Why banks need correspondent accounts

A bank needs a correspondent account in a currency when it has customers who need to pay or receive in that currency and it cannot settle those payments itself. The most common reason is trade. An importer in India buys goods from China and must pay in US dollars, so the Indian bank needs a dollar account in the United States to send the payment. The second reason is remittance. A worker in Dubai sends money home to India, so the bank in Dubai needs a rupee account in India to fund the payment. The third reason is investment. A fund in London buys bonds in Japan and must pay in yen, so the London bank needs a yen account in Tokyo. Each of these flows creates a daily volume of payments that must be funded from a nostro account in the right currency. The correspondent also provides services that go beyond simply holding the account. It can convert currencies, so that a bank that holds dollars can pay in euros by asking the correspondent to sell dollars and buy euros. It can provide intraday liquidity, so that a bank can send a payment even if its balance is temporarily low, with the understanding that funds will arrive later in the day. It can provide information, such as the status of a payment, the reason a payment was rejected, and the charges that were deducted. It can also act as an intermediary for payments that need to pass through more than one bank, for example when the respondent bank has no direct relationship with the bank in the destination country and must route through a larger correspondent that does. The choice of correspondent is a strategic decision for a bank, and it is based on the currencies the bank needs, the countries its customers trade with, the quality of the correspondent's payment service, the fees, and the compliance standards. A large global bank may have hundreds of correspondent relationships and may itself act as a correspondent for hundreds of smaller banks. A small regional bank may have only a handful of relationships, concentrated in the currencies its customers use most. The analyst who designs a cross border payment product must know which correspondents the bank uses for each currency, what their cut off times are, what their charges are, and what their service levels are, because those details decide the customer promise. Correspondent banking also creates a concentration risk that the analyst should understand. If a bank relies on a single correspondent for US dollars and that correspondent closes the account, the bank cannot send dollar payments at all until it finds a replacement, which can take months because of the due diligence involved. Prudent banks therefore maintain at least two correspondents for their major currencies, and the payment engine routes volume between them. The routing decision considers cost, speed, cut off time, and the current nostro balance, and it is logged so that operations can explain why a payment went through one correspondent rather than another. The cost structure of correspondent banking is another reason the analyst must understand it. The correspondent charges a fee per payment, a fee for the account, a fee for intraday liquidity, and a spread on foreign exchange. The respondent passes those costs to the customer through its own charges, and the customer sees a single price. A payment that passes through three correspondents carries three sets of charges, which is why the same USD 10,000 payment can cost very different amounts depending on the corridor. The analyst who prepares a pricing proposal must be able to break down the cost by correspondent, by currency, and by corridor. Compliance is the final reason a correspondent relationship matters, and it is the reason many have been closed. The correspondent must be satisfied with the respondent's anti money laundering controls, its sanctions screening, its customer base, and its transaction profile. The respondent must provide a Wolfsberg Correspondent Banking Due Diligence Questionnaire, audited financials, and evidence of its controls, and must update them every year. If the correspondent is not satisfied, it can restrict the account, raise the fees, or close the relationship. The analyst must therefore treat the correspondent relationship as a product dependency, not as a given, and must design the payment flow so that it can move to another correspondent if one is lost. For a working example, consider a mid sized Indian bank that trades with the United States, Europe and the Gulf. It holds a dollar nostro in New York, a euro nostro in Frankfurt, and a dirham nostro in Dubai. Each morning treasury checks the three balances, forecasts the day's payments from the queued instructions, and funds any shortfall. Each payment is routed to the correspondent that offers the best combination of cost and cut off for its destination. Each evening the statements arrive, MT950 or camt.053, and reconciliation confirms that the balances agree. That daily cycle, funding, routing, payment, statement, reconciliation, is the operational heartbeat of correspondent banking, and it is the cycle the analyst is designing for. Worked example with real numbers: a bank in London needs to pay in 40 currencies, and it cannot hold an account in every country, so it chooses correspondents by currency and corridor. For USD it uses two correspondents in New York, because the high-value correspondent charges USD 15 per payment and settles in two hours, while the low-value correspondent charges USD 8 and settles in six hours. A USD 2 million payment goes through the fast correspondent, costing USD 15, while a USD 5,000 payment goes through the cheap one, costing USD 8, and the choice saves the bank about USD 120,000 a year across 20,000 payments. Correspondent selection is therefore a commercial decision, not just a routing table, and the BA must document the selection criteria. Failure and recovery: a correspondent can be lost, through de-risking, where a large bank closes the account of a smaller bank because the compliance cost exceeds the revenue, and the smaller bank must then find a new correspondent, often through a nested relationship, where it holds an account with a bank that itself holds an account with the large bank. The recovery takes weeks, during which payments on that corridor are delayed or must travel through a more expensive route, and the bank must tell its customers, because a payment that took two days may now take four. A bank that has only one correspondent per currency has a single point of failure, and the BA should require at least two correspondents for each major currency, so the loss of one does not close the corridor. For a business analyst, product owner or subject matter expert, the correspondent selection requirement must name the selection criteria, cost, speed, cut-off, compliance appetite and service level, the fallback correspondent, and the de-risking contingency. The Wolfsberg Correspondent Banking Principles set the due diligence standard, and the requirement must map each correspondent to its due diligence file, its SSI and its fallback, so that when a correspondent is lost, the fallback is already defined, and the corridor does not close. A corridor with one correspondent and no fallback is a corridor that will close without warning.