Fundamentals of Correspondent Banking : How Do Cross-Border Payments and Settlements work?

Even though in their role as facilitators of cross-border payments they are critical for the modern world economy, correspondent banking relationships are poorly understood in terms of the actual balance sheet mechanics of how these payments are settled. A cursory search for the terms ‘nostro and vostro accounts’ in Google Scholar suffices to prove the point; one can barely find papers referring to these terms, which are the cornerstone of interbank cross-border settlements. Perhaps the main reason for this is the fact that statistical data on these accounts are pretty scarce and lack granularity, which has erected a barrier to how much we can know about how these payments are settled through these accounts, to what extent banks hold/issue LC/FX interbank accounts, and the specific balance sheet entries that take place when international trade and investments are settled through these accounts in different currencies. In this paper I exploit an excellent database, hosted on the Swiss National Bank’s (SNB) website, to shed light on these questions. I also distil and test the main tenets of prevailing correspondent banking theory. Of the 5 main tenets, only one is found to be true, three are found to be outright false, and the remainder is only true with qualifiers. This paper represents a novel contribution to the literature on correspondent banking, which until now has shied away from the questions this one tackles