Correspondent Banking: Making Connections in the 21st Century

Banks and businesses are increasingly looking to exploit the opportunities afforded to them by the continued growth in emerging market trade. Correspondent banking is the most effective means of gaining access to these hard-to-reach geographies and markets, as it combines extensive coverage with local expertise.

Despite these advantages, there has been a tendency in the banking industry to question the continued viability of the correspondent model. The effect of technical and financial innovation, coupled with a general impetus towards deregulation since the 1970s, has been to provide international banks with the resources and capabilities to match their desire to expand. Along with the increased consolidation in global banking, this has enabled financial institutions to expand into target markets by extending their branch networks. The result is a general movement towards fewer, larger banks, able to establish branch networks across multiple target markets.

Some in the industry expect this trend to signal a decline in the fortunes of correspondent banking. The statistics, however, indicate the opposite; as the emerging market economies become increasingly central to global trade, the popularity of the correspondent banking model is growing rapidly.

A World Bank study on Brazil, published in 2006, revealed that the number of correspondent banking outlets in the country increased from 6,000 at the turn of the millennium, to over 38,000 in 20041. This growth is indicative of the situation throughout the BRIC (Brazil, Russia, India and China) countries, and may be attributed to two primary drivers.

Firstly, the resilience displayed by these formerly emerging economies during the recession means that they have now become key markets for growth, as demand in developed economies is put under increasing pressure. Secondly, and of equal importance, the fundamentals of a properly administered correspondent banking network not only remain sound, but retain distinct advantages over alternative models.

Correspondent Banking and its Competitors

The primary alternative to the correspondent banking system is the extended branch network. Under this model, a bank increases its coverage by expanding its bank network into new regions, rather than via mutual relationships with other banks. This approach is useful as, when successful, it allows banks to increase profitability and market share while retaining direct control over their operations. However, this operating model is not necessarily preferable for either banks or their customers.

The expansion and operation of branch networks is a heavily resource intensive exercise. As a result the coverage available under a branch network model is inevitably constrained by the resource capacity of individual banks. Correspondent banking networks, on the other hand, are only limited by a bank’s ability to form dependable and constructive relationships with partner institutions. Coverage can thus be extended beyond the range of even the largest commercial banks. Commerzbank, for example, has correspondent banking relationships with over 7,000 banks globally, enabling it to operate an in-house network of some 4,500 accounts. The size of its correspondent network means that it is able to handle most transactions on its own books, with 47 currencies currently payable against the euro account. This allows for fast payment services that create efficiencies right along the value chain.

Although the history of correspondent banking is grounded in the need to find useful ways of conducting transactions in out-of-the-way locations, the face of the global economy has changed. Even small businesses are now capable of operating on a global level, and their banks must therefore be able to provide payment services to customers across the world.

The example of mainland China is particularly instructive in this regard. Two years after the launch of the ‘RMB Trade Settlement Pilot Scheme’ in 2009, over 70,000 Chinese businesses are able to make trade settlements in renminbi (RMB) – representing an enormous leap in the scale and scope of opportunity for trade with previously remote parts of China. These businesses often wish to conduct trade in RMB, yet are generally already customers of local Chinese banks that are able to cater to their regional needs. In order to take advantage of these opportunities, therefore, exporters in developed countries need banks capable of conducting trade finance operations in RMB, and in partnership with Chinese banks, to markets extending well beyond China’s main cities.

Global Coverage, Local Expertise

Correspondent banking is a means of bridging this gap, by combining the local expertise of a community bank with the trade finance infrastructure of a leading international bank. SMEs and consumers are able to benefit from the regional knowledge and local decision-making capabilities of local banks, while being able to make international currency and credit transactions through larger, globally-focused partner institutions.

Local knowledge is particularly useful in ensuring that complex trade finance processes, such as the negotiation and settlement of letters of credit (LCs), can be overseen, or even undertaken, by a correspondent bank with expert knowledge of the local regulatory environment. This is an enormous advantage when trading in jurisdictions such as China, for example, where compliance legislation is notoriously stringent.

Commerzbank, for instance, is able to open, advise and confirm LCs in close conjunction with both its own clients, and locally via the branches or correspondent banks used by Chinese mid-tier customers themselves2.  Furthermore, each of Commerzbank’s foreign branches and subsidiaries, in 19 countries, has its own documentary department for the handling of letters of credit of customers abroad.

The Benefits of Partnerships

The correspondent banking model confers distinct advantages for both local and global partners. For Commerzbank, for example, it enables the bank to extend its coverage and improve its service offering, while opening up efficiencies across the value chain. At the same time, extensive experience gained in partnership with its correspondent banking partners – and thus reducing the potential for small mistakes or even fraud – means Commerzbank is confident in its network. Consequently, Commerzbank is able to place substantial credit limits with local banks, allowing it to confirm LCs.

The benefit to local banks is that larger banks are able to assist them in managing their liquidity, enabling them to reduce their borrowing requirements and continue lending. This is especially important in light of the expected impact of the regulatory changes required by the Basel III proposals, and even the Basel II requirements enacted since 2004. Larger banks are also able to lend their expertise to help in the management of loan books, and to aid risk management.

A successful correspondent banking network, therefore, can be mutually beneficial to all interested parties – whether they are international banks, correspondent banks, or their corporate or retail clients. This has pragmatic implications for the quality of service the correspondent banking model is able to offer.

The strength of these relationships is helped in that, unlike global banks, correspondent banks do not compete with local banks in their local markets. Consequently, these institutions are happier dealing with correspondent banks than banks operating in direct competition. This is significant, as it means correspondent banks are able to build stronger, more constructive relationships with the local banks used by both large and small businesses in emerging markets.

Security and the Future

Underlying the success of correspondent banking, however, is the question of reliability and security. Clients need to be certain that the local bank providing the service is just as stable and reliable as a branch of a global bank. The key factor in this regard is due diligence.  Making certain of the soundness of all the component banks within a correspondent banking network is essential to its operation. In the case of Commerzbank this is the focus of a team of 40 representative officers, tasked with ensuring the quality of Commerzbank’s network. Their primary focus is on certifying each of the names within the bank’s network and to maintain their analysis of every relationship.

The future for correspondent banking looks bright, not because an archaic system has become deeply entrenched, but rather because it remains an excellent means of bridging the gap between local expertise and global coverage, in a manner that is beneficial to banks and clients alike. Correspondent banking networks like Commerzbank’s are able, for example,  to connect ‘Mittelstand’ companies in the developed world (including midcap companies beyond Germany) with the financial institutions used by their trading partners – and then beyond them to the rapidly-expanding consumer base in the developing world.

If anything, as globalisation continues apace, and the intensity of global trade continues to grow, correspondent banking is likely to increase in importance, particularly as clients are driven to penetrate ever further into new and previously remote markets. 

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