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WorldFebruary 1 2017

How derisking became a humanitarian issue

The withdrawal of correspondent banking from high-risk markets, or ‘derisking’, is an increasingly common response from banks wanting to avoid punitive fines. But its human cost means there is an urgent need for alternatives, as James King reports. 
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Syria- aid blocked

During a particularly brutal stage of Syria’s civil war, one of Europe’s leading aid organisations tried to deliver humanitarian assistance to the country’s civilian population. The plan involved transferring funds to a neighbouring jurisdiction before dispersing the money across the border through informal ‘hawala’ (transfer) networks, due to a lack of formal banking channels. The agency, which had a long-term relationship with a global bank, discussed its intentions with the lender. But the plan was blocked for falling well beyond the bank’s risk appetite, in part because the aid organisation could not guarantee that the funds would not be diverted on route.

This incident, detailed in a leaked and widely circulated UN document on the humanitarian impact of unilateral restrictive measures placed on Syria, is one of many cases where aid organisations and charities have been unable to effectively provide relief due to banking-related restrictions. The ongoing civil conflict, the sanctioning of Syria’s largest banks and the presence of terrorist organisations on the ground have cumulatively elevated the country’s risk profile to an extent in which correspondent banking exposure has been withdrawn.

But the factors underlying the termination of Syrian-related correspondent banking relationships are also at play in a global context. The introduction of more stringent regulations covering anti-money laundering (AML) and combating the financing of terrorism (CFT), and the challenges of sanctions compliance, among other issues, including reputational and liability risk, are making it increasingly onerous for many international banks to maintain relationships with markets and customer segments deemed to be of higher risk. This withdrawal of correspondent banking and other business relationships is known as ‘derisking’.

Fines to pay

“Derisking is being driven by a number of factors,” says Ahmad Safa, an executive board member at Lebanon’s Banking Control Commission. “These include, but aren’t limited to, a decline in the overall risk appetite of foreign financial institutions, changes to the legal regulatory or supervisory environment in foreign financial institutions’ jurisdictions, the fact that some respondent banks don’t generate sufficient volumes to recover compliance costs, and the lack of profitability of certain correspondent banking relationships’ services and products.” 

In recent years, billions of dollars in penalties have been dished out by – for the most part – US regulatory agencies to lenders deemed to have breached AML/CFT or sanctions-related regulations. In 2014, France’s BNP Paribas was fined $8.9bn for large-scale violations of US economic sanctions. Breaching sanctions regimes or regulatory frameworks thus come with an overwhelming cost for many banks, in turn leading to rising compliance costs. The British Bankers Association estimates that its members are spending, in aggregate terms, about £5bn ($6.22bn) per year on financial crime compliance.

“Derisking is essentially a process of corporate repositioning, driven by the growing costs and changing risk-reward dynamics of a more stringent regulatory environment,” says Richard Jones, chief executive of London-based financial institution Crown Agents Bank. “There aren’t many fundamental risks that can’t be managed. It’s mostly a question of a bank’s cost versus its appetite.” 

For regulators, these trends present a challenge. On the one hand, they must devise a regulatory framework that promotes responsible and inclusive cross-border financial flows. On the other, they must ensure that the regulatory environment does not drive these flows underground and out of the formal financial system.

Out in the cold

The challenge today is that some jurisdictions are effectively being cut off from the global financial system due to the withdrawal of correspondent banking relationships. As a result, regulators and international law enforcement agencies are less able to track money flows, which are instead being routed through informal networks.

Research published by intergovernmental agency the Commonwealth Secretariat in 2016 offers some context regarding the scale of the challenge. Of 23 Commonwealth countries surveyed in the study, 17 had experienced a decline in correspondent banking relationships since 2012. More than 70% of these closures occurred since 2015. The problem is most pressing in the Caribbean and the Pacific islands. All Commonwealth Caribbean countries reported losses of correspondent banking relationships, in some cases multiple relationships, while similar trends have hit the Pacific.

Small island states are seemingly more susceptible to the challenges presented by derisking. For one, the limited size of their banking systems means that the compliance costs facing correspondent partners typically dwarf any returns. In addition, these jurisdictions boast a large number of money transfer and remittance payment entities, both of which fall into the higher risk customer segment.

“In any portfolio of a bank’s business, there are a number of relationships that are on the edge of being economically viable. The changing AML/CFT regulatory environment has made these a lot more costly,” says Mr Jones.

Beyond the Pacific and the Caribbean, the picture is more varied. Most African economies, in relative terms, have fared much better in the derisking stakes. This in part reflects the dominance of larger banking institutions in most of the continent’s key economies, which have strong compliance and due diligence systems in place.

“In Africa, the issue of derisking isn’t as clear-cut as it is in other parts of the world. If you look at larger banks in larger African markets today, it is still a competitive environment for correspondent banks,” says Duarte Pedreira, head of trade finance at Crown Agents Bank. “Because the larger banks in Africa aggregate a significant portion of the business, the implications of derisking for trade remain relatively limited. For example, when it comes to the African trade finance gap, I don’t see it as being linked to derisking as much as it is to the potential challenges created by understanding and mitigating risks on a scalable basis.”

What to do?

Smaller markets have not escaped unscathed, however. In Liberia, global banks terminated 36 out of 75 correspondent banking relationships between 2013 and mid-2016, according to research from the International Monetary Fund. Meanwhile, 20 accounts held by Guinea’s central bank among seven foreign lenders have been closed since 2009.

In the Arab world, derisking is being felt more keenly. A report published by the Arab Monetary Fund in September 2016 found that about 39% of 216 banks it surveyed had registered a decline in the scale and breadth of their correspondent banking relationships between 2012 and 2015. Moreover, about 63% of the banks in the survey reported the closure of correspondent banking accounts in 2015 compared with 33% in 2012, indicating that this trend is on the rise.

“[The implications of derisking in the region] are a challenge. The impact on financial stability includes greater financial exclusion, the rise of non-bank financial institutions, the inability to attract foreign capital and foreign direct investment as well as making it increasingly difficult for local banks to manage current account transactions,” says Mr Safa.

The problem of derisking is now at the forefront of discussions among global and local regulators, banks and development agencies alike. In its end of 2016 progress report addressing the decline in correspondent banking, intergovernmental body the Financial Stability Board (FSB) suggested four ways to overcome the challenge: clarification of regulatory expectations, greater collection of data, building domestic capacity in jurisdictions that are home to affected respondent banks, and the strengthening of the due diligence tools employed by correspondent banks.

“Increased financial regulation is driving up the compliance costs for most banks, and some are responding to this pressure through derisking,” says Raza Mithani, a partner with law firm Berwin Leighton Paisner in Dubai. 

A costly approach

Ideally, regulators want banks to pursue the so-called ‘risk-based approach’ (RBA), whereby banks consider risk on a case-by-case basis. And while this position is not new – the RBA has been the default position adopted by banks and regulators for a number of years – it remains relatively opaque when put into practice.

As a research report commissioned for the UK’s Financial Conduct Authority notes, at the practical level of risk assessment and mitigation, the RBA has no standardised metrics and there is some way to go before it reaches a recognised state of maturity. Beyond this, implementing the RBA remains costly for most banks.

“In theory, banks should be treating customers and new business on a case-by-case basis and conducting a proper analysis. In practice, I think there are instances where banks are derisking on a wholesale basis,” says Mr Mithani. 

Greater success has been reported in building domestic capacity. New forms of co-operation and dialogue are emerging between global and local regulators, as well as between correspondent and respondent banks. Cumulatively, these efforts are delivering significant gains in terms of regulatory equivalence and improved banking services globally. But there is still a long way to go.

“Correspondent banks are increasingly engaging in capacity-building initiatives with their respondent partners in areas such as AML and know your customer compliance. As such, the overall quality of banking services being provided across Africa is going up,” says Mr Pedreira.

Encouragingly, this process is also unfolding in jurisdictions hardest hit by derisking. “Crown Agents Bank is working with a number of Caribbean lenders to rebuild their trade finance capabilities. This is because the Caribbean is a de facto derisked market in which many exporters and importers very quickly lost access to trade finance services following the withdrawal of correspondent banking relationships from the region,” says Mr Pedreira.

Alternative means

Mr Safa of the Lebanese Banking Control Commission suggests improved information sharing between banks, as well as between banks and regulators, as a means of addressing the situation. “[There is a need to] provide additional clarity on due-diligence recommendations for upstream banks, in particular to what extent banks need to know their customers’ customers, and further explore ways to tackle obstacles to information sharing, with the aim of identifying potential best practices,” he says.

These measures will take time to enact. And for the jurisdictions and customer segments hardest hit by derisking, the intervening period is likely to be a difficult one. In the absence of a quick fix, many businesses, and even some financial sectors as a whole, will be forced to use alternative means to conduct payments and transfers. Informal money transfer networks, of the kind used in Syria, are now flourishing in the most peripheral and isolated jurisdictions.

Meanwhile, the fairness of the derisking regulatory landscape itself is being questioned in some quarters. In November 2015, the New York branch of the Agricultural Bank of China (ABC) was hit with a $215m fine for violating New York’s AML laws. The state’s Department of Financial Services discovered "intentional wrongdoing" including efforts to conceal dollar-denominated transactions executed through the branch that “might reveal violation of sanctions or anti-money laundering laws”, according to the department’s press release.

Transactions of concern at the branch included “unusually large” round dollar transfers between Chinese, Russian and Yemeni entities, and documents suggesting US dollar trades took place with Iranian counterparties, including transactions “for the benefit of a sanctioned Iranian party”. Despite receiving warnings from the department not to increase the volume of transactions executed through the branch in 2014, due to the perceived weakness of its compliance systems, the volume of transactions trebled during 2014 and 2015 to nearly $72bn, according to The Economist.

Though it is unclear why the Agricultural Bank of China received such a relatively small penalty, the case highlights the challenges facing banks and regulators alike. First, it highlights the volume of transactions facing compliance officers and regulators when dealing with compliance issues. Second, it also demonstrates the difficulty of uncovering sophisticated breaches of AML/CFT regulations. For example, ABC employed coded messaging through the Swift network to conceal the real parties involved in some transactions, making the screening process particularly difficult for the Department of Financial Services.

But high-profile cases such as these remain the exception rather than the rule. For now, those hardest hit by derisking are the most vulnerable: small and medium-sized enterprises in frontier economies, importers and exporters, money transfer organisations and those in sanctioned territories or conflict zones. As such, getting the issue of derisking right is important not only for banks and regulators but for financially excluded and marginalised people around the world.

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