Cuba announced on Tuesday that it is ceasing almost all consular services in the United States after M&T Bank (>> M&T Bank Corporation) closed its account, sending shock waves through the booming Cuba-U.S. travel industry and threatening to undermine the Obama administration's goal of closer "people-to-people" ties.

Cuba blamed its unusual bank-less status on the longstanding U.S. economic embargo against the communist island, as well as sanctions resulting from it being included on the U.S. list of state sponsors of terrorism. These incur regulations - and potential fines - so onerous that banks are reluctant to accept such toxic accounts, experts say.

Cuba has so far not threatened any reciprocal action against the U.S. diplomatic mission in Havana, and observers were watching for signs of restraint, which diplomats would take as further indication that Cuba is pursuing improved relations.

The banking snafu was a problem not likely to go unresolved for too long because both Cuba and the United States have too much to lose from disrupting travel between the two countries, experts said.

But it exposed a conflict within U.S. policy towards Cuba which on the one hand wants closer travel ties with the island, and yet on the other brands it a supporter of terrorism.

"It begs the question how do we modernize these rules so they don't conflict with our policy goals. We want more people-to-people travel, and more family travel," said U.S. Representative Joe Garcia, a Cuban-American Democrat from Miami.

He was referring to the Obama administration's support for educational and cultural exchanges, as well as unrestricted visits for Cuban families divided by the Florida Straits.

"We have a series of rules that are at best arcane and were cumbersome when they were created three decades ago. They are out of tone and time."

CUBA NEEDS TOURISM REVENUES

Cuba also cannot afford a drop in tourism to the island, which has become a mainstay of its cash-strapped economy.

The Obama administration says it is "actively working" to help Cuba find a bank willing to handle its U.S. accounts, but officials declined to go into details.

"We would like to see the Cuban missions return to full operations," a State Department spokeswoman said.

The fastest way to do that would be by taking Cuba off the list of state sponsors of terrorism, a pariah status many Cuba analysts say the island no longer deserves.

The Obama administration may be contemplating such a move, but does not appear ready to go that far yet, analysts say.

"This banking issues is all about Cuba being on the list of state sponsors of terrorism," said Richard Feinberg, a senior fellow of the Washington-based Brookings Institution.

A heightened sanctions compliance regime in recent years was more directed at Iran, North Korea and Syria, he noted, but Cuba suffered the consequences by being stuck in the same boat.

"The huge irony is that all this is happening just as we are about to relax sanctions on Iran," he added.

Even so, the Obama administration ought to be able to come up with a way to reassure the banks that their exposure to regulation by the Treasury Department's Office of Foreign Assets Control (OFAC), which enforces sanctions, will be minimal, legal experts say.

"The Treasury Department needs to tell a Washington DC area bank that it has their blessing to handle Cuba's account through expediting the licensing," said Antonio C. Martinez II, a New York attorney who deals with Cuba sanctions compliance and edits a blog critical of the embargo.

A Miami lawyer familiar with international banking and the Cuba embargo suggested that the White House or the State Department could simply resolve the matter with the Office of the Comptroller of the Currency, which regulates all national banks.

"Banks are very nervous about any type of misstep about money flowing to any country on the OFAC list because the fines, even if you only make a small mistake, are huge," he said. "You have to scrutinize everything coming in and out. The problem is who wants to take that on? You just can't make money on these accounts."

REGULATORY HURDLES MAKE BANKS LEERY

M&T did not respond to calls for comment, but U.S. officials say over the past few years a number of banks have ceased providing banking services to diplomatic missions partly due to regulatory issues.

Some banks have paid hefty fines for bad Cuba transactions. In June Italy's second-largest bank, Turin-based Intesa San Paolo (>> Intesa Sanpaolo SpA), paid OFAC $3 million over U.S. dollar transactions involving Cuba, Iran and Sudan.

Intesa processed 53 wire transfers for more than $1.6 million to Cuba between 2004 and 2008, according to OFAC.

Last year, the Dutch bank ING Bank NV (>> ING GROEP) agreed to pay $619 million to settle U.S. government allegations that it moved money illegally through banks in the United States in violation of sanctions against Cuba, Iran and other countries. It was the biggest fine against a bank for sanctions violations, officials said.

Swiss banks UBS AG (>> UBS AG) and Credit Suisse AG (>> Credit Suisse Group AG) and Britain's Lloyds TSB Bank PLC <LLOYSY.UL> and Barclays Bank PLC (>> Barclays PLC) have also paid out hundreds of millions more in similar fines involving Cuba transactions.

U.S. officials say over the past few years a number of banks have ceased providing banking services to diplomatic missions linked to terrorism due to regulatory issues.

"Many banks and companies get caught in the sanctions web and they often can pay a costly price," said Martinez.

"The question is does Cuba belong on the terror list."

(Corrects spelling of Office of the Comptroller of the Currency)

(Editing by Cynthia Osterman)

By David Adams