What is correspondent banking?

Generally, correspondent banking arrangement involves two banks establishing reciprocal accounts with each other through bilateral agreements. These accounts are established to enable the domestic bank to make payments or money transfers on behalf of the foreign bank.

The most common services provided by correspondent banks are currency exchange, wire transfer, handling business transactions and trade documentation   on behalf of each other. Here a correspondent bank that handles the local leg of a business transaction and the associated documents, as an agent of a bank in foreign country.

Why domestic banks need a correspondent bank abroad?

The international financial transactions like exports, imports ordinarily involve foreign currency exchange. The correspondent banks are often used by domestic banks as their agent abroad for this purpose. For example an importer of India needs to make payment to the exporter of goods in USA. The Importer customer’s domestic bank (say SBI) determines the necessary foreign currency exchange transaction to facilitate appropriate payment in US Dollar to the exporter.  SBI deducts the appropriate amount in Indian Rupees from the customer’s (importers) account, then instructs its correspondent bank (say JPMorgan Chase Bank, New York) in USA to pay out the corresponding amount to the exporter ( supplier of goods) in USD from the SBI’s correspondent account with the JPMorgan Chase Bank, New York.  In this example we understand that SBI a domestic bank in India maintains funds in US Dollars with JPMorgan Chase Bank, New York and the JPMorgan Chase Bank, New York make payment to the exporter in USA by deducting appropriate amount from the dollar accounts of SBI maintained with them.

A bank that holds in a foreign currency account in another bank is called “Nostro” account. The term ‘Nostro’  is derived from the Latin word for “ours,” are frequently used to facilitate foreign exchange and trade transactions. The opposite term “Vostro accounts” is derived from the Latin word for “yours,” is how a bank refers to the accounts that other banks have on its books in its home currency.

For example, Indian Overseas Bank, Chennai India has a EURO account with COMMERZ BANK AG, Frankfurt, Germany, (Euro is home currency of Germany). To Indian Overseas Bank that is a ‘Nostro’, meaning “our account on your books,” while to COMMERZ BANK AG, Frankfurt, it is a ‘Vostro account’, meaning “your account on our books.”