The Impact of EMU on Correspondent Banking Activities(1)

EBA


INTRODUCTION

Further to its Report on the Impact of EMU on Banks' Activities, published in June 1994, the Impact Study Committee of the Ecu Banking Association (EBA) resolved to pursue in more detail the analysis of the possible effects EMU may have on the Correspondent Banking business of banks located in the European Union. The present report reflects the joint assessment made as a result of the discussions within the Committee.

As it has been the case for its first report, the Impact Study Committee has refrained from quantifying this impact, given that the impact on both costs and revenues largely depends on the migration scenario decided by the relevant authorities and the state and appropriateness of preparations within each bank.


1. DEFINITION OF CORRESPONDENT BANKING

The Ad Hoc Working Group on EC Payment Systems, set up by the Committee of Governors of the Central Banks of the Member States of the European Economic Community, in its Blue Book of September 1992, referred to Correspondent Banking as "an arrangement under which one bank provides payment and other services to another bank. Payments through correspondents are often executed through reciprocal accounts (so-called nostro and vostro accounts), to which standing credit lines may be attached. Correspondent banking services are primarily provided across international boundaries but are also known as agency relationships in some domestic contexts". (Glossary, page 323)

Such a definition is, however, somewhat restrictive. For the purpose of this report, Correspondent Banking is used as a generic term covering a wide range of operations and services which a financial institution offers to other financial institutions, both at a domestic and the cross-border level.

These services include:

Beyond this type of definition, which is simply a typology of activities, the term Correspondent Banking can also designate a comprehensive business line encompassing all bank to bank products. The business development strategy may range from a broad cross selling strategy, often based on a concept of reciprocity, to the pursuit of individual product development strategies. This broad spectrum is due to the fact that banks can view other banks as clients, as counterparties and as competitors.

The development and pursuit of a Correspondent Banking business strategy therefore is regarded as task of high complexity which makes it a business line and profit centre of its own. Correspondent banking departments have increasingly assumed relationship management functions, being the focal coordinating contact point for all the services of one bank extended to another bank. This encompasses the credit function for all products, especially assessing the counterparty risk potential for all types of interbank credit and trading activities and settlement risks, i.e. spot foreign exchange transactions, derivatives or intra-day clearing limits.


2. RECENT EVOLUTION IN CORRESPONDENT BANKING

The important increase in cross-border trade since the Second World War, followed by a true opening and internationalisation of the financial markets in the 1980ies, generated an impressive amount of commercial cross-border transactions, securities operations and payment flows. In addition, the creation of the Single Market further enhanced the intensity of cross-border commercial trade in Europe. As a result, the demand for cross-border banking grew to significant levels.

Several trends have developed in the recent past in the evolution of the correspondent banking business.

The key elements are:

- the pressure to reduce costs and to rationalise operations,
- the evolution of technology in transaction processing and telecommunications,
- the internationalisation of the financial markets and the containment of risks,
- the change in the legal and regulatory environment, in particular with the creation of a Single Market in financial services (2nd Banking Directive) and the obligations laid upon the banks relating to the prevention of fraud, insider trading or money laundering.

The effects of these changes are manifold. Some of the more relevant ones for this study are:

- a. Where in the past business between banks used to be built largely on the mutual exchange of business based on reciprocity, there is now a trend towards considering correspondent banking services as a sort of "product" which is purchased under purely commercial considerations. This is all the more true for banks that have branches or subsidiaries in a foreign country and still opt for using other banks in that country for correspondent bank services.

- b. Whilst in the past correspondent banking services were usually offered free to other banks, it is now acknowledged that services are priced individually and separately. Accordingly, a number of factors other than reciprocity have grown in importance, namely service quality, accurateness, provision of more detailed information about transactions, credit ratings, etc. In line with this, most of the banks have reviewed and reduced the number of nostro accounts they maintain with other banks.

However, to the extent that quality standards are equal, reciprocity considerations come to the fore again in conjunction with the overall relationship target and return requirements.

- c. Given the considerable EDP investments required to play an active part in the transaction processing business, a dividing line seems to develop between those banks that do not have the critical mass of business to offer cost effective services and those that try to specialise therein. This trend also applies to correspondent banking services offered at the domestic level. Several members point out that the control procedures related to the prevention of fraud, insider trading or money laundering put a limit to automation, as these procedures require manual intervention and checking.

- d. In terms of business development strategy for cross-border services, some banks pursue a strategy of setting up their own units in different countries in order to build an in-house network for producing these services, whereas others tend to establish co-operation arrangements with banks from different countries in order to develop synergies amongst complementary institutions, particularly in the area of retail payments (i.e. low value payments).

- e. Settlement risk has become a matter of increased awareness and concern, be it for cost aspects related to the operational difficulties created by settlement failures, or for considerations of counterparty risk in case one leg of a transaction is settled independently of the other one. Concepts like DVP (Delivery versus Payment) in the securities area or PVP (Payment versus Payment) in the payments area are increasingly considered as a solution to these problems, provided progress can be made to achieve clear rules on finality of order execution, in particular in the crossborder environment. With regard to the specific risks arising from the disconnection of the two parts of a foreign exchange or swap transaction between two currencies settled in different time zones, there is a trend towards prolonged opening hours for European settlement agencies in order to have a time overlap with US settlement agencies. The extension of opening hours by European settlement agencies, in particular central bank RTGS systems, may lead to the introduction of intra-day overdraft charges, which in turn will require banks to operate their internal systems on a real-time basis as well.

As a different development, a number of banks are presently undertaking significant efforts in devising netting arrangements which aim at reducing the banks' exposure to the settlement risks in the global foreign exchange market. Such initiatives, if supported by clear rules on the validity of netting, will affect the FX exposure management of correspondent banks and have a major impact on capital adequacy matters. It is believed that a generalized use of cross-currency netting in FX transactions may have an effect on Correspondent Banking similar to the introduction of a Single Currency.

- f. At the European level, there are plans of the central banks aiming at introducing in each country Real Time Gross Settlement (RTGS) systems with the central bank as settlement agent, to be followed by an interlinking of these systems to serve as an infrastructure for executing high value cross-border payments. The impact of this evolution on Correspondent Banking is difficult to predict at this stage. It will largely depend on the timing of availability of such systems and their interlinking, their geographical coverage, the exact access conditions and costs as well as their competitive stance towards private commercial arrangements.

Considering these trends, it seems reasonable to believe that Correspondent Banking in Europe will further evolve towards concentration of transaction processing around institutions that specialise in this business and that undertake the necessary efforts to achieve critical mass of transactions. At the same time, proprietary features of correspondent banking networks will disappear for the benefit of greater standardisation and, to some extent, "commoditisation". This evolution may be characterised as a maturing of this business, opening the stage for large scale co-operative ventures and public utility minded institutions to compete with the larger banks that have built up a position of strength in the transaction processing business.

In line with this evolution, particularly on account of increasing standardization, some members of the committee would not exclude that non-bank organisations may be able and authorised to produce transaction processing, be it internally, i.e. for the benefit of a closed group of adherents to the organisation, be it through a more open and competitive approach for the market as a whole. This consideration stems from the fact that a significant part of the value chain covering transaction execution services is constituted by information processing and telecommunication. Accordingly, organisations that have built their strengths in these areas may consider it commercially viable to add transaction execution services to their product range.

At this stage, it is impossible to make a forecast on what will be the equilibrium amongst all these players. Obviously, this equilibrium will largely depend on the legal and regulatory framework, like for instance obligations with regard to speed and cost of cross-border transactions, risk containment criteria for interbank payment arrangements and access rules to such arrangements, or capital requirements for operators in the payments business. When viewed together, the foregoing trends signal a substantial contraction in the existing network, a material decline in income and strenuous competition within the banking industry.


3. POSSIBLE EFFECTS OF EMU ON CORRES-PONDENT BANKING

Several issues can be raised in this context:

- Will commercial customers shop anywhere in the EMU for transaction processing services and move away from "their domestic bank", which took care so far of their payments to staff, suppliers, authorities, etc?
- Will securities markets migrate progressively to the places where bigger players provide the highest liqui-dity? Will there be competition between domestic settlement houses? How will the custodian business in "domestic securities" be affected?
- Will some countries opt for regulations aiming at facilitating the transaction processing operations, favouring thereby the concentration of this business in their banking centres?
- Will discrepancies in the legal and regulatory environment affect the creation of private cross-border payment arrangements? Will the creation of the Single Currency area impact the phenomenon of disinter-mediation?
- Will central bank based payment systems, at the national and European level, be offered as a "public utility", accessible to all banks and thereby providing a real opportunity to any bank to participate in the payments business?
- Finally, at a more fundamental level, there is a question whether the payments business, as part of Correspondent Banking, will still serves as an element in the reciprocity considerations among banks?

As stated in the Interim Report of the EMU Impact Study Committee, EMU will affect the banks' general activities due amongst others to :

- the disappearance of certain activities related to the coexistence of different domestic currencies,
- important scale effects fuelled by the creation of a considerably enlarged currency area.

These factors also apply to Correspondent Banking. Since non-resident banks so far did not generally participate directly in domestic interbank funds transfer systems and did not normally hold accounts at the central bank, they had to resort to the services of domestic banks in that country if they were requested by their customers to offer cross-border payment services in the currency of that country. Accordingly, banks in a given country, or in other words in a given currency area, benefited from a kind of franchise in offering correspondent banking services in that currency. This franchise will disappear with EMU.

At the same time, the creation of a Single Currency area including a major part of the European economy, sets the stage for a very large market with regard to Ecu transactions processing, be they execution of payments, facilitation of trades or settlement of securities transactions. This however does not mean that the volume of Ecu transaction processing in the EMU environment necessarily exceeds the sum of the transactions carried out in the present domestic currencies; it only says that there will be a very large single market in Ecu compared to present more or less large markets in the different domestic currencies. As such, the new Single Currency market provides an opportunity for banks to invest in their processing capabilities and thereby achieve significant scale effects in their operations.

In addition, the increase in the size of the market will lead to an increase in the size of transactions. This trend will again favour the position of those banks that develop the sufficient strength to credibly offer processing services for transactions of considerably increased size.

The possible scale effects are not only a matter for Correspondent Banking, they affect a bank's overall position in the business and relate to its strategy with regard to targeted size, geographical coverage and willingness to line up with other banks in creating co-operative ventures, i.e. payment clubs or other network arrangements.

The most likely scenario is that many smaller and medium sized players in the payments business will shy away from new investments on cross-border transactions processing and information technology and therefore will be bound to abandon this line of business while larger banks, with huge processing capabilities, will be able to increase their market share and revenues, either by receiving directly more transactions from their correspondents abroad or by private labelling of custody, clearing and cash letter services to domestic correspondents. The likely two-speed integration will give a competitive advantage to banks of the first tier core countries with a single currency as they will be able to attract the bulk of the account and clearing business in the new currency.


4. THE SPECIFIC CONDITIONS FOR THE EVOLUTION OF THE PAYMENTS BUSINESS DURING STAGE 3A OF EMU

As outlined in the Interim Report, Stage 3 of EMU may see at its beginning a prolonged period of coexistence of domestic currencies at fixed conversion rates, with the Ecu having a scriptural circulation only. This situation affects in a specific manner the role of Correspondent Banking as far as cross border payments between EMU member countries are concerned.

In order to illustrate the situation, one can take the case where Customer A in country A requests his Bank A to settle a bill for 1,000 A francs for the benefit of Customer B in country B, account with Bank B. The conversion rates being 1 Afranc = 2 Ecus = 5 B francs. The question then is whether

- Bank A will advise Bank B that it is credited with 1,000 A francs in its books for the benefit of Customer B, or whether:
- Bank A will advise Bank B to credit Customer B for the equivalent of 1,000 A francs, with 2,000 Ecus cover coming through an Ecu payment system. Bank B will then credit Customer B in the currency unit that suits him best, e.g. 1,000 A francs, 2,000 Ecus or 5,000 B francs.

The question has its relevance because of the full convertibility of the three involved currencies at a fixed rate. In other words, because of the fixing of conversion rates, there is no more any difference in substance, there is only a difference in the labelling of the currencies involved. It is then up to the customer to indicate in which currency he wants his value to be labelled. Given this convertibility, the question is whether banks will wish to continue using correspondent banking type nostro/vostro account relationships for executing cross-border payments, or whether they will consider these as redundant compared to using Single currency payment networks. It seems a priori that the administrative burden related to handling cross-border payments via the nostro/vostro accounts is no more justified.

This redundancy would rapidly accelerate, already at the beginning of Stage 3, the substitution of correspondent banking account relationships by cross-border payment arrangements in Ecu. More generally, the wholesale level in bank services will rapidly, though progressively, be denominated entirely in Ecu and rely upon Ecu based settlement systems. This development represents a major opportunity for the EBA. The efforts undertaken at this stage to enhance the robustness of the EBA Clearing System and in particular the introduction of binding intra-day limits, coupled with emergency settlement facilities and risk sharing agreements, as well as the migration to a new technical platform, aim at strengthening the clearing system in order to provide a robust settlement infrastructure, both before and after the start of the third stage of EMU.


5. CONCLUSION

Not all of the questions set out above can be answered at this stage. Nevertheless, it seems legitimate to consider that the creation of EMU will accelerate the evolution that presently characterises Correspondent Banking domestically and internationally, i.e. increased competition, specialisation, concentration and maturing of business.

While this evolution tends to deter some banks from continuing their involvement in the transaction processing business at the wholesale level, it offers opportunities for others to increase their market share. In this sense, EMU will fuel strong pressures to offer higher-quality services at lower prices and bring about a general increase in the efficiency of transaction processing. It will be up to each bank to make its own assessment and to decide whether it wants to buy, rather than make, transaction processing services.

In addition, and as mentioned earlier, that phase of the business cycle may create room for utility minded service providers offering access to largely standardised wholesale facilities, either run by co-operative ventures or public authorities. Similarly, the commoditisation of the service may lead to further disintermediation and generate potential for non-bank service providers. This perspective, although highly speculative at this stage, represents undoubtedly a less acceptable effect of EMU on banks' activities. Inevitably, the changes in technology and business patterns, as well as the strategic re-positioning of each bank towards this business, will raise significant social issues. While these issues will need to be addressed at the managerial level in each bank, they ultimately represent a policy issue for public authorities.

As regards the situation of banks having their home market in an EU country that does not participate in EMU, it is likely that their customers will develop a significant demand for high quality services in Ecu. Inasmuch as such banks will be required to offer transaction processing services, they will need to entertain correspondent banking relationships with EMU based banks, unless they are given access to public or private Ecu payment and securities settlement systems. Failing the latter, they will not be in a position to compete in an equitable manner with EMU resident banks for Ecu denominated transaction processing business, be it in their own country or internationally.

02/1995


(1) Report by the EBA (Ecu Banking Association) EMU Impact Study Committee, published initially in February 1995. ABE/EBA 4 rue de la Paix 75002 Paris.


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