Chapter

Chapter 12. Loss of Correspondent Banking Relationships in the Caribbean: Trends, Impact, and Policy Options

Author(s):
Krishna Srinivasan, Inci Otker, Uma Ramakrishnan, and Trevor Alleyne
Published Date:
November 2017
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Author(s)
Trevor Alleyne, Jacques Bouhga-Hagbe, Thomas Dowling, Dmitriy Kovtun, Alla Myrvoda, Joel Chiedu Okwuokei and Jarkko Turunen 

Introduction

A correspondent banking relationship (CBR) is a bilateral arrangement between banks, often involving a cross-border relationship in multiple currencies. According to Erbenová and others (2016), a correspondent banking arrangement involves one bank (the correspondent, for example, a major international bank) providing a deposit account or other liability accounts and related services to another bank (the respondent, for example, a bank located and doing business in the Caribbean). The arrangement requires the exchange of messages to settle transactions by crediting and debiting those accounts. Correspondent banking relationships are a key component of a well-functioning international financial system. They enable a range of crucial transactions and services, including the execution of third-party payments such as wire transfers and credit card transactions, trade finance, and transactions related to the banks’ own cash-clearing, liquidity management, and short-term borrowing or investment needs.

Following the global financial crisis, banks reduced their involvement in less profitable and riskier activities worldwide, including correspondent banking. Large global banks have recently come under increasing pressure to increase their capital, streamline their business models, and reevaluate their risk exposures (Lagarde 2016). As a result, these banks have been reducing activities in areas that they perceive to be either less profitable or, more generally, detrimental to their risk tolerance—a process that is sometimes referred to as “de-risking.”1 The underlying drivers of this global de-risking trend are multidimensional. They include advanced economy regulators’ attempts to strengthen prudential regulations and enhance economic and financial stability; their concerns about tax avoidance, money laundering, and terrorist financing; and business decisions by correspondent banks in a new macroeconomic environment characterized by low interest rates and increased costs of regulatory compliance. This global trend has been most evident in the reduction of CBRs.

Banks across the Caribbean have lost CBRs, with negative impacts on some services and sectors. Surveys show that the extent of CBR loss varies across Caribbean countries (Table 12.1).2 Existing studies of the withdrawal of CBRs in the Caribbean draw from diverse and sometimes anecdotal sources to document the loss of CBRs and the resulting impact on financial institutions and the economy more broadly. Further analysis is hampered by a lack of timely data on the number of CBRs, the value and volume of related financial flows, and the nature of the factors driving the loss of CBRs. This chapter brings together existing evidence on the loss of CBRs in the Caribbean, drawing from global surveys (such as World Bank 2015b); regional surveys by Caribbean authorities (CARICOM 2016), the Caribbean Association of Banks (CAB 2016), and IMF staff (IMF 2016b; Alleyne and others, forthcoming); and discussions with both authorities and banks in the context of the IMF’s engagement with member countries. The chapter also examines the key drivers of the loss of CBRs and the potential economic effect of a substantial loss of CBRs. Finally, it reviews policy responses thus far and discusses available policy solutions for the Caribbean.

Table 12.1.Banks that Have Lost Correspondent Banking Relationships(share)
IMF 2016bCAB 2016
The Bahamas
Belize
Barbados
Guyana
Jamaica
Suriname
Trinidad and Tobago
ECCU
Montserrat
St. Vincent and the Grenadines
Antigua and Barbuda
Anguilla
Dominica
St. Kitts and Nevis
St. Lucia
Grenada
Legend:
More than 75%
Between 25% and 75%
Fewer than 25%
Sources: IMF 2016b; and Caribbean Association of Banks 2016.Note: ECCU = Eastern Caribbean Currency Union.
Sources: IMF 2016b; and Caribbean Association of Banks 2016.Note: ECCU = Eastern Caribbean Currency Union.

Why Do CBRs Matter?

Caribbean economies, characterized by their extensive interconnections with the global economy, depend on the reliable functioning of CBRs. Additional potential links arise from the presence of offshore sectors in several countries. The loss of CBRs can affect the economy through reduced international trade, remittances, or investment flows (Figure 12.1):

  • International trade and commerce. All countries in the Caribbean rely heavily on international trade, including tourism and other services, requiring CBRs to carry out cross-border transactions. The average openness ratio (the sum of exports and imports of goods and services divided by GDP) in the Caribbean amounted to 95 percent during 2011–15, which is slightly higher than the world average of 91 percent. An increase in the cost of making payments or a disruption in the ability to make or receive international payments would seriously undermine economic activity.
  • Remittances. The degree to which Caribbean countries rely on remittances varies significantly. Remittances amounted to 6.3 percent of GDP, on average, in 2011–15, which was higher than the world’s average (4.8 percent of GDP), with Guyana (13 percent of GDP), Haiti (22 percent of GDP), and Jamaica (15 percent of GDP) exhibiting high dependence on these flows. Thus, a reduced ability to receive remittances inflows would pose a significant risk in these economies. In addition, reduced access to money transfer services or an increase in transfer costs could push remittances to informal channels, making them more difficult to monitor.
  • Financial account flows. Financial account flows contribute a major part to financing investment. The average of financial account balances in the region was close to 9 percent of GDP over 2011–15. Foreign direct investment (FDI) is especially important for the Caribbean, with total inflows averaging nearly 8 percent of GDP in 2011–15. A disruption in CBRs could constrain these investment flows, including through difficulties in repatriating reinvested earnings.
  • Offshore banks. Risks to offshore banks and subsequently to the economy depend on the size of offshore sectors and their links with domestic economies. Some countries in the region have large offshore sectors consisting of offshore banks, other financial institutions, and international business companies that provide various services. In principle, the “firewall” between the domestic and offshore sectors should limit the risks to domestic economies, but large offshore sectors can nevertheless be an important source of employment and government revenue. For example, the offshore sector contributed 0.7 percent (2015) and 4.1 percent (2013) of fiscal revenues in The Bahamas and Barbados, respectively. There are also examples of more direct links between these sectors; for instance, Belize’s offshore banks are an important source of financing for the domestic economy and have direct ties with the domestic banking system.

Figure 12.1.The Caribbean: Balance of Payments Linkages

Sources: World Bank, Remittances Database; IMF, World Economic Outlook Database; and IMF staff estimates and calculations.

Note: FDI = foreign direct investment. Data labels in figure use International Organization for Standardization (ISO) country codes.

The Withdrawal of CBRs—How Severe has it Been?

Global Trends

Recent surveys have highlighted key features of the global pressure on CBRs. Global evidence on loss of CBRs is largely based on surveys of banks (such as World Bank 2015a, 2015b; IMF and Union of Arab Banks 2015; ASBA 2015), complemented by other evidence collected in the context of the IMF’s engagement with member countries. Erbenová and others (2016) summarize this survey evidence as well as regional implications based on a few specific country case studies. Finally, BIS (2015) and IMF (2017) analyze global trends in cross-border transactions using SWIFT data.3 Although the information and data are far from comprehensive, they point to the following stylized facts:

  • Globally, no clear trends in CBRs are apparent. The BIS (2015) indicates that while CBR trends vary widely across countries, the aggregate data on volumes and values of transactions show no clear trend in correspondent banking activity. However, based on median statistics, the number of correspondent banks and the value of transactions fell during 2012–15, even as the volume of transactions increased.
  • Loss of CBRs has affected different types of countries. The largest declines in CBRs as measured by transaction values were observed in advanced economies under economic stress (for example, Cyprus and Greece), fragile states under sanctions or involved in social and political conflict (for example, Chad, Syria, Ukraine, and Yemen), and small island states (for example, Dominica, Timor-Leste, and Seychelles).
  • The economic impact has been limited thus far. There is critical pressure on CBRs in some countries, especially in smaller countries in the Caribbean and the Pacific, the Middle East and North Africa (MENA) region, Central Asia, Africa, and Europe, but the economic and financial stability impact has been limited thus far. Financial institutions have typically found other arrangements to compensate for the loss of CBRs.
  • Financial fragilities have been accentuated in some affected countries. The pressure on CBRs exacerbates financial fragilities in some affected countries because of the concentration of cross-border flows through fewer CBRs or CBR maintenance through alternative arrangements.

Caribbean Developments

Respondent banks have largely avoided serious disruption to correspondent banking services. In most cases, Caribbean banks have found alternative cross-border means of payment, including relying on remaining CBRs or finding replacement CBRs. World Bank (2015b) suggests that Latin America and the Caribbean has experienced a greater loss of CBRs than many other parts of the world, and that within the region, the incidence of withdrawals of CBRs was greater in the Caribbean. A survey by the Caribbean Association of Banks (2016) indicates that 58 percent of banks had lost at least one CBR, directly affecting 12 countries.

Results from a 2016 IMF survey confirm that banks in several Caribbean countries have lost CBRs.4 However, only five out of 14 countries that responded to the survey experienced a decline in the aggregate number of CBRs in the five years up to September 2016. Belize saw the largest decline by far, losing more than two-thirds of its CBRs, with most of the decline taking place from April 2015 to February 2016 (Box 12.1). Loss of CBRs has been less dramatic in other Caribbean countries. Among commercial banks, the smaller indigenous banks have tended to be the most affected. These banks generate a relatively small volume of cross-border business for correspondent banks and are less likely to have sophisticated transaction monitoring mechanisms to satisfy correspondent bank’s own anti-money laundering/combating the financing of terrorism (AML/CFT) protocols. In contrast, foreign-owned branches and subsidiaries, which often have the backing of a larger parent institution and can rely on its network of CBRs, do not seem to have been affected at all. In many Caribbean countries, these establishments include subsidiaries of large Canadian banks that play an important role in the domestic banking system. Banks in several countries have found replacement CBRs (also in line with CAB 2016), although some banks have had difficulties. Available SWIFT data also point to a decline in active correspondent banks over the 2011–15 period, accompanied by declining value of cross-border transactions.5

Box 12.1.Potential Macroeconomic Impact of Loss of CBRs: An Illustrative Case for Belize

Following the taxonomy of channels through which correspondent banking relationships (CBRs) can affect an economy as described in the main text, bank-level data are used to illustrate the potential impact of the withdrawal of CBRs in Belize, which has experienced the largest loss of CBRs of all countries in the Caribbean. The analysis examines the effect on exports and imports, foreign direct investment (FDI), remittances, bank deposits, disposable income, and bank balance sheets from the inability of economic agents to send or receive cross-border payments. The exercise simulates two scenarios, a “low-stress” scenario that assumes that loss of CBRs reduces the value of cross-border transactions by 10 percent, and a “high-stress” scenario in which 70 percent of transactions are eliminated.

Key Findings

The loss of CBRs could have a sizable impact on economic activity and financial stability. Fewer CBRs, the different business models of the local banks, and stricter due diligence requirements could remove many economic agents from formal trade and finance channels. Under the high-stress scenario, real GDP could drop by as much as 5.3 percentage points annually relative to the baseline during 2017–21. Trade (that is, the value of exports and imports of goods and services) would fall by 23–26 percentage points of GDP during the same period, and FDI would decline by about 1.9–2.5 percentage points of GDP. The banking system’s capital adequacy ratio would fall by close to 7.5 percentage points but would remain above the prudential minimum of 9 percent, although some banks could become insolvent.

Table 12.1.1Impact of the Loss of CBRs: Stress Scenarios Relative to the Baseline
20172018201920202021
Low-Stress Scenario
Changes in Real GDP (US$ million)−14.2−13.9−14.4−14.2−14.4
Changes in Real GDP Growth (percent)−1.0−1.0−1.0−0.9−0.9
Changes in Exports (percent of GDP)−3.3−3.3−3.3−3.3−3.3
Changes in Imports (percent of GDP)−3.7−3.6−3.5−3.5−3.5
Changes in FDI (percent of GDP)−0.3−0.4−0.4−0.4−0.4
Changes in Banks’ NFA (US$ million)−3.2−6.9−6.8−6.0−5.3
In months of imports−0.03−0.07−0.07−0.06−0.05
Changes in Banks’ CARs (percent)−3.6−3.5−3.4−3.2−3.1
High-Stress Scenario
Changes in Real GDP (US$ million)−75.6−76.2−76.4−77.1−78.9
Changes in Real GDP Growth (percent)−5.3−5.2−5.1−5.1−5.1
Changes in Exports (percent of GDP)−23.3−23.1−22.8−22.8−22.8
Changes in Imports (percent of GDP)−25.7−24.9−24.6−24.6−24.6
Changes in FDI (percent of GDP)−1.9−2.6−2.5−2.5−2.5
Changes in Banks’ NFA (US$ million)−22.2–48.2−47.6−41.7−36.9
In months of imports−0.2−0.5−0.5−0.4−0.3
Changes in Banks’ CARs (percent)−7.4−7.3−7.1−7.0−6.9
Sources: Central Bank of Belize; and IMF staff calculations.Note: CAR = capital adequacy ratio; CBR = correspondent banking relationship; FDI = foreign direct investment; NFA = net foreign assets. For details, see IMF 2016a.
Sources: Central Bank of Belize; and IMF staff calculations.Note: CAR = capital adequacy ratio; CBR = correspondent banking relationship; FDI = foreign direct investment; NFA = net foreign assets. For details, see IMF 2016a.

Even in cases in which respondent banks have maintained CBRs, certain types of services have been adversely affected. The services most affected include operations that are cash intensive or that involve large numbers of relatively small transactions. Thus, all countries that responded to the IMF survey reported that money transfer services have been affected, including cambios in Jamaica, where a leading bank no longer accepts foreign instruments and remittances from some money services businesses. A bank in The Bahamas has lost its cash-intensive Western Union money transfer business. Other bank services that have been negatively affected include foreign currency check clearing, cash letter deposits, bank draft settlement, trade finance, and routing of funds for charities and foundations (CAB 2016; CARICOM 2016).

The costs of maintaining correspondent banking services have risen substantially in some cases. Such costs can be both explicit (charges by correspondent banks for accessing CBRs) and implicit, such as those arising from more robust due diligence efforts, expenses dedicated to improvements in AML/CFT compliance, and training of employees. The IMF survey found that correspondent banking fees have increased for some of the banks in each Caribbean jurisdiction (Figure 12.2). In the Eastern Caribbean Currency Union (ECCU), for example, correspondent banking fees doubled or tripled for some banks. In Belize, costs of cross-border transactions, particularly wire transfers, have also increased significantly (CARICOM 2016). The IMF survey found that some of the costs, both explicit and implicit, may be transmitted to consumers: jurisdictions that noted an increase in explicit correspondent banking fees generally reported significant increases in fees charged to bank customers for wire transfers and foreign currency drafts. However, available data do not definitively point to an increase in the cost of inbound remittances.

Figure 12.2.Cost of CBRs and Remittances

Sources: Panels 1 and 2, country authorities and banks; panel 3, World Bank, Remittances Prices Worldwide (http://remittanceprices.worldbank.org).

Note: In panels 1 and 2, the bars represent ranges of increases in fees over past five years as reported in IMF 2016b. In panel 3, the lines represent an average cost of sending an equivalent of US$5OO to a particular destination from sources covered by the database. CBR = correspondent banking relationship; ECCU = Eastern Caribbean Currency Union. Data labels in figure use International Organization for Standardization (ISO) country codes.

To safeguard their CBRs, some respondent banks have terminated relationships with clients from certain sectors, notably those undertaking seemingly riskier businesses. In Belize, for example, banks have discontinued processing international wire transfers for credit unions because this process represents “nesting,” that is, a situation in which a financial institution uses the CBR of another bank to carry out cross-border transactions. Nesting is strongly discouraged, and in many cases prohibited by the correspondent bank because of concerns about the inability of the respondent bank to carry out appropriate due diligence on the customer of the financial institution that is generating the transaction. For similar reasons, foreign-owned banks in St. Vincent and the Grenadines discontinued deposit services to local credit unions in mid-2016, resulting in a consolidation of credit unions’ deposits in an indigenous bank. Termination of banking services to online gaming companies in some ECCU jurisdictions has forced these companies to search for banking services providers in Asia. According to the IMF survey results, services to customers in gambling and gaming sectors have also been negatively affected in The Bahamas, Suriname, and Trinidad and Tobago. Although statistics are unavailable at this stage, anecdotal evidence suggests that some banks have increased the level of scrutiny for deposits associated with citizenship programs in some ECCU jurisdictions, refusing to accept such deposits in some cases.

As respondent banks have replaced lost CBRs, there has been a change in the type of correspondent banks serving the region. Historically, banks in the Caribbean had CBRs with major international banks, mainly of U.S. origin, given the importance of U.S. dollar transactions. Because these banks have withdrawn from the region, some Caribbean banks report establishing replacement relationships with smaller, less well known (“second tier”) banks (IMF 2016b). In Belize, some banks managed to establish relationships, often with a restricted menu of services, with banks in Europe and Asia, or with smaller banks in the United States.

The withdrawal of CBRs has had a more serious impact on the offshore financial sector. CBRs are particularly important for offshore banks, which rely on international transactions for their core business. Regulations in several jurisdictions also require an offshore bank to have an active CBR before a license is granted or renewed. Declines of CBRs in this sector and the resulting decline in the number of license applications have put the future growth of the offshore sector at risk in many Caribbean economies.

  • In St. Lucia, for instance, several offshore banks have had their CBR relationships terminated; some of these banks have been unable to find replacements. Some newly licensed offshore banks have been unable to commence operations, while others have had to surrender their licenses, largely because of the inability to establish CBRs.6
  • In Belize, whose five offshore banks were the most affected, 13 out of 16 CBR accounts were lost from April 2015 to February 2016. Thus, offshore banks have scaled down operations, and domestic banks now play a greater role in the banking system.
  • In The Bahamas, responses to a 2016 central bank survey revealed that 10 offshore banks had CBRs terminated or restricted, up from just three banks the previous year.7
  • Meanwhile, the provision of banking services to international business companies (IBCs) has declined consistently across the Caribbean, largely affecting Barbados and the ECCU.
  • In Barbados, banks have terminated relationships with some corporate vehicles established in the international business and financial services sector, which is depressing that sector’s growth prospects.8 This phenomenon has been largely reflected in the closing of entire business lines, termination of services, or placement of arduous restrictions on IBC accounts. Some IBCs reportedly have also had to search for alternative financial partners in other jurisdictions. Along with greater due diligence and scrutiny, account terminations and waiting periods for new accounts have increased significantly, jeopardizing future development of the IBC sector.

Potential Factors behind the Withdrawal of CBRs

Withdrawal of CBRs reflects business decisions by global banks. They have reassessed their individual business models, adopting different strategies in response to changes in the macroeconomic and regulatory environment. In general, macroeconomic conditions, such as persistently low interest rates since the global financial crisis, together with changes in regulatory frameworks have reduced the attractiveness of high-volume, low-return business lines like correspondent banking.

Four main groups of factors have contributed to global banks’ decisions to end their CBRs. First, compliance issues related to AML/CFT regulations are the most often cited reasons for termination of CBRs, in the context of more aggressive enforcement by regulators, especially in the United States. Second, tax transparency agreements impose an additional regulatory burden that carry their own set of compliance costs. Third, trade and economic sanction violations have very large fines and require another layer of due diligence. Fourth, additional profit-and risk-related reasons for withdrawing CBRs, not directly related to AML/CFT compliance, reflect shifts in the banking landscape since the global financial crisis. These factors are not mutually exclusive and any one of them can be a sufficient reason for a bank to decide to terminate a CBR. Examining these factors can help explain the extent to which Caribbean countries have been affected by the withdrawal of CBRs.

More Intense AML/CFT Efforts

AML/CFT compliance–related issues are the most widely referenced reason for withdrawal of CBRs. The international standard for AML/CFT efforts was updated by the Financial Action Task Force (FATF) in 2012 with a view toward broadening the assessment to include effective implementation and with a greater emphasis on a risk-based approach. The compliance costs associated with the due diligence required to meet these standards, combined with low expected profits and the large fines and reputational damage for violations, are primary reasons given for withdrawing CBRs (World Bank 2015). Banks have identified potential channels of exposure to AML/CFT risks associated with shortfalls in the supervisory or legal frameworks in the countries of the respondent banks; uncertainty about the quality of respondent bank’s customer due diligence processes; and the presence of relatively higher-risk businesses such as money or value transfer services, payment settlement services, offshore sectors, or gaming, especially those businesses lacking physical presence (IMF 2017).

Various characteristics of the Caribbean economies make them more vulnerable to perceptions of potential AML/CFT risks. For example, many Caribbean countries tend to transact a higher-than-average volume of remittances per capita (see Figure 12.1). Money or value transfer services can be a channel through which banks face exposure to AML/CFT violations owing to the large number of cash transactions (often in relatively small amounts per transaction), which makes due diligence more challenging. Another common feature of several Caribbean economies is the presence of cash-intensive casino operations or online gambling. In some cases, regulation and supervision of both money or value transfer services and gaming operations are less established than for the banking system and, as a result, may elicit concerns from correspondent banks. Several Caribbean jurisdictions also offer offshore services, which are sometimes perceived to be higher-risk businesses.

Available evidence reveals no clear relationship between the loss of CBRs and compliance with the 2002 FATF standard in the Caribbean (Figure 12.3). This is consistent with results in Collin, Cook, and Soramaki (2016), who examine the impact of AML/CFT regulation on cross-border transactions using detailed SWIFT payment data. They find that while inclusion of a country in a list of high-risk countries reduces the number of payments received from other jurisdictions, there is no impact on outgoing payments. This finding is also aligned with the results presented by IMF (2017), indicating that correspondent banks are more focused on the quality of an individual relationship with a respondent bank than on the country’s AML/CFT framework.

Figure 12.3.CFATF Ratings and Changes in Cross-Border Transactions

Sources: Bank for International Settlements; Caribbean Financial Action Task Force (CFATF); and IMF staff estimates and calculations.

Note: The charts plot percent change in volume or value of CBR transactions during 2012–15 against the ratings (authors’ assessment) based on the latest follow-up reports of the Third Mutual Evaluation Report. C = compliant; LC = largely compliant; NC = noncompliant; PC = partially compliant. Higher values on the vertical axis represent better anti-money laundering/combating the financing of terrorism compliance. Each color represents a country. Bubble size represents the number of categories corresponding to a particular rating (for each color-coded country). For example, looking at the light-blue color-coded country, although the CFATF ratings are high (that is, all categories compliant or largely compliant), the country still experienced a large decline in the volume of CBR transactions. Follow-up reviews of the Third Mutual Evaluation Reports based on the 2002 FATF standard are used except for Jamaica and Trinidad and Tobago, where the latest CFATF ratings refer to the Fourth Mutual Evaluation Report (based on the 2012 FATF standard).

Caribbean countries have made significant progress since their initial AML/ CFT assessments.9 To address new and emerging issues, and to clarify and strengthen many of the existing obligations, FATF released a set of revised standards in 2012 that seek to assess the effectiveness of the AML/CFT institutional framework, with a focus on a risk-based approach. However, at this stage, only two Caribbean countries, Jamaica and Trinidad and Tobago, have completed the initial evaluation based on the 2012 FATF recommendations. Both countries were assessed with at least a “moderate” level of effectiveness in about half of the categories and a “low” rating in the other half.

Increased Focus on Tax Transparency

Increased global pressure in recent years to enhance tax transparency may have contributed to the loss of CBRs. This issue is particularly relevant for jurisdictions that have offshore financial services centers, including several Caribbean countries, and that have traditionally relied on zero or low tax rates to attract business. Offshore financial services are a major industry in many Caribbean countries. As a result, several jurisdictions that in the past have been identified as destinations for tax avoidance have come under increasing international pressure to share more information in a timelier fashion. For example, failing to comply with the U.S. Foreign Account Tax Compliance Act (FATCA) can have serious consequences for countries doing business with U.S. firms. Compliance with tax information agreements, such as FATCA and the Organisation for Economic Co-operation and Development’s (OECD’s) tax information exchange agreement and Common Reporting Standard (CRS), imposes an additional regulatory burden that increases compliance and transaction costs (Erbenová and others 2016). This increase in costs, as well as the cost of potential fines and associated reputational risks, is likely to reduce global banks’ appetite for dealing with offshore financial institutions (Worrell and others 2016).

Several Caribbean jurisdictions have or are in the process of entering into agreements to share tax information. Most Caribbean countries are already implementing FATCA or are moving toward FATCA compliance (Table 12.2). The OECD Global Forum on Transparency and Exchange of Information for Tax Purposes assesses jurisdictions according to three key criteria for tax transparency: (1) compliance with the standard for exchange of information on request, (2) commitment to implement the CRS on automatic exchange of information, and (3) participation in the Multilateral Convention on Mutual Administrative Assistance in Tax Matters. Many Caribbean countries comply with at least two of the three criteria. Many countries have agreed to a multilateral agreement on tax information sharing and are committed to the CRS, which standardizes the financial account information to be shared and implements an automatic exchange of information (Table 12.2).10 However, implementation of the CRS is at an early stage, requires significant effort toward both domestic legislation and international negotiations, and is not expected to be completed before 2018.

Table 12.2.Tax Information Compliance1
United StatesOECD
JurisdictionFATC AConvention on Mutual Administrative Assistance in Tax MattersCommitted to First Exchange under CRS1Multilateral (MCAA) or Bilateral Exchange AgreementCompliance with EOIR
Anguilla
2017MCAAPC
Antigua and Barbuda
2018MCAAPC
Aruba
2018MCAALC
The Bahamas
2018BilateralLC
Barbados
2017MCAALC
Belize
2018MCAALC
Curaçao
2017MCAAPC
Dominica
2018BilateralPC
Grenada
2018MCAALC
Guyana
-
Jamaica
-LC
Montserrat
2017MCAALC
St. Kitts and
2018MCAALC
Nevis
St. Lucia
2018MCAALC
St. Vincent and the Grenadines
2018MCAALC
Suriname
-
Trinidad and Tobago
2017BilateralNC
Sources: U.S. Treasury; and OECD.Note: CRS = Common Reporting Standard; EOIR = Exchange of Information on Request; FATCA = Foreign Account Tax Compliance Act; LC = largely compliant; MCAA = Multilateral Competent Authority Agreement; NC = noncompliant; OECD = Organisation for Economic Co-operation and Development; PC = partially compliant.

As of September 19, 2016. In Trinidad and Tobago, FATCA legislation was passed by the House of Representatives and the Senate in early 2017, and is currently awaiting proclamation by the president. http://www.oecd.org/tax/automatic-exchange/international-framework-for-the-crs/MCAA-Signatories.pdf.

Sources: U.S. Treasury; and OECD.Note: CRS = Common Reporting Standard; EOIR = Exchange of Information on Request; FATCA = Foreign Account Tax Compliance Act; LC = largely compliant; MCAA = Multilateral Competent Authority Agreement; NC = noncompliant; OECD = Organisation for Economic Co-operation and Development; PC = partially compliant.

As of September 19, 2016. In Trinidad and Tobago, FATCA legislation was passed by the House of Representatives and the Senate in early 2017, and is currently awaiting proclamation by the president. http://www.oecd.org/tax/automatic-exchange/international-framework-for-the-crs/MCAA-Signatories.pdf.

International Sanctions

Economic and trade sanctions require banks to implement another layer of compliance and due diligence. Like AML/CFT violations, sanctions can result in expensive fines and increase the cost of maintaining CBRs. Evidence indicates that countries that face U.S. economic and trade sanctions have seen a larger decline in CBRs as well as in the volume and value of CBR transactions. For Caribbean countries and their domestic banking systems, this is unlikely to be an important driver of CBR withdrawals in the region. However, even though Caribbean countries have not been directly affected by those sanctions, they are indirectly affected (and therefore subject to increased scrutiny for customer due diligence) because offshore banks in the region facilitate international transactions from all over the world and citizenship-by-investment programs receive applicants from around the world, including from countries subject to sanctions.

Lower Profitability and Risk Aversion by Global Banks

Global banks have also decided to withdraw CBRs because of the macroeconomic environment and the enhanced prudential regulations they face. Since the global financial crisis, banks have been reexamining their business practices for exposure to risk. Vulnerabilities in banking systems as well as in individual banks during the crisis have led to consolidation of the banking sector, particularly in the United States and Europe. Regulators have also sought to increase buffers, requiring banks to hold more capital and more liquid assets, thus increasing the cost of holding risk in their balance sheets. In addition, the low growth, low interest rate environment has prompted banks to become leaner and more risk averse while concentrating on higher profits and core businesses, leading them to withdraw their CBRs, particularly from jurisdictions with low volumes or regulatory shortfalls (Erbenová and others 2016).

As small states, the Caribbean countries are likely to generate a relatively low level of CBR transactions, making it more difficult for correspondent banks to generate economies of scale and therefore higher profits from CBR activity. Countries with smaller or less developed financial systems may also present fewer opportunities for “bundling” less profitable CBR activities with other financial services activities that can generate profits. However, there is no statistical evidence that the size of the country or the domestic banking sector matters for CBR loss.11 Many Caribbean countries have, however, experienced relatively low real GDP growth since the global financial crisis, and some evidence suggests that stronger economic activity is associated with an increase in the number of CBRs and in the value of CBR transactions.

Our analysis suggests that some of the drivers mentioned above may have played a role in the withdrawal of CBRs.12 The results point to statistically significant correlations between CBR loss and a set of explanatory variables that serve as proxies for potential drivers at the country level, although these drivers explain a relatively small portion of the change in CBR activity (Table 12.3):

  • Size and growth. The proxy for size—log of nominal GDP—has the expected positive (but not statistically significant) sign for the change in active CBRs and change in the value of transactions. Somewhat counterintuitively, the size proxy is significant and negatively correlated with the change in volume of transactions. The regressions indicate that an increase in economic activity is perhaps the most important determinant of changes in CBR activity, suggesting that banks remain profit driven and will increase CBRs in a country experiencing growth.
  • Other. As expected, U.S. economic and trade sanctions are an important determinant of changes in CBR activity. The European Union crisis indicator variable is also highly significant, with large negative estimates for all three dependent variables. This outcome is in line with the notion that banking crises have negative effects on foreign transactions and on CBRs. The significant negative estimate for the constant term in the regression that models changes in active CBRs suggests that, to some extent, the decline in CBRs may be a general phenomenon that is due to reasons not captured in the econometric model.
  • Caribbean. Controlling for several possible determinants of CBR activity, the regressions point to the expected negative (albeit not always statistically significant) estimates of the regression coefficients on the Caribbean dummy variable, suggesting that the decline in CBR activity may be more pronounced in the Caribbean for reasons not captured in the other explanatory variables. In addition, a negative sign is observed for changes in CBR values and volumes for offshore financial centers, as expected.
Table 12.3.Regression Results
(1)(2)(3)
VariablesChange in CBRsChange in VolumesChange in Value
Caribbean−0.439

(0.865)
−5.982

(0.367)
−18.23*

(0.0732)
Offshore Financial Center1.013

(0.607)
−6.320

(0.213)
−3.193

(0.680)
Real GDP Growth, 2011–15 Average0.498***

(0.000840)
1.169***

(0.00225)
0.998*

(0.0847)
Log (Nominal GDP in US$)0.0935

(0.751)
−1.816**

(0.0176)
0.812

(0.484)
U.S. Sanctions−7.336***

(0.00872)
−6.605

(0.355)
−24.13**

(0.0278)
European Union Crisis−20.10***

(2.42e-07)
−33.29***

(0.000676)
–47.60***

(0.00143)
Constant−3.151**

(0.0277)
20.31***

(1.03e-07)
1.341

(0.810)
Observations176176176
R20.2310.1680.129
Source: IMF staff estimates and calculations.Note: CBR = correspondent banking relationships. p-value in parentheses.*** p < 0.01, ** p < 0.05, * p < 0.1
Source: IMF staff estimates and calculations.Note: CBR = correspondent banking relationships. p-value in parentheses.*** p < 0.01, ** p < 0.05, * p < 0.1

Policy Options to Address the Loss of CBRs

The loss of CBRs has generated great concern throughout the Caribbean. At the regional level, via CARICOM, Caribbean policymakers have established a task force to study the de-risking phenomenon, and have made it a key aspect of their engagement and dialogue with international financial institutions and advanced economy financial regulators and political leaders.13

Given the various drivers, there is no “silver bullet” that can solve the problem of withdrawal of CBRs. Coordinated efforts by various stakeholders are called for to mitigate the risk of financial exclusion and the potential negative impact on financial stability (IMF 2017). Policy initiatives must address drivers related to risk or risk perceptions as well as those related to profitability.

Initiatives to Address Drivers Related to Risk or Risk Perceptions

  • Ensure compliance with international standards. Caribbean countries need to continue to prioritize efforts to meet international AML/CFT and tax transparency standards. For example, national programs to ensure compliance with the 2012 FATF standards should move ahead expeditiously, as should those aimed at complying with the OECD’s CRS on tax transparency and exchange of information. One notable example has been the ECCU’s move to consolidate national AML/CFT supervision into one regional operation at the Eastern Caribbean Central Bank to maintain consistent standards of supervision across the region and mitigate concerns about AML/CFT risks. Technical assistance by international financial institutions and the U.S. Treasury has been provided to aid capacity building. The efficacy of a regional information repository that could share information on suspicious transaction flows among regional financial intelligence units could enhance the effectiveness of countries’ AML/CFT frameworks and should be explored.
  • Clarify regulators’ expectations of global banks. Although regulators and international standards-setting agencies (such as FATF) have recently issued clarifications, correspondent banks still remain concerned about the clarity and consistency of regulatory expectations. Thus, more outreach by regulators would be beneficial. Authorities in some home countries of global banks are already taking steps to clarify regulatory expectations. For example, the U.S. Department of the Treasury has put considerable resources into educating financial institutions on the precise nature of transactions and behaviors that are subject to sanctions. In a recently issued fact sheet, it noted that 95 percent of AML/CFT-related violations are corrected without penalties, and the very few instances in which large fines have been imposed were a result of repeated failure to correct practices that had been ongoing for more than five years (Board of Governors of the U.S. Federal Reserve and others 2016). In addition, regulators should provide more guidance and oversight to banks regarding their voluntary remedial actions undertaken in lieu of formal enforcement actions by regulators. These voluntary actions, which in some cases go beyond what might have been required by regulators, have also influenced bank behavior in ways not necessarily intended by regulators. It is within this context that the FATF issued revised guidance on correspondent banking, clarifying, among other things, that “know your customer’s customer,” which correspondent banks had come to view as an obligatory part of their customer due diligence process, was not required.
  • Improve information sharing and communication between respondent and correspondent banks. Respondent banks in the Caribbean have at times been taken aback by the withdrawal of CBRs by correspondent banks after many years of a business relationship without any reason provided for the decision nor an opportunity to correct the unknown problem. Enhanced communication could allow global banks to express to respondent banks their own risk tolerance policies or their reasons for terminating a specific CBR. It would also allow respondent banks to better convey the steps that they have taken to address drivers of CBR withdrawal. Some global correspondent banks that maintain a strong presence in the region have highlighted their close engagement with their respondent banks as key to sustaining the relationship because it allows them to understand their clients’ customer due diligence protocols and provide guidance on what changes they require. Similarly, some respondent banks have indicated that their success in maintaining CBRs has been attributable to the close lines of communication they maintain with their correspondent bank. The Caribbean Development Bank is launching a program to assist commercial banks with raising their capacity to address the growing requirements associated with customer due diligence and transaction monitoring. Some respondent banks have noted that an important factor in maintaining CBRs has been their investment in automated transactions monitoring systems, which can quickly transmit information to correspondent banks when requested. To facilitate enhanced communication, countries may need to ensure that no legal barriers prevent cross-border information sharing.
  • Improve the quality of payment messages. The quality of information contained in payment messages can be improved to enhance information available to banks, helping reduce compliance costs and reduce concerns about the legitimacy of cross-border payments. To this end, all commercial banks regulated by the ECCB have complied with its instruction to adopt the SWIFT system. Establishing guidelines that would increase the amount of mandatory information contained in SWIFT messages would also be useful. In the longer term, the development of know-your-customer utilities that allow respondent banks to store and update their customer information, which could easily be accessed by correspondent banks, should continue to be pursued. Similarly, the wider adoption of standardized legal entity identifiers—to identify and trace distinct legal entities as they engage in financial transactions—should be promoted.
  • Special protocols for higher-risk activities by respondent banks. Terminating relationships with clients in high-risk sectors (such as gaming, offshore business, money transfer services, charities, and citizenship-by-investment) may indeed lower the overall risk level of CBRs and assuage concerns by global banks. However, such actions may exclude legitimate but risky business and hamper financial inclusion. An example is remittances, which are generally considered to be a high-risk activity but have an overall positive social and economic impact. Thus, respondent banks should develop special protocols, in consultation with their correspondent banks, for customer due diligence with respect to higher-risk but legitimate activities. A longer-term solution, which has been proposed by some regulators in the Caribbean, would be to replace the use of cash with digitized payments for commercial transactions to facilitate tracking the trail of the funds underlying the transactions.
  • Use central bank CBRs on behalf of a commercial bank’s clients. This approach could be a short-term or emergency measure in the event of a complete loss of CBRs in a country and has already been used in Belize. However, assessing the legal and operational feasibility of this solution, and the central bank’s ability to mitigate potential risk exposures so as not to jeopardize its own CBRs, would be important.

Initiatives to Address Drivers Related to Profitability

  • Consolidate transactional traffic to exploit economies of scale.
    • The Caribbean’s small size and the high-volume, low-return nature of correspondent banking may suggest that region could be “overbanked” from the standpoint of the number of correspondent banks serving the region. Coordination among respondent banks to maintain or establish CBRs with fewer specific correspondent banks could provide economies of scale and increase the volume of transactions and income for those correspondent banks and reduce their average costs associated with providing correspondent banking services. Such consolidation is already taking place because of the exit of some correspondent banks. The consolidation of transactional traffic through “downstreaming” is also gaining traction in the region. Downstreaming refers to a situation in which the correspondent bank has a relationship with an intermediary bank, which has relationships with other respondent banks and provides for a transparent flow of customer and transaction information to the correspondent bank.
    • An alternative way to consolidate transactional traffic would be for respondent banks to bundle correspondent banking services with other products. Thus, a respondent bank can offer its correspondent bank additional business lines (for example, credit card clearing, letters of credit, and wealth-management operations). This bundling would generate economies of scale by allowing the correspondent bank to use the same robust compliance system to spread the cost of compliance over a wider set of banking services.
    • The consolidation and merger of small respondent banks is another potential solution that could produce sufficient volume and profitable traffic to large foreign correspondent banks, as well as provide economies of scale to reduce average due diligence costs for both correspondent and respondent banks. For the respondent banks, the investment in more sophisticated information technology systems and implementation of better risk management protocols for higher-risk activity becomes more feasible, thereby also addressing risk concerns of the correspondent bank. The ECCU is promoting this solution for the subregion, but it will take some time. However, some banks are already exploring possible mergers.
  • Increase fees charged by correspondent banks. Charges have already increased across the Caribbean, and respondent banks have passed some of these costs on to customers. There may also be scope for risk-based pricing by correspondent banks to allow them to factor compliance costs into their fee structure and make the risk-return profile more favorable. However, higher prices for cross-border transactions, although allowing CBRs to be maintained in some cases, will have a negative effect on both competitiveness— by raising the cost of doing business—and financial inclusion. The extent to which a respondent bank might pass on costs to its customers is, of course, limited, making this solution one of restricted scope and short-term effectiveness.
  • Explore technological innovations to reduce costs and improve risk management. Emerging Fintech solutions could provide a more efficient alternative to CBRs for carrying out cross-border transactions. For example, blockchain providers have suggested that their technology could alleviate some correspondent banking issues by reducing costs of transfers, improving risk management and transparency, and shortening the time required to settle transactions. However, these technologies, which correspondent banks are already exploring, seem to be longer-term solutions. Moreover, effective oversight frameworks for new payment methods would still need to be developed to safeguard public confidence and financial stability.
  • Subsidize compliance costs. Where compliance costs exceed the benefits from maintaining the business relationship and prevent financial inclusion, the public sector may need to consider subsidizing part of the compliance costs of respondent banks or the fees charged to their customers (or both). This approach may be required to sustain remittances or to safeguard access to finance for charitable organizations or trade finance for small and medium enterprises. However, such a solution may create market distortions and run into budgetary constraints and would face the practical challenge of defining the scope of categories at risk of being financially excluded.
  • Establish CBRs with smaller second- or third-tier U.S. banks. The provision of correspondent banking services to small Caribbean banks could provide a more significant income stream for smaller banks than for the major international banks and hence may fit better into their business models. Given the smaller scale, the costs and fees would likely be higher than those charged by large banks, but (1) respondent banks would avoid withdrawal of CBRs and (2) given the importance of the relationship to both sides, the correspondent bank would have an incentive to understand the respondent bank’s business model, customer due diligence processes, and the like, and potential cost savings could be explored. Caribbean banks have been reasonably successful in establishing new CBRs with smaller correspondent banks to replace lost CBRs with major international banks. However, moving toward second- or third-tier providers may also carry reputational costs for respondent banks, including because these lower-tier banks may process transactions less efficiently than their first-tier counterparts.

Conclusion

Global banks have reassessed their individual business models, adopting different strategies in response to changes in the macroeconomic and regulatory environment that have lowered the expected profitability of correspondent banking. Depending on specific country characteristics and those of the correspondent and respondent banks, we see a full spectrum of outcomes: some global banks have broadly withdrawn from CBRs worldwide, others have withdrawn from the Caribbean region or a particular country (Belize, for instance), others have targeted individual banks, and others have maintained services only to a restricted set of clients of respondent banks and charged higher fees.

Available evidence confirms that the number of CBRs and the value of CBR transactions have indeed fallen in several Caribbean countries over the past few years. Some services, such as international wire transfers, and sectors, such as offshore financial services and gaming, have been particularly affected. However, the loss of CBRs has so far not resulted in major disruptions to financial intermediation. Most Caribbean banks have found replacements or are coping with a reduced number of CBRs. Although a confluence of factors potentially drive this phenomenon, evidence for the Caribbean points to specific perceived risk factors related to respondent-bank business models. For example, banks in various countries are involved in activities that global banks consider riskier, such as offshore financial services and banking services to the gaming industry. Indeed, there is some evidence that the reduction in CBR activity has been more pronounced in countries that are offshore financial centers. In contrast, the available data provide little support to the suggestion that the size of the economy or the banking system is an important driver. The size of the bank could be important, however.

Further loss of CBRs remains a significant risk to the region and could have large economic costs. Caribbean countries are small open economies with extensive links to the global economy, making them vulnerable to a loss of CBRs. A disruption in CBRs could adversely affect the economy through several links, including (1) reduced international trade, remittances, and investment flows; (2) higher costs of doing business; and (3) direct negative impacts on key sectors or activities (such as gaming and offshore financial sector and citizenship-by-investment programs). Stress scenarios that attempt to model these links using bank-level data in Belize suggest that the loss of CBRs could result in a sizable reduction in real economic activity, ranging from 1 percent of GDP in a low-stress scenario to up to 6 percent in a high stress-scenario.

Caribbean authorities have taken several steps to address risks. Caribbean authorities are strengthening the region’s voice in global forums and are improving communication across stakeholders. Country-specific efforts are also underway to improve compliance with international standards and enhance risk-based supervision, even though challenges remain in ensuring effective implementation of national AML/CFT frameworks.

Nonetheless, enhanced international coordination and action by all stakeholders are still required to address the CBR challenge. Home authorities of global banks should continue to proactively communicate their regulatory expectations to correspondent banks. International standards-setters need to be more mindful of the unintended consequences to developing countries of efforts to improve the resilience of the international financial system. At the same time, the affected countries should continue to strengthen their regulatory and supervisory frameworks, including for AML/CFT, to meet relevant international standards, with technical assistance where needed. Respondent banks need to proactively engage with correspondent banks to reassure them of the adequacy of their own customer due diligence, transaction monitoring, and AML/CFT frameworks. Similarly, correspondent banks need to be more forthcoming with respondent banks about their expectations with respect to these issues. Industry initiatives will be crucial to facilitating enhanced customer due diligence expectations and to helping reduce compliance costs. Small respondent banks in the region should actively explore options, including through mergers or other forms of collaboration, to bundle transactions to generate more business volume for correspondent banks and improve their own risk management processes. In countries facing a severe loss of CBRs and diminishing access to the global financial system, the public sector may need to consider the feasibility of temporary emergency mechanisms, such as the use of the central bank’s CBRs, to avoid a disruption of crucial cross-border transactions. The IMF has launched a Caribbean CBR initiative to help the region find solutions in line with these recommendations. The initiative includes technical assistance in the area of AML/CFT as well as forums involving correspondent and respondent banks aimed at coming up with actionable policies, including related those related to improving communication and information sharing, consolidating transactions to exploit economies of scale, and addressing gaps in risk management.14

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This chapter is based on an IMF Working Paper (Alleyne and others, forthcoming) by the same authors.

1

IMF (2017) has argued that that the indiscriminate use of the term “de-risking” has confused the dialogue on the trends and drivers of the withdrawal or termination of CBRs.

2

Data show the number of banks that have been affected as a share of banks that were surveyed. Differences across the two surveys can be explained by different samples and time periods. The IMF Survey from Alleyne and others (forthcoming) covers all commercial banks in many countries, while CAB (2016) represents a sample of members of the Caribbean Association of Banks.

3

SWIFT, an electronic financial messaging system, is used to transact payments between financial institutions worldwide. Metadata attached to each transaction provide information about the sender and receiver and the type and purpose of the transaction.

4

The IMF survey, which is detailed in Alleyne and others (forthcoming), was undertaken in September 2016 in 14 Caribbean countries and covers commercial banks operating in the domestic banking system. The survey does not cover international (ofshore) banks, which primarily focus on providing services to nonresident customers. In some countries, the responses cover only a part of the onshore domestic banking sector.

5

Based on SWIFT data published in BIS (2015).

6

St. Lucia Financial Services Regulatory Authority, Annual Report, 2016.

7

However, the central bank warned that the apparent increase in affected banks could be explained partly by the difference in coverage between the 2015 and 2016 surveys.

8

See Worrell and others (2016) for a discussion of how more stringent regulations by advanced economy regulators have driven IBCs away from offshore financial centers in the Caribbean to those in advanced economies, despite equal or sometimes stronger institutional frameworks in the Caribbean.

9

Initial Caribbean Financial Action Task Force (CFATF) 3rd mutual evaluation of compliance with the 2002 FATF standards was conducted between 2007 and 2010 for most Caribbean countries. Most countries were found to be noncompliant or partially compliant in the majority of categories. Follow-up assessments were conducted to evaluate ongoing improvements in compliance.

10

Worrell and others (2016) compare several Caribbean international financial centers with those outside the region, including advanced economies, and argue that Caribbean compliance is comparable or superior.

11

The opportunity to generate profits from a higher volume of transactions is likely to depend more on the size of the financial institution than on the size of the country or the financial system. However, data on CBRs and correspondent banking transactions are not available at the bank level.

12

Based on SWIFT data reported in BIS (2015) for a sample of 204 economies, which includes estimates of changes between 2012 and 2015 (in percentage terms) in the number of active correspondents, volume, and value of SWIFT transactions.

13

The CARICOM Task Force on De-Risking is led by the prime minister of Antigua and Barbuda, with technical work coordinated by the Central Bank of Barbados.

14

IMF (2017) provides some detail on the results of the first roundtable held in Barbados in February 2017.

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