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% of its capital and reserves if the loan is fully secured. Fully secured loans are one which are backed by adequate collateral. In India too, the Reserve Bank of India has specified a limit for how much a commercial bank can lend to a single borrower or a group of related borrowers. The response to such barriers is what is termed as consortium or syndicated lending, where a group of banks pool their resources and provide a loan. Besides helping the borrower to surmount such legal barriers, loan syndication also helps in risk diversification for the lenders.
Consider the case of ICICIs account in London. ICICI would term it as a nostro account, which means our account with you. Thus a nostro account for ICICI is its record of its funds that are held by another bank such as Barclays. The correspondent bank will refer to the same account as a vostro account, meaning your account with us. That is, a vostro account for Barclays is its record of funds that are held with it by another bank. In other words the term nostro refers to the account from the respondent banks perspective, while vostro refers to the same account from the correspondent banks perspective.
A nostro with a credit balance connotes an asset for the respondent bank. Thus from ICICIs perspective, a credit balance in its account with Barclays would represent an asset for it. Obviously from the correspondent banks perspective, a credit balance would be a manifestation of the fact that it is holding someone elses money and consequently would tantamount to a liability. Thus from Barclays perspective the credit balance in the account is a liability. Sometimes the vostro account may have a debit balance. This would be the case if Barclays were to have extended a loan to ICICI. In such a situation obviously the account is an asset for the correspondent bank.
A third term that is used infrequently in banking circles is what is termed as a loro account. The term refers to an account held by someone else on behalf of a third party and arises in the case of complex consortium or syndicated lending. For instance, if ICICI were to have a record of an account maintained by UBS with Barclays in London, it would term it as a loro account. In simple English the term refers to our record of their account with you.
It should be noted that from a banks perspective any account that is maintained with it is a vostro irrespective of whether or not it is maintained by another bank. Thus all checking or current accounts, savings accounts, and fixed or time deposits held with it by its clients would be termed as vostros.
The writer is author of `Fundamentals of Financial Instruments, published by Wiley, India.