The Importance of National The Importance of National Payments Systems in Payments Systems in Reducing Market RiskReducing Market Risk

S.W.I.F.T. Regional Conference in Central and Eastern EuropePrague, Czech Republic: March 24,

1999Robert H. KepplerThe World Bank

Market risk andrisk reduction

techniques

The Importance of National Payments The Importance of National Payments SystemsSystemsin reducing market riskin reducing market risk

Presentation structurePresentation structure

Risk assessmentfrom a

commercial bankperspectiveWorld Bank role

in financial sectordevelopment

World Bank role in the World Bank role in the financial sectorfinancial sector

Convertibility of capitalConvertibility of capital Stability of exchange ratesStability of exchange rates Quality of informationQuality of information Political uncertaintiesPolitical uncertainties Government borrowings from Government borrowings from

the banking systemthe banking system

World Bank role in the World Bank role in the financial sectorfinancial sector

Strengthen the legal and regulatory Strengthen the legal and regulatory systemsystem

Improve basic banking skillsImprove basic banking skills Clarify the role of the central bankClarify the role of the central bank Commercialize / privatizeCommercialize / privatize Improve quality of informationImprove quality of information Strengthen the clearance and Strengthen the clearance and

settlement systemssettlement systems

Payment System Payment System ReformReform

Active participation of all Active participation of all stakeholdersstakeholders

Satisfy needs of all usersSatisfy needs of all users Customer to customer perspectiveCustomer to customer perspective Operational and strategic elementsOperational and strategic elements Twin- track approach / short term Twin- track approach / short term

problem solving consistent with problem solving consistent with longer term visionlonger term vision

Risk Assessment -Risk Assessment -Commercial Bank Commercial Bank

perspectiveperspective The source and significance of The source and significance of

payment system riskpayment system risk Regulatory impact on commercial Regulatory impact on commercial

banks’ participation in payment banks’ participation in payment systems - BIS initiatives (Lamfalussy systems - BIS initiatives (Lamfalussy Standards and SIPS Core Principles)Standards and SIPS Core Principles)

Commercial bank response - Commercial bank response - undertake structured assessmentsundertake structured assessments

Risk Assessment - A Formal Risk Assessment - A Formal ApproachApproach

System documentationSystem documentation Risk assessment Risk assessment

worksheetsworksheets Preparation of the risk Preparation of the risk

assessment summaryassessment summary

System DocumentationSystem Documentation Description of an operating Description of an operating

cycle of the systemcycle of the system Rules of the systemRules of the system Legal opinion covering the Legal opinion covering the

system participation agreementsystem participation agreement System membershipSystem membership Money laundering implications - Money laundering implications -

laws, policies and procedureslaws, policies and procedures

Typical Assessment Typical Assessment WorksheetsWorksheets

Financial standing - owner / Financial standing - owner / operatoroperator

MembershipMembership Risk managementRisk management System settlementSystem settlement LegalLegal System operationsSystem operations

Risk assessment worksheet - Overall systemRisk factor Above standard Acceptable Below standard

1 Financial standing

Operated by Central Bank Acceptable financial strength and earning power

No Central Bank or Government responsibility

Government regulation and audit

Weak financial standing

2 Membership standards

Minimum capital standards with proactive removal of high risk institutions

Acceptable financial standards with annual review

No standards or review process

3 Risk management System administered limits that have effectively controlled risks during periods of stress

Monitoring of debit positions and proactive risk reduction as required

Lack of effective controls

4 System settlement

Guaranteed by Central Bank Net End of Day Settlement/ acceptable collateral or mutual liability / loss sharing

Inadequate mechanisms or recourse to unwinding alone.Electronic systems with settlement delay of one day or more

Risk assessment worksheet - Overall system

Risk factor Above standard Acceptable Below standard

5 Legal Operates under Government regulation or Code of Law

Clearing House Rules with favorable legal opinion

Clearing House Rules without force of Law. Netting is not legally enforceable.

6 System operation Proven technology/ability to handle large volumes. Adequate and tested back-up arrangements

Adequate systems and back-up. Good experience

Untested system/periodic problems or inadequate back-up. Obsolete hardware/maintenance risk

Risk Assessment WorksheetCommercial bank policies and procedures

Service risk factor Above standard Acceptable Below standard

1 Customer credit controls

No "CB" settlement exposure All "CB" exposure is against allocated credit lines

"CB" cannot recover credits to customers in the event of settlement failure. Uncovered "CB" exposure

2 "CB" funding Access to adequate Central Bank funds in case of payment systems emergency

Adequate private bank committed liquidity lines/reserves

Lack of adequate funding of to cover unplanned payment fails or other events

3 Legal Customer service agreement or account documentation mitigates "CB" risks/ no risks in legal opinion

Acceptable legal opinion covering customer documentation

No documentation or documentation without acceptable legal opinion, incomplete or missing documentation

Risk Assessment WorksheetCommercial bank policies and proceduresService risk factor Above standard Acceptable Below standard

4 Money laundering

Local money laundering policy fully implemented and well documented incorporating both US and local requirements.

Detailed local money laundering policy implemented.

No money laundering policy or not implemented

Know your customer procedures in place including transaction monitoring for higher risk customers

Know your customer procedures in place

Know your customer procedures not in place

5 Service operations and computer support

Corporate audit has reviewed within the past year with a satisfactory rating. All issues have been addressed. Operations are supported by an approved branch emergency preparedness plan

Last audit review was more than one year ago but was rated satisfactory. If rated less than satisfactory, all issues have been addressed. Approved systems backup and contingency plan

Never audited by Corporate Audit. Audit or last review ass rated unsatisfactory, and not all issues have been addressed. Systems backup and contingency plan not approved.

Summary of key risks and Summary of key risks and mitigantsmitigants

Key risk of system participation

1. Failure of a member of the system

Incoming electronic and paper-based credits are made immediately available by “CB” for customer withdrawal.

If a paying bank fails, the credits are subject to reversal by the Central Bank at the end of the day. In order to avoid a loss “CB” would have to recover funds from the customer. There is a risk that a reversal of a credit to a customer’s account may not be enforceable under the law.

2. Treasury management There is a risk of “shortfalls” as a

result of “fails.”

Mitigant Customers using services have been

informed by letter that payments are provisional until settlement at the next day. Incoming funds from clearing banks designated high risk by the Senior Credit Officer are only posted after clearing has been declared final. The Central Bank has demonstrated that it will intervene to protect both domestic and foreign banks from a settlement failure and that it is committed to protecting the systems from systemic failure

The branch maintains collateral facilities at the Central Bank in excess of the highest fail historically.

Summary of key risks and Summary of key risks and mitigantsmitigants

Key risk of system participation

3. Computer failure “CB” is subject to potential

financial loss.

4. Fraud There is a potential for fraud losses

from transfers based upon physical documents that are forged or false telephone or fax instructions. Fraudulent transfers occur frequently in this market.

Mitigant

There have been no major failures of the system or “CB” systems. Because volumes are low conversion to paper settlements is possible. Successful offsite tests have been conducted annually.

Fax or telephone instructions for a payment requires implementation of a Bankwide Standard including the approval of a second officer and a confirming telephone call to a customer. An audit of these procedures was satisfactory.

Action plans to control Action plans to control payment riskpayment risk

Controls for Receiver RiskControls for Receiver Risk New account documentationNew account documentation Establish emergency funding facilityEstablish emergency funding facility Increase daylight overdraft facilitiesIncrease daylight overdraft facilities Settlement limits for trading counterpartiesSettlement limits for trading counterparties Customer daylight overdraft controls - Customer daylight overdraft controls -

possibly discontinue customer payment possibly discontinue customer payment serviceservice

Contingency system plan- operational Contingency system plan- operational considerationsconsiderations

Write to Central Bank/Bankers Association Write to Central Bank/Bankers Association urging payment risk controlsurging payment risk controls

Lamfalussy Report on Netting Lamfalussy Report on Netting SchemesSchemes

Well-founded legal basisWell-founded legal basis Limits that permit participants to Limits that permit participants to

manage their credit exposuremanage their credit exposure Limits on the maximum level of Limits on the maximum level of

exposure for a participantexposure for a participant Assurance of daily settlement if the Assurance of daily settlement if the

largest debit position fails / defaultslargest debit position fails / defaults Published criteria for membership / fair Published criteria for membership / fair

accessaccess Back-up facilities capable of Back-up facilities capable of

completing a day’s processing if a completing a day’s processing if a primary system failsprimary system fails

Core Principles - SIPSCore Principles - SIPS Well-founded legal basis under all Well-founded legal basis under all

relevant jurisdictionsrelevant jurisdictions Participants should have a clear Participants should have a clear

understanding of the system’s impact understanding of the system’s impact on each of the financial risks they incur on each of the financial risks they incur through participation in itthrough participation in it

Should have clearly defined Should have clearly defined procedures for the management of procedures for the management of credit risks and liquidity risks, which credit risks and liquidity risks, which specify the responsibilities of the specify the responsibilities of the system operator and the participants system operator and the participants and which provide appropriate and which provide appropriate incentives to manage and contain such incentives to manage and contain such risksrisks

Core Principles - SIPS Core Principles - SIPS

The system should provide prompt The system should provide prompt final settlement on the day of value, final settlement on the day of value, preferably during the day and at a preferably during the day and at a minimum at the end of the dayminimum at the end of the day

A system in which multilateral netting A system in which multilateral netting takes place should, at a minimum, be takes place should, at a minimum, be capable of ensuring timely completion capable of ensuring timely completion of daily settlements in the event of an of daily settlements in the event of an inability to settle by the participant inability to settle by the participant with the largest single settlement with the largest single settlement obligationobligation

Core Principles - SIPSCore Principles - SIPS

Assets used for settlement should Assets used for settlement should preferably be a claim on the central preferably be a claim on the central bank; where other assets are used, bank; where other assets are used, they should carry little or no credit riskthey should carry little or no credit risk

The system should ensure a high The system should ensure a high degree of security and reliability and degree of security and reliability and should have contingency should have contingency arrangements for timely completion of arrangements for timely completion of daily processingdaily processing

The system should provide a means of The system should provide a means of making payments which is practical for making payments which is practical for its users and efficient for the economy its users and efficient for the economy

Core Principles - SIPSCore Principles - SIPS

The system should have objective and The system should have objective and publicly disclosed criteria for publicly disclosed criteria for participation, which permit fair and participation, which permit fair and open accessopen access

The system’s governance The system’s governance arrangements should be effective, arrangements should be effective, accountable and transparentaccountable and transparent