The derisking debate - the future of correspondent relations

Feature | 11 April 2017

Katharine Morton looks at the challenge of derisking and what it means for the future of correspondent relations

The term 'derisking' has been gaining focus. It's difficult to define, but it has been a useful excuse for larger banks reducing relations in more challenging markets. For many, derisking is also demarketing. Call it what you will, but trade finance professionals globally can't fail to have noticed the fall off in correspondent banking relations. With nearly six in 10 of bankers polled at the BAFT Europe Bank to Bank Forum expecting to continue to cut relations over the next year, 'derisking' will continue.

But some argue that the whole 'derisking' debate should be looked at on a case-by-case basis as it may in parts be a smokescreen.

"You have to be realistic when you talk about derisking in places such as Africa," says Duarte Pedreira, head of trade finance at Crown Agents Bank. "You are not getting larger countries such as Kenya and Ghana derisked that easily as it's still a key income stream for larger banks, so they are still competitive markets. The gap comes with the smaller countries and players." Pedreira adds: "There are so many other factors justifying the trade finance gap that sometimes the term 'derisking' is just an excuse." Crown Agents Bank, as a smaller player is taking the opportunity to focus on markets where it can add value where other banks have exited under the umbrella of derisking - for instance in the Caribbean.

Sometimes maintaining an effective correspondent relationship network is a question of hard work and feet on the ground. Torgny Krook, head of financial institutions, non-OECD, at Danske Bank believes in the need for proper due diligence on correspondent banking relations. "It's simple, you need to know who you are doing business with," he says.

"At Danske Bank we run a network of around 150 countries where we have correspondent banks and last year I took the opportunity to do more than 100 onsite due diligence inspections in 24 countries. That's a lot of travelling - and to do due diligence, as our regulator requires, each visit took around two hours. We sit down with the local regulators and central banks too. It's an excellent way to do due diligence and I think it's necessary, and important, to know who you are doing business with, so I don't disagree with our regulators. I say if you can't afford it, get out. It's simple."

Not everyone has the deal flow that will justify such intensive visiting. The problem has been more intense in smaller countries. For sure, a risk-based approach is important - a site visit isn't always necessary if it's not high risk. Says one banker, "A lot of our competitors are hiding behind the word derisking as it's not worth their while to send somebody to visit one bank in a country far away if the relationship doesn't justify it."

An old badge of honour

However, there are those in the banking sector that take a view that something had to change with the whole capillary network of correspondent relations. After all, times have changed. And that's not all about derisking per se.

"With the correspondent banking issue we need to take a step back," says one banker who didn't want to be named. "Not so long ago, the number of correspondent relationships was treated as a representation of your global reach. In India, for instance, the bigger the number of correspondent relations, the better." Indeed, having a large correspondent network used to be something of a badge of honour. Why has that changed? "At that point in time it was how the system worked. Clearing systems were fragmented and if you needed to have a payment in, say, Guangzhou, you needed to have relations with a bank that was located there. Now you can have national high value or low value clearing as part of that, so the change in correspondent relations had to happen.

I don't see a network effect [on our network] of derisking. In fact, I wouldn't call it derisking at all."

The whole topic of derisking is a contentious one between international regulators and banks, and many banks don't want regulators to see them as using the process of managing risk as an excuse to exit some correspondent relations and want to tread carefully.

Inevitability or excuse, correspondent relations are going to have to keep changing and whether that's under the guise of derisking or not, time will tell.

Katharine Morton is the editor-in-chief of TFR

Box-out 1

Steven Beck, head of trade finance for the Asian Development Bank (and winner of the TFR Fellowship award in 2016), talks derisking with Katharine Morton

How big do you see the derisking problem to be (especially for SMEs in smaller markets) in terms of the gap in trade finance availability?

We're concerned about derisking and its impact on all segments of the economy, not just smaller businesses. Our trade finance business has been moving into the Pacific where banks are approaching us consistently to say they fear having no correspondent bank. There is a real possibility that entire countries, and all the large and small companies within them, could be shut out from the global financial system. And if money can't flow in and out of a country, a whole lot of bad stuff follows, including trade, and all the growth and jobs that come from it, being shut down.

When international banks weigh the cost of doing KYC (know your client) and the AML (anti-money laundering) risks against the potential gain from corresponding with banks in small islands in the Pacific they'd rather not bother. The Pacific is an extreme example, but derisking is not limited to these beautiful island countries. The trend started a few years ago has impacted most emerging markets and has resulted, thus far, in the exiting of more than 38,000 bank-to-bank relationships, important intermediaries in trade, mostly impacting emerging markets.

That said, not all derisking is bad. In some cases, the cost and effort of onboarding and maintaining a correspondent relationship is simply not justified by the amount of business it generates. After all, banks need to manage their business, as their depositors and shareholders expect. However, there needs to be some coordination to ensure at least one, if not two correspondent(s) remain in place, lest we isolate entire countries from the global financial system. How we ensure there is at least one or two correspondents
is an open question, one that we'll address at April's
ICC Banking Commission meeting in Jakarta.

Moving away from the correspondent bank world, the issue of financial institutions derisking from companies, especially those smaller companies that are harder and more expensive to do KYC is also a concern. Here again, if the cost and effort required to maintain KYC on an SME outstrips the potential gain for banks, the easy, and perhaps logical conclusion is to exit the relationship. Derisking is contributing to the trade finance gap and is hitting at our ability to generate growth and jobs.

While we cannot do away with KYC and AML due diligence, we can streamline regulatory requirements to make them more efficient and inexpensive for banks to comply. We can also employ technology and pool information to make complying less onerous.

What's ADB doing to help?

We're doing four things to address this problem.

(i) We're supporting in every way we can SWIFT's KYC register. As many of your readers will know, the register collects into one repository information required for KYC/AML, making compliance easier and cheaper. We've been actively promoting the register with all partner banks. SWIFT has attended a number of our workshops with partner banks to discuss the register. We have been encouraging banks to submit their information and to keep it current. Digitising this information through the register and making it available to everyone makes a lot of sense. There is no cost to submit the information and the cost to access the information is reasonable, especially given that the register is a not-for-profit initiative.

(ii) A globally harmonised digital identifier for all companies, including financial institutions, could be transformative. To the extent identification systems exist nationally, they are not harmonised, many aren't reliable, and the information is difficult if not impossible to access cross border. The G20 inspired Global Legal Entity Identifier Foundation (GLEIF) is the umbrella organisation implementing such an identifier system. The system will verify three things: (1) who is who, (2) who owns whom, (3) who owns what. If widely and globally adopted, it would make KYC and all other forms of due diligence much easier and cheaper. Imagine the impact that could have on derisking of SMEs. And the impact on developing meta data and other information sources that would contribute to assessing risk more credibly, leading to more access to finance for SMEs. ADB's Trade Finance Programme (TFP)has been pushing this issue and is coordinating with the ICC and the World Trade Board - both of which have been quick to take up the mantle - to promote global adoption. The Holy Grail is for G20 governments legislating a requirement for all companies to have the globally harmonised LEI by a specific date. I hope we'll be encouraging G20 to create this legislative requirement through the ICC Banking Commission B20 consultation process, which I co-chair with Alexander Malaket [president of Opus Advisory Services].

(iii) Picking up on a clever idea from Rogier Schulpen [global head of trade and working capital solutions] at Santander we're coordinating several banks to create data on compliance infractions. The objective would be twofold: first, understand trends and typology to create early warning systems; and second, develop information to underpin a more informed and substantive discussion with regulators. The derisking process was accelerated through increased regulation and fines, but little attempt has been made to standardise KYC requirements. The result of banks pooling data to analyse trends in compliance infractions will underpin a more informed discussion with regulators and could mean 'smarter', more streamlined and standardised KYC/AML regulatory requirements, and early detection that lowers risk and cost to onboarding new clients, including SMEs. This could help on the derisking front. Michael Vrontamitis [global head of trade, product management] at Standard Chartered has sensibly suggested we propose placing this initiative under a joint ICC-BAFT initiative.

(iv) My colleagues at ADB are doing a great job expanding our TFP to the Pacific. They are contacting correspondent banks thinking of derisking from the Pacific and encouraging them to maintain their relationships. And they're contacting prospective correspondent banks, encouraging them to consider onboarding Pacific banks. Even if they don't cross the finish line, their efforts help us get closer. We're playing with the idea of developing a warning system for countries where banks have less that two correspondents capable of clearing dollars and euros. By discussing the issue with banks, and by exploring various possibilities, we learn more about the issue and hopefully get closer to finding solutions.

How is ADB stepping in to fill the 'trade finance gap (however it's caused)'?

The ADB's TFP fills market gaps by providing partner banks with loans and guarantees to support trade. In 2016 we did 2,079 transactions supporting over US$3bn in trade. While TFP is in 20 markets, including central Asia and the Caucasus, its most active are Bangladesh, Pakistan and Vietnam.

We've started a supply chain finance business, which has been active in China and Malaysia. We supported US$200m in business in 2016. We have a lot of deals in the pipeline, including some innovative transactions and hope to build up this business over the coming years to make a bigger contribution to closing gaps.

In addition to providing guarantees and loans, we close market gaps by generating and sharing information. For example, we created the Trade Finance Register to generate the first ever statistics to prove just how low default and loss rates are in trade finance. This information was critical to Basel changing capital requirements for trade finance, which we believe has contributed to reducing market gaps. The register is now commonly known as the ICC Trade Finance Register.

Another 'knowledge product' created by ADB's TFP is our annual trade finance gap study, which quantifies global trade finance gaps and their impact on growth and jobs. These figures are widely cited in both the private and public sectors and help shed light on issues related to the gap and the importance of overcoming them to create more growth and jobs. Awareness is the first step to addressing a problem and the study is, at the very least, an annual reminder that we need to do better at reducing the gap.

Providing our partners with information about TFP countries of operation, and about TFP counterparty (issuing) banks helps partners move into more challenging markets in developing Asia. Partner banks are hearing consistently from their corporate clients that they see opportunities in developing Asia, but need more support to realise the potential. TFP exists to help banks do just that. TFP sharing this information helps banks move into new markets and that reduces gaps.

What are the limits to multilateral agency/involvement?

ADB is a 'whole sale' bank. We don't have the staff and branch network of a commercial bank to have the direct relationships with SMEs and corporates. While it is rapidly expanding, ADB's entire private sector operations consists of fewer than 150 professionals, to do everything from infrastructure, equity, microfinance, agribusiness, trade and supply chain finance. So to operate effectively, we need partnerships with banks wherein we leverage off our respective strengths and capacity to get things done.

What will the market look like in 10 years?

Hopefully the market will be infused with fintech, backed by meta data that will reduce trade and other financing gaps. To get there, we need leadership to coordinate all the parties required to develop the technology, regulations, laws and other elements needed to realise our full potential. A shared vision for where we want to go and how to get there is critical. To ensure we marshal our comparative strengths to do just this, we need an open conversation. ADB's TFP is pleased to be partnering with the ICC, the WTO and the new World Trade Board to move the discussion forward.

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