The decision by a New York bank to close Cuba’s checking account in the United States has presented an unusual diplomatic quandary that will test the newfound pragmatism in relations between the two longtime foes.

Cuba announced Tuesday that it is ceasing almost all consular services in the United States after M&T Bank 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 long-standing U.S. economic embargo against the communist island and sanctions from its inclusion on the U.S. list of state sponsors of terrorism. The resulting regulations — and potential fines — Cuba faces are so onerous that banks are reluctant to accept such toxic accounts, experts say.

The Cuban government has not threatened 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 issue is a problem not likely to go unresolved for too long, because both Cuba and the United States have too much to lose from disrupted travel between the two countries, experts said.

But it has exposed a conflict within U.S. policy toward Cuba. On one hand the United States wants closer travel ties with the island, yet on the other it brands Cuba a supporter of terrorism.

“It begs the question, how do we modernize these rules so they don’t conflict with our policy goals?” said Rep. Joe Garcia (D-Fla.), a Cuban American from Miami. “We want more people-to-people travel and more family travel.”

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,” Garcia said. “They are out of tone and time.”

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

The Obama administration said 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 issue is all about Cuba being on the list of state sponsors of terrorism,” said Richard Feinberg, a senior fellow with 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, D.C.-area bank that it has their blessing to handle Cuba’s account through expediting the licensing,” said Antonio C. Martinez II, a New York lawyer 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 Controller 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.”

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

Some banks have paid hefty fines for bad Cuba transactions. In June, Italy’s second-largest bank, Turin-based Intesa Sanpaolo, paid the 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 the OFAC.

Last year, the Dutch bank ING 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 and Credit Suisse and Britain’s Lloyds TSB and Barclays have also paid out hundreds of millions more in similar fines involving Cuba transactions.

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

“The question is, Does Cuba belong on the terror list?”

— Reuters