De-Risking in International Banking, Part 1: Understanding the Problem
In recent years, as U.S. regulators have stepped up enforcement of laws designed to curb illicit finance, large international banks have begun exiting relationships with countries or client sectors perceived to be high-risk or else not worth the cost of compliance. This phenomenon, known as “de-risking,” poses a challenge to financial inclusion and may disrupt international trade and financial flows. Those most affected by de-risking often are already among the most vulnerable populations, such as migrant workers and people living in fragile states. Ironically, de-risking may even make it harder to combat illicit finance by pushing more activity (both legal and illegal) into unregulated channels.
Until last year, however, what was known about de-risking was largely anecdotal, and the extent and scope of the problem remained a matter of debate. That has changed with the publication of compelling new evidence by the World Bank and others that confirms the seriousness of the de‑risking problem, while also demonstrating that its impact has fallen unevenly across different regions and sectors. Among the hardest-hit regions are the Caribbean and sub-Saharan Africa and among the hardest-hit sectors are correspondent banking, remittances and trade finance. As the issue has gained traction among policymakers, the conversation has evolved to focus on devising workable solutions to de-risking while maintaining the integrity of the financial system.
For the Milken Institute’s Center for Financial Markets (CFM), it was the appropriate time to host a follow-up to last year’s roundtable on de-risking. At a recent high-level policy dinner in Washington, D.C., CFM facilitated an informative and vigorous discussion among more than 20 representatives of major banks, law firms, affected parties and nonprofit organizations, as well as the U.S. government and multilateral agencies.
As a response (at least partly) to more stringent anti-money-laundering/combatting-the-financing-of-terrorism (AML/CFT) enforcement, de-risking is a striking example of how difficult it can be to effect a policy change without introducing adverse side effects, especially in a complex ecosystem like international banking.
For the banks engaged in de-risking, a wide array of factors may shape their decision-making process, not just money laundering/financing terrorism (ML/FT) risk and its attendant compliance risk. There are, for example, uncertainties that banks face — about whether they fully understand what regulators expect of them; about how severely they might be punished if they fall short; about the efficacy of their own ML/FT risk controls and those of their clients or counterparties; and about how well they understand the transactions they are being asked to process (opacity is still a problem in international banking). Profitability is another factor. As compliance costs have risen, so has the hurdle rate for maintaining customer accounts and business lines. And low-margin business lines like correspondent banking, which depend on high volume to be profitable, have been squeezed. Finally, there are shifting opportunity costs. As new prudential requirements have raised the cost of capital, banks are now giving more careful consideration to how they deploy their balance sheets. These factors have combined to make banks more conservative; for at least some of them, the burden of proof now rests on the question of whether to keep a business, not whether to exit it.
For their part, affected parties usually seek to meet the requirements of both their correspondent banks abroad and their local regulators. But these requirements are not always in perfect alignment, owing to variations in AML/CFT regulations across jurisdictions. What’s more, affected parties may face capacity constraints as well as legal limits on their ability to share information. Even if they do not, they still may not generate enough business to establish themselves on the right side of international banks’ increasingly conservative risk-return calculus.
Finally, financial policymakers and regulators remain deeply concerned with the abuse of the financial system by criminals, terrorists and sanctioned parties. Over the past decade, they have made AML/CFT safeguards a top priority for the financial system. And they are wary of jeopardizing their hard-won progress. Further, ISIS’s rampage, the latest in a cavalcade of transnational threats, ensures that political pressure for tough AML/CFT policies is unlikely to abate anytime soon.
In Part 2, we explore potential solutions to de-risking.