Nationalism: Global risks rise as banks beat a retreat
For decades the world’s banks followed their multinational corporate customers across borders and built up international networks to finance trade and serve surging capital flows. Now those cross-border flows of traded goods lag even weak global GDP growth. Nationalism is on the rise. The era of the global banks may have already ended with the financial crisis. Is the entire concept of global banking at risk too?
Could the de-risking of global banking, insisted upon so vigorously both by regulators and shareholders since the financial crisis, actually be making the world financial system more dangerous?
The IMF seems to be coming round to this view, suggesting in a recent report that global banks ending correspondent relationships with banks in emerging markets may be “potentially undermining financial stability”.
That’s quite a grave charge in IMF-speak – and one that comes as a surprise. As recently as 2015, the IMF posited that global banks’ retrenchment, and in particular their reduction in cross-border lending, was making the global financial system safer. Its April 2015 Global Financial Stability report argued that “the relative shift on the part of foreign banks away from cross-border lending and toward more local lending through affiliates has a positive effect on the financial stability of host countries”.
Back then, the IMF appeared to cast international lending by global banks as a source of systemic risk, saying: “Cross-border flows are likely to contribute to the transmission of foreign shocks and may thus increase volatility. For example, deleveraging by international banks can reduce funding sources for banks in host countries. These banks in turn may be forced to contract lending even in the absence of domestic credit problems.”
Now, it says that the retreating global banks are draining the lifeblood from vulnerable countries – and not just smaller emerging countries but even larger economies such as Mexico and the Philippines.
In part, the IMF has shifted its emphasis. An excess of cross-border lending, especially if poorly underwritten in expectation of ever-higher commodity prices, may well be a bad thing. Providing links to the global payments infrastructure is a good thing. But cutting provision of the first leads almost inevitably to withdrawal of the second.
And how unstable the financial system feels depends very much on whereabouts within it you happen to sit.
Banking supervisors in Europe and the US, home to those developed market banks that once had aspirations to cover the globe, probably think it is much more stable today. Their chief concern has been for banks to increase capital, shrink balance sheets, rein in the complexity of businesses that had pursued revenues into many more markets than senior management teams could ever hope to control or understand and so reduce the contingent liability of home-country taxpayers.
Job certainly not complete – the banks may be more utility-like but they can’t seem to make much money or attract investors’ capital, while many in Europe are still burdened by legacy NPLs – but pretty much on track from a risk- and complexity-reduction standpoint.
For those banks bailed out in the crisis, the quid pro quo was always clear: concentrate your resources closer to home.
Developed market banks that once boasted of their global capabilities and scale have become keen instead to highlight both to regulators and shareholders that they are shedding customers and businesses in emerging markets to reduce both regular annual operating expenses and the chance of extraordinary legal costs.
Citigroup was the preeminent bank of the era of globalization led by US multinationals. Its old leaders were overjoyed when its list of country presences passed 100. But more recently its new leaders have drawn attention to its retrenchment. Chief executive Michael Corbat highlighted to Euromoney last year the halving of its network of retail banks.
“It can be a tough decision in some countries that may have attractive demographics but where you lack scale or where there are near-term political risks, but we have gone from 50 countries to a target of 24,” Corbat told Euromoney. “And often it is a straightforward decision.”
Exiting countries has become the new default mode.
One of the first things Stuart Gulliver did on becoming chief executive of HSBC in 2011 was to relegate the label of being the world’s local bank from a statement of its strategy to a mere happy-clappy marketing slogan. Running a far-flung network to integrate financial flows is no longer HSBC’s job, especially not when it lands the bank with big financial penalties for handling the accounts of Mexican drug dealers.
“The world is actually surprisingly concentrated,” Gulliver told shareholders on his first investor day as chief executive. “If you dig into trade flows, 35 countries account for 90% of growth in trade flows over the next 10 years, and that also holds true for external debt, bank profit growth, wallet available for bank profits and, indeed, FDI.”
He added: “We are not going to try to be all things to all people in all markets.”
Hit by investigations into so-called mirror trades in Russia last year, Deutsche Bank, to take another example, simply closed its markets business in Russia. It reminded shareholders at the start of this year that it would also retreat from 10 other so-called high-risk countries and would be off-boarding hundreds of thousands of customers.
For global banks, retrenching is the new expanding. It has been that way for some years now.
Shortly after taking on the role of Deutsche Bank chief executive in 2015, John Cryan said that in its signature global markets business, it would exit half of its customer relationships.
But there's always a downside. If you are the corporate treasurer of a medium-size business in Africa, the Caribbean, in Central Asia, or in the Pacific region, the retreat of global banks may look very different and quite alarmingly unwelcome. It’s not just the reduction in sources of credit that hurts companies, although refinancing risk is a big concern for many leveraged corporations in emerging countries. Even more worrying is the withdrawal of non-lending banking services and most especially payments. Caught up in the de-risking of global banks has been a wholesale withdrawal from correspondent banking relationships with smaller lenders in many countries across all regions.
Banks have been told to cut back their international operations by home regulators that have ring-fenced both capital and liquidity and raised capital requirements against operational risk for banks deemed highly complex and exposed to fines for sanctions breaches and anti-money laundering failures. It’s a bit thick if global policymakers now blame banks for not leaving in place just those parts of their international operations, the payments infrastructure, that policymakers now realize was actually quite useful, but with no other banking business to pay for it.
“It can be a tough decision in some countries that may have attractive demographics but where you lack scale or where there are near-term political risks, but we have gone from 50 countries to a target of 24. And often it is a straightforward decision”
Michael Corbat, Citi
In its simplest form, correspondent banking is the process by which a large, global bank in a developed market undertakes to handle international payments for the customers of a smaller bank in an emerging market. Christine Lagarde, managing director of the IMF, pointed out in a speech at the New York Federal Reserve in July that: “Correspondent banking is like the blood that delivers nutrients to different parts of the body. It is core to the business of over 3,700 banking groups in 200 countries. A global bank like Société Générale, for example, manages 1,700 correspondent accounts and processes 3.3 million correspondent transactions every day.”
In fact, the biggest banks have been turning away from correspondent banking for some time. Local banks in smaller countries managed to find other providers in the first years of global banking’s great retreat after the crisis, increasing their dependence on fewer and fewer international partners, but still remaining in the game of enabling cross-border payments for their local customers. As the retreat continues, however, local lenders are running out of partners.
This risk of national or regional exclusion from the global financial system owing to the retreat of global banks from correspondent banking is set to be a big topic at the annual IMF/World Bank meetings.
In June, an IMF staff discussion note pulled together some data. It found that fully 75% of surveyed global banks had been withdrawing from correspondent banking relationships, most prominently the US, UK and Swiss banks, but also Canadian, German and French lenders. The overwhelming majority of national banking authorities report reductions in dollar wire transfers and remittances as a consequence.
The report’s authors judge that: “The impact of the withdrawal of correspondent banking relationships (CBRs) on certain jurisdictions can become systemic in nature if unaddressed.”
They also say that while the cutting of correspondent relationships is intended to de-risk individual banks, at a system-wide level, the process could “disrupt financial services and cross-border flows, including trade finance and remittances, potentially undermining financial stability, inclusion, growth and development goals”.
And no one wants that.
Talk of undermining financial stability sounds extreme. Yan Liu, assistant legal counsel at the IMF, concedes: “We have not observed macroeconomic consequences at the global level, but we have definitely seen the impact on certain regions, for example the Caribbean”.
Liu uses the example of a company in Barbados trying to make a $100,000 payment for imported materials to a supplier in Belize. That payment is likely to be denominated in US dollars, which requires handling by a bank with access to the Federal Reserve system. Most domestic banks in the Caribbean do not have such access. In the past, they have been able to conduct such payments for their customers with the help of US correspondents. But US banks have been cutting those relationships for several years now. European banks are fast catching up with this process.
Liu says that a survey of 16 leading banks across five countries in the Caribbean region shows that they have all lost some, or even all, of their correspondent relationships. In Belize, for example, just two out of nine banks still benefit from full banking relationships with global correspondent banks. Even the central bank is down to its last two such relationships.
It’s not just trade finance payments that may be disrupted. Large companies headquartered in one Caribbean country typically need access to dollars to pay salary to employees based in another. Remittance flows also are threatened. And these are not just a nice-to-have. Liu says: “In some countries, remittances account for a large share of GDP… 10%, 20%, sometimes 40%. So you can see the impact.”
No one should blame any global bank for re-examining its relationships with respondent banks far from its home base. The large banks are all compelled to do this, just as they must re-evaluate the cost/income dynamics, capital consumption and returns of every single activity they engage in.
Capital requirements on systemically important banks rise partly in lock-step with their complexity and exposure to operational risk, including liability for large fines. It is no surprise they have been getting out of businesses and of countries where the potential revenues don’t match up to the costs, including swollen annual compliance expenses and the risk of billion-dollar fines for breaches of anti-money laundering and know-your-customer regulations.
What is rational for each bank may be bad for the system as a whole.
Liu observes: “Simultaneous actions by many banks to cut off these relationships could leave certain countries or regions at the brink of losing access to the international system.”
It may be too late to harp on about the downside of de-risking the global banks so soon after the enforcement actions of 2014, when BNP Paribas forfeited $8.9 billion over sanctions busting, JPMorgan paid out $2.4 billion over anti-money laundering failures related to Bernie Madoff, and Credit Suisse paid $2.6 billion for helping US individuals evade taxes.
Regulators and policymakers have been pushing banks in one direction only since the crisis: back towards their home markets and core functions.
The ending of so many correspondent-banking relationships is evidence that the clean-up of global banking is working. Yes, exclusion is a bad consequence for some smaller economies. But need it be permanent?
Developed-market regulators may point out that if those countries did a better job of excluding tax evaders, criminals and terrorists from their domestic banking systems then access might be restored. Mexico is a revealing example.
The authorities there have issued new regulations to increase anti-money laundering and combating the finance-of-terrorism controls, including a requirement for legal entity identifiers for banks and large firms involved in certain high-risk transactions. These steps were taken in coordination with the home authorities of global banks, both to reduce the risk of disruption in correspondent banking and bolster the domestic regulatory framework at the same time.
"Why should we care? Because affected countries often are very vulnerable, withminimal access to financial services in the best of circumstances"
Christine Lagarde, IMF
“In other jurisdictions, efforts may need to go beyond improving compliance, however,” Lagarde admitted in her July speech. “Business models that depend on opaqueness, offshore structures and a lack of transparency clearly need to be reassessed.”
If certain banks and even whole countries find themselves at risk of exclusion in the meantime, surely that is a call to action.
“Why should we care about this problem?” Lagarde asked. “Because affected countries often are very vulnerable – they include small island economies and countries in conflict. These are countries with minimal access to financial services in the best of circumstances.”
Lagarde highlighted the impact on smaller countries such as Liberia, where global banks have terminated almost half of the existing 75 correspondent relations, severely affecting the ability of local banks to conduct US dollar transactions, and Samoa, where remittances account for 20% of GDP and banks have been terminating accounts of Samoa-linked money transfer agents.
The impact is being felt on larger countries as well: not just Mexico but also the Philippines, and other economies that rely heavily on cross-border flows such as remittances, and where development is now at risk.
“And even if the global implications of these disruptions are not visible so far,” Lagarde warned, “they can become systemic if left unaddressed.”
Lagarde did not specify what systemic risks she means, leaving listeners to hear confirmation of their own fears: rising defaults and bad debts, perhaps failed states and heightened geopolitical risk and regional insecurity.
Expect at the annual IMF meetings to hear developed-market regulators covering their backsides and claiming that they never intended the banks under their charge to terminate correspondent banking relationships or exit countries on such a scale and in such knee-jerk fashion in response to a mere handful of multi-billion dollar pay-outs extracted from the worst repeat offenders.
That’s self-serving piffle at best, admission of a fundamental misunderstanding of banks at worst and a reminder for regulators and policymakers to be careful what they wish for.
But it’s largely irrelevant because there are bigger forces at work here.
End of an era?
Are we witnessing the end of the era of globalization that has defined most of our lifetimes? In February, McKinsey published a landmark study on how cross-border data flow is increasingly important to the global economy. These digital data flows seem, in so far not well-understood or much-studied ways, to be picking up the baton from the now-floundering drivers of the global economy in the late 20th century and the first decade of this: namely the cross-border flows of capital in bond and equity purchases, in foreign direct investment and in international bank lending often linked to trade in manufactured goods and commodities.
McKinsey points out that cross-border capital flows have fallen sharply since 2008 and show no sign of recovery. For 25 years before the 2008 financial crisis, these flows grew faster than global GDP, rising from $0.5 trillion in 1980 to $11.9 trillion in 2007.
Since that peak, financial flows dropped from the equivalent of 21% of global GDP in 2007 to just 7% in 2014. Much of the decline is evident in cross-border lending. Partly it is a direct consequence of deleveraging by a ludicrously swollen financial system and a welcome retreat from the excessive financialization of developing economies. This briefly threatened to mimic that in developed markets where issuance of, and trading in, synthetic derivatives with synthetic counterparties became the norm, accepted and even encouraged by greedy investors and sovereign tax authorities and nodded through by supine regulators.
McKinsey is in no doubt why this collapse in cross-border flows has happened. “Facing new regulations on capital and liquidity, as well as pressures from shareholders and regulators to reduce risk, many banks in advanced economies are winnowing down the geographies and business lines in which they operate.” The consultancy firm points out that from early 2007 through the end of 2012, commercial banks sold off more than $722 billion in assets and operations, with foreign operations accounting for almost half of that total.
This retrenchment has not simply seen developed-market banks shunning emerging markets. In the first years of recovery after the financial crisis and subsequent recession, flows into emerging markets actually picked up as these appeared to offer growth amid a developed-market downturn. As they de-levered in the first five years after the financial crisis, eurozone banks cut cross-border lending by $3.7 trillion, but loans and claims on other European countries accounted for three quarters of that decline or fully $2.8 trillion.
Beyond the retrenchment in cross-border lending, international investment flows in bonds, equities and FDI are also flat or down. Cross-border bond and FDI flows have declined 41% and 35%, respectively, in absolute terms between the end of 2007 and the end of 2014, McKinsey finds. Cross-border equity flows are essentially flat in value but have declined relative to global GDP.
Data for 2015 show that global financial flows declined further across a broad range of developing countries. The most recent BIS quarterly lending report published in June covers data up to the end of 2015. The BIS reports that cross-border lending in 2015 shrank by 3%, continuing the sharp retrenchment from a 20-year average positive growth rate of 6%. It noted that the decline in the fourth quarter of 2015 was evenly spread, but highlighted some new signals.
Interbank lending has seen the greatest fall in the era of declining cross-border flows. In Europe for example, the ECB has effectively replaced the interbank lending market. Now, the BIS reports that in the most recent quarter for which data have been compiled “interbank activity again accounted for the largest share and mainly drove the overall decline. But claims on non-bank borrowers, which had previously held up better, also fell substantially (by $177 billion)”.
It also noted a new trend: the appearance of certain emerging market banks, notably Chinese lenders, as an increasingly important source of international bank credit. At the end of December 2015, they were the 10th largest creditors in the international banking system, according to the BIS, with cross-border assets of $722 billion. Chinese banks are an especially important source of US dollar credit: their cross-border dollar assets totalled $529 billion, larger than those of banks in all but five countries, namely the US, UK, Japan, the Cayman Islands and Hong Kong.
Despite the emergence of large local emerging market and regional banks to take up some of the slack from global banks, it seems unlikely there will be any revival of cross-border lending this year. Indeed analysts are now looking for hopeful signs amid the wreckage of global banking in this decline in cross-border exposure. In August, BNP Paribas once again tried to figure out the systemic consequences of a Fed rate hike later this year, thinking of developed-market bank and investor exposure to over-valued emerging market financial assets and mal-investment driven by low and even negative yields in developed markets.
Assessing cross-border claims on the larger emerging countries at the end of the first quarter of 2016, BNP Paribas noted a 28% year-on-year decline in cross-border claims on China; a 23% decline in claims on Russia; a 16% decline in claims on Brazil and a 7% decline on claims in India. Cross-border lending to China, extended mainly by developed-market banks, had surged to $1.1 trillion in mid-2014. It was down to just under $700 billion at the start of the second quarter of this year. “This decline in cross-border bank lending reduces global systemic risks resulting from US policy adjustments,” says Wike Groenenberg, analyst at BNP Paribas.
If the slowing growth in many of those large Asian emerging markets continues into outright recession, presumably only a churl would ask if slowing cross-border lending might be the cause of that faltering growth rather than its consequence.
The BIS advises that any analysis of the vulnerability of emerging market economies to further disruption in cross-border capital flows ought to start by recognizing the substantial growth in aggregate indebtedness of corporations, on credit drawn from both domestic as well as international sources.
This is already ringing alarm bells.
Slowing cross-border flows may not be a sign of stability at all. According to the BIS’s debt statistics, corporate debt in the big emerging market economies increased on aggregate from less than 60% of GDP in 2006 to 110% at end-2015, much of it raised in bond markets. The BIS warns: “Given the steep repayment schedule that lies ahead, the refinancing capacity of highly leveraged emerging market companies is likely to be tested soon, especially if the rise of the US dollar continues.”
The BIS points out that while corporates’ international debts are smaller than their domestic debts, international flows are regularly the marginal source of financing in the run-up to crises. “International capital outflows could affect overall investor sentiment and credit conditions, either by leading directly to defaults or by steering corporates to seek funding from the already stretched domestic markets and banks”.
In a global economy characterized by an absence of demand, most central banks are striving to weaken their currencies to revive trade while also holding down the servicing cost for vast government and private-sector debt stocks they have no hope of repaying by any conventional meaning of that term, or of inflating them away.
It is somewhat ironic, given the IMF’s concern about the termination of correspondent banking relationships, that the only cross-border financial flows that have continued to grow since the global financial crisis and ensuing recession are remittances. These were up 7% annually over the five years to the start of 2016 and are now worth $583 billion annually. Of course, the growth in remittances reflects the increasing flows of migrants, against which there is now a growing populist political backlash in Europe, most evident in the UK vote to leave the EU, and in the rallies supporting Donald Trump’s campaign for the presidency of the US. At the same time as saying they will erect real or metaphoric barriers to immigration, politicians riding the surging wave of new nationalism are also increasingly hostile to free trade.
Stephen Gallagher, an economist at Société Générale, looking ahead to the economic impact of the US presidential election, notes: “Both candidates have criticized the Trans-Pacific Partnership (TPP). Their positions reflect voter sentiment. Clinton is more likely to maintain the current trade status quo, whereas Trump promises to re-open discussions on the North America Free Trade Agreement (Nafta).”
Gallagher admits that: “Precisely what he wants to renegotiate is unclear – Canada and Mexico are not eager to negotiate, and changes from a Trump administration could be unilateral.”
He also notes Trump’s talk of throwing up punitive tariffs, which tends to go down well at rallies, and says: “These signals on trade could reduce potential US GDP over a long time period.”
The candidacy of Donald Trump is part of a populist, nationalist trend
In a survey published in June of trade measures implemented between mid-October 2015 and mid-May 2016, the WTO reports a marked rise in protectionism, with 145 new trade-restrictive measures introduced in that period, and these are now coming at the fastest monthly rate since the WTO began surveying such measures in 2009.
“In the current environment, a rise in trade restrictions is the last thing the global economy needs,” says Roberto Azevêdo, director general of the WTO, drawing the traditional link between trade and economic growth. “This increase could have a further chilling effect on trade flows, with knock-on effects for economic growth and job creation.
“We hope that this will not be an indication of things to come, and clearly action is needed,” he says. “Out of the more than 2,800 trade-restrictive measures recorded by this exercise since October 2008, only 25% have been removed.”
This adds further uncertainty to the outlook for trade. The WTO pleads with the leading G20 economies to set an example in the fight against protectionism by rejecting new trade-restrictive measures and rolling back exiting ones. Even with Trump trailing in the autumn polls, let’s hope no one at the WTO is holding their breath on that.
McKinsey points out that for two decades in the run-up to the financial crisis, the world’s trade in goods, including commodities, finished goods and intermediate inputs, grew roughly twice as fast as global GDP, as multinationals expanded their supply chains and established new bases of production in countries with low-cost labour.
Global trade in goods soared from 13.8% of world GDP in 1986 to 26.6% in 2008 on the eve of the financial crisis. This was the heyday of globalization, when global elites largely embraced the so-called Washington consensus lionizing unfettered free markets, free movement of capital and goods everywhere, whatever the consequences for populations. They hoped that voters’ fear of falling wages and rising unemployment might be bought off with cheap imported TVs and, of course, low-rate financing to speculate on housing and financial assets to compensate for declining regular earnings from traditional sources like… actual jobs.
After a sharp decline following the financial crisis and a short-lived rebound after the ensuing recession, however, the goods trade has been growing more slowly even than lacklustre world GDP in recent years, puzzling economists and business leaders alike.
In July, after the UK population voted to leave the EU, the IMF refined its forecasts for global GDP growth this year and next. It now forecasts global growth of 3.1% in 2016 and 3.4% in 2017. In April, the WTO forecast global trade to grow at below this rate, at just 2.8% in 2016, the same rate at which it grew in 2015. Instead of exceeding and leading GDP growth, which was 3.1% for 2015, trade continues to lag.
According to McKinsey: “Some of this decline is cyclical. Our analysis suggests that weak demand and plummeting prices for commodities account for nearly three-quarters of the decline in trade.”
But trade in both finished and intermediate manufactured goods has also declined. The makers of many finished goods are beginning to place less importance on labour costs and more on speed to market, McKinsey argues. As a result, some production is moving closer to end-consumers. Trade is also declining for many intermediate goods such as chemicals, paper, textile fabrics, and communications and electrical equipment. This suggests that global value chains may be shortening, at least in part because of the cost of managing complex, lengthy supply chains.
There is also an argument that organized labour in developed markets has been battered into submission. Even in countries such as the US, seemingly at the point of full employment, hourly wages are not rising. Does this reflect lack of investment in productivity-enhancing technology, or perhaps workers in developed economies accepting they must compete with hourly rates in emerging markets? “In the decade ahead, the global goods trade may continue to decline relative to world GDP,” McKinsey suggests.
That’s not good news for banks that have depended on a rise in globalization for much of their growth for a generation or more. Structurally lower trade means less need for cross-border payments, cash management, foreign exchange, cross-border investment flows and inter-regional M&A. How banks react to these challenges will define the industry for the next generation.