Costly compliance

Opinion | 30 May 2017
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Afreximbank's Dr Hippolyte Fofack counts the cost of the changing regulatory landscape for African financial institutions

Ongoing changes in the regulatory and enforcement landscape, especially in regards to compliance with more rigorous prudential requirements and anti-money laundering and counter financing of terrorism (AML/CFT) regulations in the context of the transition from rules-based to risk-based systems are strengthening the corporate governance framework and improving global security.

But the unintended and costly consequences of these regulatory reforms have been significant for global and African corporates, specifically in terms of trade finance, corporate balance sheets and client relations in the financial industry.

Average lending by banks has been growing much more slowly in the new and more stringent regulatory and enforcement regime which emerged from the 2008 global financial crisis. In a context of decreasing risk appetite, partly due to the increased likelihood of sanctions, two requirements have particularly affected the balance sheets of banks and financial institutions.

First, the requirement to markedly increase capital and reduce leverage in the banking industry and second, the requirement to set aside greater amounts of capital to cover for potential losses. Both requirements are increasing the costs to banks of holding risks in their balance sheets, and have been depressing bank lending.

Counting the cost

In part, the decrease in the growth of bank lending during the zero-lower bound interest rate regime is attributable to a host of factors, including the stringent regulatory regime under the Dodd-Frank Act and tighter capital requirements under Basel III rules. More rigorous than its predecessors on capital requirement, Basel III sets the minimum Common Equity Tier 1 ratio consistently at 4.5% of risk-weighted assets, up from 2% under Basel II.
 

Though adopted to mitigate systemic risks, the regulatory changes are eating into banks' common equity and, in the process, constraining their capacity of financial institutions to boost revenue growth by expanding their balance sheets. Of course, in the deepening culture of shareholder capitalism that is increasingly shaping the global corporate governance architecture, the growth of banks' common equity and their ability to expand their balance sheets are also being hampered by such factors as stock buybacks and high dividend payments.

In addition to the costs of regulatory tightening imposed to raise corporate governance standards in financial institutions, other costs to the financial industry relate to compliance, most notably with know your customer (KYC) and customer due diligence (CDD) requirements. A global survey of major international banks carried out last year by Thomson Reuters, highlighted the rising costs and complexity of KYC and their adverse impact on business. While the average costs incurred by most financial firms to meet their obligations have risen to US$60m annually (according to the survey), the largest banks are reported to be allocating US$500m a year in order to comply with KYC requirements.

Even though the reported global average costs may reflect the level of investments undertaken by large international financial institutions, they are highly indicative of the global trend of CDD-related expenditures on banks' operating costs. The number of employees working on KYC issues has increased significantly in most financial institutions too. Still, lengthening KYC procedures in a constantly changing regulatory landscape are putting more strain on on-boarding processes and client relations. The Thomson Reuters survey shows that the average time to bring a new customer on board has increased by about 22% since 2015.

Offloading perceived risk

Another important consequence of the changes in the regulatory and enforcement landscape is a marked decline in correspondent banking relationships (CBRs). These relationships ensure the provision of domestic and cross-border payments in support of investment and trade. At the global level, banking authorities have reported a reduction in CBRs, whether motivated by banks' cost-benefit analysis or by derisking in the context of the increasingly large fines and sanctions associated with violating AML/CFT regulations.

Immediately after the introduction of new regulations in response to the 2008 global financial crisis, the total value of turnover in correspondent banking accounts fell markedly in the euro area - it has not regained its pre-crisis levels. Likewise, the number of US dollar denominated CBRs of selected major financial institutions decreased during 2010-14. The most recent estimates show that the number of banks providing correspondent banking services declined in 2015.

Point estimates derived from global surveys by various institutions since the global financial crisis have been concordant and staggering, consistently showing dramatic declines. More than 60% of local banks have reported a decline in CBRs, and 75% of large global banks have reported a withdrawal from CBRs in several countries and jurisdictions, primarily from emerging and developing market economies.
In Africa, more than half of the banks surveyed have reported either a moderate or a significant decline in CBRs, largely in reflection of retrenchment by US and European banks in the face of increasing costs of compliance with CDD requirements and the deterrent effect of sanctions-enforcement (see Figure 1).

Across the board, global banks and other financial institutions are either reducing their correspondent banking services or simply halting the provision of such services to countries or clients they perceive to be high risk. Where these institutions are not terminating CBRs, they are changing the nature of the services they provide or are increasing their charges to specific clients and countries they consider highly risky. They are also reducing their provision of correspondent banking services in US dollars and scaling back on nested correspondent banking and payable-through-accounts services, which they consider
as higher-risk services.

The decline in CBRs is particularly affecting certain categories of customers and business lines, including small and medium-sized exporters who have difficulty accessing FX, small and medium-sized banks, and money- or value-transfer services, that are leaders in channeling remittances to a growing number of recipients in the developing world. International wire transfers, clearing, and settlement services, as well as trade finance, have been particularly affected. The decline in CBRs is also disproportionately affecting emerging and developing market economies, especially in Africa, Latin America, and the Caribbean region.

Figure 1: Regional breakdowns of Nostro accounts - percentage of authorities reporting terminations

Note: a nostro account is a bank account held in a foreign country by a domestic bank, denominated in the currency of that country

Sources: World Bank (2015) and ASBA (2016)

The regional toll

In Africa, the withdrawal of CBRs has been widely felt, reaching critical levels in several countries, particularly where the financial landscape is largely dominated by foreign banks. In Botswana, concerns about compliance with AML/CFT regulations have led some correspondent banks to close their accounts with the central bank, which were used for a range of counterparties available for foreign exchange transactions and investment operations.

Similarly, in Liberia, where CBRs accounted for more than one-third of interbank activity and where more than 60% of bank income is derived from non-interest revenue, the withdrawal of such relationships has been sharply felt. Between mid-2013 and mid-2016, global banks terminated 36 out of 75 CBRs in the country, citing a number of concerns including the country's risk rating, need for compliance with AML/CFT regulations, and low volume of transactions.

Beyond Liberia and across Africa, the adverse effects of declining CBRs have been widespread, extending to both small and large economies. According to Swift data, many African countries reported reductions in their foreign counterparties between 2013 and 2015, reaching 10% in South Africa and more than 37% in Angola. More generally, several global banks have stopped clearing US dollar payments from several countries in the region.

The withdrawal of CBRs from African countries is also attributable to several factors beyond the higher costs inherent in extra-territorial US tax legislation and compliance with CDD requirements. The additional factors include the correspondent banks' reduced appetite for risk, their concerns about maintaining their reputation in a context of increasing enforcement of sanctions, the disproportionate representation of higher-risk categories of customers (for example, politically exposed persons) in their customer base in some African countries, and their concerns about the degree of monetisation of the economy in a region where informal sector activities and cash-intensive firms still account for a sizable share of corporations.

A further cause of the decline is the nature of financial services that banks provide in African countries. Money- or value-transfer services to vulnerable segments of a population that increasingly depend on remittances for consumption smoothing have been singled out as carrying higher risks. In some of the most affected countries and jurisdictions, a further cause of the decline is the perceived low profitability of certain correspondent banking services - these were a low-margin business that has become even less profitable in the zero-lower-bound interest-rate environment.

 

Not surprisingly, these developments in the global financial system are further undermining trade, especially in commodity-dependent African economies where the shortage of foreign reserves caused by sustained declines in commodity terms of trade and widening trade deficits has been a source of macroeconomic management challenges, as well as a decline in trade finance in recent years. Still, these changes in the global financial system have several other implications besides trade finance. Correspondent banking is key for a broad range of transactions in the financial industry, including banks' own cash clearing, liquidity management and short-term borrowing, or investment needs in a particular currency. Thus, the current reversal in the dynamics of CBRs could be stifling the growth of banks' balance sheets and corporates across Africa in several ways.
 

At the same time, however, these developments in the global financial system provide the opportunity to deepen financial intermediation and intra-regional financial links. In this regard, ongoing efforts by the African Export-Import Bank (Afreximbank) to expand activities under its African Correspondent
Banking (AFRICORRBANKING) initiative are timely and highly germane. These efforts were designed to help sustain African banks'
access to correspondent banking services, and may ensure continuity in the provision of such critical services during the retrenchment of global financial institutions.

Dr Hippolyte Fofack is the chief economist of the African Export-Import Bank

References: 
  1. Thomson Reuters 2016 know your customer survey: http://tmsnrt.rs/2qm0thC

  2. ECB 10th survey on correspondent banking in euro, 2016: http://bit.ly/2pFm1cK

  3. Swift article, 'De-risking in Africa on the rise, according to latest Swift data': http://bit.ly/2pt3eQR

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