How Does Interbank Transactions and Abroad Banking Work?

Learn how banks send money among themselves and how they deal with international transactions

Banking transactions are part of people's routine. From your every morning's coffee cup to the billions movemented everyday inside intercontinental companies and governments, towns work everyday thanks to bank transactions. However, few people know what really means to transfer funds from your bank account to another. Also, how banks manage transfers between users of different institutions (or even different countries) is a complete mystery for many users who have it as part of their daily activities.

In this article we will explain what internally a bank transfer means for banking institutions. But there are a few concepts that must be clear before we try to navigate into the international banking system network.

What's a deposit?

The first thing we have to understand is that once we send funds to our banking accounts, the institution will not simply store it somewhere until the day when you need it. What's actually happening is a loan: you are lending your money to the bank. Based on your contract, they may or may not reward you for doing so, but they're given the rights to use your money as they want to. This includes lending your money to someone else and getting the profits of this operation.

When our bank statement tells us our bank balance is US$ 1,000, this means that the bank owe us US$ 1,000. At the same time, if our balance is negative, we owe that amount to the bank.

So, how does a transfer happen?

Let's say you liked our blog post and wanted to pay us a coffee cup, which costs US$ 5. You know which institution we bank in as well as our client number. This way you initiate a transfer and the magic happens: your bank debits US$ 5 from your account and, meanwhile, we are US$ 5 richer.

What really happened is that since you've told your bank that you want US$ 5 of the amount they've borrowed from you to belong to us. So now your bank owes you less US$ 5 and owes us more US$ 5. This is what we call a "bank transfer". Pretty simple, isn't it?

But… what if we bank from different institutions? How could your bank ask our bank to start owing us US$ 5? And how did our bank accept this offer?

It's estimated that only about 8.3% of the world's money is put into physical cash and coins (M0). Banks do know it and therefore are smart enough not to put your US$ 5 on an armored car and driving it until our bank.

Banks find two different ways to do so: through correspondent bank accounts or through central banks.

Interbank transaction through correspondent bank accounts

In simple words: banks maintain several bank accounts on each other and keep (lend) funds on them. These funds are usually sourced by mutual lending or paid through assets. Back to our scenery, your bank, say YourBank, has an account with our bank, say OurBank, whereas our bank also has an account with your bank. This way, the funds are actually sent by YourBank's account on OurBank's system, onto our account, and not directly from your account.

It works this way: once you initiate a funds transfer to us, YourBank debits (stops owing you) US$ 5 from your account. Subsequently, YourBank makes a transfer on its OurBank account to our account. As a result, OurBank stops owing YourBank US$ 5, which it now owes to us.

However this method brings issues and risks. First of all, it wouldn't be easy for bank administrators to own and control accounts on every bank that their clients might want to transfer to. Secondly, there is the risk of a bankruptcy.

Interbank transaction through a central bank

This kind of transaction takes place on the country's, normally State-owned central bank, which holds accounts that are owned by the country's associated banking institutions.

In this model, transfers between banks are done through the central bank. Your bank has an account with funds on the central bank. And so does our bank. When you initiate your US$ 5 transfer to our account, once your bank realizes it's an interbank transaction, two steps do follow:

1. Your bank tells the central bank its intention to transfer US$ 5 to our bank. The central bank, then, stops owing your bank this amount and now owes it to our bank.
2. Finally, your bank tells our bank about this transaction, the amount and who is it destined to. Our bank will understand it and, knowing that the US$ 5 that just entered their central bank account belongs to us, now owes us this amount.

Although this method is a lot safer than the previous one, there is still a limitation: central banks will not support abroad transfers, nor other currencies than the country's official one.

With this limitation, banks had to start looking for ways to transfer money across countries.

International transfers

If we are not banking on the same country, similar measures are taken from your bank. However the bank must deal with the currency you want us to receive, usually selling it to you at their exchange rate.

Banks make use of systems named RTGS (Real Time Gross Settlement) or DNS (Deferred Net Settlement) in a process that works like with a country's central bank: the two banks are registered on the RTGS, which clears the transaction.

However, there are cases that the two banks aren't registered on the same RTGS. In this case, a route is traced by the bank system, trying to find the best way to movement the funds through the accounts controlled by your bank, until it reaches our bank or a RTGS where our bank is also registered. At the end, the RTGS clears the transaction.

The problems on this process are mostly time-related: although RTGS transactions are instant, the bank may not be able to movement your funds on all these accounts as quickly as you need, or holds the funds for some days trying to prevent frauds.

Furthermore, since it's a long process, if something goes wrong (i.e. the destination's IBAN code is incorrect), the whole process is cancelled and it may take days until you're aware of what happened, for then being able to get back the funds and initiating a new transfer.

Money transfers are present everywhere on our activities, jobs, meals and leisure moments. We could ask ourselves how can money go from our credit cards to the seller's account. An interesting fact to note is that most bank activities consist in owing money to different parties, and not exactly on the amount being withdrew.