It is a common practice for smaller banks located in towns and non-urban areas to maintain accounts with large banks in major cities. It is equally common for large banks in every country to have accounts with major banks abroad. These arrangements are referred to as ‘Correspondent Banking Relationships’. The bank that seeks to maintain the account is referred to as the ‘respondent bank’, while the bank that offers the account maintenance facility is referred to as the ‘correspondent bank’.
In the United States, for example, banks located in major money centres such as New York City and Chicago are invariably characterised by an excess demand for funds relative to the inflow from local deposits. On the other hand small banks located in rural and semi-urban areas in states such as Alabama and Georgia are usually unable to lend their deposits fully to local borrowers since such states are characterised by relatively low industrial and business activities. Consequently, banks in smaller towns and cities, which invariably have surplus funds, maintain accounts in large metropolises such as New York City and Chicago, help in capital flows from surplus regions of the country to regions characterised by deficits.
Correspondent banking also plays a role in international banking. Take an Indian bank such as ICICI Bank. It will have a correspondent banking relationship with banks in global commercial centres such as London, New York and Tokyo. Let us assume that ICICI Bank has such an account with Barclays Bank in London. Any cheque denominated in pounds that is deposited with ICICI in India will be routed through the account in London for clearing and collection.
Similarly, payments in the form of pounds, to parties in the UK and elsewhere that are affected by clients of the bank in India will be made in the form of instruments drawn on the account in London. Any electronic fund transfer, both inward and outbound, will entail a role for the bank in London. A bank like Barclays will also usually play a role if a bank in India were to seek access to a loan in the UK.
In many countries there are restrictions on how much a bank can lend to a single borrower or a group of related borrowers. For instance in the US, a federally chartered bank cannot lend more than 15% of its capital and reserves to a borrower, if the loan is unsecured, and 25%