Rethinking correspondent banking 3

Rethinking correspondent banking

Correspondent banking—in which one financial institution carries out transactions on behalf of another, often because it has no local presence—has been used as the instrument for cross-border payments since the time of the Medicis. The intervening centuries have brought surprisingly little in the way of fundamental change, and banks still generate considerable value from cross- border payments. According to the 2015 McKinsey Global Payments Map, these transactions represent 20 percent of total transaction volumes in the payments industry, yet they generate 50 percent of its transaction-related revenues (Exhibit 1, page 4).

Olivier Denecker What’s more, revenue margins in cross- growing as domestic retail payments un - bor der payments have remained healthy dergo rapid digitization. Florent Istace over time. As margins for domestic pay - • Regulatory compliance is driving up the Pavan K. Masanam ments were squeezed by regulation and cost of cross-border payments systems Marc Niederkorn competition in recent decades, banks were and forcing banks to review their corre - forced to pare back costs and improve the ef - spondent relations. ficiency of their systems and products. But cross-border payments have not yet experi - • Digital innovators are attracting cus - enced such pressures, so banks have had lit - tomers with new solutions and enhanced value propositions that threaten not only tle incentive to work on their back-end to cut banks out of their correspondent systems and processes or to develop innova - banking relationships but also to loosen tive customer offerings. banks’ ties with end customers, at least That is now changing. The traditional corre - where payments-related activities are spondent banking model for cross-border concerned. payments has come under acute pressure If these growing pressures were to drive from customers, regulators and competitors cross-border revenue margins down to do - alike: mestic levels, industry revenues would drop • Customer expectations for real-time, digi - by 70 percent, inflicting losses of $230 bil - tally enabled cross-border payments are lion on banks globally. To avert this stark 4 McKinsey on Payments June 2016

Exhibit 1 Payments Trade finance3 xx Revenue margin, bps

Cross-border Domestic Cross-border payments represent 20141 20142 20141 20142 20% of global payments transactional payments transactional payments flows but flows revenues flows revenues

50% of transactional $ trillion $ billion $ trillion $ billion revenues 240

110 75 From and to 22 325 consumer 2

550 285 30

160 1 Excluding flows between banks.

2 Includes transaction fees, float income and 120 255

FX fees; excludes revenues not directly Business- linked to individual transactions, mostly 2 20 maintenance fees, net interest income, to-business and incident fees related to cards. 3 Includes fee revenue from documentary business but not revenues from Share of total domestic and cross-border payments 20% 50% trade-related financing. Source: McKinsey Global Payments Map

scenario, banks need to embrace change great experience in terms of transparency, and grow the market by delivering new cus - convenience, price and speed. These bene - tomer solutions through far more efficient fits are gradually becoming table stakes for operations. This article examines how cor - all participants in the industry. Meanwhile, respondent banking is changing and pro - domestic payments are moving to real-time poses options for banks to consider to solutions at marginal cost to the user. defend and enhance their position in cross- Cross-border payments have yet to embrace border pay ments. these developments, and the gap between customers’ expectations and their experi - Drivers of change ence is widening. Three forces are driving change in corre - spondent banking: the customer impera - In fact, cross-border payments continue to tive, the efficiency squeeze and the be expensive, slow and lacking in trans - nonbank offer. parency on both costs and delivery times. In 2015, a McKinsey survey on consumer cross- The customer imperative border payments found that consumers typi - As consumers and businesses grow accus - cally pay a fee of €20 to €60 on top of the tomed to the benefits of using technology in prevailing foreign-exchange spread. And this their daily lives, their expectations rise. In fee does not even guarantee timely delivery: , digital entrants are offer - although most cross-border payments could ing products and services with thoughtfully in theory be executed in one to two days, the designed user interfaces that provide a survey revealed that a typical retail cross- Rethinking correspondent banking 5

border payment took three to five working 2015 study by Traxpay indicates that about days to complete. 60 percent of business-to-business (B2B) payments require some kind of manual in - More positively, the correspondent banking tervention, each taking at least 15 to 20 network still provides distinctive benefits to minutes. Major variations in account struc - users. It remains the only solution that is tures, messaging and bank systems generate genuinely ubiquitous. It can reach any coun - far more corrections, investigations, returns try or currency and can be used by anyone with a bank account. It is also safe. Banks and stalled payments than are seen in do - act as trusted providers of both bank ac - mestic payments or in payments where one counts and the elaborate compliance-driven party controls the transaction from begin - regulatory framework that guarantees neces - ning to end. Over 90 percent of the resulting sary security for the cross-border payments costs are incurred in banks’ efforts to man - that underpin the global economy. age counter-party bank relationships in the back office, rather than in the technologies and networks that handle the value transfers Even leading transaction banks can no between banks. As a result, the cost of han - dling international payments is counted in longer afford to maintain large dollars, not cents. international correspondent bank The nonbank offer networks, and have been closing down The high margins and low efficiency of less profitable locations. cross-border payments have long attracted the attention of money-transfer operators (MTOs) such as MoneyGram and Western The efficiency squeeze Union. In the past, these companies mostly Maintaining an open global network across targeted unbanked or under-banked con - many different standards and under a strict sumers and differentiated their offerings by regulatory framework incurs high costs for speed, convenience and predictability rather banks, making cross-border transactions than price. They barely competed with considerably more expensive than domestic banks, as each institution targeted different payments. Even leading transaction banks segments: banked customers and businesses can no longer afford to maintain large inter - for banks, and unbanked customers using national correspondent bank networks, and cash-to-cash payments for MTOs. Today have been closing down less profitable loca - MTOs command some 40 percent of global tions and reducing the extent of their net - revenues for cross-border consumer-to- works. During 2013 and 2014, one leading con sumer (C2C) payments, but less than 5 U.S.-based global bank stated that it had cut percent in the business-to-consumer (B2C) ties with 500 network banks, mostly in the and B2B segments. Middle East. But things are changing. PayPal was the The complexity of cross-border transactions first successful digital player to threaten brings with it a relatively high failure rate. A banks’ payments business. More recently, 6 McKinsey on Payments June 2016

Exhibit 2 New solutions Customer-to-customer cross-border payments; customer Worse than the average for new solutions experience ranked 1 to 5 (1 lowest, 5 highest)1 outperform Better than the average for new solutions

correspondent Remittance banks New solutions banking on most (ICICI Bank Customer experience Correspondent Money2India, State TransferWise dimensions of dimensions banking Bank of India) PayPal Western Union customer experience 5 Speed 1 5 4 4

1 Price 5 5 3 5

Security and 1 5 4 3 compliance 5 Transparency and 4 5 3 5 1 McKinsey researchers acted as retail predictability 2 customers and transferred €100 or the local currency equivalent back and forth Convenience and 2 across a set of corridors (routes between ubiquity 4 5 2 3 the sending and receiving countries, such as UK to India) chosen to be representative Openness and of the market conditions encountered by inclusivity 4 4 4 3 3 customers across the globe. Source: McKinsey Global Payments Practice

digitally enabled attackers have intensified This disruption is now moving up at an ac - competition by altering the ways that pay - celerated pace from C2C to business-driven ments are made. Companies such as Trans - cross-border payments, starting with small ferWise and Xoom have gained traction and medium-sized enterprises (SMEs) ( Ex - with banked as well as unbanked cus - hibit 3). Companies such as Traxpay and tomers by offering superior consumer value Taulia provide business solutions for finan - propositions for C2C cross-border trans - cial supply chains that mimic the features of fers, outperforming traditional correspon - consumer digital offerings, including pay - dent banking offerings on key dimensions ments functions. Western Union’s wu.com such as price, speed, convenience and offers an increasing array of business serv - transparency ( Exhibit 2). For instance, ices. Companies such as Earthport deliver TransferWise provides full upfront trans - cross-border mass payments such as payroll parency on fees, exchange rates and deliv - at lower costs using a direct link to local au - ery time at a very low cost. Seeing the tomated clearing houses. opportunity, MTOs are rapidly boosting These solutions often include support for in - their digital capabilities. Some banks, in - tegrated accounting software (as PayPal pro - cluding India’s ICICI, have also started of - vides with ), supply-chain finance or fering customer experiences comparable to dynamic discounting (like Taulia). For trade, those provided by digital attackers, and are some solutions redefine the customer need bypassing the traditional correspondent by introducing services such as conditional banking infrastructure. payments, as Traxpay does, or alternative fi - Rethinking correspondent banking 7

Exhibit 3 Disruption is shifting Cross-border solutions from consumer to B2B Corporate SAP Revenues CAGR, Bank share SME and corporate, Traxpay $ billion 2014-19 Percent where banks derive Taulia Percent most of their Western Union Business Solutions transaction revenues B2B 255 6 >95%

B2B/B2C SME PayPal TransferWise B2C 15 3 95% Traxpay Western Union Business Solutions

C2B 20 16 70%

C2C PayPal Consumer TransferWise C2C 40 1 60% Western Union

Source: McKinsey Global Payments Map

nancing, like Alipay. All of these innovative cially those with strong transaction banking offerings weaken banks’ relationships with franchises that have the most to lose. their customers. Rethinking correspondent banking Such moves by new players are triggering change in correspondent banking. As Ex - Banks are aware they need to act. At Sibos hibit 3 shows, B2B cross-border payments 2015 in Singapore, a session on the need to account for almost 80 percent of all cross- reinvent correspondent banking attracted border payments revenues, and this segment the second-largest attendance of the week. is expected to grow rapidly as the economic Cross-border payments must become role of SMEs expands and their supply cheaper, more transparent and more effi - chains fragment. For banks, maintaining cient. Although change will mean forfeiting their hefty share of this sector—more than some revenues in the short term, success will 95 percent—is a battle worth fighting, espe - bring substantial rewards in the form of cially since new rivals increasingly offer links structurally lower costs, higher volumes as to other services such as alternative sources SMEs and commerce globalize, and oppor - of financing or fully digital foreign-exchange tunities to cross-sell to satisfied customers. services. But banks face a challenge. How can they Overall, the new wave of innovation set in quickly change while continuing to meet motion by financial technology providers is customer expectations, remain compliant proving unsettling for many banks, espe - and maintain their global reach? Moreover, 8 McKinsey on Payments June 2016

this is not a time for going it alone: collabo - more into line with those of attackers, espe - ration will be key to ensuring reach and cially where pricing and transparency are adoption. There are three major initiatives concerned. that banks need to pursue in parallel: Banks that start to prepare now will be able to 1. Redefine core processes and capitalize on the opportunities that emerging customer value proposition interbank capabilities will create, including Change is inevitable in cross-border pay - shorter cycle times, increasing cross-sell op - ments. Smart banks will work to future- portunities and lower operational costs. Get - proof their products by accelerating ting ahead of the curve will enable them to operational redesign and rethinking their benefit from changing customer expectations, customer value proposition. while taking advantage of the global foot - prints that give them a distinct advantage over new attackers.

Banks that prepare 2. Move to correspondent banking 2.0 now will capitalize on the Banks can already deliver payments in less opportunities that emerging than a day, and at cost levels comparable to those of attackers. However, this applies interbank capabilities will create, only to clean straight-through-processing including shorter cycle times, (STP) payments between banks that strictly adhere to industry practices. Not all pay - increasing cross-sell opportunities ments follow this pattern, and the excep - and lower operational costs. tions dramatically increase the overall cost to the system. Increasing the share of STP payments or differentiating them from the Legacy architecture will need to be over - exceptions would allow banks to bring hauled to meet the coming real-time imper - cross-border payments to market at prices ative. That means reconstructing core on a par with attackers’ offerings, while banking platforms so that they can be up - safeguarding margins. And this could hap - dated in real time; ensuring that fraud plat - pen in a very short time frame. forms and processes can operate in very near To reduce inquiries and corrections and real time; and making clearing systems ca - speed up payments times, banks could es - pable of handling real-time exchange of in - tablish a clear set of enforceable obligations formation, posting of transactions to on how to initiate and collect payments, and customers and funds availability. Opera - set maximum limits on response times be - tional changes will also be needed to move tween banks. This could be achieved with toward 24/7 availability. today’s technology, but would require strong Even with today’s internal and interbank op - commitment among participating banks and erational constraints, banks have ample op - an enforcement mechanism for any failure portunities to revisit their cross-border to comply with requirements —neither of payments value propositions to bring them which is in place yet. Rethinking correspondent banking 9

Another major improvement would be for However, solutions based on these technolo - banks to inform payors in advance about the gies are still in their infancy. It will take time total cost of a transaction and its “crediting” for them to achieve universal reach in desti - time, as well as confirmation when the benefi - nation and currencies, resolve compliance ciary is credited. The real-time tracking of questions, and equip themselves to handle payment status would be even better. No tech - the high-value, high-volume payments re - nical wizardry would be required, but banks quired for international trade. To be valid al - would need to share information, handle con - ternatives they would also need to enable firmations diligently and ensure they commu - full connectivity across all countries, curren - nicate appropriately with customers. To make cies and bank accounts worldwide—a mas - this happen, banks could introduce a binding sive undertaking. industry rulebook enforcing the sharing of The immediate focus of these new solutions standardized information across the payments should be on reducing banks’ back-office journey and defining who charges for the costs rather than improving infrastructure. transaction. Early blockchain initiatives are therefore These modifications could usher in a new likely to focus on internal operations first. world of cross-border payments where Finally, solutions based on distributed ledger transactions are handled in a real-time flow technologies still require banks to make cor - and delivered on the same day anywhere in respondent-like agreements to define the the world with full upfront end-to-end pric - rights and obligations of participants in ing transparency and real-time tracking for these systems. Technology alone is not a suf - the customer. Such a value proposition ficient condition for success. As a result, the would match or even exceed those of emerg - investments that banks make in simplifying ing providers hampered by local infrastruc - and tightening their existing correspondent ture capabilities. banking relationships are likely to be useful 3. Investigate new infrastructure tech - even when new technology-based solutions nologies with a mid- to long-term view reach maturity. In this age of digital innovation, banks are * * * paying a lot of attention t o new networking technologies that promise greater efficiency, Tomorrow’s cross-border payments will go be - especially distributed ledger solutions such yond utility models based on legacy systems as blockchain. Such technologies bypass ex - and old-school correspondent banking. They isting infrastructure and connect banks di - will adopt future-proof digital technologies rectly across the world, as well as provide and industry standards that promote cross- alternative sources of settlement, such as the country integration and greater transaction concepts developed by Ripple. (See “Toward efficiency. Such moves can help banks rede - an of Value: An interview with fine their international networks, reduce the Chris Larsen, CEO of ,” McKin - need for manual intervention in investiga - sey on Payments , Volume 8, Number 21, tions and reconciliation, and deliver customer May 2015.) value throughout the transaction cycle. 10 McKinsey on Payments June 2016

These changes will mean much lower prices itable, and make corporate and retail cus - for cross-border payments and lower shares tomers happier. for banks, forcing them to review their com - Olivier Denecker is director of knowledge for mercial and operational set-up. However, a payments and Florent Istace is a senior knowledge business with improving operational per - expert, both in McKinsey’s Belgian Knowledge formance, more accessible global commerce Center; Pavan K. Masanam is a senior research solutions and better service to customers can analyst in the Indian Knowledge Center; and accelerate volume growth, be more prof - Marc Niederkorn is a senior partner in the Luxembourg office.