CORRESPONDENT BANKING: AVOIDING THE UNINTENDED CONSEQUENCES OF STRICTER REGULATION

By Ruediger Geis, Head of Product Management, Trade Services & Issues at Commerzbank

In the post-crisis era, a new concerning trend is emerging in the banking industry: an increasing number of trade banks are exiting banking relationships and closing down their credit lines to certain countries. But why? For one, the rising cost of compliance is putting banks under pressure and making the provision of trade finance more expensive. And stricter regulation is also playing a major part; more rigorous Know Your Customer (KYC) regulation, for example, is causing numerous global correspondent banking relationships to be progressively scaled down.

Yet losing so many international banks from the trade finance arena could clearly have a significant negative impact on global trade, a key driver of economic recovery. As such, while banks are now widely embracing regulatory reforms – requiring them to prove that they are fulfilling all regulations and meeting stricter criteria – ensuring the existence of all market participants must also remain a priority.
In this respect, some of the unintended consequences of stricter regulation may be mitigated by attempting to standardise some areas of trade finance in order to promote a common understanding and more transparency in trade lending, which will in turn help to save time and cut costs for all market participants. And key industry organisations, such as the International Chamber of Commerce (ICC) and the Bankers Association for Finance (BAFT), have been proactive in leading industry-wide efforts to improve standardisation of trade finance products and documentation.

Smaller banks under pressure

Rüdiger Geis

Certainly, banks are under more pressure than ever due to regulatory reform, including KYC and Anti-Money Laundering (AML) regulations – introduced to help prevent money-laundering and terrorist financing – as well as stricter capital adequacy requirements in the form of Basel III. But it is often the smaller banks that are most at risk of being forced out of the trade finance arena over the coming years as they struggle to justify the rising costs of compliance on their relatively small trade finance portfolios.

Likewise, it is the smaller regional banks that are in danger of being cut off from global correspondent banking networks as the introduction of KYC regulation requires banks not only to know their own clients, but also their clients’ clients up and downstream. As a result, an increasing number of large global banks are pulling out of high-risk countries and withdrawing their support to smaller partners in these areas. A continuation of this trend raises the possibility of not only individual participants being forced out of the market, but also, worryingly, whole regions or countries becoming “unbanked”.

But it is not only regulation making it difficult for smaller banks to keep their trade businesses afloat. In the light of globalisation, demand for international trade finance has increased exponentially over the last decade, putting pressure on banks to provide quick and efficient services at competitive rates. Letter of credit checking, for example, requires extensive screening and some banks are now struggling to deliver this unique documentation within the tight timeframes expected by corporates.

How standardisation can help

However, the unintended consequences of stricter regulation and the struggles of smaller banks have not gone unnoticed by the industry, which has recognised that a move towards standardising the market may prevent those banks from exiting the trade finance business.
For example, more standardised trade finance documentation would reduce the cost associated with performing due diligence on a portfolio of unique transactions, while also reducing legal fees and the time spent negotiating contracts.

Indeed, the introduction of the Master Loan Agreement (MLA) in May by BAFT for bank-to-bank trade loans is a case in point. Certainly, the MLA will open the trade business to a wider range of banks and countries because it will provide uniformity by establishing universally-agreed definitions (such as the meaning of Libor for example). This will also make the entire process more transparent, saving time and money for all banking participants.

Certainly, standardising definitions will also help improve all market participants’ understanding of trade finance products and processes. This was one of the reasons why the ICC Banking Commission formed the Global Supply Chain Finance Forum in April with the purpose of standardising Supply Chain Finance (SCF) terms. This was the first time that six leading organisations –the ICC, BAFT, the Euro-Banking Association (EBA), Factors Chain International (FCI), International Factors Group (IFG) and the International Forfaiting Association (IFA) – joined together with such a purpose.

Such initiatives should also help boost the investment appeal of the trade finance asset class; important given that stricter capital adequacy requirements are forcing many banks to seek alternative funding sources in order to reduce their risk-weighted assets. Indeed, several leading banks are now seeking to securitize their loans, for example, to attract institutional investors, such as pension funds. Yet, there have so far been a limited number of deals in the market, partly due to investors’ lack of awareness of trade finance assets.

One final area where standardisation can help smaller banks overcome some of the current challenges is by streamlining back office processes. In this respect, larger partners can offer streamlined, low-cost processing and back-office capabilities in order to help process some of their smaller correspondents’ trade flows. For instance, Commerzbank has two trade processing centres in Poland and Malaysia, which provide 18 hour per day processing across Asia and Europe. This allows the bank to deliver LCs to the world within 24 hours, resulting in lower costs for clients.

These significant efforts to standardise key areas of trade finance will go some way towards helping smaller banks continue to offer trade finance services and deal with the regulatory reforms taking place. As while banks have rightly placed compliance at the top of their priorities, they should not forget the importance of the correspondent banking network and its role in connecting businesses and economies, ensuring the facilitation of trade finance and global trade.

About the author:

Ruediger Geis is an active member in various trade initiatives and co-chaired the BAFT Trade Loan Documentation Working Group. He is also an executive committee member of the ICC Banking Commission and plays an active role in various ICC working groups.