The nature and management of payment system risks: an international perspective

BIS Economic Papers No 36
February 1993

Introduction

Over the last two decades rapid technological change, deregulation and a tendency for asset prices to display greater volatility have all contributed to an explosion in financial activity and hence in the volume and value of payment flows, both within and across national borders. This trend is clearly illustrated by the surge in the value of interbank fund transfers handled by the major systems in the United States Japan and the United Kingdom in proportion to GNP. As the value of commercial transactions tends to grow in line with GNP, the major rise in the ratio is essentially due to the surge in financial activities. Among these, foreign exchange and cross-border transactions have played a prominent role.

As a result of this spectacular rise, the total value of interbank funds transfers has become very large indeed. For the three countries shown in the graph, it stood at around 80, 115 and 45 times GNP respectively in 1990. Put differently, the interbank funds transfer systems in Japan took just over two business days to turn over the value of the country's annual GNP In the case of the United States and the United Kingdom, this took only three and five and a half days respectively. Figures of a similar order of magnitude also apply to other Group of Ten (G-10) countries. This explosion in the volume and value of transactions has not only represented an important source of revenue for the providers of payment services, particularly banks; against a background of heightened competition, it has also radically altered the dimension of the liquidity and credit risks involved. As a result, payment and settlement systems are now a more important potential source of, and propagating mechanism for, financial crises. Episodes such as the Herstatt bank crisis (1974) and the stockmarket crash (1987) have helped to raise awareness of these issues. In this new environment, safeguarding the integrity of the payment system is a goal that acquires particular significance and that calls for the upgrading of risk management procedures through concerted efforts by market participants and the relevant authorities, notably central bank. Moreover, the pursuit of this goal inevitably takes on an international dimension: the spectacular growth in foreign exchange transactions, where settlement brings into contact otherwise largely separate domestic payment systems, has highlighted the issues that arise from the coexistence of different operating, regulatory and legal arrangements.

The objective of this paper is to clarify the nature of the risks connected with payment systems, to consider possible arrangements for their management and to review brief recent policy initiatives. These issues are illustrated with reference to the G-10 countries and primarily from the perspective of central banks.

Section I sets out the key elements of a stylised payment system. It also briefly describes the main characteristics and recent evolution of payment arrangements in the G-10 countries as well as the international linkages. The main focus is on the structure of interbank funds transfers and on the role of the central bank. Section II analyses the nature, magnitude and distribution of the credit and liquidity risks associated with payment systems. Section Ill considers the rationale for public intervention in risk management before analysing in more detail three areas where significant policy initiatives have been taken: large-value interbank funds transfer systems, the settlement of securities transactions and the settlement of foreign exchange transactions. Finally, the conclusions summarise the key points emerging from the analysis.