Long reads

Correspondent banking relationships: how can fintech resolve burgeoning issues?

Madhvi Mavadiya

Madhvi Mavadiya

Head of Content, Finextra

Fintech can help resolve issues related to financial exclusion and make strides where the traditional financial services industry has fallen short. Ensuring technology is widely accessible to deliver meaningful change has allowed fintech firms to offer far more comprehensive solutions than legacy players and provided banking services for certain areas that their traditional counterparts believe are not worthwhile, or too expensive.

The fintech ecosystem is responsible for plugging such gaps and could reduce the risk profile of these areas and in turn, the cost of ownership for technology solutions that can help push correspondent banking networks forward. For example, a standalone, digital, cloud banking platform could be created to remedy this problem and support a correspondent bank’s digital transformation strategy. 

Fintech could also be used as a redundancy. Rather than respondent banks waiting to get cut off from the network or from certain currencies, improving digital transformation in a holistic manner must be incorporated into the bank’s risk strategy. Via the concurrent incorporation of a fintech solution, and utilising technology-led initiatives such as automation, artificial intelligence and straight-through processing, banks are ensuring that the cost of compliance is reduced. 

Finextra spoke to Richard Stockley, global director of partnerships at Currencycloud; Manav Daryanani, director, global partnership development, Mambu; and Franciso Morandeira, client solutions director, retail banking, GFT about how fintech can help tier two, three or four banks access correspondent networks, how it can plug the correspondent banking gap and how it can also become a preventative measure that is embedded into banks’ risk strategy.

How can fintech firms help tier two, three or four banks access correspondent networks? 

As Stockley highlighted, “there is an increasing trend that we are seeing in the market where the risk appetite for the tier two and three regional bank correspondent networks has reduced and this has resulted in these banks being cut off. It is unfortunate because a lot of these banks deal with remittances, which is a large part of both the banking services provided in some regions, as well as a major contributor to the economy.”

Banks have historically had a strong and extensive network of correspondent relationships, but this is changing and there is evidence that banks are reducing the number of these partnerships. This is occurring within respondent banks that do not generate sufficient volumes to recover the cost of compliance and are in regions that do not have sufficient information or processes to reduce KYC risk. Further to this, some banks are becoming reluctant to provide correspondent banking services in particular foreign currencies where the risk of economic sanctions seems to be higher.

In response to this, Stockley added that from a Currencycloud solution perspective, the infrastructure that Currencycloud provide can act as the “technology layer on top aggregating complex international banking capabilities thus making the consumption of services seamless. This simplifies a lot of the issues, cost, risk, and complexity around international money movements respondent banks suffer through their legacy relationships with corresponding banks nostro and vostro accounts.”

The relationship is simplified and access to several routes, currencies and institutions is through an easy-to-use consumer interface. Further to this, the net benefit with this is that a bank would relinquish the complexity of managing multiple relationships amid changing risk appetite and the possibility of being cut off with little warning. Working with an organisation such as Currencycloud can help banks manage this complexity, the relationships and the technology integration required to facilitate those trades.

Daryanani added that for tier two, three or four banks to access correspondent networks, fintech firms must provide agility, speed and scalability across borders. From the perspective of Mambu, “tech-enabled financial services should enable speed to market and time to value, allowing banks and organisations to scale very quickly, both horizontally across geographies, but also vertically if they want to offer new product lines or different types of propositions.”

He said that while this is one aspect of increasing access, the other piece is around customer centricity and how this is where many banks are falling behind, but an area where fintech firms could support. “By addressing specific customer needs, fintech firms can help banks plug gaps, whether it's around correspondent banking or money flows.”

Daryanani also said that working with fintech firms can alleviate inherent risks that are present when moving capital across borders. “Having technology that can reduce that single point of failure and can keep your lights on, keep banks available and running and can link you to new services and new offerings through APIs.”

On this point, Morandeira summarised that “the correspondent banking network is increasingly concentrated, so the shortest route to market is to leverage existing correspondent relationships of other payment service providers or payments focused fintech firms. The fintechs can offer technology solutions that use the existing providers to increase market access to these services or provide key functions that will look at the regulatory controls, such as compliance checks or transaction monitoring.”

Why is the risk profile of certain markets measured by Western standards? What impact does this have on the risk vs. reward methodology for banks that find it too expensive to bank certain areas? 

The cost of correspondent banking has increased, and only some parts of the business are profitable. As mentioned, many banks have been cutting off less profitable customers or regions, especially in situations where the returns do not equal the investment cost – which is the case for correspondent banking relationships that must bear the burden of AML regulation. This can have a severe, negative impact on the country’s GDP and financial inclusion.

As highlighted by the BIS, costs of the model have increased: “the most common cause for this reduction of profitability is the increasing cost of regulatory compliance, especially in relation to AML/CFT regulation. According to anecdotal evidence, these costs have reached such a level that, for certain financial institutions, there is no business justification for continuing to engage in correspondent banking. In addition to the increased compliance costs, interviewed banks also mentioned the high degree of uncertainty as to what exactly constitutes compliance with the requirements in order to avoid penalties and related reputational damage.”

However, profit can still be derived from correspondent banking, as the BIS continued. “Some correspondent banks are specialising in the provision of correspondent banking services as a source of profit, and are thus focusing on respondent banks that provide a business volume that is sufficient to justify the increasing costs (including fixed costs) and which are located in jurisdictions perceived to constitute an acceptable level of risk. These banks consider the increased complexity in the correspondent banking business as a challenge but at the same time as an opportunity to increase their competitive advantage.

“However, the majority of institutions seem to be maintaining existing correspondent banking services only insofar as these services are necessary to serve the needs of corporate customers for cross-border payments and trade finance or to support the cross-selling of other products to respondent banks (ie the profit is made in other business areas and correspondent services are  considered as a necessary ancillary service) or to preserve reciprocity in their correspondent relationships. As a result, respondent banks that fit within any of these business strategies are likely to maintain relationships, whereas others might risk being cut off from the international payment networks.

“Banks which might risk losing access to correspondent services tend to be smaller institutions that do not generate volumes considered to be sufficient, that are located in jurisdictions perceived to be too risky, that are not part of an international group or that provide payment services to customers about which the necessary information for an adequate risk assessment is not available. This trend implies a risk that cross-border payment systems will fragment, reducing the available options for these transactions.

However, due diligence costs and financial crime compliance are reducing risk appetite. Because this leads to decreased profitability and increased risk of fines, correspondent banking relationships can be strained and could lead to a withdrawal of relationships in areas where there are weak compliance practices and risk of money laundering, harming developing economies. However, this could be the case because the risk profile of certain markets is measured by Western standards.

In Morandeira’s view, “the traditional international payments scene is heavily dominated by Western economies, with Swift being founded, headquartered and administered by American and European entities. Almost 80% of the value of payments they process are concentrated in USD and EUR, despite Swift connecting over 200 countries and territories.

“More generally, the Western financial system has developed a set of best practices for managing risks in banking payments systems, which have been widely accepted and adopted globally. These practices include strong anti-money laundering and anti-terrorism financing measures, secure payment processing systems, and robust risk management frameworks. Banks usually implement tighter controls on payments arising from, or being to so-called ‘high-risk’ countries, which results in more friction and a higher cost of operation. When assessing the feasibility of operating in certain areas, banks consider potential risks and returns. If the risk is deemed too high, banks may opt out or scale back their operations.”

But what impact does this have on the risk vs. reward methodology for banks that find it too expensive to bank certain areas? Morandeira stated that using Western standards for risk evaluation may raise risk assessments and reduce returns.

“For instance, in markets with weak regulatory and legal frameworks, Western banks face higher compliance costs and reputational risks. As a result, they may require higher returns to cover the added risk, making it more expensive to operate in such markets. In extreme cases, Western standards can limit banking services, such as cross-border payments or correspondent banking, resulting in reduced financial inclusion and stunted economic growth,” he continued.

How can the fintech ecosystem plug the correspondent banking gap, as well as reduce the cost of ownership? What are the benefits of working with a technology partner?

According to Stockley, “no person is an island. You don’t just consume a single service from a single product for a single outcome. There are interdependencies everywhere. Although we work to simplify those interdependencies, we manage all the relationships with the supplier banks in our network, as well as alongside adjacent ecosystem partners such as core banking platforms, local banking infrastructure and front-end experiences.”

He went on to explore how all organisations across the ecosystem must ensure that at the point of consumption, the actual consumer is benefiting from the service, that the user journey is seamless, and the independent systems all work together. “A big spaghetti stack of legacy technology is very hard to innovate with,” Stockley said and mentioned that the industry can look to technology stacks of neobanks like Monzo and Starling, their modular cloud approaches as a blueprint and embed innovation into the entire experience.

Daryanani agreed: “Flexible architecture can bring best of breed technology at the best of times. Making it possible to swap in and swap out components freely, change and react to the market and customer needs.” He also said that when working with a technology partner, banks could see a reduction in infrastructure costs by 50% because there is no need for large armies of IT teams to manage and develop internally, as well as large maintenance contracts.

“These are typically solutions managed on the public cloud, which allow you to focus on your core business and not hire people just to keep the lights on, so there's a big cost reduction lever as well.” Morandeira believes that success can be achieved by democratising access to the network through seamless integration, best of breed technology and creating economies of scale.

“Technology partners can bring to the table the know-how and the expertise in similar implementations across a wide range of banks and fintechs, together with helping instil best practices in the use of technology, development, and ways of working. They also enable accelerated outcomes, as typically the partners will have completed projects of this type previously, harvesting methods and assets for re-use and reducing the time to deliver for clients,” he commented.

Why won't a one size fits all fintech solution work? How best does the partnership come into play – by enhancing the digital transformation strategy, or supporting API integrations? 

Morandeira also believes that the requirements of each bank are unique and whether a one-size-fits-all fintech solution will work will depend on their current position – their existing processes, legacy systems, use cases, customers, and markets they want to address in future.

He continued: “Successful partnerships should not just be limited to implementing a new feature or integration. They should deliver sustainable change that supports banks in their long-term transformation journey. Clearly partners will be able to support on both aspects of these and each has its own merits, but additionally each fintech is likely to have its own individual skillsets and its own strategy. The best use of a partner is to add skills or experience to the bank team, where there might be gaps, or where the most benefit can be delivered to the business,” Morandeira said.

But how can this partnership come into play? Stockley thinks that there are nuances here that need to be considered. The key distinction is that it is one stop shop vs. purchasing independent parts and the bank being forced to assembling itself. “With big monolithic structures, regional complexities will be exacerbated as all platforms have a home turf where they grew up and they will have natural biases around that region. Alternatively assembling the requisite best in class solutions and choosing those partners carefully, existing relationships and architectural patterns that work together can be leveraged. This means that whatever region you’re in, banks can choose the best partner to go with.”

How can technology facilitate correspondent banking to be easier, cheaper, and better?

Looking to the future, as Morandeira surmised, that if managed correctly, technology can help to accelerate innovation within correspondent banking “by enabling the implementation of standards such as ISO 20022, extending the operating hours of existing payment systems, or supporting the early adoption of emerging alternatives to traditional correspondent banking.

“The biggest support that technology can provide at present is to continue to push ahead with the idea of instant payments across borders, with instant settlements, using the newer blockchain type technologies and starting to make use of the new Universal Digital Payment Network (UDPN) that is currently being trialled by many banks around the globe,” he continued.

Providing a concluding statement, Stockley said that “being able to provide a better experience for your end consumer is the focus for Currencycloud. We are cognisant of the journey a bank will have to take to accommodate that transformation. While by no means trivial, the benefits for the end consumer are material and worth the effort.”

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