Rolling up the welcome mat: A crackdown on financial crime means global banks are derisking

WHEN some of Latvia’s banks became infected with dirty money, all paid the price. “Correspondent” banks—international banks that clear smaller banks’ foreign-currency transactions through big financial centres—began detaching from the Baltic country. JPMorgan Chase withdrew in 2013. By last year only Deutsche Bank was left. It soon stopped serving half of Latvia’s lenders, and in March began dropping the rest, leaving them at risk of being unable to conduct dollar-denominated transactions, from paying remittances to financing trade.

The exodus happened despite Latvia’s improved financial oversight. In the past two years its regulators put a dozen banks through stringent anti-money-laundering audits. The banks shed 19,000 high-risk clients in the past year alone. As Deutsche continues its phased withdrawal, Latvian banks are trying to persuade it to change its mind, while scrambling to find alternatives. A switch to settling in euros, Latvia’s currency, might be an option, but that poses problems in sectors where goods are priced in dollars, such as commodities.

Strict new rules on capital and liquidity after the financial crisis have tilted the cost-benefit balance away from global banks’ least-profitable clients. But another cause of Latvia’s travails is “derisking”: banks dropping customers in places or sectors deemed to pose a high risk of money-laundering, sanctions evasion or terrorist financing. Though correspondent-banking traffic has continued to rise, banks in small or poor countries are increasingly shut out. The number of correspondent-banking relationships fell in all regions between 2011 and 2016, according to a survey of banks and payments data published on July 4th by the Financial Stability Board, a group of international policymakers (see chart 1). Worst-hit was eastern Europe, which saw a decline of more than 20%. The number in the Caribbean fell by around 10% in 2016 alone. Money-transfer firms and charities have also been hit. Big banks have “unbanked everyone from porn actors to pawnbrokers”, says a regulator.

Banks are driven by fear: fines for aiding financial crime have shot up, in both amount and number (see chart 2). A decade ago banks were paying fines in America, the most punitive country, of tens of millions of dollars a year between them; now they are paying billions. In 2014 France’s BNP Paribas stumped up $ 8.9bn for violating sanctions on Sudan, Iran and Cuba. Deutsche has been fined several times, including $ 630m in connection with Russian money-laundering.

In some countries a complete shut-out from correspondent banking looms. The Central African Republic and Nicaragua, as well as Latvia, are down to a single correspondent; in Belize and Liberia even the central banks have lost correspondent-banking services. Some countries, like Belize, brought this upon themselves with lax financial oversight. But others were simply caught in the rush to derisk. The International Monetary Fund says the retreat from correspondent banking has made the global finance system more fragile by concentrating cross-border flows.

The smaller firms that handle remittances are suffering, too. Some 250 had their accounts closed by Barclays in 2013; other banks soon followed. The banks were, in part, reacting to a declaration by the Financial Action Task Force (FATF), an intergovernmental forum that shapes anti-money-laundering policy, that such clients were high-risk. Remittances to developing countries fell in 2015 and 2016 (to $ 429bn)—the first two-year decrease in three decades—partly because money-transfer firms’ travails made it harder and pricier for migrants to send money home. (Low oil prices, which hit South Asians working in the Middle East, also played a part.)

Dominic Thorncroft of the Association of UK Payment Institutions (AUKPI), which represents money-transfer firms, says 65-70% of its members describe banking as a major challenge. Some have given up their independence and become agents of giants such as Western Union and MoneyGram, for whom international clearing is not a problem. A banker based in the Bahamas says that correspondent banks often tell local institutions: “You can deal with small remittance firms, or you can deal with us, but not both.”

Charities have suffered even more. A recent survey of several hundred by Charity & Security Network (C&SN), a lobby group, found two-thirds had experienced financial problems such as delayed transfers or account closures. Fear of being caught up in funding terrorism has made banks particularly wary of charities active in conflict zones. Though some have indeed been used as fronts by terrorists, “many innocent people are harmed when donations do not get to their intended destination,” says John Byrne of the Association of Certified Anti-Money Laundering Specialists. Imran Madden, the UK director of Islamic Relief, says the charity had accounts abruptly closed by UBS and HSBC, delaying distribution of life-saving aid. It has found other banks, which have taken the trouble to understand its “painstaking” due diligence, says Mr Madden. But four years ago it had fewer than 50 transfers queried each year; now hundreds are.

Most charities will speak only on condition of anonymity, fearful that publicity might suggest elevated risk and cause their banks to turn them away. One Syrian-American charity had a transfer to a Turkish vendor blocked by an American bank. It was intended for a hospital in Aleppo; by the time it was approved the city was no longer under siege. An NGO working in Afghanistan says that delays to wire transfers for blankets and other supplies to help a remote village through the harsh winter meant that people froze to death.

Path of least resistance

Concern has grown among the FATF’s members that derisking is actually increasing the risk of financial crime, by boosting cash transactions and the use of informal, unregulated financial networks. More charities are carrying cash: 42% of respondents in the C&SN survey said they were now doing so at least occasionally. A group of 190 American non-profits has formed a lobbying network, InterAction, to raise awareness of derisking in Washington.

Banks argue that they are reacting rationally to zero-tolerance regulation. Regulators have imposed a risk-based approach on banks, given them little guidance and then punished them for making some wrong calls, says Jason Sharman of Cambridge University. The IMF has described regulators’ expectations as often “unclear, inconsistently communicated [and] unevenly implemented”.

Until recently, regulators mostly ignored complaints about collateral damage. But they have started to come in for more criticism. Leaving people to die as charities struggle to transfer money does not play well. And the governments that want to clean up financial flows also want to boost poor countries’ development. That requires international banking services, both for firms and for people. For many countries, remittances from their migrant workers dwarf international aid.

So regulators are trying to improve their guidance. The FATF, for instance, has said that correspondent banks need not “KYCC” (know your customer’s customer)—that is, look through their client banks to scrutinise those banks’ account-holders. It has toned down sweeping assertions about charities and money-transfer firms being particularly likely to be involved in financing terrorism. The IMF is working with regulators in the most severely affected countries to improve their financial oversight. Big banks are starting to chip in. Standard Chartered, for example, runs correspondent-banking “academies”, sharing expertise in due diligence; the most recent, in Dubai, was for Middle Eastern banks.

Some of the countries affected are responding creatively. Mexico, long plagued by drug-money-laundering, is working out how to make payments easier to trace. A domestic dollar-payments system requires payment messages to include an IP address and biometric data from a legal representative of the sender. Similar identifiers are used for cross-border transactions, allowing regulators to spot suspicious patterns. These go into a database to which banks must refer when doing risk assessments. This has reassured some foreign correspondent banks, says Miguel Diaz, the head of payments at Mexico’s central bank. “We knew we had a particular problem here and had to go the extra mile.”

Better, cheaper compliance should allow banks to take back some of the clients who were ditched because they were not profitable enough to outweigh the risk, says Vijaya Ramachandran of the Centre for Global Development, a think-tank. About 3,700 of the banks that are members of SWIFT now use the payment-messaging system’s data registry to collect required information about the banks for which they act as correspondents, thus cutting compliance costs. Takis Georgakopoulos of JPMorgan Chase, the largest clearer of dollar transactions, holds out hope for the blockchain technology behind bitcoin, a digital currency. This encodes a record of valid transactions with time stamps, which can be a cheap, easy way to verify customers.

At a recent conference for American bankers, only one in ten said they expected to reduce the number of correspondent-banking partners in the next year. In contrast, an earlier straw poll of European banks suggested more than half thought they would. This may suggest that American banks, which were first to derisk, will also be first to ease off.

Emile van der Does de Willebois of the World Bank says that big banks seem a bit more willing than a couple of years ago to service small banks in places like the Caribbean and Africa—albeit often indirectly, through mid-sized regional banks in “nesting” arrangements. As for money-transfer firms, Mr Thorncroft at the AUKPI cites two potential improvements: proposals to require banks to give their reason for rejecting a client, and the rise of new “challenger” banks in Britain, which seem keen to woo his members.

Paralysed by fear

But these are only tentative signs. Anti-money-laundering compliance costs remain high: $ 60m a year for the average bank and many times that for the largest. And the screening products used by banks are still far from perfect: in February, for instance, the Finsbury Park mosque in London won an apology and damages from Thomson Reuters after being wrongly placed in a terrorism-linked category on a database compiled by the financial-information firm. That had made banks wary of serving the mosque.

Most banks still worry that if they dare to “re-risk”, it could lead to a fresh round of hefty fines. Charities remain pessimistic, too, despite talk of creating government-endorsed lists of vetted humanitarian-relief groups that banks could safely serve. “Banks are responding to a regulatory crackdown,” says Tom Keatinge, a former banker now with the Royal United Services Institute, a think-tank. “Regulators worry about the strength of that response but don’t want to micromanage risk. Both are acting rationally, but combined they create a problem that looks intractable.”

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