Market dynamics and its impact on correspondent banks
The correspondent banking industry in Europe is facing a number of challenging dynamics, not least declining revenues, mounting regulation and AML /KYC obligations and digitalisation, all of which are going to facilitate major changes in the world of cross-border payments. Societe Generale discusses the key trends impacting the European correspondent banking landscape and assesses how organisations can best address them.
Low interest rates hamper margins
In response to the global financial crisis in 2008, a number of Central Banks adopted unconventional monetary policies, namely the introduction of quantitative easing (QE) initiatives and the imposition of ultra-low interest rates, both of which were designed to stimulate the economy and create a fertile ecosystem for investment. While Central Bankers arguably staved off a much deeper recession than otherwise what might have been, the prolonged continuation of low, zero or even negative interest rates is having adverse impacts elsewhere. One casualty of this unprecedented monetary policy has been the correspondent banking industry’s traditional profit model.
Intertwined with a decline in payment volumes at correspondent banks and the reduction in fees resulting from the EU’s SEPA (Single Euro Payment Area) initiative, a number of providers are struggling to make revenues or even cover costs through spreads on their account balances due to the record low rates. Most European correspondent banks have reflected the cost of negative interest rates to all of their Vostro accounts carrying long overnight balances. However, the correspondent banks are often granted a threshold up to which there are no charges and this is directly correlated to the volumes of payments being registered on the account.
Such practices encourage prefunding of Vostro accounts allowing for payment processing at the beginning of each business day. Looking ahead, an ECB rate rise is not expected until the end of 2019, although providers are hopeful that when normal monetary policies resume, so will their traditional profit model.
Making sense of PSD2
A lot of what has been written about the Payment Services Directive 2 (PSD2), an EU rule that was introduced in January 2018, has focused almost exclusively on its open banking provisions, which allow TPPs (third party providers) to be given access to banks’ customer data and account information. EU regulators believe the open banking framework will augment competition by providing consumers with more services through TPPs, many of whom are likely to be new market entrants. This component of PSD2 will naturally have a bigger impact on retail operations, but elements of the directive are making themselves felt in correspondent banking too.
Under PSD2, all intra-EEA transactions must adopt the SHA (shared the total costs of transaction) charging option. This means that transaction charges will be borne by both payer and payee, instead of just the originator, as was the case under OUR. Providers have since confirmed that transactions must use SHA for PSD2 payments, with some stating that any OUR payments will be converted to SHA.
Instant payments (IP) are not only going to benefit consumers but will confer on institutions and corporates a number of advantages, most notably enhancements to their existing liquidity and cash management processes. Several initiatives are currently in play, which are implicitly designed to accelerate the roll-out of IP across Europe, and these are being monitored closely by correspondent banks such as Societe Generale. In addition to localised IP infrastructure in markets such as The Netherlands and UK, EBA Clearing launched a euro-denominated instant payment system (RT1) in November 2017, while the ECB said it would go live with its Target Instant Payment Settlement (TIPS) platform in late 2018, which will support real-time settlement. While IP solutions have been notoriously fragmented across member states, there is a growing shift towards greater cross-border standardisation.
The ultimate objective of any correspondent bank must be to engineer a solution or system that can seamlessly connect to all of these domestic IP schemes. At the most basic level, providers are leveraging SWIFT’s gpi (global payments innovation) allowing them to support faster payment transactions on behalf of customers. The SWIFT gpi scheme is a good starting point for any correspondent bank looking to augment customer experiences, both in terms of speed and transparency.
Low interest rates and other market headwinds are frustrating the correspondent banking model, and the sector is at risk of consolidating even more and being partially usurped by new entrants. Only the leading correspondent banks such as Societe Generale, which have the resources to invest, will thrive, as they look to respond to these wholesale changes and contribute to invent the business model of tomorrow.