What is a Correspondent Bank?

Correspondent banking is an agreement between two banks whereby one bank (correspondent bank) carries on representative services (such as maintaining deposits, offering settlements, etc.) for another bank (respondent bank).

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How Does a Correspondent Bank Work?

A respondent bank may contract with a correspondent bank to carry on transactions as a representative of the respondent bank. In other scenarios, the correspondent bank will serve as an intermediary between the respondent bank and a third-party bank. The respondent bank's client will undertake a transaction at the third-party bank, such as a deposit or withdrawal. The third-party bank will seek settlement of the transaction by going through the correspondent bank. The correspondent bank will settle the transaction with the third-party bank before seeking a settlement from the respondent bank. This arrangement is popular when the respondent bank does not have operations in a given area - such as in foreign countries.

Correspondent banks are capable of processing documentations, accepting deposits, and posing as funds transfer agents at the local level. Respondent Bank accounts held at the correspondent banks are commonly referred to as a Nostro Accounts. The correspondent bank holding these accounts refer to them as Vostro accounts.

Correspondent banking is not limited to simply clearing customer transactions. Other services provided by the correspondent bank include:

• Local Branch Services,
• Third-party payment processing,
• Commercial Financial Arrangments,
• Cash clearing,
• Liquidity controls, and
• Short-term borrowing/lending.

Example of a Correspondent Bank Transaction 

Let's assume instructions to transfer funds to a bank located in Italy has been received by a bank located in China. The bank in China is not capable of transferring the funds directly to the bank in Italy if it doesn't have a working relationship with the bank in Italy. Since a majority of international transfers are conducted by the Society for Worldwide Interbank Financial Telecommunication (SWIFT), the bank in China can search for a correspondent bank that has a working relationship with it and the bank in Italy on the SWIFT network. It then transfers funds to its Nostro account in the correspondent bank; which in turn transfers the funds to the receiving bank in Italy after deducting a fee ranging from $25 to $75.