Bank De-Risking Likely to Trump Calls for Financial Inclusion

For Some Activities Risk Avoidance Makes More Sense Than Risk Management

On September 8^th, the Hong Kong Monetary Authority (HKMA) issued a circular to the CEOs of all Authorized (financial) Institutions (AIs) in the HKSAR (Hong Kong Special Administrative Region) entitled “De-risking and Financial Inclusion”.

The circular sets forth the HKMA’s expectations (read “instructions”) that AIs adopt a risk based approach (RBA) to implementing anti-money laundering AML) and countering the financing of terrorism (CFT) regulations and cease the practice of de-risking, that is refusing to open or maintain accounts for certain customers.

As outlined below, the HKMA is rowing against some very powerful tides.  The circular is unlikely to have the stated desired effect.

Some quotes from the circular to set the stage for this post.  I’ve added boldface to highlight certain points. 

Noting the progressive tightening of AML regulations over recent years the HKMA states “While it is important to ensure that AML/CFT controls are sufficiently robust and comply with all the relevant regulatory requirements, the HKMA expects AIs to adopt a risk-based approach (RBA) and refrain from adopting practices that would result in financial exclusion, particularly in respect of the need for bona fide businesses to have access to basic banking services.”  

In a similar vein, the HKMA defines “de-risking” as “The phenomenon of banks declining or discontinuing business relationships with customers or categories of customers to avoid, rather than manage, the risk involved. “

On the subject of an RBA, the HKMA makes the following points: 

"RBA does not require or expect a “zero failure” outcome. While AIs should take all reasonable measures to identify ML/TF risks at the account opening stage and, for existing customers, on an ongoing basis, it is unrealistic to expect that no ML/TF activities would ever occur through the banking system. AIs are not required to implement overly stringent CDD processes with a view to eliminating, ex-ante, all risks. Otherwise, such an approach would result in a large number of bona fide businesses and individuals not being able to open or maintain accounts. CDD is only one part of an effective AML/CFT regime. AIs are also required to implement a system that can monitor and detect suspicious transactions in order to report them to the relevant authorities and take the necessary mitigating measures, such as enhanced CDD."

News reports suggest that the HKMA's action was occasioned by several banks “tossing” existing customers.   Bloomberg refers to the alleged abrupt closure by HSBC of accounts of a long standing client that is an offshore fund. 

That’s borne out in the circular itself which also notes the refusal of some unnamed FIs in the HKSAR refused to accept new clients or set “onerous” requirements.  See the annex to the circular.

The HKMA’s circular follows one issued in late August by five US regulators of financial institutions in the country.  Yes, you read that right “five”.   Apparently one regulator is insufficient for the USA's financial sector.  It's that big!  That circular also contained an appeal for banks to adopt a RBA, but did not include the HKMA’s statement that it didn’t expect RBA AML/CFT to prevent all illegal transactions.  Instead the five US regulators offered the comforting thought that “the Treasury and the FBAs do not utilize a zero tolerance philosophy that mandates the strict imposition of formal enforcement action regardless of the facts and circumstances of the situation”.  

I trust like AA you find those words comforting in a particularly baffling way.  Are these regulators saying that existing regulations allow them to take formal enforcement action regardless of facts and circumstances but that they will kindly forbear from exercising these powers?  Instead might they apply strict non formal enforcement actions? On that score, what is a “strict” imposition and how does it differ from a “strict” enforcement action?  Or are they saying that existing US laws and regulations are so written that they could impose draconian penalties for a “slip or two” in compliance?  Finally, if the posture of the regulators is based on a “philosophy” and not the law, could that “philosophy” change with the next administration? If that’s the case, should banks be advised to prepare for the worst?       

The widespread use of the US dollar in both commercial and financial transactions and the propensity of the US to use that position to levy fines and impose extraterritorial requirements make US regulations and the “philosophy” of the US regulator of paramount concern to internationally active banks. 

The HKMA may have “expectations” but Hong Kong and other foreign banks are likely to be more sensitive to what the US “expects” as evidenced by its past behavior.   Thus, the HKMA’s appeal is almost certain to collide with banks’ self-interest and certain “objective conditions”.

First, banks are profit oriented not public service institutions despite some manifestly absurd industry positioning / brand development advertising campaigns that are currently running. 

In other words, profit is job #1.  Financial “inclusion” like charity work is well down the list of priorities.  And is a miniscule part of activities.  Thus, despite its ad campaign running on the Bloomberg TV, Bank of America Merrill Lynch doesn’t devote a major portion of its efforts to bring clean water to folks in Africa.

Profit on an account is a function of revenues less costs.

Providing bank accounts and related services is a low margin high volume business. Contrast that with investment banking transactions where the volumes are significantly lower but the margins are immense.  

Considering only operating costs, many SME accounts at best offer marginal profitability. We’re talking about maybe tens of thousands of dollars profit per account for many accounts. 

When the costs of customer due diligence, monitoring, preparing and filing of suspicious transaction reports are included, profit is even less.  Customer due diligence (CDD) at the inception of a relationship is particularly labor intensive.  Much of the subsequent monitoring can be done via computer programs, but at the end of the day someone has to review the reports generated, decide whether to investigate further, and ultimately whether to approach the customer for more information and/or file a suspicious transaction report STR).  

On that score, banks file a good portion of their STRs for defensive (CYA) reasons.  It demonstrates they have a working compliance system.  If something untoward about a customer turns up in the future, the bank can say to the regulators “But I reported to you.  By the way you never got back to me.”  Thus, monitoring “risky” customers taken on to promote financial inclusion may trigger the need for a CYA STR even if the bank thinks the customer is "clean".  One can't be too careful because regulatory hindsight is often more than 20/20.

Fines take a potential bite out of profit.  But by increasing expenses they can also affect the capital a bank is required to maintain for operational risk under the Basel framework.  Lower Basel capital adequacy ratios can affect credit and stock ratings.  Increasing capital can lead to declines in ROE if the profits do not cover the cost of capital.  If capital cannot be increased, then the bank may have to reduce certain other activities (e.g. credit or market risk related) thus reducing income/profit.  

Second, it’s important to remember that banks are free to select or reject customers according to their own criteria.  Even in countries that have laws to prevent discrimination, banks may reject customers as long as the as criteria used are business principles-based, e.g., risk not race and are consistently applied.  Not every applicant for a new loan or new account will get one.  Not every customer with an existing loan will be granted a renewal or extension.  Similarly, not every customer with an account is guaranteed the right to retain it. So the appeal is a request not a command.

Third, there are a variety of objective conditions and not simply bloody-mindedness that are pushing banks to “de-risk”.

Chief among these are regulatory and legal risks, but there are others.

Regulatory Risks.

Billion dollar fines concentrate the minds or bankers quite sharply.  Settlements with regulators include more than fines.  Often settlements are (legally) structured as deferred prosecution agreements or DPAs.  As the name suggests, the DPA holds a sword over the head of the financial institution and compel compliance on an extraterritorial basis.

But don’t take AA’s word for it. 

Here are two 2016 quotes attributed to Assistant Attorney General Leslie Caldwell. “[w]e can require that the banks cooperate with our ongoing investigations, particularly in our investigations of individuals. We can require that such compliance programs and cooperation be implemented worldwide, rather than just in the United States. We can require periodic reporting to a court that oversees the agreements for its terms.”

Under the right circumstances, the government “will not hesitate to tear up a DPA or NPA and file criminal charges, where such action is appropriate and proportional to the breach.”

Here are some illustrative examples of DPAs.  Standard Chartered 2014 with DFS New York State.  The consent order triggered significant de-risking by SCB in the UAE as you may recall.  Here’s  HSBC 2012. 

So if you were a financial institution considering opening or maintaining an account relationship, would one of your key risk mitigation concerns be avoiding the risk that a regulator could suddenly be dictating how you run your business worldwide?  See the requirements in the HSBC DPA Paragraph #5.  Note not only the number of requirements but also the short leash in later points Paras 8 and 14-16. 

But as they say on late night TV.  “Wait there’s more”.

­Civil Lawsuits

Lawsuits such as that against the Arab Bank or the one in progress against HSBC, Barclays, Standard Chartered, the Royal Bank of Scotland and Credit Suisse are no doubt worrisome.  The latter suit is predicated on these banks’ admission of transferring money for Iran which the plaintiffs assert helped finance terrorist attacks against US military personnel in Iraq. There is to my knowledge no assertion that these banks actually transferred money for those attacks.  More here.  

Banks might be forgiven--particularly in light of the Arab Bank case—for questioning whether fair trials or impartial juries are available in certain jurisdictions.

Both the regulatory and legal actions highlight what is perhaps the key factor here.  Banks are subject not only to their own regulators and laws but to those of other countries.  The primary role of the US dollar in international financial transactions exposes not only major international banks but also smaller banks to US enforcement or legal actions.

Staff Risks

International banks operate in many countries.  Staff attitudes toward government regulations vary greatly.  In many countries the population treats their own government's laws and regulations as suggestions rather than binding constraints.  In some countries as a direct challenge to find a creative workaround.  An even more casual attitude often applies to laws of foreign countries.   Bank managements have to deal with the staff they have not the staff they wish they had.  In which case exposure can be neatly mitigated by not doing certain types of business or dealing with certain customers.  Eliminate discretion and one eliminates potential problems.

Recidivism Risk

If a bank is unfortunate enough to have encountered enforcement action, a further “slip” could trigger a severe response from at least one particular country, e.g., “tearing up DPAs” “filing criminal charges” as AAG Caldwell is quoted above.  Or additional fines or additional business conditions imposed.  Or even the threat of such action could cloud an institution’s stock price, customer confidence, etc.  Here’s an example.

Conclusion

When the risk reward ratio is highly skewed, the most effective risk management is risk avoidance.  

I suppose I could construct an RBA for running with scissors. But I will forgo running with scissors rather than “managing the risk” of doing so.  Simply because the potential return is dwarfed by the risk.

Banks are likely to do the same with respect to financial inclusion.   The lesson of Nogales Arizona and other similar stories of US banks closing branches on the US-side of the border with Mexico and “tossing” customers may be illustrative on this point.  Banks are likely to be much less solicitous of foreign than domestic customers. And the solicitude for domestic customers seems minimal in these cases. 

As outlined in the above press report, the US banks apparently claimed that their domestic de-risking was related to revised regulations requiring additional regulatory reporting and closure of “risky” accounts.  If you close your branch, you neatly “solve” both problems. 

月餅

When the Moon is Full All Mankind is One

Five nut mooncake no egg.  AA's favorite.  

Mooncake courtesy of one of AA's new colleagues and shipped along with two others at considerable expense. 

The other two sent are not pictured as they disappeared rather quickly after the package was opened.

Both AA and Ms. AA pronounced them better than Hong Kong

If there were any hidden messages, they are lost to history.  We didn't stop to look. 

What is A Lepo?

One Toke Over the Line

All Hat No Cattle

There's been a lot of unwarranted piling on Candidate Gary Johnson over his honest but simple question in an interview with MSNBC "What is Aleppo?"  Video here.

Many have assumed this reflects a lack of knowledge about geography.  Johnson has explained that "he was thinking of an acronym and not the Syrian war."

Does this explanation hold water?

First, the interview was verbal.  We really don't know what Candidate Johnson said, "What is Aleppo?"  Or "What is a LEPO"?  Or "What is a lepo?"

Second are there any terms that he might have been thinking about that could relate to Syria?  Drawing on his vast knowledge of matters financial and linguistic, AA offers the following possibilities.

1. LEPO Low Exercise Price Option - A financial innovation credited to the Land of Oz.  Perhaps, Johnson was trying to clarify if  MSNBC was asking for him to provide a low cost option to resolve Syria.
2. Lepo - A Basque word for "neck" - a common expression for a kill or choke point.  Hence, a request for him to identify the one action that would end the conflict. Why would he be thinking about Basque expressions?   Those with some knowledge of US history know that immigrating Basques settled primarily in California and the Southwest of the US. While New Mexico (where Johnson was governor) was not a major destination, Basques did settle there.
3. Lepo - A Finnish word for "at rest" used by the Finnish military to mean "at ease". Think of it as a way of conveying "Mission Accomplished" but without using those specific words.  Or perhaps a criticism of the current Administration's policy.

On the other hand, perhaps he didn't know.  Or in the glare of the spotlight froze.

A worthy nominee for the Rick Perry "statesman" award.   

SWIFT RMB Tracker August 2016 Issue - Further Thoughts on the Increase in RMB Usage in South Africa

SWIFT issues an excellent free monthly publication on use of the RMB in payments outside the PRC:  RMB Tracker.   As part of tracking RMB usage, RMB Tracker provides a monthly value-based comparison of the top twenty currencies so even if you're not interested in RMB usage you can track the fate of other currencies. 

You can either sign up for a monthly email or browse issues at SWIFT’s website.

The report is based on customer and bank payment orders (SWIFT MT Series 100 and 200 instructions).  SWIFT, of course, isn’t the only messaging system that financial institutions use.  However, it is widely used—probably the most widely used method for sending payment orders.  Thus, the report should give a very good indication—though more directional than precisely locational—about changes in the use of the RMB.  

The August issue focused on the Republic of South Africa (RSA).  Immediately below are extracts from the August RMB Tracker.  I've used boldface to highlight key points as well as the comments I will focus on. 

"Brussels, 24 August 2016 – SWIFT data shows that Renminbi (RMB) usage in payments in South Africa increased by 65% over the last 12 months and by 112% in the last two years, moving the country from position #30 in July 2014, to #24 in July 2016. Excluding domestic traffic, RMB payment messages increased in volume by 70% in the last 12 months. In addition, nearly 40% of RMB payments by South African institutions have been offshore payments exchanged with countries other than China and Hong Kong, compared to 16% in July 2015."

 “South Africa has experienced a major shift in RMB growth over the last two years, strengthening the country’s trade relations with China and Hong Kong,” says Harry Newman, Head of Banking, SWIFT. “The establishment of an RMB clearing centre in South Africa in July 2015, as well as Singapore’s increased use of the RMB for payments with South Africa, have been a catalyst for RMB growth in the region.”

A couple of things caught my eye.

But before I begin a technical note:  SWIFT’s analysis on the RSA is based on the change in the number (not value) of RMB payments to/from the RSA.  (Page 2).   The number of transactions is one way to measure adoption of the RMB for transactions.  However, I’d prefer analysis based on value, assuming both weren’t available.   If the volume increase is being driven by a large number of small value payments that would put a different spin on the increase figures than if the increase in number were closely tracking value.  

Why doesn’t SWIFT provide this?  They have the data.  In addition to the (free) RMB Tracker, SWIFT have a paid subscription sister publication and  presumably aren’t going to cannibalize its appeal by providing more information in Tracker.

As you read what follows, bear in mind that the lack of information on aggregate payment value constrains the analysis that follows.

Now to my comments.

As written, the report could be read to imply that South Africa has dramatically increased its RMB denominated transactions.   This is not strictly speaking the case.  Since the PBOC’s appointment of Bank of China’s Jo’burg branch (hereafter BOCJ) as the RMB clearing bank in RSA, BOCJ has marketed RMB correspondent banking services elsewhere in Africa.  The increase in volume reflects transactions from other African countries, not just the RSA.

We can find details of this activity in a February 2016 article by Yu Meng in The Peoples' Daily Online and which the South African China Economic and Trade Association relayed on its website.  I’ve highlighted the relevant portions in red and added some comments of my own in boldface blue.

"According to Bank of China, in the "first ten months of 2015, the Renminbi trade settlement and investment amount in and out of Africa (AA: that is, not just RSA) has grown 35% to 126.6 bn yuan (R254 bn).  Half the amount is facilitated by Bank of China’s Johannesburg branch (AA: Here we have a USD equivalent number.  Note BOCJ handles one-half of the aggregate value amount for Africa not just RSA) , which was authorized in July 2015 by China’s central bank, the People’s Bank of China, to serve as the clearing bank for Renminbi business, the first in Africa."

"At the moment, the Johannesburg Branch’s Renminbi service has reached more than 30 African countries, and opened 69 Renminbi clearing accounts for financial institutions in Africa."

(AA:  While we don’t have the volume of these non-RSA transactions nor the amounts, they could well account for a significant portion of the RMB payments attributed to RSA by SWIFT).

"Li, executive vice president of the Johannesburg branch, oversaw a 2.7 bn yuan (R6.08 bn) transaction on Nov 30th for a Mauritian client — the bank’s biggest single clearing deal in Africa. “We wouldn’t have even imagined a transaction in Renminbi this big last year and because of the PBoC’s authorization we expect to do more,” says Li."

(AA:  The wording is ambiguous.  It’s not clear if this was an outgoing or incoming payment.  In either case, it seems a rather large amount for single commercial transaction especially given the amount and nature of bilateral trade between the two countries. Mauritius annually imports roughly US$1 billion equivalent from the PRC – making this single payment over 40% of annual imports. 

The PRC is not among Mauritius five largest export markets.  RSA is in fifth place and annual exports are roughly US$200 million equivalent so it’s unlikely this was an incoming payment for Mauritian goods.   

Given that and the fact that Mauritius is an offshore financial center,  AA suspects that this transaction was financial not commercial.  This was a relatively large RMB transaction—apparently the largest or one of the largest in Africa.  If it is an outgoing payment, its origin may not be Mauritius.  If it is incoming ,its final destination may not be Mauritius.  

Given reports of Chinese parties engaging in “gray” cross-border transactions (AA’s euphemism of the post), AA imagines that a lot of parties might have an interest in finding out more details, particularly if this were a repeating transaction.

Second, Singapore’s increase in RMB payments to the RSA is also interesting. 

If they are trade related, that would imply that the RSA has either redenominated invoicing on existing trade or has "new" trade conducted in RMB.  If so, I’d expect that that pattern would be evident in RSA trade with other countries.  That’s based on the assumption that if the RSA is moving to a greater use of the RMB in its trade, it would be doing so with more than one country. 

That doesn’t have to be the case of course.  Perhaps, there was a unique opportunity to increase sales with Singaporean entities.  As well, the information SWIFT has provided on the increase is based on number of payments not value. 

Assuming that value is tracking to some extent the number of payments (again this need not be the case), as above, I suspect that transactions are financial not commercial.  Perhaps, BOCJ is obtaining RMB for its operations from Singapore via for example FX transactions. While ICBC Singapore is the PBOC-designated RMB clearing bank (in Singapore) and not BOC Singapore, Singapore has some 110 or so banks.  Besides local banks that are active in the RMB, the country has a variety of foreign banks including banks from the PRC (BOC has a full branch) and from Hong Kong SAR who likely have RMB-denominated business and could serve as counterparties.

China CIPS - How is It Likely to Operate?

March 2016: CIPS and SWIFT Sign the MOU

Introduction:

If you read my previous post, then hopefully you’ve accepted the argument that CIPS is designed as a payment utility (analogous to CHIPS) not as a replacement for SWIFT (a global secure messaging utility).

Thus, if CIPS is an alternative to anything, it is an alternative to currently existing cumbersome methods for parties outside of Mainland China to make and receive RMB payments.

By way of fleshing out this analogy, let’s look a bit closer at CHIPS and how it fits into the domestic US payment system.  CHIPS processes US dollar payments –largely those related to cross border transactions.  FEDWIRE and ACH (for smaller payments that are made in very large numbers, e.g., salaries) handle the bulk of domestic (US) oriented dollar payments. 

Similarly CIPS will handle internationally oriented RMB denominated payments, while CNAPS2--the local equivalent of FEDWIRE-- (primarily) will process domestic oriented RMB payments in the PRC.

Key Results of CIPS Likely Method of Operations

There are four key likely effects:  

1. Requirement that CIPS member banks be located in the PRC.  Banks around the world are not going to be connected to CIPS as they currently are to SWIFT.
2. Reliance by foreign banks wishing to use CIPS on Chinese correspondent banks. 
3. Use of SWIFT means that perceived risks associated with the use of SWIFT are not mitigated. 
4. Negative impact on existing RMB clearing banks and centers, with Hong Kong potentially hard hit.

Domestic Membership:  Like CHIPS, CIPS almost certainly will require that its members (the institutions who can directly enter payment orders into the system and who directly receive payments from the system) be in the PRC (not offshore) and have accounts with the (local) central bank (the PBOC) to settle transactions.  Credit concerns over settlement of transactions, including minimizing systemic risks to the national payment system and economy, and operational needs motivate this requirement.

Reliance on Correspondent Banks: Offshore banks that want to send payments via CIPS will have to maintain RMB accounts with Chinese correspondent banks who are direct CIPS members or with other banks who themselves maintain such accounts.  This latter option is more operationally complex and not one that many banks are likely to take -- unless they have credit concerns about maintaining large balances in accounts subject to PRC jurisdiction.   Offshore banks who want to send USD payments through CHIPS or Sterling payments through London-based CHAPS have a similar reliance on correspondents. 

Use of SWIFT by Foreign Banks: What this means then is those offshore banks are very likely going to use SWIFT to send messages to the correspondents (CIPS direct members) and receive information from CIPS members about transactions via SWIFT just as they do with CHIPS USD transactions. 

If as it  seems, foreign banks will send their payment instructions to CIPS members via SWIFT, then if sanctions or other pressure forces SWIFT to deny a Chinese bank access to SWIFT, that bank will no longer be able to receive SWIFT payment messages from foreign banks or send them messages.  

Potential Use of SWIFT by CIPS:  If CIPS direct participants use SWIFT to send payment instructions to CIPS, then a denial of SWIFT services to Chinese banks could “shut down” CIPS. 

Impact on Perceived Risks Associated with SWIFT Usage:  As I hope is evident, to the extent that SWIFT is used with CIPS, concerns about “spying” or sanctions-induced denial of SWIFT access—assuming that these really exist--are not eliminated.

But note, at this point it’s not clear –at least to AA—if CIPS will 

• rely on SWIFT for such “internal” communications or 
• operate a separate secure communication system of its own.   
• Target, the Europe-based payment system that makes euro denominated payments, uses SWIFT for this purpose.  
• CHIPS has a different model.  It relies on its own secure communication system to send payment instructions to CHIPS.   

Of the two options, I expect that China will adopt the CHIPS model, if not immediately, as soon as it can. 

Problems that both Iran and Russia faced no doubt have been noticed by PRC decision makers.   Iran’s SWIFT access was suspended --now restored in the wake of the nuclear agreement.  US sanctions restricted Russian domestic debit and credit card processing almost all of which was offshore and thus outside of Russian authorities’ control until that processing was subsequently brought onshore.  Calls by the then British PM and other EU entities for Russia to “de-SWIFTed”  threatened the potential shutdown of the country’s SWIFT-based domestic payment system with potentially devastating economic effects, causing the Central Bank of Russia to  introduce a replacement non-SWIFT-based payment national payment system.  

But I think that the Chinese need little “education” on this topic. 

Well before Iran’s or Russia’s problems, the PRC required that domestic credit and debit card transactions be processed by a domestic system. Some of this was likely motivated by a desire to promote local business as well as to limit the risks of reliance on foreigners.

Impact on Clearing Banks and Centers –Particularly Hong Kong: Finally, another often overlooked result of CIPS is the impact on offshore clearing banks. Under the current “clearing bank” arrangement designated banks outside the Mainland handle offshore and cross-border RMB transfers.  Hong Kong is particularly vulnerable as it handles roughly 70% of all offshore RMB transactions.  (Page 7)

Once CIPS is successful, Hong Kong banks (particularly Bank of China Hong Kong) are likely to experience a dramatic fall in transaction volume and fees. Customer RMB deposits are also likely to decline as deposits are shifted to CIPS member correspondent banks on the Mainland. 

Factors that could mitigate that fall are

1. the utility of offshore accounts for “workarounders’” and “investors’” currency exfiltration and infiltration transactions with the mainland, a lot of HK – Mainland trade is actually composed of regulatory avoidance transactions dressed up as trade, 
2. more “legitimate” regulatory planning reasons for maintaining offshore RMB deposits similar to those for offshore US dollar deposits, and 
3. a possible depositor preference for banks and jurisdictions perceived to be more creditworthy and offering more legal protection to depositors than those on the Mainland.

CIPS (China International Payment System) Hysteria Largely Dispelled?

AA Reporting from His Secure Location: Sometimes You Need More Than Just the Hat

When the PRC announced its intent to create CIPS--the China International Payment System, now renamed the Cross- Border Interbank Payment System--some trumpeted it as a replacement for SWIFT and another, perhaps, the fatal step in global de-dollarization, heralding the end of the primacy of the US dollar.  Here’s one particular brilliant “insight” cast in terms of “white and black hats” and “blessings”. 

Most of this commentary was ideologically-driven:  a preconceived notion in desperate search for  validation. When your ideology gives all the answers, analysis is not only very easy but very facile. You just fit the facts or what might pass as “facts” around the preordained answer.

My favorite exemplar of this way of “thinking” is the assertion that the ruble is fully supported by gold and thus in some way superior to the US’s “fiat” money.  That’s “supported” like Golden Belt Sukuk was “asset backed” –“way back” it turned out.  No doubt AA is missing the opportunity of a lifetime by not converting his deposits to rubles and depositing them in a Russian bank. What could possibly go wrong?  But then I resisted buying Golden Belt Sukuk so I have a track record for missing out.  

Some of it was based on the latent hysteria that often informs discussions of politics and economics, particularly when certain actors are involved.  Here there was a veritable trifecta:  possibly including China, Russia, and Iran – an “axis of evil” for some.  But as the video above shows for others an “axis of virtue”.  Count your blessings!   And note the white cowboy hat on the wall in the video!

At the time there were more balanced analyses like this one from the FT which cast CIPS  as an attempt to simplify the process of making cross-border RMB payments to promote internationalization of the RMB and perhaps lessen exposure to alleged spying and the threat of denial of SWIFT services.  As it turns out these latter goals appear not to have been met as will be outlined in a following post.  CIPS may well facilitate greater “regulatory supervision” (but not “spying” for sure) of offshore RMB-denominated transactions by PRC authorities.

SWIFT’s 25 March 2016 press release by and large put an end to nonsense about CIPS as a global replacement for SWIFT or should have. 

“The MOU sets out plans for a strategic collaboration to develop China’s Cross-border Interbank Payment System (CIPS) using SWIFT as the secure, efficient and reliable channel to connect CIPS with SWIFT’s global user community.”

But there are still holdouts.

Ideology is a powerful thing in the face of mere facts. Here’s one from Jim Willie over at the aptly named website “Before It’s News” carrying a dateline four days after SWIFT’s press release.  I guess the site name means the articles are written before looking at the news.

What’s clear or should be now is that CIPS is not a replacement for SWIFT.  It’s analogous to CHIPS – a New York-based bank-owned utility that makes the bulk of cross-border payments in the US dollar. That is, CIPS is a payment utility like CHIPS or CHAPS, not a secure messaging system like SWIFT. 

Why create CIPS? 

The PRC is looking to promote the internationalization of the RMB.  CIPS is designed to streamline the currently cumbersome process of making cross border RMB payments.  It is also a way to bring this payment “traffic” within the PRC.  As a result of bringing that traffic onshore, PRC authorities will have more visibility into offshore RMB payments than they previously had.  

But could we have figured out that CIPS was highly unlikely to replace SWIFT when CIPS was first mooted?  Yes!

Because there’s a lot of apparent confusion about precisely what SWIFT does, let’s start with some basic facts as they’re part of the foundation of the argument to follow.

SWIFT not hold any accounts, nor does it execute any payments.  It transmits payment instructions to financial institutions that then “make” payments either (a) through utilities (like CHIPS or CHAPS) or national payment systems (like FEDWIRE, CNAPS2—China’s domestic RMB payment system) or  (b) on their own books (book transfer) when they hold the account of the intermediary or final beneficiary. 

That is, assume Bank A receives a SWIFT message from Bank B ordering Bank A to debit Bank B’s account and pay Bank C for account of Person or Company K. 

1. If Bank A holds the account of Bank C, it will make payment on its own books (an internal payment or book transfer) unless Bank B instructs it otherwise. As the name implies, the payment is made within Bank A.  Bank A’s assets and liabilities don’t decline when the transfer is made.  All that happens is that the amount of the payment is moved from Bank B’s to Bank C’s account –an internal shift within liabilities.   
2. If Bank A doesn’t hold Bank C’s account, it will pay the correspondent Bank that holds Bank C’s account either through the utility or national payment system (in banker speak a “wire transfer”).  In this case Bank A’s assets and liabilities will decline by the amount of the payment and Bank C’s correspondent bank’s assets and liabilities will go up by the amount of the payment.  Here there’s an actual movement of funds out of Bank A to Bank C’s correspondent.

While SWIFT is probably the most convenient and most used method to send and receive payment instructions, it is not the only way.  If SWIFT denies a financial institution access to its system, that financial institution can use a variety of other methods (proprietary PC based systems that mimic SWIFT, or other methods like telex, facsimile, email, letters) to send payment instructions to its correspondent.  These will often be more cumbersome and costly and less secure, but if the correspondent is willing to accept them, the payment can be made.

What’s involved in creating a global replacement for SWIFT?  

First a side digression to place this question in context. Creating a bi-lateral alternative or regional alternative would be much easier.  Most internationally active banks offer their customers PC-based systems for transmitting payment orders and receiving account information though such services are limited to two-way communication between the specific customer and a single bank.  Banks in Russia and China offer these services and could easily set up a communications system. If there was a preference to avoid the internet, a cable could be laid.  But that would not be a global replacement.

Putting aside the not inconsiderable cost of creating a new SWIFT, one would have to build a system offering similar services at the same or lower costs, persuade existing SWIFT clients that there was a good reason to shift from SWIFT, and at least for now convince them to shift a large portion of their transactions to the RMB.  That of course would require that the banks’ customers shifted their transactions to the RMB away from the dollar or other currencies.  All this seems to AA to be well beyond a hard slog.

SWIFT works.  That’s why it is the global communication utility. It is as embedded in the payments world as Microsoft software is in the PC world, though I’d argue that SWIFT has the better product. 

Here’s the hill to climb.

1. More than 11,000 financial institutions in more than 200 countries use SWIFT. 
2. SWIFT supports more than 150 payment and settlement systems around the globe.  
3. In 2015 SWIFT handled over 6.1 billion messages related to payments (in a wide variety of currencies not just one), securities transactions, treasury operations (FX dealing, interbank deposits, swaps, loan syndications, gold trading), trade finance (letters of credit, collections).   With this sort of volume fixed cost per transaction is low.  Variable cost is very low.  How does an upstart match this advantage? 
4. SWIFT offers a robust range of products beyond “mere” payments, including financial messaging, bulk file transfers, secure internet browsing/web access for SWIFT members’ clients, a comprehensive suite of compliance and analytical tools --anti-money laundering, sanctions enforcement, etc. 
5. And does so with 99.999% reliability year after year after year.  Its credibility as a reliable partner is proven.

Beyond these obstacles there is another very serious impediment to getting banks to embrace CIPS as an alternative to SWIFT: currency.

CIPS is likely to be limited to a single currency—the RMB.   Today only about 40 percent or so of SWIFT payments are in dollars (Page 5).  What do foreign banks do with the other 60% of their payments?  Run two communication systems?  SWIFT for everything but RMB? And CIPS for RMB?  That’s operationally cumbersome and thus expensive in an environment when cost minimization is key.

On top of that the RMB is less attractive than the dollar and likely to remain so for a long time because of concerns about transparency, business ethics and fair dealing, legal redress, market size (availability of sufficient investable RMB denominated assets), and their liquidity and credit quality to name just a few of the challenges the PRC faces in making the RMB a true alternative to the US dollar. 

Don’t mistake this comment as a Pollyannaish view that the dollar’s place in the world economy is unassailable.  It isn’t.   Sadly, our “own goals” are likely to be the main factor in the dollar’s fate.  Richard Dunne step aside for the real pros!  Any alternative currency will also have to offer the same or greater benefits than the dollar.

Next post will discuss some of the issues arising from how CIPS is likely to operate.

EU Commission Irish Tax Ruling in Re Apple: Tim Cook and Abu Arqala Outraged

AA is Paying Attention.  Are You?

This Tuesday the EU leveled some pretty serious allegations against both Ireland and Apple regarding Irish tax treatment of two Apple subsidiaries. 

Tim Cook, Apple's CEO, is outraged.  With just nineteen eloquent words he both defended Apple's reputation and demolished the EU's apparently baseless allegations. More here.

“When you’re accused of doing something that is so foreign to your values, it brings out outrage in you.”

I've boldfaced a few words above to highlight what I think is the central point in Tim's argument. 

Values!  Values, indeed. 

Where would we all be if people and corporations didn't have values? It isn't and shouldn't be "all about the Benjamins."  There are some principles or values that should guide our lives as individuals and corporations. Character informs the values chosen. And actions more than words demonstrate both character and values. 

That being said, sometimes things are "foreign to one's values".  In AA's experience often when they are foreign (cross-border).

Frankly, since learning about the EU's no doubt intemperate ruling, I've been so outraged that I haven't been able to post. 

But today I'm calm enough to go on record in joining Tim in his outrage, or perhaps, more precisely in outrage.  

In the interest of fairness and to show you how the EU has apparently overstepped the bounds of common sense as well as the sovereignty of Ireland, let's give voice to the EU's allegations.  After reading them, I'm sure you will be as outraged as AA and equally comforted by Tim's eloquence! I've added boldface to some of the text below to highlight the EU's no doubt spurious reasoning and overreach.

"Member States cannot give tax benefits to selected companies – this is illegal under EU state aid rules. The Commission's investigation concluded that Ireland granted illegal tax benefits to Apple, which enabled it to pay substantially less tax than other businesses over many years. In fact, this selective treatment allowed Apple to pay an effective corporate tax rate of 1 per cent on its European profits in 2003 down to 0.005 per cent in 2014."

In fact, the tax treatment in Ireland enabled Apple to avoid taxation on almost all profits generated by sales of Apple products in the entire EU Single Market. This is due to Apple's decision to record all sales in Ireland rather than in the countries where the products were sold. This structure is however outside the remit of EU state aid control. If other countries were to require Apple to pay more tax on profits of the two companies over the same period under their national taxation rules, this would reduce the amount to be recovered by Ireland

The two tax rulings issued by Ireland concerned the internal allocation of these profits within Apple Sales International (rather than the wider set-up of Apple's sales operations in Europe). Specifically, they endorsed a split of the profits for tax purposes in Ireland: Under the agreed method, most profits were internally allocated away from Ireland to a "head office" within Apple Sales International. This "head office" was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. Only a fraction of the profits of Apple Sales International were allocated to its Irish branch and subject to tax in Ireland. The remaining vast majority of profits were allocated to the "head office", where they remained untaxed 

Therefore, only a small percentage of Apple Sales International's profits were taxed in Ireland, and the rest was taxed nowhere. In 2011, for example (according to figures released at US Senate public hearings), Apple Sales International recorded profits of US$ 22 billion (c.a. €16 billion[1]) but under the terms of the tax ruling only around €50 million were considered taxable in Ireland, leaving €15.95 billion of profits untaxed. As a result, Apple Sales International b. In subsequent years, Apple Sales International's recorded profits continued to increase but the profits considered taxable in Ireland under the terms of the tax ruling did not. Thus this effective tax rate decreased further to only 0.005% in 2014.

 The EU has prepared an "infographic" which provides a summary overview of the tax structure.

I trust you share my outrage and Tim's too.