receiving the remittance transfer. “This liability puts a lot of risk on the bank and could encourage fraud, thus discouraging banks, especially those with lower volumes of payments such as community banks and credit unions, from offering the service,” he says. “Those that do offer the service will do so at a greatly increased price. To manage this liability, they will be careful who they deal with and limit access to consumers.”

There are some temporary exemptions. As long as the fee and FX rate disclosed “provide a reasonably accurate estimate of the foreign currency to be received”, the financial institution will comply with the rule, at least until 2015, the CFPB says. But that will just lead to overestimates in charges, warns Ms Atkinson.

Plus, the rule now only applies to institutions that make more than 100 transfers a year, instead of the 25 that was originally stipulated. About three-quarters of the 7000-plus community banks and 20% of the 7535 credit unions are covered by this exemption. Instead of creating more choice and competition, Mr Whaley and Mr Edwards are concerned that this actually discourages these institutions to grow their remittance services due to the high costs associated with compliance, compared with the dollar values sent (see Chart 2).

Technical burdens

Above all else, Section 1073 is clearly a major technical challenge. “Most banks use wire transfer systems to make fast payments. Now they have to separate consumer wires from commercial wires, find a way to hold consumer wires for half an hour, or risk refunds if the consumer changes their mind. This has potential negative implications for FX rates,” says Ms Atkinson.

A cancellation within 30 minutes could cause a bank to lose money as wire transfers have a fee attached to them and the FX rate may change by the time the payment is cancelled. A solution, Ms Atkinson suggests, would be to use in-house methods to set futures and options, so banks could quote a spot rate and protect themselves from a negative fluctuation in FX rates overnight.

“Ironically, the rules are easier for non-bank remittance service providers to follow than they are for the banks,” says Ms Atkinson. “This is penalising banks. The likes of Western Union are not facing the same challenge because their closed networks provide ability to know the total cost and time funds will be available.”

As Ms Atkinson points out, wire transfers are the main system used for domestic transfers. The regulators have been trying to increase the uptake of automated clearing house (ACH) payments, which are also used domestically, but with little success to date, says Mr Lodge.

Although wire transfers are more expensive than ACH payments, ACHs operate on a next-day basis, whereas a wire transfer is often settled within the hour. That, coupled with the investments already made into wire transfers and the higher revenues banks make from wire transfer fees compared with ACH fees, leaves banks little incentive to start using ACHs.

To increase the uptake, and possibly lower fees for consumers, there is a specific section under Dodd-Frank that actually calls for the expanded use of the ACH network for remittance transfers. But Mr Sullivan says regulation as it is currently written will in fact hinder the uptake of ACHs. “Congress felt the ACH network improved both the service and the cost to consumers. But the rule will likely lead to a decrease in the use of the ACH network for international funds transfer services because of the numerous disclosure issues and shift in liability.”

The only real alternatives to correspondent banking would be a network such as Swift or an organisation such as Earthport, suggests Mr Lodge at Celent. But many banks perceive the Swift network as more suited for higher-value transactions and it is more expensive than ACH transactions. So correspondent banking provides a simpler alternative for lower-value transactions.

“As international low-value trade grows, we have to ask ourselves if there is demand for another product that might better serve this market,” says Mr Lodge. Indeed, Mr DeCicco at JPMorgan says the industry is currently developing codewords for payments messages to identify Dodd-Frank transactions in Swift, which could flag up foreign fees and taxes.

Correspondent banking under Dodd-FrankGRAPHS2

Not the end

Smaller banks in particular face some, albeit few, options. First, they could use white-label processing solutions or outsource payments to larger banks. Mr Sullivan believes the CFPB essentially assumed larger institutions would develop downstream solutions, but heard from the member institutions of Nacha that it “doesn’t have solutions in place for smaller institutions yet and doesn’t know if this is a strategic direction it will take”.

Many of the large banks The Banker approached declined to comment, but JPMorgan’s Mr DeCicco confirms the bank is developing a service for downstream domestic banks specifically for Dodd-Frank, Section 1073, but only to targeted customers. According to Mr Edwards, Wells Fargo is another bank that, among larger banks, is “ahead of the curve” in developing downstream solutions, but the bank, like other big players, declined to comment. 

“Some larger banks told me they will provide white-label services further, but the small bank needs to be in the big bank’s target market – and the volumes at many community banks are just too small for them to be of interest to the larger banks,” says Ms Atkinson.

This pickiness among larger banks worries Mr Whaley. “Our banks rely on upstream correspondents, who focus on their own volumes before they scale down their products for community banks. There will be short-term competitive disadvantage,” he says.

Another option would be a deal with the likes of Western Union, “but frankly, the volumes of [many] smaller banks are not large enough to make them a desirable partner,” Ms Atkinson argues.

The golden kid

These limited options and the need for cheaper, but secure processing solutions have benefited one service provider in particular: Earthport. As Ms Atkinson puts it: “Dodd-Frank may create a big boom for its business [as] just about every bank is talking to Earthport, including a number of smaller ones.”

The business-to-business provider has emerged as a viable alternative to numerous correspondent banking relationships. It has direct access to clearing houses in more than 50 countries, so payments get settled in local currencies.

“From a technical perspective, we make two local transactions: one in the country of the sender, one in the country of the beneficiary. We process it all as a local transaction in the destination country. From a regulatory standpoint, we still treat it as a cross-border transaction, so we perform all Know Your Customer, anti-money laundering and other regulatory procedures,” says Neil Burton, director of product strategy at Earthport.

But time is running out. Ms Atkinson argues that financial institutions “are burying their heads in the sand and hoping for Dodd-Frank 1073 to go away after the November elections”. The issue seems to be not so much ignorance, but confusion on how to achieve compliance. Even if a new administration came in, Ms Atkinson says Dodd-Frank is unlikely to become a top priority for them. So banks have to get used to the new normal and find a solution by February 2013, or risk losing out on a growing business.

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