Following the global financial crisis in 2008, correspondent banks began reassessing their emerging market strategies. In recent years, both compliance costs and potential regulatory risks have grown sharply, making it more challenging to stay engaged.

Many banks have already decided they would rather not take on the challenge – as the 22% global decline in the number of active correspondent banks in the last decade shows.

Taking a closer look at the numbers, the steepest declines are seen in emerging markets where remittance and cross-border funds are a vital lifeline for households and businesses.

With this in mind, what are the opportunities and risks in emerging markets, are there gaps in the correspondent banking system, and how are digital innovators coming into the picture to solve the problem?

Emerging markets: Rewards, but also risks

Typically, emerging markets have low to middle income per capita, but they post rapid economic growth rates as they develop their capital markets and industries. The biggest emerging markets include Brazil, China, India and Russia, while many mid-sized emerging economies can be found in Africa, the Middle East and Southeast Asia.

Globally, the value of cross-border payments is projected to hit more than US$250 trillion by 2027, or an increase of more than US$100 trillion in 10 years.

At the same time, buoyed by positive macroeconomic fundamentals, advances in technology and increasingly robust digital and non-cash mechanisms, payments businesses are set to add $1 trillion in new revenue through 2027.

There will be diverging growth across regions, with change likely proceeding at a dramatically faster speed in emerging markets than in mature markets, driven by economic and population growth.

While emerging market economies offer banks strong revenue growth potential, they also come with higher risks and costs. The threat to banks of doing business in these geographies potentially outweighs the benefits of services to their clients, even if there may be good business opportunities to pursue. There could be a higher risk of money laundering, for example, which would draw an increase in compliance costs.

Compliance costs could also outweigh the market opportunity as some of these countries are too small to justify the investment.

Banks would need to conduct a thorough cost-opportunity analysis before deciding to open or continue operating in a country.

De-risking – a troubling global trend

Compliance costs, particularly regulatory penalties imposed for violations of anti-money laundering (AML) rules, have prompted US and European banks to cut their correspondent banking activity in the riskiest regions. Just last year, AML penalties peaked at US$9 billion, compounding the challenges banks face in high-risk geographies.

When banks de-risk a country, the decline in access to correspondent services is felt deeply at a micro-level. The impact on banks in affected countries includes loss of customers, mostly companies and exporters; a significant drop in remittance volumes; loss of profitable businesses such as the supply of US dollars; and adverse effects on banks’ ratings.

Businesses in emerging markets end up struggling to access the global financial systems to finance their operations. Without this access, local banks are forced to use non-regulated, higher-cost sources of finance and risk exposing themselves to predatory practices.

In extreme cases, the country could find itself unable to send or receive international settlements or payments altogether.

Where traditional banking falls short

For traditional banks, maintaining an open global network across many different standards and under a strict regulatory framework incurs high costs, making cross-border transactions considerably more expensive than domestic payments.

Even leading transaction banks can no longer afford to maintain large international correspondent bank networks and have been closing less profitable locations and reducing the extent of their networks.

Ultimately, this is a deterrent for businesses looking to expand to emerging markets. Faced with high margins and low efficiency of cross-border payments through traditional banking channels, their business model in emerging markets won’t see much success.