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Correspondent Banking

Correspondent banking refers to an arrangement in which one financial institution (the correspondent bank) provides services on behalf of another financial institution (the respondent bank), often located in a different country or jurisdiction.

Through this relationship, the correspondent bank facilitates international transactions such as payments, wire transfers, trade finance, and foreign currency exchange, enabling respondent banks to access global financial systems without maintaining a physical presence abroad.

Purpose & Importance

Correspondent banking is vital for the global economy, as it supports cross-border trade, remittances, and investment flows.

Smaller or regional banks depend on correspondent relationships to provide international payment services to their customers.

For example, a local bank in a developing country may use a correspondent bank in New York or London to settle transactions in U.S. dollars or British pounds.

From a compliance perspective, however, correspondent banking is considered a high-risk activity because it creates multiple layers between the originator and the beneficiary of a transaction.

These layers can obscure the true source or purpose of funds, making it an attractive conduit for money laundering, terrorist financing, and sanctions evasion.

How Correspondent Banking Works

In a typical arrangement, the correspondent bank holds accounts—known as nostro or vostro accounts—for the respondent bank.

  • A nostro account is an account a bank holds in a foreign currency with another bank.
  • A vostro account is the account that a foreign bank holds with a domestic bank in local currency.

When a respondent bank’s client initiates an international payment, the correspondent bank processes the transaction through its network, ensuring settlement in the appropriate currency.

Correspondent banking relationships also enable foreign exchange transactions, liquidity management, and trade finance operations.

Correspondent Banking in AML & CFT Context

Because of its cross-border nature and the number of intermediaries involved, correspondent banking presents significant AML/CFT risks.

Illicit actors can exploit these relationships to move large sums of money across jurisdictions, especially where AML controls are weak or inconsistent.

Common risks include:

  • Lack of visibility into the respondent bank’s customer base.
  • Potential misuse by shell banks (banks without physical presence or effective supervision).
  • Inadequate due diligence or monitoring by either party.
  • Exposure to high-risk jurisdictions or politically exposed persons (PEPs).

To mitigate these risks, global regulators impose strict due diligence and monitoring obligations on financial institutions that maintain correspondent relationships.

Key AML/CFT Requirements for Correspondent Banking

  • Due Diligence on Respondent Banks: Institutions must collect and verify information about the respondent bank’s ownership, management, business activities, and AML controls.
  • No Shell Bank Relationships: Correspondent banks are prohibited from maintaining relationships with shell banks or banks that permit shell banks to use their accounts.
  • Senior Management Approval: Establishing new correspondent relationships typically requires approval from senior management.
  • Ongoing Monitoring: Transactions processed through correspondent accounts must be continuously monitored to detect unusual or suspicious activity.
  • Documentation and Record-Keeping: Banks must maintain comprehensive records of their correspondent relationships and all due diligence performed.

Global Regulatory Framework

Several key international standards and regulations govern correspondent banking:

  • Financial Action Task Force (FATF) Recommendation 13 mandates that financial institutions apply enhanced due diligence (EDD) measures when establishing cross-border correspondent banking relationships.
  • The USA PATRIOT Act (Section 312) requires U.S. financial institutions to identify foreign correspondent accounts and assess their associated risks.
  • EU AML Directives (AMLD5 and AMLD6) reinforce transparency and due diligence requirements for EU-based banks engaged in correspondent relationships.
  • Basel Committee on Banking Supervision (BCBS) provides risk management principles for banks involved in cross-border relationships.

Challenges in Correspondent Banking

  • De-risking: Many large banks have reduced or terminated correspondent relationships with smaller or high-risk banks to minimize regulatory exposure. This trend, known as de-risking, can limit access to the global financial system for developing countries.
  • Information Sharing: Data privacy laws and confidentiality restrictions can hinder the exchange of information between correspondent and respondent banks.
  • Complex Transaction Chains: Payments often pass through multiple intermediaries, making it difficult to identify the ultimate originator or beneficiary.
  • Regulatory Divergence: Variations in AML/CFT standards across jurisdictions create compliance inconsistencies and increased costs.
  • Technological Gaps: Some smaller institutions lack advanced systems for real-time transaction monitoring or screening.

Best Practices for Effective Risk Management

To ensure compliance and reduce exposure, financial institutions involved in correspondent banking should:

  • Adopt a risk-based approach that tailors due diligence to the risk profile of each respondent bank.
  • Conduct periodic reviews of all correspondent relationships, especially those involving high-risk jurisdictions.
  • Implement robust transaction monitoring systems capable of detecting anomalies across currencies and corridors.
  • Participate in information-sharing initiatives such as the Wolfsberg Group Correspondent Banking Due Diligence Questionnaire (CBDDQ).
  • Foster transparency and cooperation between correspondent and respondent banks to strengthen collective oversight.

Emerging Trends

Technological innovation is reshaping correspondent banking.

Distributed ledger technology (DLT) and blockchain-based payment solutions are being explored as alternatives to traditional correspondent networks.

These systems promise faster settlements, lower costs, and greater transparency, potentially reducing AML risks.

However, regulators caution that new technologies also introduce novel compliance challenges.

Related Terms

  • Nostro Account
  • Vostro Account
  • Shell Bank
  • De-risking
  • Wolfsberg Group
  • FATF Recommendations
  • Cross-Border Payments
  • Enhanced Due Diligence (EDD)

References

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