Correspondent banking, the collective term for banking services provided by a bank in one country to a financial institution in another, has been the backbone of international banking operations and payments for some time. Smaller banks without a large international network of their own, in particular, rely on their relationships with correspondent banks in other countries to make cross-border payments.
For the past two to three years, however, correspondent banks in the United States, Europe and Canada started severing ties with banks in the Caribbean.
The Caribbean Association of Banks warned in August that the decline of correspondent banking relationships among financial institutions in the Caribbean undermines trade and business activity and threatens the economies in the region.
At least 16 banks in five Caribbean countries have lost all or some of their correspondent banking relationships.
Worldwide the situation is similar. Although the overall volume of payments increased between 2011 and 2015, the Committee on Payments and Market Infrastructure of the Bank for International Settlements determined that the number of active correspondent banks declined in 120 of the 204 countries it examined.
According to a May 2016 IMF report, there are several reasons for the decline in banking relationships.
On the one hand, banks are more broadly reassessing the cost benefits of their business lines, including transaction banking activity like correspondent banking. On the other hand, the IMF stated in its research paper, banks are uncertain about their regulatory obligations and fear large penalties and reputational risks in connection with the enforcement of sanctions, tax transparency and anti-money laundering, which have significantly increased the compliance costs for global banks.
The confusion and uncertainty is in part related to the U.S. Justice Department’s Operation Choke Point, which in 2013 identified certain industries, such as money remittance services, as high risk for fraud and money laundering.
Although the Federal Deposit Insurance Corporation later clarified that U.S. banks should use a risk-based approach to determine the risks rather than cut business ties with all potentially risky sectors, banks have been exiting unprofitable business lines and businesses they perceive as risky, amid a general decline of cross-border activity.
As a result, correspondent banking has been high on the agenda of both the Cayman Islands Bankers Association and Cayman Finance for some time.
Responding to questions by the Journal, both associations said in a joint statement that Cayman’s retail banks enjoy strong and long-standing relationships with U.S. correspondent banks.
“But as large correspondent banks exit business lines globally in the region, primarily due to ‘de-risking’ driven by regulatory obligations and pressures, it is important to proactively engage to ensure there are no unintended consequences that could affect efficient and effective access to the global financial payments and settlement systems,” they said.
The Cayman Islands Bankers Association, Cayman Finance and the Ministry for Financial Services therefore continue to work closely and proactively “to reinforce the message that the Cayman Islands is a well-regulated and key international financial center for the global economy which gives international correspondent banks comfort both at an institutional and jurisdictional level,” they added.
The effect in Cayman
In the Cayman Islands, the pressure on correspondent banking relationships has shown its effect in two ways.
Money service businesses, essential for sending remittances by migrant workers, found themselves cut off from all banking services after Fidelity Bank told its money service provider clients that it had decided to “de-risk” and exit the business of processing payments on their behalf because it had been made unprofitable by increasing regulatory obligations.
Other banks followed suit, also citing the anti-money laundering risk profile of this type of business.
This resulted in significant disruption with money service businesses closing operations until they were able to secure suitable alternative arrangements. “In that situation the Cayman Islands Bankers Association, Cayman Finance and the Ministry for Financial Services and the Cayman Islands Monetary Authority worked very hard to ensure an appropriate solution was found,” the financial services associations said.
In addition, Cayman Islands class B banks, which rely on correspondent banks to make international money transfers on behalf of their clients, have also encountered greater difficulties in maintaining their correspondent banking relationships.
The number of class B banks in Cayman has dropped to less than 200 from a high of 600 some 10 years ago. While this may be largely due to consolidation in the industry, correspondent banking difficulties are a contributing factor.
“There have been many global factors affecting the banking industry such as consolidations, increasing compliance and regulatory costs and de-risking by correspondent banks,” CIBA and Cayman Finance said. “The result of some of these global issues is that it is becoming increasingly difficult for class B banks to obtain new local correspondent banking facilities and also difficult to establish direct correspondent relationships with international banks, In addition, Cayman correspondent banks are finding it difficult to provide correspondent banking facilities to class B banks due to pressure from their own correspondent banks that prefer not to have ‘nested accounts.’”
So far, no Cayman banks have been completely cut off from the international payment system, but problems with sending remittances has already resulted in a greater consolidation of services.
A regional and global threat
In areas where correspondent banking relationships have ceased, the Caribbean Association of Banks said in August, the de-risking exercise of large global banks threatens to lead to financial exclusion, shrinking financial sectors, the thriving of underhand economies, the increased use of unregulated payment options and slower economic development.
In Jamaica the de-risking issue is at the top of government’s concerns. Jamaica’s Foreign Affairs and Trade Minister Kamina Johnson-Smith said at a conference in Washington, D.C., on correspondent banking problems, “Given the severity of the challenge of de-risking by international banks, the government has accorded the highest priority to this matter.”
Prime Minister Andrew Holness considers this issue to be “a clear and present danger to the growth and development prospect of Jamaica,” the minister said.
Jamaica is tackling the problem through diplomatic channels and by strengthening financial oversight and regulatory frameworks to ensure compliance with international banking standards.
“Jamaica has raised the issue in a number of international forums and will continue to let its voice be heard on this important subject. We are also exploring the feasibility of strengthening our anti-money laundering and counter-terrorist financing (AML/CTF), due diligence and monitoring infrastructure,” Kamina-Johnson said.
Meanwhile, the Caribbean Community (CARICOM) has deepened its partnerships within the region in order to strengthen its efforts to address the withdrawal of correspondent banking services from some regional institutions.
Prime Minister of Antigua and Barbuda Gaston Browne, who is leading CARICOM’s advocacy on the matter, met with the heads of the Caribbean Development Bank and the Jamaica National Building Society to discuss CARICOM’s high level advocacy in response to the emerging de-risking practices by correspondent banks.
“De-risking of correspondent banking services is an existential threat facing the Caribbean region which has the potential to decimate our living standards. We must work collectively as a region to address this threat to our survival,” Browne said following the meeting in St. John’s.
Earlier this year, CARICOM members appointed Browne to lobby policymakers in the United States, Canada and the United Kingdom on the threat to Caribbean economies from the withdrawal of correspondent banking services.
Browne says the Jamaica National Building Society and the Caribbean Development Bank will provide technical assistance to advance CARICOM’s advocacy efforts and work with CARICOM to identify solutions to the challenges. They will also be assisting CARICOM to coordinate implementation efforts and to strengthen monitoring mechanisms.
“Correspondent banking services are a public global good that is essential for participation in global trade, and is particularly important for small island economies,” Prime Minister Browne said.
The general manager of the Jamaica National Building Society, Earl Jarrett, pointed to the threat to services such as remittances, on which the region depends. Highlighting challenges faced by his organization’s remittance company in the Cayman Islands, he said that the value of remittances was equivalent to a significant percentage of gross domestic product for many receiving countries in the region.
“Remittances are the lifeline for migrant communities across the region. And, Jamaica alone, with a diaspora population of some 3 million, represents one of the largest recipient countries in the region, accounting for amounts equivalent to approximately 17 percent of our gross domestic product,” he said.
Last year, the IMF highlighted the challenges for banks in the Caribbean, concluding that while the impact had been contained, the risks related to correspondent banking relationships have strongly increased for all banks, and remittances and other payment flows may have been affected.
If all correspondent banking relationship were lost in one country, the IMF said, the consequence would be systemic risks for the financial system.
This has not gone unnoticed by the Financial Stability Board, the organization that deals with financial systemic risks globally.
The FSB presented a plan to leaders of the 20 largest economies in November 2015 to address the decline of correspondent banking. The plan consisted of further analysis, the clarification of regulatory expectations, including more guidance from the Financial Action Task Force, domestic capacity building and the strengthening of due diligence tools used by correspondent banks.
In March 2016, the FSB established a Correspondent Banking Coordination Group to implement the action plan. An initial report on the progress was published in September.
The FATF has since updated its guidance in areas where it affects correspondent banking. In February the organization clarified its guidance for a risk-based approach for money transfer services, and in June it updated one of its anti-money laundering recommendations in relation to nonprofit organizations.
U.S. regulators, concerned that banks have gone too far, have also pledged to be more clear in terms of what they expect from banks. In September the U.S. Office of the Comptroller of the Currency, which regulates large banks, said it will offer guidance on how banks evaluate foreign banking risks and make decisions on whether to shut down accounts.
Agency head Thomas Curry told a Las Vegas anti-money laundering conference, “The global financial system cannot be paralyzed by risk.”
The de-risking by banks could “lead to entire regions being cut off from the positive effects of modern financial systems and broader financial inclusion,” Curry said. “This is not the solution.”
A report by the FSB suggests a number of measures to improve the situation. For instance, several service providers have developed KYC utilities, which store customer due diligence data in a single repository. The idea is to give correspondent banks more transparency and the ability to identify and mitigate the risks associated with respondent banks and their underlying clients.
In particular, for banks that err on the side of caution in the absence of clear regulatory guidelines, additional information about the risks in foreign banking partners could tip the scales.
Grada, a Cayman Islands-based company, is in the process of offering such a solution to local banks. Owner Peter McKiernan says large banks want to make money with transactional banking business in the Caribbean because they are not making money on interest anymore. “But they are stifled by their Treasury departments which think it’s too risky.”
Grada’s solution provides these banks with more transparency in the risks associated with their Caribbean client banks and the customers of those clients. Grada’s service consists of conducting the due diligence on all of a bank’s underlying customers and validating that the information, such as passports, is correct.
The U.S. correspondent bank would not have access to details of each customer, but it would see a statistical breakdown of the customer types, where they are based, where they conduct business, the percentage of enhanced due diligence and due diligence completed for the bank’s customers and so on.
Based on the analysis, U.S. correspondent banks may have more comfort in their ability to assess the underlying risks. They may also establish certain rules or ask their respondent banks to exclude specific customer types.
Overall this combination of due diligence and KYC outsourcing and validation across several banks would help lower the compliance costs for banks.
The FSB believes that in addition to cost savings, KYC utilities would reduce the amount of information that needs to be collected several times, for example when customers have accounts with a number of banks. The information would also be more standardized and reliable, and the process would be faster.
Cayman’s financial services associations confirmed that the issue is being discussed by the banks as a potential option in the future to supplement internal compliance programs. However, they pointed out that all banks have to meet international and local regulatory requirements and head office requirements, so that a minimum standard must be met by the banks that would not be covered by an outsourcing or independent external validation process at this time.
The FSB also promotes the use of unambiguous Legal Entity Identifiers as an improvement that could help make correspondent banking more transparent.
Another Grada solution focuses on money service providers and the ability to verify the identity of the person sending a payment via a smartphone app. Before the money transfer is carried out, the customer will take a selfie using the app. In combination with the time stamp and the geolocation of the phone placing the customer near the money store, the payment is approved for a limited time, as long as it is in line with pre-approved parameters such as maximum transaction amounts and the designated country the payment is going to.
In sum, these efforts could increase the comfort of onshore correspondent banks doing business with the Caribbean and other alleged “risky” business regions.
In addition, Cayman banks will continue to maintain strong systems and processes that meet global AML standards. And they will maintain their ongoing regular communication with CIMA to ensure they are aware of all regulatory requirements and expectations, Cayman Finance and CIBA said.
“The jurisdiction will maintain its robust regulatory and supervisory framework and ensure that correspondent banks are aware of the strength of our regulatory regime,” they noted.
Paul Byles, CEO of First Regents Bank in Cayman, agrees that the issue has to be tackled directly with banks and regulators onshore.
The banks should already know that the Cayman Islands and its regulator the Cayman Islands Monetary Authority adhere to very high global standards, he said. “But apparently that is not sufficient. So the only way to tackle the issue is to meet directly with the major institutions onshore and educate them on the nature of the regulatory regime for banks in Cayman. It would also make sense to go a step further to ask these banks to be specific about what types of systems and risks they wish to see managed better from an operational perspective, so that local banks facing this challenge can consider adopting such practices,” he argued.
A similar approach should be pursued with onshore regulators to better educate them on Cayman’s banking supervisory regime. There should also be more regional meetings and coordination to tackle the issue.
CIMA has been engaged in correspondent banking discussions by attending international working groups with entities such as the IMF, FSB, World Bank, global banks, regional regulators and law enforcement agencies including the IRS, the SEC and the FBI, Cayman Finance and the Bankers’ Association confirmed. In addition, CIMA has reached out to local associations to provide guidance on enhanced regulatory requirements and expectations.
Although there have been some industry surveys to better understand the nature and magnitude of the problem, Byles said, “The truth is, there has been very little progress in terms of getting U.S.-based banks to change their current approach.”
In the meantime, some banks are turning to other options such as finding more “lenient” institutions that will open correspondent accounts for them. That may be effective in the short term, Byles said, but generally this approach also poses some risks, so each bank will have to carry out its own due diligence on these options.
Globally and locally there is also a certain amount of opportunism within the banking sector, he noted, with some banks “hiding behind the ‘de-risking’ excuse knowing full well that they stand to gain because the lack of correspondent banking accounts means fewer banks and therefore less competition.”
This works well from an individual bank’s perspective, Byles said, but regionally or globally, it is not the best long-term solution because it encourages a very high concentration of client assets in a smaller number of institutions.
“Those institutions then fall into the ‘too big to fail’ category which itself leads to a host of other problems. That result can’t be good for anyone,” he said.