It’s impossible for all banks and financial institutions in the world to have a direct relationship with each other. If having a direct relationship was the only way to conduct financial transactions across borders, global trade would grind to a halt.
Therefore, a solution was required for the global financial system that enabled banks in different jurisdictions to do business, even in the absence of a relationship. This solution is what’s known as a correspondent bank.
What is a Correspondent Bank?
A correspondent bank is a third-party financial institution that acts as an intermediary between domestic and international banks. Correspondent banks effectively act as an agent of a foreign bank to conduct business transactions with the domestic bank on its behalf.
They’re able to provide a variety of financial services to both parties, including but not limited to, treasury services, processing international wire transfers, handling global investments, and trade financing. The correspondent bank charges a fee from the foreign bank for the services rendered.
Correspondent banks are able to act as a liaison since they typically have direct banking relationships with both the domestic and foreign banks. This enables them to provide services to both banks.
Domestic banks commonly use correspondent banks to handle transactions that either originate or terminate in a foreign country.
How Does a Correspondent Bank Work?
Since correspondent banks are third-party banks, think of them as the middleman between two financial institutions. Without them, it wouldn’t be possible for the domestic and foreign banks to process the transaction if they don’t have a formal relationship.
The correspondent bank receives instructions to process a transaction such as a funds transfer, settlement, currency exchange, etc., along with the requisite funds. It relays that to the other bank, thereby executing the transaction.
Correspondent banks are most commonly used when funds need to be transferred to a foreign country. This is done through SWIFT or the Society for Worldwide Interbank Financial Telecommunication. SWIFT is the largest network of correspondent banks worldwide. Its members include 11,000 financial institutions in over 200 countries and territories.
If the domestic bank doesn’t have a relationship with the overseas bank that it needs to do a transaction with, it will search the SWIFT network for a correspondent bank that has a formal relationship with both banks. When one has been found, the transaction will be initiated by transferring the funds to the special accounts held at the correspondent bank.
Vostro and Nostro Accounts: The Secret to Correspondent Banking
Banks rely on nostro and vostro accounts to keep track of the funds required for settling cross-border transactions. They typically have several nostro and vostro accounts on their balance sheets.
Nostro is Latin for “our” and in the terms of correspondent banking, it means “our account, on your books.” Vostro means “yours,” and in this case it stands for “your account, on our books.” It’s these accounts that make it possible to track cross-border debit and credit transactions.
So, when a domestic bank needs to transfer funds overseas, it will send the money into their nostro account at the correspondent bank. The transaction fee is deducted and the funds are transferred by the correspondent into the receiving bank’s vostro account.
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Example of a Correspondent Banking Transaction
Jim needs to acquire some machinery from Japan for his business. The supplier needs to be paid in foreign currency in a JPY-denominated account. Since his US bank doesn’t have a direct relationship with the supplier’s Japanese bank, the transaction will need to be processed through the SWIFT network.
The banker at Jim’s bank will use the SWIFT network to find a correspondent bank that has a relationship with both their institution and the Japanese bank. When the correspondent is found, Jim’s bank will send the funds to their nostro account held by the correspondent, which will then deduct a fee, and deposit the money into the receiving bank’s vostro account.
Correspondent banking thus makes it possible for Jim to conduct business with a supplier in Japan without having a bank account in that country. He doesn’t even need to change banks in the US.
His existing bank is able to process the transaction, even though it doesn’t have a relationship with the Japanese bank, by simply selecting a correspondent bank through the SWIFT network that can act as the intermediary.
Does a Correspondent Bank Charge Fees?
Correspondent banks do charge fees for the services they provide. These can vary depending on several factors. For international wire transfers, the fees can typically range from $25 to $75 per transaction.
The banks inform their customers about the fees for such transactions. Some might only charge customers what they pay to the correspondent bank, others may include a markup on the actual cost.
Pros and Cons of Correspondent Banks
The biggest advantage that correspondent banks provide is that they empower domestic banks to access the global financial system without having to set up branches in foreign jurisdictions. Such an endeavor will no doubt be costly and fraught with regulatory risk for banks.
By simply working with a correspondent bank, a domestic bank is able to offer its customers global funds transfers, check clearing, and related services, without even having a formal relationship with the bank at the other end. The correspondent bank handles everything for them.
One disadvantage to customers is that transactions processed through correspondent banks tend to take time, often more so than they’d expect. A wire transfer can usually take a couple of days to be processed. It feels like an inordinate delay in a day and age where money is expected to move in mere seconds.
The added cost is another disadvantage. Since correspondent banks charge a fee for the services that they provide, customers usually have to bear these charges. This can increase transaction costs for them significantly, particularly if their bank tends to charge a premium on the fees. Nevertheless, this is all in the interest of providing safe and reliable international transactions.
Correspondent banks are a key facilitator of global trade. Without them, domestic banks would be unable to provide the financial services that enable companies to conduct business on a global scale.
It’s impossible for any bank to have a direct relationship with every other bank or open branches in every city across the globe. It’s only through the correspondent banking network that they’re able to tap into the global financial system for their clients.