By Katie Nguyen

LONDON, Feb 3 (Thomson Reuters Foundation) - A decision by a U.S. bank to stop doing business with companies that transfer money from Somalis living in the United States to families back home could have a "catastrophic" impact on the fragile Horn of Africa country, development groups said.

The lack of a formal banking system in Somalia is one of the legacies of conflict and instability that has gripped the nation since military dictator Mohamed Siad Barre was ousted in 1991.

Each year Somalis abroad use money transfer operators to send home an estimated $1.3 billion, more than all humanitarian and development aid combined, according to a 2013 report by aid groups Oxfam, Adeso and the Inter-American Dialogue.

The money provides a lifeline to millions of people in a country rebuilding itself despite an insurgency by Islamist militants, hunger and recurring drought.

The United States is the biggest source of remittances, accounting for nearly 20 percent of the total, Oxfam says.

But virtually all major U.S. banks have ended remittance services to Somalis in the United States because of regulations designed to stop money falling into the hands of groups branded "terrorists" by Washington, such as Somalia's al Shabaab.

Last week, Merchants Bank of California, which handles an estimated 60 to 80 percent of the money bound for Somalia, said it was terminating its business with Somali-American money transfer companies.

"I regret to inform you that Merchants Bank of California, N.A. has decided, effective February 6, 2015, to discontinue its relationship with your company. We regret having to take this action," the bank said in a letter dated Jan. 27, a copy of which was provided by Oxfam America.

Merchants Bank said the Office of the Comptroller of the Currency (OCC), an independent bureau within the U.S. Treasury Department, had issued it with a so-called "consent order" instructing it to enhance its policies and procedures to detect potential violations of the law.

"We cannot in good faith meet the obligations of the Consent Order given the complexity of your business," the letter to the money transfer companies read.

Merchants Bank officials did not immediately respond to a request for comment.

ECONOMIC BACKBONE

"The remittance companies and the whole sector is the backbone of the Somali economy. We think this is going to have some serious and possibly catastrophic impact," said Degan Ali, executive director of Adeso, a humanitarian and development group working in Kenya, Somalia and South Sudan.

"We really worry about what's going to happen to the millions of Somalis who are dependent on this for their daily lives. This is basic needs. We're talking about food, shelter, medical needs, education for the children," she told the Thomson Reuters Foundation by telephone.

Remittances cover basic needs and have also been used to build hospitals, schools, water infiltration systems and other development projects, Oxfam says.

Money transfer companies are also used by the government to pay civil servants, traders to buy goods, and non-governmental organisations including U.N. agencies to deliver aid.

Oxfam and Adeso say there is no alternative to money transfer companies that is formal, transparent and legal.

"Financial criminals and criminal networks would have a field day because this kind of environment where there is very little transparency and where regulators really can't follow the money is where financial criminals tend to flourish," said Scott Paul, Oxfam America's senior humanitarian policy adviser.

"Unless there's urgent intervention by the U.S. government, we're going to see less money going to people who need it and more money going to criminal networks," he said by telephone.

Adeso's Ali said: "It just defeats the purpose. We're talking about resiliency. That's the new hot word now. Well, this is the most resilient system we have, Somalis helping other Somalis, so why are we destroying it?"

(Additional reporting by Maria Caspani in New York, editing by Tim Pearce