What is Correspondent Bank?

Global trade cannot be sustained if every bank and financial institution worldwide must have a direct connection with one another. Correspondent banking is a necessary alternative for conducting cross-border financial transactions. In wire transfers or other international payments, correspondent banks are often utilized. This article will explain what correspondent banks are, how they function, and their role in bank-to-bank transfers.

What is a correspondent bank?

A bank acts as a mediator between domestic and foreign banks for cross-border payments through correspondent banking. Correspondent banks have formal agreements with both banks, allowing them to provide a range of services such as wire transfers, check and payment processing, financial management, payments, and loans.

The largest correspondent bank network is the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which connects over 11,000 financial institutions in 200 countries and territories. The SWIFT network facilitates global transactions for individuals and businesses without requiring two financial institutions.

For instance, if you reside in the United States and want to transfer money to a friend in Italy, the bank employee would search the SWIFT network for banks that have agreements with financial institutions in Italy to ensure a smooth transaction.

How does the bank work?

The bank primarily conducts international money transfers through the Society for Worldwide Interbank Financial Telecommunication (SWIFT).

An analogy for SWIFT payments is like your money taking a series of connecting flights to reach its destination. If the sending bank has no direct connection to the recipient's bank overseas, it will be routed through an intermediary bank, similar to how a traveler might take a connecting flight. The bank will then transfer the funds to the intermediary bank, which will then transfer the funds to the recipient's account. Once the payment has been received, it's like the traveler arriving at their destination.

However, this system has a significant drawback in that it takes time for the bank to process the payment and charges a fee for the transfer amount. Although it is a secure and reliable option, it is also slow and expensive.

Relationship with the correspondent bank

A beneficial banking relationship allows a respondent to access services from the relevant business. Effective interbank relationships enable respondents to offer services to customers requiring connections to specific regions where they do not have branches, relying on local correspondent banks to meet their needs. Such bank relationships provide several advantages, including:

• Increased number of customers
• Boost in revenue
• Competitive advantage
• Reduced costs of geographic expansion for the banking organization

Using the services of a financial institution is much more cost-effective than opening a branch in a foreign country. Therefore, outsourcing international payments or other banking services is a convenient way to avoid losing customers when international transactions are required, especially if the bank has no interest in establishing local operations.

Bank correspondent versus brokerage bank

While communication banks and brokerage banks share similarities, the significant difference between the two is that communication banks act as a third party for other banks, whereas brokerage banks do not. Communication banks typically handle transactions involving multiple currencies, while intermediary banks complete transactions involving a single currency. This is particularly essential for domestic banks, which may lack the capacity to handle such transactions.

An example of Correspondent bank transaction

To purchase a car in Japan for business, payment to the supplier must be made in yen to an account denominated in that currency. However, if the buyer's bank in the U.S. has no direct relationship with the supplier's Bank of Japan, the transaction must be conducted through the SWIFT network.

To accomplish this, Jim Bankers would utilize the SWIFT network to locate banks that have connections to both their institution and the Bank of Japan. Once a suitable correspondent bank is identified, Jim Bankers would send the funds to their Nostro account, which is owned by the correspondent bank, and the fee would be deducted before the money is deposited into the recipient bank's Bostro account.

Through this process, the correspondent bank allows Jim to conduct business with suppliers in Japan without needing to establish a bank account in Japan or change banks in the U.S. Jim's existing bank can process the transaction by selecting the correspondent bank through the SWIFT network, which can act as an intermediary even if it has no direct relationship with the Bank of Japan.

Correspondent bank fees

International transactions often involve various fees charged by different banks and financial institutions involved in the process. These fees can vary depending on the institution and the specific details of the transaction. For example, the fees can depend on whether the transfer is inbound or outbound, the currency used, and whether the transaction is initiated online or at a local branch.

It's important to note that some of these fees may go to the intermediary bank, not your local bank. For instance, when sending an international transfer through Chase, starting from your account through their website or mobile app, the cost is $50. At Bank of America, international transfers in other currencies may cost $16, but the actual amount may vary depending on factors such as your account type or the current exchange rate.

Furthermore, some banks may add their own fees to the cost, while others only charge the amount paid to the intermediary bank. Therefore, it's essential to check the fee structures of both your local bank and the intermediary bank before initiating any international transactions.