The return of relationship banking

Rigorous due-diligence requirements can be a “significant impediment” to the bank-to-bank relationships that underpin global trade, says the Asian Development Bank’s ‘ADB Trade Finance Gap, Growth, and Jobs Survey’ (ADB Brief no. 25) of December 2014. Compliance with today’s anti-money laundering (AML) and know-your-customer (KYC) rules can be “the driver behind cancelled relationships,” the survey continues.

“I don’t think anyone’s saying that financial institutions shouldn’t improve their AML/KYC processes, but there are unintended consequences,” says Steven Beck, Head of Trade Finance, Asian Development Bank. So how should banks most effectively conduct their correspondent and other key banking relationships, given the in-depth and ongoing due diligence that they must apply?

In the current regulatory and geo-political climate, perhaps the answer is this simple: a customer worth knowing will quickly recognise the potential and actual benefits to such a deep investigative dialogue. Michael Cho, Head of Global Financial Institutions Compliance, Wells Fargo, says, “The need for enhanced due diligence is not just a regulatory expectation any more, but something that the banks have truly come to appreciate.”

For the larger US banks, as Cho goes on to explain, the ongoing tightening of rules on financial crime compliance has been a key regulatory theme for more than a decade. For the smaller firms with which those major banks have relationships, or those in less regulated jurisdictions, awareness levels are lower. “At first, the need to go out and ask a lot more questions was met with some resistance,” says Cho. “Going out and truly knowing your customer means knowing a lot more today than just asking about their tools, their monitoring, their staffing, their governance. It becomes a matter of: do we know their customers’ customers and their transactions and what risks their products go through?”

Taking a deep dive Mark Gem, Chief Compliance Officer at international central securities depository Clearstream, agrees that the need to understand one’s own business and that of clients at a deeper level gives a different perspective: “Compliance forces you to ask very basic questions about the business model that in other roles, you just take for granted.” But this can be a valuable learning process, suggests James Freis, Chief Compliance Officer for Deutsche Börse Group (Clearstream’s parent). “More so than ever before, banks need to understand about the source of a payment, who the customers are that are involved in the payment, and what is the type of activity that is behind the payment,” he says.

There is scope for much deeper understanding between counterparties here. Cho continues, “Knowledge share is much better. One thing we’ve tried to focus on is doing business with people who believe what we believe, in terms of who they will and won’t bank, and the controls they use.” But this is not a matter of scale. “It doesn’t mean that we will only do business with large banks, or banks that are the same size as us, but from a risk-appetite perspective, does a bank share our beliefs? If they don’t, that may be okay, but it’s going to take a lot more effort and cost on our part,” Cho explains.

Does this imply that there might be regional differences in banks’ approaches to KYC/AML? How do extra-territoriality concerns alter the responsibility of banks? “You do have to adapt regionally,” says Cho. “Making sure that you have good understanding of local laws and local compliance, having a local legal team involved, is really important. The rules vary country by country, so you have to adjust country by country.”

A burden on growth? For the ADB’s Beck, a key issue is the impact of financial crime compliance efforts on economic growth, particularly in emerging markets where information – and significant deal flow – may not be readily available. “A financial institution operating in multiple jurisdictions and having to spend a lot of money on due diligence, with a number of relationships in smaller markets that don’t necessarily justify that cost, might be inclined to pull out of markets entirely. In a disproportionate way, this is damaging emerging markets,” says Beck. On the one hand, governments are working to stimulate economic growth via various forms of quantitative easing initiatives delivered through banks, he notes, while on the other, the same central banks and governments are unintentionally “impeding” banks’ ability to deliver more liquidity into the market by adding to their regulatory burdens.

But if economic growth implies opportunity, just as an emerging market offers the prospect of greater deal flow in future, perhaps the appropriate long-term strategy is to engage – with correspondent banks, and with markets, and with the discussion itself. Commenting further on the stimulation/regulation balance, Beck says: “It’s a difficult question as to where the line needs to be drawn. We’re having the discussion to some extent, but it needs to come to the fore.” And in the meantime, what is the safe approach to due diligence?

“We should not lose sight of what KYC actually means – that you know your customer,” says Clearstream’s Gem. “If the relationship is deep and mutually beneficial, then the challenge will be simply evidencing how well you know your customer. If it’s shallow and unilateral, you’re going to have to invest in acquiring that knowledge from people who have no real incentive to give you what you need.” Key word: relationship. Gems notes that senior relationship managers tend to find KYC easier than do their juniors. “If you are entertaining a relationship with a business partner as an equal, you find yourself naturally asking curious questions about their business,” he adds.

Good for business The safe approach to due diligence is to know your customer – but the safest approach to doing that is by nurturing a “deep and mutually beneficial” relationship. Happily, that also turns out to be the cost-effective approach because both sides will tend to have an incentive to share information. Gem suggests a positive change in tone. “Relationships are definitely more selective, there’s no question about that, and I would like to think that they are deeper and richer,” he says. On this point, Freis concurs: “Banks are being much more careful about choosing the relationships in which they want to be involved.” Perhaps summing up the post-crisis zeitgeist, Cho says, “We have fewer customers than we used to have, but we go much deeper with them.”

Knowing our clients is more than a regulatory requirement – a business model built on doing business with complete strangers contains greater, possibly unacceptable risks. But if it is to be meaningful, the KYC obligation needs to go beyond compliance. “Conduct needs to be seen, if not from an ethical then at least from a behavioural standard, rather than simply a legal standard,” Gem observes.