- Key insights: Correspondent banking has been around since the 14th century, when Italian merchant-banking houses used a network of partner banks and agents to settle trade debts without physically shipping coins, and has since become a vital piece of infrastructure to facilitate global payments.
- What's at stake: Digital assets are challenging some of the traditional economics that have supported correspondent banking.
- Expert quote: "Correspondent banking is the invisible plumbing of the global financial system. Just like water flows through pipes that most people never think about, money flows through correspondent banking networks that connect banks, currencies and payment systems around the world." –Michael Levens, vice president and financial services payments lead at Capgemini.
For more than half a millennia, correspondent banking has been the engine that has enabled global commerce and international trade. But digital assets are challenging some of the traditional economics that have supported interbank clearing.
Correspondent banking traces its roots back to when Italian merchant-banking houses such as the Medici family used a network of partner banks and agents in other cities to settle trade debts without physically shipping coins, according to Phil Philliou, a payments industry consultant.
"The correspondent then executes payments, clears checks, handles foreign exchange, or settles wire transfers on the respondent bank's behalf, using
Think of it as the invisible plumbing of the global financial system. At its most basic level, a correspondent bank acts as an intermediary for another bank in a market where that bank does not have a direct presence.
Without the correspondent banking system, international trade, investment and cross-border commerce would be significantly more difficult and costly, according to Michael Levens, vice president and financial services payments lead at Capgemini.
"Just like water flows through pipes that most people never think about, money flows through correspondent banking networks that connect banks, currencies and payment systems around the world," Levens told American Banker.
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One can think about correspondent banking as an international postal network for payments.
"You may post a letter at your local post office, but it travels through a network of trusted partners before reaching its destination," Levens said. "Correspondent banks perform a similar role for money, helping move payments securely and reliably between countries and financial systems around the world."
Real money is not exchanged between the two banks every time a cross-border transaction is completed. Instead, banks keep track of transactions moving between them through ledgering of two reciprocal accounts held at both banks that are denoted with the Italian words, "nostro," and "vostro" accounts. "Nostro" means, "our money held with you," and "vostro" means, "your money held by us."
"They stage things in advance, and they maintain liquidity in the accounts," Aaron McPherson, principal at AFM Consulting, said.
"The two banks just do accounting transfers between those two accounts," McPherson told American Banker. "Anytime one bank needs to move money to another bank, they do a matching series of accounting transactions, debiting one account and crediting the other."
Periodically, the two banks have to reconcile, which often happens once a month, but can happen more frequently based on the velocity of payments. The idea is to avoid foreign exchange costs by not having to tap foreign exchange markets too often.
Correspondent banking is slow, but represents a big revenue opportunity for the large financial institutions that participate in the system.
Capgemini estimates that foreign exchange spreads, correspondent banking fees, float income, and transaction processing and settlement fees represent approximately $230 billion of payments revenue globally, according to data provided exclusively to American Banker.
But correspondent banking also comes with high compliance costs related to know-your-customer, anti-money-laundering and Countering the Financing of Terrorism requirements, which can be prohibitive to smaller banks.
"There are all these rules, all these restrictions that banks have to maintain," McPherson said. "It's a fairly manual process. That's one of the reasons why it's slow and expensive: There's real people having to examine each transaction to figure out whether it's permissible or not."
The number of active correspondent banks over all corridors has steadily declined between 2011 and 2022 as the volume of cross-border transactions has increased, according to Swift and the Bank of International Settlements.
Recently, the correspondent banking system has come under pressure as payment technology advances and the needs of businesses evolve. In fact, 74% of corporates describe cross-border payments as slow, costly and unpredictable, according to Capgemini.
"Corporates increasingly expect faster payments, greater transparency, real-time cash visibility, improved liquidity management and simpler reconciliation across multiple markets and banking relationships," Capgemini's Levens said.
"At the same time, stablecoins, tokenized deposits and wholesale CBDCs are emerging as alternative ways to move value. By combining settlement, value transfer and business rules into a single execution layer, these new forms of digital money have the potential to reduce operational complexity and improve efficiency," Levens said.
That does not mean that correspondent banking will disappear. "Our research shows that large corporates still operate across multiple markets and banking relationships, with many cross-border transactions requiring coordination across different institutions, currencies and regulatory environments," Levens said.
Correspondent banking, at the end of the day, provides the framework that enables this coordination at global scale.
