How do banks pay each other? When banks want to transfer money to each other, perhaps upon instruction from a customer, they don’t put bundles of banknotes in a van and drive it off to the recipient. They pay each other digitally. How does this work?
The Problem
Steve who banks with Bank A wants to transfer a £100 to Dwayne who banks with Bank B. When Steve makes the transfer online, all he sees is that his account balance goes down by a £100. Dwayne’s account at Bank B goes up by £100.
But if that’s all that happened, this would be quite problematic for the banks. Your account balance with a bank is how much the bank owes you. So after this transfer:
- Bank A now owes Steve less money. It’s really happy.
- Bank B is not happy at all, it now owes Dwayne £100 more.
The transfer left Bank A better off and Bank B worse off. This must be balanced by a bank to bank, or interbank, transfer. There are two main ways banks pay each other:
- Correspondent bank accounts
- Central bank payment systems
Correspondent Bank Accounts
Bank A simply opens a bank account with Bank B. Then it can instruct Bank B to transfer the £100 from its account to Dwayne’s account.
In this way, nobody is worse off:
- Bank A owes Steve £100 less, but it has £100 less in its bank account with Bank B
- Bank B owes Dwayne £100 more but owes Bank A £100 less.
This is called correspondent banking. Bank A would call Bank B its correspondent bank, and calls its account there a nostro account. Nostro is Latin for our.
Seed funding
The above mathematics assumes Bank A had some money in its account with Bank B to begin with. How did the money get there? How did Bank A fund this account initially?
- Both banks can open accounts with each other at the same time, funded with the same amount. This could be any number, and they don’t need to have actual money backing it as it call cancels out anyways.
- Bank A could sell an asset to Bank C. Say, sell a bond and ask Bank C to credit its account with them.
Pain point
If you were a bank, maintaining accounts at every other bank would be quite a pain administratively. It would be very expensive too, as you will have to have money sitting there doing nothing, in anticipation of payment instructions. Currents account pay very low interest. Most importantly, it’s extremely risky. What happens when the other bank goes bankrupt? You’d lose your money.
Central Bank Payment System
One bank to bank them all. All banks hold a bank account with a super bank, and thus they don’t need to hold accounts with each other. Banks instruct the super bank to make payment from their account to any of the other banks with an account there. This system is called a settlement system and the super bank is typically called the Central Bank.
A Real Time Gross Settlement (RTGS) system makes transactions as they come during banking hours. A Deferred Net Settlement (DNS) system queues up payment for a period of time, then at the end of the period (typically end of day) calculates the net payable and transfer the appropriate sums.
Central Bank settlement systems are naturally limited to one country and one currency only.
Clearing
A transaction is said to be cleared when no further adjustments need to take place anywhere. In the above example, the party that makes the ± £100 adjustment to their ledger is the clearer.
- If both customers bank with the same bank, then the bank clears the transaction.
- If there is a correspondent banking relationship, then the receiving bank clears the transaction.
- If payment was made through a central bank system, say RTGS, then the central bank clears the transaction.
Banks who participate in the settlement systems and have accounts with the central bank are known as clearing banks and they have a higher status than non-clearing banks. The non-clearing banks need to use clearing banks to participate in the settlement systems.