Correspondent Banking

Correspondent Banking is an arrangement in which one bank (the correspondent bank) provides banking services on behalf of another bank (the respondent bank) — usually located in a different country or region. It enables banks to conduct business and offer financial services in locations where they do not have a physical presence.
Through this relationship, banks facilitate international trade, cross-border payments, foreign exchange transactions, and remittance services, thereby connecting the global financial system.

Meaning and Concept

In simple terms, correspondent banking acts as a link between banks across borders. A smaller or domestic bank maintains an account (called a nostro account) with a larger foreign bank (the correspondent), which performs financial transactions on its behalf.
For example, if an Indian bank does not have a branch in the United States, it may establish a correspondent relationship with a U.S. bank to execute U.S. dollar transactions for its customers.
This network of relationships allows banks to serve clients globally without establishing costly foreign branches.

Key Terms Used in Correspondent Banking

Functions of Correspondent Banking

1. International Fund Transfers:
   • Facilitates cross-border payments and remittances on behalf of the respondent bank’s customers.
   • Used in foreign trade transactions for import and export payments.
2. Foreign Exchange Transactions:
   • Provides access to foreign currency markets.
   • Helps banks conduct currency conversions and manage forex risk.
3. Trade Finance Services:
   • Correspondent banks assist in issuing Letters of Credit (LCs), Bank Guarantees, and Bills of Exchange for international trade.
4. Clearing and Settlement Services:
   • Enables settlement of international transactions between banks in different countries.
   • Plays a key role in interbank money transfers via SWIFT (Society for Worldwide Interbank Financial Telecommunication).
5. Investment and Treasury Services:
   • Correspondent banks provide investment, liquidity, and cash management services for other banks.
6. Information and Advisory Support:
   • Assist smaller banks with regulatory compliance, risk management, and access to international financial systems.

Example of Correspondent Banking Relationship

Suppose Bank A in India has no branch in the United Kingdom but needs to make payments in British pounds for its customers.

• Bank A opens a Nostro Account with Bank B, a UK-based bank.
• When Bank A’s customer needs to make a payment in pounds, the funds are transferred through Bank B.
• Similarly, if a UK business wants to pay an Indian exporter, Bank B uses the same relationship for remittance.

This process ensures smooth and cost-effective international transactions between two regions.

Benefits of Correspondent Banking

For Banks:

• Global Reach: Enables smaller or domestic banks to offer international banking services without setting up foreign branches.
• Operational Efficiency: Reduces the cost of international operations.
• Access to Foreign Currencies: Provides easy access to multi-currency accounts and forex markets.
• Enhanced Service Offerings: Allows banks to provide trade finance and remittance services to customers.

For Customers:

• Ease of International Transactions: Facilitates quick and secure cross-border transfers.
• Convenience: Enables importers, exporters, and travellers to transact in foreign currencies.
• Lower Transaction Costs: Avoids the need for intermediaries or setting up direct banking operations abroad.

Risks in Correspondent Banking

Despite its advantages, correspondent banking carries certain risks that must be managed carefully.

1. Money Laundering and Terrorism Financing:
   • Correspondent relationships may be exploited for illicit fund transfers if due diligence is not followed.
2. Reputational Risk:
   • The misconduct of a respondent bank may harm the correspondent’s reputation.
3. Compliance Risk:
   • Non-compliance with global financial regulations (such as AML/CFT norms) can lead to heavy penalties.
4. Operational and Technological Risks:
   • Failures in communication, SWIFT systems, or technological errors can disrupt transactions.
5. Country and Political Risk:
   • Political instability or sanctions in a respondent bank’s country can affect banking relationships.

Regulatory Framework

In India:

• The Reserve Bank of India (RBI) regulates correspondent banking relationships through its Foreign Exchange Management Act (FEMA) and anti-money laundering guidelines.
• Indian banks are required to:
  • Conduct due diligence before entering into foreign correspondent relationships.
  • Follow Know Your Customer (KYC) and Anti-Money Laundering (AML) policies.
  • Ensure compliance with international sanctions and regulations.

Globally:

• Financial Action Task Force (FATF): Sets international standards for preventing money laundering and terrorist financing.
• SWIFT: Provides a secure platform for global financial communication.
• Basel Committee on Banking Supervision (BCBS): Establishes guidelines for managing correspondent banking risks.

Correspondent Banking vs. Interbank Relationship

Importance of Correspondent Banking in the Global Economy

• Facilitates International Trade: Enables seamless financial transactions between importers and exporters.
• Promotes Financial Integration: Connects domestic financial systems to the global network.
• Encourages Economic Growth: Supports cross-border investment, remittances, and tourism.
• Strengthens Small Banks: Provides smaller institutions access to international markets and foreign exchange services.
• Enhances Payment Efficiency: Reduces transaction time and improves liquidity management.

Recent Developments and Challenges

• Many global banks have recently reduced correspondent relationships (a phenomenon called de-risking) due to stringent AML/CFT regulations and high compliance costs.
• Technological innovations like blockchain-based cross-border payment systems (e.g., Ripple) are emerging as alternatives to traditional correspondent banking.
• The RBI’s promotion of digital cross-border payments through systems like UPI–PayNow (India–Singapore) aims to modernise international remittance networks.