How does corresponding banking work?

What is a corresponding banking?

The corresponding banking is when a financial institution (FI) acting as a third-party bank that conducts banking services on behalf of a local bank, usually in a foreign country. The network of such establishments, called correspondent banking, is a crucial part of the global payment system and international trade is contingent largely on it. Through such banking relationships, local banks can provide foreign banking services to their customers without setting up branches abroad.

Overview of correspondent banking:

Correspondent banks serve as intermediaries between different banking institutions. The services offered by such establishments include currency exchange, business transactions, gathering documents, and funds transfer among others. Also, such FIs operate as domestic bank agents abroad. They collect a fee for the provision of their services.

It should be noted that they have lots in common with intermediary banks—  they operate as 3^rd parties for other institutions. However, there is a significant distinction between them: correspondent banks conduct transactions operating with various currencies, while intermediary banks work only with a single currency.

A correspondent banking relationship includes one financial establishment (the correspondent) providing banking services to another financial establishment (the respondent), where the financial establishments conduct activities or business at or through permanent establishments in different countries. Thus, two banks enter into an agreement to open and keep a correspondent account (also known as Nostro or Vostro accounts), which empowers a local bank to carry on payments or do money transfers in the local currency as a representative of a foreign bank.

Third-party banks play a focal role in the global financial services market as they create a path for local banks to conduct their services when they cannot establish branches abroad. For example, a small local bank with international customers can cooperate with a correspondent bank to satisfy the needs of its customers abroad. Thus, corresponding banking makes international financial markets accessible for local banks.

How does correspondent banking work?

The accounts set between correspondent banking institutions and the other banks they partner with are Nostro and Vostro accounts.

A Vostro account is kept by a foreign institution with a local one in domestic currency. A Nostro account is a mechanism used by a bank to track capital in other banks in foreign currency. In general, both financial establishments in a correspondent relation hold reciprocal accounts for one another to track financial operations between each other.

The correspondent accounts empower banks to conduct cross-border transactions for their customers that require foreign currency exchange. As a rule, they conducted between an exporter from one country to an importing party in another country.

Example:

Such cross-border wire transfers usually take place between FIs that have no agreements for cooperation. For example, a bank in Los Angeles that instructed to transfer an amount of money to a bank in Tokyo has no opportunity to conduct the operation directly without an established relationship with that bank. Since a majority of cross-border transfers conducted by SWIFT, the US bank can find a third-party bank that has an arrangement with it and the Japanese bank on SWIFT. The respondent delivers the capital to the correspondent which, in its turn, withdraws the fee and forwards the appropriate amount of money to the Japanese bank. Operating in this way, the correspondent bank brings two essential benefits: it solves the problem of opening a physical office for the local bank in the foreign country and alleviates establishing direct relationships with other banks across the world.

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