Correspondent banking remains an important channel for financial flows in the eurozone, but it is becoming increasingly concentrated in the hands of just a few banks.

The number of correspondent banking relationships is falling as the popularity of alternative payment systems grows and regulators shine their spotlight on the sector, the results of a biennial eurozone survey show.    

The ninth survey on correspondent banking by the European Central Bank (ECB) released earlier in 2015 found that despite large volumes still being settled through the correspondent banking system, the biggest European lenders are in the process of severing their links with smaller peers – in 2014 the number of linkages between banks hit an all-time low of 12,207 (see chart 1). 

This has led to fears that the pressures on correspondent banking could push the industry towards consolidation in the hands of the few banks that can afford the supervision and compliance costs.

Regulatory spotlight

There are several reasons for such fears. As the survey points out, in the pre-euro days the need to maintain correspondent relationships was much greater than after integration. After the launch of the euro, much of the business was relegated to the euro payment systems, which is how the majority of payments in the eurozone are now settled (see chart 2).

Later, in the wake of the financial crisis, the industry went through a wave of consolidation and consequently banks became more reluctant to maintain relationships with institutions whose reputation was tarnished during the crisis.

All of this is old news, yet lenders are still beating a retreat from the correspondent banking business. Last year was marked by a drop of nearly 2000 in the number of relationships relative to 2012.

Instead, the decline can be attributed to the recent spike in the cost of creating and maintaining a correspondent relationship. In 2013, the EU adopted legislation that reflected the global Financial Action Task Force anti-money laundering and know-your-customer standards. In January 2014, the Bank for International Settlements followed with a set of guidelines supplementing these standards.

The legislation requires that banks not only know their customers but also their customers’ customers, which can substantially increase the costs of doing business abroad. Maintaining a relationship of that sort is expensive, as the business of the correspondent needs to be vetted periodically.

Moreover, the regulatory pressure European banks face is global, with the US leading the charge. In 2013 there was a $9bn settlement between France's BNP Paribas and the US regulator over the violation of sanctions against Cuba, Iran and Sudan. Other European lenders have also been charged by US regulators, including HSBC, UBS and ING, leading to increased caution in correspondent banking relationships.

Specialised business

Wholesale banking makes up the major share of correspondent relationships. Retail relationships reached their peak in 2005, when they climbed to more than 11%, but fell to about 5% just two years later. Retail’s share of correspondent transactions has stayed around the 5% mark ever since.

The small scale of retail payments often makes the business unprofitable and now, owing to the establishment of a new clearing house for retail payments, the volume has decreased further.

However, the business model across banks is not uniform. The survey found that two of the banks surveyed had very low average transactions, meaning that they chose to specialise in retail.

Still, although the daily turnover of correspondent transactions also declined in 2014, it still remains above the pre-crisis levels. Also the daily turnover volume of €966.3bn in transactions suggests there is still strong demand for correspondent banking relationships (see chart 3). The increase in total turnover in 2012 in particular happened due to larger than average transaction sizes, meaning higher wholesale activity.

There are indications, however, that this too could be delegated to single payment systems. The actual number of correspondent banking transactions has inched up in the past two years, while the average value of transactions experienced a slight drop. 

Some banks suggested that the decrease in the daily turnover might be a consequence of the Single Euro Payments Area (SEPA) implementation. It appears that when banks are presented with settling a transaction through either correspondent banking channels or SEPA, they often choose the latter, even in the case of infrequent, high-value payments.

A separate matter is the effect the Single Supervisory Mechanism is going to have on correspondent banking. The system came into existence after the period covered by the survey ended, November 2014, and is targeting uniform regulation of banking in the EU. This mandate will have a significant impact for European correspondent banking, which is now under the supervision of local authorities.

The mechanism could increase the strain on the correspondent banking model, or, alternatively, uniform banking standards could make implementation of know-your-customer principles much easier.

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