A correspondent bank is a financial institution that provides essential services to another bank, usually located in a different country. By acting as an intermediary, it facilitates wire transfers, business transactions, accepts deposits, and gathers important documents on behalf of the latter. This relationship enables domestic banks to serve international clients and access foreign financial markets without the need for establishing physical branches abroad.
Key Takeaways
- A correspondent bank delivers services on behalf of another financial institution.
- These services may include funds transfer, settlement, check clearing, wire services, and currency exchanges.
- The banks interact through nostro and vostro accounts - terms used respectively by the holding and counterparty banks.
- Domestic banks leverage correspondent banks to access global markets and serve international customers without opening foreign branches.
How a Correspondent Bank Operates
Correspondent banks act as crucial intermediaries between different financial institutions, especially across countries. They offer essential services such as:
- Funds Transfer
- Settlement
- Check Clearing
- Wire Transfers
- Currency Exchange
When clients travel abroad, correspondent banks process local transactions on behalf of their banks, facilitating deposits, documentation, and fund transfers. The nostro and vostro accounts help to track debits and credits between the banks involved in correspondent arrangements.
Correspondent banks become pivotal when the sending and receiving banks lack a direct agreement for wire transfers. For instance, through a correspondent bank, a small domestic bank can efficiently serve international clients without the formalities of setting up branches.
Example of Correspondent Banking
Consider a small bank in San Francisco with numerous international clients. Instead of setting up a branch in every client’s country, the bank collaborates with a correspondent bank. This correspondent bank can effectuate the client’s transactions overseas, including wire transfers and currency exchanges, while charging a service fee that can be passed on to the customer.
Special Considerations
When conducting international wire transfers, especially between banks without an established financial relationship, the process often involves the SWIFT network. The originating bank looks for a correspondent bank – within the SWIFT network – that has ongoing arrangements with both the sender and receiver banks. The correspondent bank then deducts appropriate fees and completes the transfer.
This setup benefits the domestic bank by negating the necessity of establishing foreign branches or direct arrangements with other global financial institutions.
Risks of Correspondent Banking
Correspondent banking carries risk management challenges. Correspondent banks depend on their client banks (respondent banks) to carry out due diligence, like the Know Your Client (KYC) policy. This reliance is fraught with risks, mainly concerning money laundering, as correspondent banks may not perform KYC checks on every payee.
Correspondent Bank vs. Intermediary Bank
While both correspondent and intermediary banks serve as third-party facilitators for other banks, the major difference lies in currency management. Correspondent banks typically manage multiple currencies in their transactions, whereas intermediary banks deal with transactions in a single currency. This is especially pivotal for smaller domestic banks handling cross-border transactions.
How Correspondent Banks Add Value
In transactions requirements, correspondent banks add immense value by saving the domestic banks from the trouble of establishing overseas branches and direct arrangements with global financial institutions. This ensures smoother, more efficient transactions for international commerce.
The Bottom Line
Correspondent banks are authorized financial entities providing intermediary service on behalf of another bank, usually across international borders. By leveraging correspondent banks, domestic banks can offer international transaction services without setting up foreign branches, thus efficiently accessing overseas markets and serving global clients smoothly.
Related Terms: intermediary bank, SWIFT network, money-laundering
References
- World Bank. “The Decline in Access to Correspondent Banking Services in Emerging Markets: Trends, Impacts, and Solutions”.
- Congressional Research Service. “Overview of Correspondent Banking and ‘De-Risking’ Issues”, Page 2.
- Financial Industry Regulatory Authority. “Obligations to Your Customers”.
- Dow Jones. “What Is Correspondent Banking”?
