This post was co-authored by Veronica Ramcharan
Small states, like the Caribbean countries, have been negatively affected by recent "de-risking" policies implemented by international banks, with particularly damaging consequences on correspondent banking relationships. While recommendations from the Financial Action Task Force (FATF) to deal with risks of money laundering and terrorism financing have often been mentioned to justify those de-risking practices, a wide variety of factors seems to have been at play. Urgent action to address the issue is needed to avoid unintended potentially devastating effects on the economies of those countries.
Managing risks is no de-risking
The Financial Action Task Force (FATF) has recommended banks to follow a risk-based approach in doing their part of the Anti Money Laundering and Combating the Financing of Terrorism (AML/CFT) efforts. Together with competent government authorities, financial institutions are expected to identify, assess and understand the risks of money laundering and terrorism financing to which they are exposed and take AML/CFT measures commensurate to those risks in order to mitigate them effectively.
Several international banks have referred to such recommendation as the reason for taking recent de-risking decisions, through which they have denied and/or restricted entire classes of costumers from financial services without conducting a comprehensive assessment of their level of risk or risk mitigation measures for these customers. The public statement issued by FATF in October 2014 refers to "de-risking" as the occurrence of financial institutions terminating or restricting business relationships with clients or categories of customers, to avoid, rather than manage, risk in line with the FATF's risk-based approach. According to that same statement, such behaviour is contrary to the intended purpose of FATF's risk-based approach, which is a fundamental aspect of the FATF standards. FATF recommendations only require financial institutions to terminate customer relationships, on a case-by-case basis, where ML and TF risks cannot be mitigated.
The recently intensified de-risking has had a disproportionate negative effect on small state countries, where specific challenges faced by those countries have exacerbated the effect of de-risking and the subsequent loss of correspondent banking relationships (CBRs) with tier 1 financial institutions in advanced economies. These challenges typically include relatively shallow banking systems, under-developed financial markets, highly concentrated financial systems dominated by foreign banks, domestic currencies that are not internationally traded and often a heavy reliance on remittances. Not only is the adverse effect of de-risking intensified in these countries, but the timeline for an acceptable solution to be implemented has significantly shortened, as the underdevelopment of financial sectors in the majority of these countries make a potential economic collapse imminent if a viable solution is not found in the near future.
Correspondent banking is an essential component of the global payment system, especially for cross-border transactions. Through CBRs, banks can access financial services in different jurisdictions and provide cross-border payment services to their customers, supporting, inter alia, international trade and financial inclusion. In addition, most of the payment solutions that do not involve a bank account at customer level - such as remittances - rely on correspondent banking for the actual transfer of funds. Therefore, the effects of de-risking through the termination of CBRs have been particularly severe.
De-risking in the Caribbean Small States
In the Caribbean region, comprised mainly of small island developing states, CBRs with financial institutions from advanced economies have steadily declined over the last couple of years. The adverse impact of de-risking is significant and can impact these countries on several fronts, primarily through international trade, financial stability and growth. While the problem associated with de-risking is not entirely new to the Caribbean, it became progressively worse over the years and has now reached a critical point. For example, several years ago a major US correspondent bank ceased offering cash services to several central banks in the region. Nonetheless, this loss was replaced by another international bank as the Caribbean countries acceded to more stringent due diligence processes including "know your customers' customer" attestations - despite the significant constraints and uncertainty of the process. It should be noted that at the FATF Private Sector Consultative Forum Meeting held in March 2015, it was reiterated that the FATF standards do not require a "know-your-customer's-customer" approach to conducting customer due diligence.
While Caribbean countries have struggled to abide by ever changing standards and requirements, the amount of CBRs continue to decline. The problem is further compounded by the fact that they do not have a long list of international institutions to choose from to begin with, as only a small number of tier 1 financial institutions offer financial services to the Caribbean region. Therefore, given the limited pool of institutions with which they can engage - in most cases there may be only one or two institutions - the loss of each correspondent bank successively increases the already disproportionately high level of operational risk.
The impact of de-risking on money transfer businesses (MTBs) is of particular concern, as money transfers to the Caribbean exceeded all other forms of external finance in 2014. Remittances to the Caribbean increased by 6.3 percent compared to 2013, totalling US$9.9 billion. However, the MTBs are the latest regional casualties, as correspondent banks have begun to sever ties with these institutions, citing excessive compliance cost to meet corresponding requirements. While it is generally accepted that MTBs are among the higher risk clients, this does not automatically imply that they are conducting illegal business activities, as they are often held to the same standard of AML/CFT requirements as the banking sector.
Further to this, remittances themselves have intrinsic "growth value" as they can promote development and facilitate greater financial inclusion, all of which can help drive strong, sustainable and balanced growth. Therefore, the continued erosion of CBRs can significantly reverse the level of financial inclusion in small state countries. De-risking also presents challenges for financial inclusion goals by further limiting access to formal bank accounts for potential customers - who may not meet requirements because they lack a previous banking history - and MTBs who cannot operate without a centralized account to temporarily hold funds.
Difficulties to address the de-risking challenge
To avoid penalties and the related reputational damage, financial institutions in advanced economies have developed an increased sensitivity to the risks associated with correspondent banking. However, a major challenge in addressing the problem of unwarranted de-risking is the ambiguity surrounding the criteria for de-risking actions and a lack of uniformity in its implementation across institutions. Moreover, there seems to be no obligation on the part of international banks to provide a comprehensive explanation to regional banks for the withdrawal of their financial services. This has proven to be a significant obstacle for the Caribbean and other small states, to appropriately address the issue as they are unable to determine the specific causes for the loss of the CBRs, despite considerable efforts on their part. The general experience of the Caribbean countries is that global banks have not been transparent and forthcoming on their reasons for terminating CBRs. According to regional authorities, when international banks withdraw their services, there is normally no explanation for the action taken, or in a few instances when a reason was cited, it was as a result of an "operational decision" being made by the international bank.
Consequently, given the lack of clarification for the heightened level of de-risking taking place, several possible reasons have been put forward, with the most obvious being possible deficiencies in the AML/CFT frameworks of the respondent banks in the Caribbean region. Unfortunately, this perception continues to prevail, despite being unsubstantiated, as no Caribbean country is currently subject to FATF's monitoring process.
Beyond this primary rationale, another assumption for de-risking is that correspondent banks took the decision to sever high risk relationships--such as the cash intensive businesses--and product lines that are not sufficiently profitable to justify the significant associated risk or compliance assessment requirements. However, this indiscriminate blanket approach to de-risking by foreign correspondents runs counter to the expectation that the global banks can and should assess the risk of their customers on a case by case basis.
A further reason cited is the fear of regulatory enforcement action that carries substantial litigation costs. This idea is by no means far-fetched as the penalties for US, UK and EU banks are exorbitant, even if they are found to have unknowingly facilitated money laundering and tax evasion. Other possible reasons for de-risking include, but are not limited to (i) general retrenchment by global banks; (ii) apprehension about possible reputational damage; (iii) misinterpretation of the FATF standards on correspondent banking and customer due diligence; and (iv) a domino effect caused by the actions by other international correspondent banks.
Possible way forward
De-risking thus appears to have been driven by a variety of factors. Given the ambiguity surrounding the de-risking process, explicit guidance to all relevant stakeholders is strongly needed. This guidance should be specific to the level of requirements and expectations, within a comprehensive and measurable framework under which the risk-based approach can be applied. There is also a need for a greater level of accountability from correspondent banks who withdraw their services, whereby they are mandated to provide tangible evidence that they undertook all the required measures, prior to withdrawing their services.
According to the International Alliance of MTO Associations the expectations and responsibilities of correspondent banks in relation to sanctions and extraterritoriality also need to be defined. Clarification is essential on the responsibilities and extent of liability of correspondent banks, pertaining to sanctions and AML/CFT requirements, if they are operating in foreign countries and/or providing overseas correspondent banking facilities. Consideration of legislative changes to shift the liability of extraterritorial sanction and AML/CFT breaches to the entity immediately responsible for that breach as opposed to the correspondent bank itself was also put forward by the association.
Several possible actions to address the challenge of de-risking were also outlined at the Alliance for Financial Inclusion (AFI) and G-24 roundtable in Peru October 12. They include: (i) Central banks as regulators should be proactive, especially in terms of the guidance given to financial institutions, and move quickly to stem the tide when de-risking happens. (ii) Greater partnership among the IMF, World Bank, Financial Stability Board, G24, Alliance for Financial Inclusion and the Commonwealth Secretariat, is required to advocate for developing countries with regards to implementation of FATF's risk-based approach. The issue has only started to be discussed at G20 meetings (iii) A safe harbour and/or "freeze" on de-risking actions should be instituted, until the various on-going studies by international organizations are concluded. This will provide a clearer picture of the scale, drivers and impact of de-risking and put the relevant regulatory bodies in a more enlightened position, in order to implement appropriate risk-based policy solutions. (iv) A review of best practices among jurisdictions to build a "bottom-up" approach to strengthening AML/CFT regimes. (v) Assistance for capacity building efforts, enabling countries to undertake mandatory natural risk assessments (NRSs) to more efficiently identify, assess and manage ML/FT risks.
The presence of CBRs is essential to small states for trade and investment. Given their dependence on CBRs with financial institutions in advanced economies, loss of these relationships as a result of de-risking can have severe and almost immediate implications on their macroeconomic stability and potentially result in financial destabilization, financial exclusion and ultimately economic collapse. These countries depend on correspondent banking arrangements as they represent their lifeline with the world. The urgency of the matter cannot be over-emphasized, as the current efforts by the international community may not provide a viable solution in time to prevent the economic devastation of some countries, making it imperative that these efforts are accelerated, and/or some interim action is taken to ensure that the development and stability of these countries are preserved.
Otaviano Canuto is an Executive Director at the International Monetary Fund and Veronica Ramcharan is a Senior Adviser to the Executive Director. All opinions expressed here are their own and do not represent those of the IMF or of those governments Mr. Canuto represents at the IMF Board.