www.ifc.org/thoughtleadership NOTE 48 • JAN 2018 Increased Regulation and De-risking are Impeding Cross-Border Financing in Emerging Markets Correspondent banking relationships connect banks and people across borders and are critical to finance and trade. They are a vital link between emerging markets and the broader global economy. Yet efforts to combat money laundering and the financing of terrorism have increased compliance requirements for banks. Difficulties adhering to these requirements and increased costs associated with them threaten the ability of banks to serve their customers, while also eroding the number and quality of correspondent banking relationships. A recent IFC survey shows that many banks are feeling the pressure of increased regulation and de-risking, and emerging market banks are bearing the brunt of it. Banks enable virtually every part of a market to function relationships with customers to avoid risk. Changes in by facilitating the availability and the formal transfer of capital reserve requirements have contributed to financial money. Correspondent banking, the channel through which system resiliency, but have also limited the amount of banks provide payment services and foreign currency capital banks have to invest in cross-border banking settlements to each other, represents a vital link that relationships and their customers. The introduction of connects local firms and citizens to the global economy, new international banking standards under Basel IV could giving them access to new markets and foreign exchange. exacerbate this development. Correspondent banking also supports remittances, a major Greater efforts to bolster anti-money laundering (AML) source of income for many families. efforts and to combat terrorism financing (CFT) have Research has shown that efficient and competitive financial been consequential. FATF has proposed global standards flows bolster economic growth and bring additional people for AML and CFT that follow a risk-based approach into the financial system in a formal and transparent that allows banks more flexibility to develop their own manner.1 However, when transactions go unmonitored, it risk assessment and response processes and procedures can create financial systems that are rife with illicit activity. to identify and address money laundering and terror financing risks. De-risking These international standards are then implemented at In the wake of the 2007-2008 financial crisis, global banks the national and sometimes subnational level, with each have faced a combination of challenges that have changed country interpreting and adapting them to local conditions. their decision-making calculus. There is greater complexity Emerging market banks are subject to the resulting in the global risk environment with significant geopolitical ambiguity, as well as variance and inconsistencies between dynamics, as well as concerns about the use of the financial jurisdictions. These often leave banks to absorb, manage, sector to finance terrorism and launder money. and apply regulations that deliver a significant set of According to the Financial Action Task Force on Money complexities. Laundering (FATF) and the Wolfsberg Group, “de-risking” These shifts in the compliance landscape may help combat refers to financial institutions terminating or restricting money laundering and terrorism, yet they also increase 1 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. costs for many banks in multiple ways. Improvements (CBRs). De-risking can limit the contribution that banks in customer due diligence are undeniably beneficial and financial systems can make in strenthening a country’s to financial system stability, but the increased risk of stability and macroeconomic growth, as financial sector large penalties for violations has created a new class of development matters for economic development and “compliance risk” that must be managed. poverty reduction. This compliance risk raises costs for financial institutions in De-risking effects on emerging market banks four areas. First, the threat of penalties raises the potential Survey findings suggest that the drivers and effects of cost of cross-border exposure. Second, the additional scrutiny de-risking are subtle, complex, and pervasive. Results of some banks’ customers raises costs, particularly for adding show that emerging market banks in countries at all new customer relationships or markets. Third, a lack of stages of development are at risk of being de-banked, harmonization in compliance requirements raises costs as due to compliance ambiguity and correspondent-banking banks seek to understand and apply requirements across relationship stress. In fact, all 450 segments—regions, jurisdictions. Fourth, there are situations where regulations poorest countries, fragile country states, World Bank are changing on a monthly or even weekly basis. As banks income classes, oil exporters, investment grades, GDP spend more on compliance, the typically lower-margin levels, total imports, percentage of imports to GDP, correspondent banking business line is more vulnerable to bank assets, bank customers, bank equity, and bank supply pressure. Thus, de-risking threatens to inhibit critical risk rating—of IFC’s 2017 report face difficulties in financial flows into smaller and poorer markets. correspondent banking. Such difficulties potentially Money transfer organizations (MTOs) are struggling to separate people, businesses, and eventually entire countries offer their services, as they rely on correspondent banking to from access to critical aspects of cross-border finance. move funds across borders. The importance of MTOs to a Seventy-two percent of banks globally and 80 percent financial sector is amplified in some jurisdictions, including of banks in Sub-Saharan Africa are noting the impact small countries, where there are a limited number of banks of external impediments. These findings suggest that a in operation. MTOs support remittances and international diminished ability of banks to serve their customers is a wire transfers, among other person-to-person transactions, widespread phenomenon. which both families and non-governmental organizations rely on to gain access to finance needed for critical aspects of aid, assistance, and basic goods critical to survival. SURVEY Bank-intermediated trade finance, which supported more 92 markets, over 300 banks, $5 trillion in assets than $6 trillion of global trade in 2013, is vulnerable to declines in correspondent banking relationships. 2 There is In 2017 IFC launched a survey, capturing responses already a considerable gap between trade finance demand from client banks in 92 emerging market coun- and supply: Financial institutions have been unwilling to tries to gather quantitative and qualitative data on the impact of de-risking. Results were detailed provide $1.4 trillion in trade finance, 3 which threatens in this 2017 IFC report: Starnes, Susan, Michael global economic growth by disrupting trade and financial Kurdyla, Arun Prakash, Ariane Volk, and Shengnan flows that move through banks affected by the loss of Wang. 2017. “De-Risking and Other Challenges in correspondent banking relationships.4 the Emerging Market Financial Sector: Findings Increasing concerns over banks’ capacity to settle in U.S. from IFC’s Survey on Correspondent Banking.” IFC, dollars, combined with increasing transaction times or costs World Bank Group, Washington D.C. for U.S. dollar settlements, raises the costs of cross-border Over 300 emerging market banks representing capital account flows, including most forms of portfolio combined assets of nearly 5 trillion responded to flows, foreign direct investment, and cross-border bank the survey. According to an IFC extrapolation from lending based in U.S. dollars, euros, or other currencies. Moody’s and IMF data survey participants repre- sented approximately 10 percent of emerging mar- Ultimately, de-risking has the potential to impact many ket banking assets and approximately 30 percent cross-border banking activities, particularly those of assets in Sub-Saharan Africa. underpinned by correspondent banking relationships 2 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. 0% 20% 40% 60% 80% 100% 1 72% 28% Yes 2 69% 31% No 3 62% 38% 4 70% 30% 5 75% 25% 6 63% 37% 7 83% 17% FIGURE 1 Banks reported that external challenges hindered their ability to serve customers Source: Susan Starnes, Michael Kurdyla, Arun Prakash, Ariane Volk, and Shengnan Wang, 2017, “De-Risking and Other Challenges in the Emerging Market Financial Sector: Findings from IFC’s Survey on Correspondent Banking,” IFC, World Bank Group. Challenges limit EM banks’ ability to serve Compliance costs continue to rise customers Despite significant investment in AML/CFT systems and Banks faced challenges that decreased their ability to processes in 2016, banks expect compliance costs to rise serve customers in 2016. The most frequently cited driver substantially in 2017. Along with their global peers, most for a reduction in banks’ ability to serve their customers emerging market banks are tackling several compliance was compliance requirements, followed by correspondent issues. These include expensive implementation of software banking stress, and market competition and prices. A or system upgrades; limitations in customer information; quarter of banks faced more than three challenges, and 12 a lack of harmonization in global, regional and local percent faced five or more challenges. regulatory requirements; variable data requests from multiple cross-border correspondent banks; and a shortage Banks are adapting their offerings in response of training or knowledgeable staff. Banks noted a multitude of adaptations made in 2016 to adjust their business models in response to a changing Regulatory challenges contribute to growth environment. The two most common adaptations were obstacles a reduction to or limits on overall customer lending, The survey also offers insight into more general barriers to and increased rates or fees charged to customers. Others business growth overall in the current global environment, reported reductions in the number of customers served, of beyond obstacles related specifically to compliance. which importers and exporters were most severely hit. When asked to identify general growth barriers (beyond More than a quarter of survey participants noted that the compliance and correspondent banking stress), regulatory number of their active CBRs in 2016 decreased. More than requirements and costs were still the second most common 20 percent of banks in all regions except for South Asia saw challenge globally. Institutions in low- and lower-middle- a decline in CBRs, which is a material difference from bank income countries were more likely to report regulatory experiences in prior years. Across regions, Sub-Saharan driven growth challenges than those in high-income Africa, Latin America and the Caribbean, and Europe and countries. It is noteworthy that banks that face regulatory Central Asia reported declining correspondent banking challenges are often already dealing with business networks with the greatest absolute frequency. environments that have difficult macroeconomic conditions, Regions that had relatively lower frequency of reported CBR internal business barriers, and intense market competition. reductions still reported different and significant challenges One-quarter of all banks indicated that the implementation regarding both compliance and CBR stress. This reflects the and/or costs of international or domestic regulations complexity of this broader challenge on a global scale. regarding compliance or capital reserve requirements represented a significant barrier to business growth. 3 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Implementation and/or maintenance of software/tech 27% Limitations with client information 20% Lack of regulatory harmonaization and/or frequent changes 18% Resources needed for monitoring 17% International regulatory requirements 13% Limited training opportunities 8% Correspondent requirements 8% Difficulty educating or obtaining information from clients 7% Local regulatory requirements 7% Cost of implementation or maintenance of CBRs 7% Increasing complexity of transactions 5% FIGURE 2 Most challenging aspects of AML/CFT/KYC implementation Source: Starnes et al., 2017, “De-Risking and Other Challenges in the Emerging Market Financial Sector: Findings from IFC’s Survey on Correspondent Banking,” IFC, World Bank Group. Advocacy for harmonized requirements 76% Central KYC registry for correspondents’ CDD requirements 64% Guidance on systems’ alignment with correspondents’ CDD requirements 59% Training on basic AML/CFT/KYC rules and regulations 52% Guidance on tech-based solutions and implementation advice 50% Guidance on interpreting regulations and implementation advice 48% Introductions to new correspondent banks 42% Briefings on global, U.S. or European regulatory standards 42% Direct provision of correspondent banking services by DFIs 29% FIGURE 3 Banks identified compliance-related solutions that could help them grow Source: Starnes et al., 2017, “De-Risking and Other Challenges in the Emerging Market Financial Sector: Findings from IFC’s Survey on Correspondent Banking,” IFC, World Bank Group. Systems and technology are among the most Middle East and North Africa were particularly concerned challenging aspects of regulatory implementation about software and technology implementation. IFC asked its emerging market bank partners about the Incomplete or inadequate customer information was the most challenging aspects of their compliance efforts. Most second most commonly cited aspect across all participants. prominently, systems and technology implementation Many banks operate in an environment where there is were a concern, which underlines the need for advanced no centralized database to validate customer identities or and accessible technology for banks. The most frequently national data privacy laws that limit information sharing mentioned challenge was implementation or maintenance of between regulators and banks. In some countries, formal software and technology required to monitor for compliance client addresses are not as common as in more advanced or lack of automation in this area. Several banks indicated economies. This complicates the fulfillment of regulatory they were in the process of implementing formal compliance requirements. In addition, legal and financial architecture reporting and/or systems and noted that, in the absence of gaps make it more difficult and time-consuming to identify these systems, they were required to manually verify customer the corporate ownership structures and, thus, the ultimate identities. Banks in Latin America and the Caribbean and beneficial owners. 4 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. 100% 80% 60% 40% 20% 0% EAST ASIA AND EUROPE AND LATIN AMERICA AND MIDDLE EAST AND SOUTH ASIA SUB-SAHARAN THE PACIFIC CENTRAL ASIA THE CARRIBEAN NORTHERN AFRICA AFRICA Decreased ability to serve customers Need to adapt business Experienced a decline in CBRs Expects increased compliance costs FIGURE 4 Challenges described by banks vary by region Source: Starnes et al., 2017, “De-Risking and Other Challenges in the Emerging Market Financial Sector: Findings from IFC’s Survey on Correspondent Banking,” IFC, World Bank Group. A lack of adequate and sequential numbering of We note increased concern over smaller economies, import- residences and businesses, along with the problem of dependent countries, and countries with lower income per verifying identities and addresses, compound the issues capita, as well as relatively smaller (but still creditworthy) with monitoring compliance risks and responding financial institutions and importers/exporters. to correspondent banks’ compliance-related queries. Even regions that appear to have fared better, such as East The complexity of customer due diligence required by Asia and the Pacific and South Asia, indicate that their correspondent banks increases transaction processing offerings are not keeping pace with increasing demand. In time, which deterred customers or limited respondents’ East Asia, Europe and Central Asia, Latin America and the ability to process entire classes of transactions. The Caribbean, and Sub-Saharan Africa, banks more frequently lack of regulatory harmonization between banks and reported increased demand than increased capacity to countries represented a significant compliance hurdle, meet that demand. Furthermore, individual respondents together with frequent changes in legislation. Regulatory from South Asia also highlighted challenges with differences across jurisdictions have resulted in cases throughput speed of transactions and a higher percentage where requirements in one country are in direct conflict of transaction refusals with correspondent banking with those in another. This creates confusion for banks. counterparts, despite the maintenance of open lines. In addition, early adopters of regulatory change face a form While much of the research to date has focused on smaller or of “regulatory arbitrage,” as customers abandon banks more “at-risk” markets, these survey results make clear that for competitors rather than bear more stringent reporting the challenges associated with both correspondent banking requirements and the higher service costs associated with them. and compliance are pervasive. Solutions need to help Notable regional differences emerge financial sectors across all emerging markets shore up their capacity to serve their customers as well as their capacity to Sub-Saharan Africa appears to be facing the greatest meet the growing demand for international banking. challenges overall, along with the Middle East and North Africa, Europe and Central Asia, and Latin America Banks need harmonization, advocacy and support and the Caribbean. Among all regions, Sub-Saharan To help manage some of the potentially detrimental African banks most often reported a decreased ability to consequences of compliance regulations on cross-border serve their customers, the need to adapt their businesses, banking, IFC asked banks which actions that address and a reduced capacity to meet customers’ requests for de-risking would be most valuable to emerging market international banking services (Figure 4). However, the financial institutions. Three responses stood out. data show that every region faces its own set of challenges. First: Over three-quarters of respondents said that While countries of all sizes and risk levels are affected, advocacy for harmonized regulations across jurisdictions certain subgroups of respondents appear more vulnerable. would be helpful. Emerging market banks are clearly 5 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. looking to international organizations to advocate for their Regulators need to address the web of regulatory interests and voice their concerns before global regulatory applications that emerging market banks face—by bodies. This was the most frequently requested solution clarifying those applications at the national and bank level, for banks in every global region except South Asia, where by synchronizing regulations across jurisdictions, and banks expressed greatest interest in advice on financial by making client information readily available through technology, or fintech. potentially national, regional, or global registries. Further, Second: Nearly two-thirds mentioned a centralized registry emerging markets need a consistent, systematic advocate, for due diligence data. Emerging market banks note that e.g., development financial institutions (DFIs) to ensure they have to devote more and more resources to managing their voices are heard when global decisions are made.5 information requests from correspondents due to the high Competent and properly focused regulation is a must for a frequency, irregularity, and significant differences in requests healthy financial sector, and recent efforts to strengthen the from correspondent to correspondent. Building a central global financial system will ultimately contribute to greater registry to hold respondent data, applying a standardized financial stability and a safer world. However, the de-risking format to that data, and ensuring that the data is regularly that has accompanied these efforts threatens to undermine updated would reduce the reporting burden faced by many economic stability and growth, financial inclusion, and respondents and make it easier for correspondents to assess poverty reduction. the risks of doing business with them and facilitate the Those best placed to address this challenge—through development of new correspondent-banking relationships. regulatory adjustments, funding, capacity building, Third: Assistance with understanding and adapting to knowledge sharing, and technological innovation—are rising new standards was high on the list of actions that would to the occasion. The intention was never to hinder growth be helpful for banks. Respondents in emerging markets or harm the most vulnerable. The G20, along with many would benefit from training about the current requirements multilateral bodies, has worked to understand and address and how to interpret rules and regulations. Awareness the challenges created. But the solution is not yet complete. n and understanding of compliance expectations of local regulators in the markets in which they operate would also ABOUT THE AUTHORS help respondent banks continue to support their customers Ariane Volk, Research Analyst, Thought Leadership, Economics with international banking services. and Private Sector Development, IFC (avolk@ifc.org) Susan Starnes, Global Lead, Trade and Commodity Finance Conclusion Strategy, Sector Economics and Development Impact, IFC Banks in all corners of the world are vulnerable to having (sstarnes@ifc.org) their cross-border banking connections severed. Emerging market banks are bearing the brunt of opaque regulatory ACKNOWLEDGMENTS guidance and disharmony in regulatory application. This The authors would like to thank the following colleagues can be harmful for banks and weaken economies. Failed for their review and suggestions: Michael Kurdyla, Strategy or sluggish correspondent banking slows business growth, Officer, Syndications, IFC; William Haworth, Consultant, keeps people poorer longer, weakens links to the global Financial Institutions Group, IFC; Thomas Rehermann, Senior financial system and markets, and disrupts the connections Economist, Thought Leadership, Economics and Private that countries desperately need. Sector Development, IFC. 1 Lowery, Clay, and Vijaya Ramachandran. 2015. “Unintended Consequences of Anti-Money Laundering Policies for Poor Countries.” Center for Global Development, CGD Working Group Report. https://www.cgdev.org/sites/default/files/CGD-WG-Report-Unintended-Consequences-AML-Policies-2015.pdf. 2 Per estimates by Bank for International Settlements (BIS). 3 WTO. 2016. “Trade Finance and SMEs: Bridging the Gap in Provision.” World Trade Organization. www.wto.org/english/res_e/booksp_e/tradefinsme_e.pdf. 4 As outlined in EM Compass Note 25, “De-risking by Banks in Emerging Markets: Effects and Responses for Trade,” by Susan Starnes, Michael Kurdyla, and Alex J. Alexander, IFC, November 2016. 5 See also proposed solutions that can be found in this op-ed by Philippe Le Houérou. 2017. “Financial abuse curbs weigh on emerging markets”, Financial Times, ft.com, September 7, 2017. 6 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Please also refer to EMCompass Note 22, “Mitigating the Effects of De-risking in Emerging Markets to Preserve Remittance Flows,” by Vijaya Ramachandran, on how de-risking is a threat to the poorest, and EMCompass Note 24, “De-Risking by Banks in Emerging Markets–Effects and Responses for Trade,” by Susan Starnes, Michael Kurdyla, and Alex J. Alexander, on how trade finance in emerging markets suffers from de-risking, as well as the IFC 2017 Correspondent Banking Survey: Susan Starnes, Michael Kurdyla, Arun Prakash, Ariane Volk, and Shengnan Wang (2017): “De-Risking and Other Challenges in the Emerging Market Financial Sector: Findings from IFC’s Survey on Correspondent Banking,” World Bank, IFC, Washington, D.C. For media queries, please contact Nadine Ghannam: nsghannam@ifc.org. ABOUT IFC AND CORRESPONDING BANKING IFC, a member of the World Bank Group, is the largest global development institution focused on the private sector in emerging markets. Working with more than 2,000 businesses worldwide, we use our capital, expertise, and influence to create markets and opportunities in the toughest areas of the world. In FY17 we delivered a record $19 billion in long-term financing for developing countries, leveraging the power of the private sector to help end poverty and boost shared prosperity. For more information, visit www.ifc.org. As the largest private sector development institution in the world, IFC has built strong relationships with financial institutions, real-sector companies, government officials, and representatives of regulatory bodies throughout its 60-year history. To contribute to the global dialogue, identify solutions for the challenges presented by de-risking, expand financial inclusion, and ultimately increase its impact on financial sector development, IFC harnessed its global client network to collect data and capture the experiences from a broad set of private-sector emerging market banks through the 2017 Correspondent Banking in Emerging Markets survey, and analyzed responses of 300 correspondent banks in 92 countries and markets. 7 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.