Trade finance services make up a vital part of the correspondent banking offering for financial institutions, but to maintain a stake in this market banks need to continue to adapt. Ben Poole reports.
Correspondent banks are not immune to the economic challenges of recent years, and their trade services are feeling the squeeze. Globally, unless banks can offer genuine added value, trade finance is becoming less profitable. To combat this, banks should focus on delivering value across the spectrum from supply to buy side, rather than just focusing all of their energies on risk mitigation.
“For banks to remain competitive, they will need to provide competitive pricing,” says Suresh Chaytoo, senior manager and regional head, banks and development financial institutions, Africa and Latin America at Rand Merchant Bank (RMB).
“Alternatively, they will have to package structured solutions using a portfolio approach. These two points could well decide which banks successfully continue with trade finance and make a success of it, and which leave it behind,” says Chaytoo.
While correspondent banking is still an attractive business, financial institutions are under pressure from new regulation and increasing competition. Banks need to ensure that they remain competitive and relevant in this space, says Wim Raymaekers, head of banking market at Swift.
“Banks need to continue to improve efficiency of their operations. There are a number of ways to achieve this: through right-sizing; through focusing on the business of their correspondents by using business intelligence tools to see where there are business opportunities and through centralising their correspondent banking operations into global transaction services – all of which can improve the efficiency of their operations,” he says.
With correspondent banking having a core trade element, there is still a strong proposition for the banks in terms of areas such as open account. However, these are still being settled through the traditional channels. “The interesting thing is how the payments landscape might change and the challenges for correspondent banks around the payments arena more generally,” explains Kevin Brown, global head of products, transaction services at RBS.
This is not just the case around mobile payments. There is a demand now from clients for lower cost, low value cross-border payments, not just in the single euro payments area (SEPA) but a broader proposition on a global basis. “I think that there will be continued pressure on the traditional correspondent banking model for payments to drive a lower cost, more economic solution,” says Brown.
The regulatory burden
There are two main areas of regulation that are proving to be a burden for correspondent banking. The first of these is Basel III. With its increased capital requirements and the focus on trade and non-trade exposure, the way that banks are treating liquidity is under scrutiny. With this regulation, the Basel committee wants to ensure that banks are financially secure, that they are adequately covered in the event of a run on funds and that liquidity that can be moved very quickly and efficiently.
They want to ensure that if there is a significant outflow, that banks will remain in a strong position to conduct business.
Basel III has a large impact on correspondent banking, as more capital is required for the trade business. This will have the effect of reducing some banks’ appetite for correspondent banking and trade because they may not want to put aside that extra additional capital, or it may increase the cost of providing these services, again because there is more capital required.
There is also a cost from Basel III to the associated payments business and liquidity with correspondent banking. Liquidity has a price, and this price has not necessarily been factored into the correspondent banking equation in the past. This has had the effect of making banks on all sides of the correspondent banking spectrum run numbers and simulations, looking to find the banks that have been ahead of the game in terms of raising capital for the future to protect business for the next few years.
And while some banks have prepared well and increased the capital they hold, some other banks will be behind the curve a little bit in this regard. The costs associated with Basel III and other compliance and regulatory initiatives are putting off some banks from further developing their correspondent banking business.
Typically, every bank has had some level of correspondent banking, but in light of the cost burdens, will all banks continue to participate in classic correspondent banking?
Jeremy Shaw, head of trade finance Emea at JP Morgan, suggests not. “Personally, I think this market will consolidate into fewer banks actively engaged in correspondent banking. There will still be a significant number involved, but we will see consolidation as the normal practice of supporting 3,000-4,000 correspondent banking relationships faces a heavy burden from the various compliance requirements, and this will only increase,” he says.
“If the financial dynamics don’t make sense versus the risks, coupled with the increasing need for core capital, then some institutions will question whether they need to maintain full-scale correspondent banking departments.”
Beyond Basel III, the second main regulatory challenge that correspondent banks are facing, via a number of different legislations, is the amount of anti-money laundering (AML), screening, and know your customer (KYC) processing requirements.
The EU directive on AML and the USA Patriot Act, in particular, are challenging the activities of correspondent banking departments. All banks are looking at the cost of compliance, not least in ensuring that they are able to keep up with changing standards and requirements in terms of filtering and AML checking. Banks are eating into a lot of their development costs just to maintain their current position.
Even as far back as 2009, regulatory changes were forcing managers to reprioritise their spending plans. This was seen in a poll at that year’s North America banks conference held by Citi in New York.
“In their ideal transaction banking investment spend, we found that management wanted 82% to go on new client solutions, with 11% marked out for managing core capabilities and 7% on improving operational efficiency,” says Matthew Hodgson, managing director of Citi’s bank services group.
“But when we compared this to actual spend the picture is very different. New client solutions were down to just 10% of the spend; managing core capabilities was up to 48%, while operational efficiency was at 23%. In addition, the amount of spend dedicated to regulatory changes made up 19% of this budget,” he adds.
While there are opportunities within correspondent banking to innovate and create additional value for customers off the back of the regulatory changes, the main driver for the banks is to make sure that they are compliant. This will continue to give all banks a continued challenge in terms of cost and development.
Most banks today have consolidated their correspondent banking arm into their global transaction business, as this makes commercial sense. Take Citi as an example; the bank self-clears 77 different currencies as a payment provider to banks and corporations, and makes payments in over 130 currencies throughout the branching network and its network of third-party enabled banks.
“Because of the cross-border nature of our client base – top-tier financial institutions, public sector, and multinational corporations – we are connecting directly to clearing houses, exchanges and depositories to allow our clients to get direct access to these markets and these systems to be able to support their own clients,” says Citi’s Hodgson. “Our correspondent banking business is core to our global transaction services business.”
Consolidation is not a new thing.
Most banks have already been quite proactive in restructuring their correspondent banking units over the past three to four years with a focus on consolidation and improving efficiency.
“That said, there could still be some more consolidation in Europe as a result of the reorganisation of banks there – this would be a function of mergers and acquisitions (M&A) in the European banking sector,” says RMB’s Chaytoo.
Today the correspondent banking world is dealing with a number of trends in addition to the fundamental challenges already mentioned. For example, there is currently limited US dollar liquidity, particularly in Europe.
Another problem seen in Europe at the moment is the deleveraging of bank balance sheets in the wake of the various regulatory measures recently introduced, such as the new capital requirements following the EBA stress test.
This translates into yet another challenge to trade. “Through a variety of risk mitigating measures, we are seeing non-banking organisations such as insurance companies, hedge funds and trade funds getting more and more involved. They are all moving into this area of trade finance,” says Reinhard Furthmayr, head of financial institutions products and marketing at Commerzbank.
Despite this, opportunities still exist. There is a lot of opportunity for banks in financing payable and receivable assets. Also, there is more of a movement from clean payments into more structured trade-related payments. Meanwhile, the US dollar liquidity situation creates a demand that will be of interest to the larger players.
While challenges remain, correspondent banking is still an attractive proposition for those institutions committed to the cause. GTR