9 Payment System Policy Issues and Analysis (2024)

Efficiency from Users’ Standpoint (Demand Efficiency)

In a market economy, the users of payment services—demanders—will determine whether a particular payment instrument is used and, if so, to what degree. In general, because payment instruments are used to transfer money in exchange for goods and services, the resource costs and the efficiency of the means of payment in an economy may affect the levels of production and exchange of some or all goods and services. In developing economies, in particular, slow, unreliable, and costly means of payment may dampen business activity and retard the development of liquid financial markets. In economies with high inflation rates, slow and unreliable payment mechanisms can aggravate the implicit “inflationary tax” on the use of money in business activity.

It is also important to recognize that payment instruments are typically exchanged between two parties in payment for underlying transactions involving goods or services. Thus, a payment instrument must be accepted by both parties as a means of payment in a transaction, and possibly also by the banks involved. It is not sufficient for only one party to a transaction to find the instrument acceptable. For example, in retail purchases, both merchants and consumers must accept a particular type of payment order or currency in payment for ordinary goods. In dealings between nonfinancial businesses, different types of payment instruments may be acceptable and customary. In dealings between banks, particularly those involving large-scale interbank settlements for money market or other financial activities, large-value payment systems may be used.

Experience in developed countries suggests that users of payment services may consider a wide range of attributes when judging the expected costs and benefits of using particular payment instruments for particular purposes. Some of the key attributes, in addition to fees, include the speed and predictability of settlement; the physical characteristics of the payment instrument, including paper or electronic forms; the complexity of using the instrument—an issue particularly when new mechanisms are introduced; and, perhaps, purely psychological qualities associated with an instrument. In addition, important risk attributes may include the susceptibility to loss by theft, fraud, error, or counterfeiting associated with a particular instrument. Further, the possibility of losses owing to default on the payment instrument by the payor or the payor’s bank may influence choice of payment instrument. In evaluating the importance of these risks, users will necessarily take into account the effort and expense they would incur by taking security and other precautions to reduce risk to tolerable levels.

The opportunity cost of forgone interest from holding a stock of money such as currency may be important in some circ*mstances, as would the benefits or costs associated with float, in the collection or processing of paper or electronic instruments or messages. Privacy may be important to both businesses and individuals. The compatibility of certain payment instruments with consumer or business financial record-keeping systems and practices may also affect usage, particularly in new electronic payment systems.

The expected benefits or costs of the attributes of different instruments and associated communication, and processing mechanisms may depend on factors such as the value of a payment, the distance over which payment is made, and other circ*mstances that are unique to each payment. For example, in face-to-face transactions, currency provides immediate and predictable settlement with a great deal of privacy accorded to the individuals completing the transactions. For these reasons, currency is often used for illegal as well as legal transactions, and as noted in Chapter 8, the overall movement to more automated and technologically sophisticated payment methods may be seriously affected by the perceived lack of privacy attached to such new methods.

In addition, for small-value payments the risks of loss as a result of fraud and error inherent in currency are negligible, and those from handling currency are manageable at reasonable cost. At the same time, the risk of loss from the theft of currency can be substantial, even for small-value payments. As payments increase in value, the bulk and weight of currency impose additional expected costs on users, even as bills of higher denomination are introduced. Thus, in general, businesses and banks find that the expected costs of using currency outweigh the expected benefits, particularly when making large payments over long distances.

On net, the costs associated with using currency may well have given rise over time to the widespread use of deposit money for payments. Even with such use, however, different types of payment messages and processing systems may have different attributes with different benefits and costs to users. For example, in contrast to currency, electronic payments can offer speed and predictability even over long distances without physical inconvenience. On the other hand, the susceptibility of some electronic systems to fraud, error, or default may be significant. The degree of privacy of information associated with electronic systems will depend on the laws and official policies applicable to such systems as well as the operational safeguards contained in the systems.

Paper payment instruments, such as checks or bank drafts, may present either larger expected benefits or costs than currency or electronic payments. On the one hand, paper instruments may be made to the order of named individuals and present a lower risk of loss from theft than currency. Moreover, paper instruments, like electronic messages, may provide significant additional security benefits to users when coupled with the use of deposit accounts for holding money and settling payments. On the other hand, for face-to-face transactions involving relatively small values, the use of paper instruments may entail slower and less predictable settlement, and, therefore, larger expected costs for at least one party to the transaction, than the use of currency. Further, for large-value payments, paper documents may be significantly more costly and risky to use than electronic payment systems, particularly if large numbers of such payments are to be made routinely, as is typical in the interbank markets.

Two classic examples exist in the United States of payment instruments that were developed without sufficient attention to user costs and benefits associated with the attributes described above. In the late 1970s, a one-dollar coin was introduced in an effort to reduce the volume of one-dollar notes in circulation, and thereby reduce the resources devoted to providing one-dollar payment instruments to consumers and businesses. Either because the coin was easily confused with the commonly used 25-cent piece, or because of a strong psychological preference for one-dollar notes, the dollar coin was never accepted by the general public as the standard for one-dollar payments.

In the mid-1970s, predictions were made that electronic payments would quickly come to dominate the use of currency and checks for small-value retail payments in the United States. The Automated Clearinghouse mechanism for processing bulk electronic payments was put in place and a “cashless” society was predicted. Acceptance of this payment mechanism, however, was relatively slow for most of the 1970s and 1980s. Consumers and businesses did not readily adapt to the payment mechanism, and indeed, with the advent of electro-mechanical automated teller machines, the use of currency in the United States apparently increased during that time. Currently, the use of electronic point-of-sale payment mechanisms is growing rapidly in the United States, albeit from a low initial level of usage.

The expected benefits and costs associated with important attributes of different payment instruments is likely to differ, depending upon variables such as payment value, distances over which payments are to be made, and the relative importance of recurring versus nonrecurring payments. Thus, in theory, as observed in practice, different payment instruments will be used by the same individuals or institutions, depending on the circ*mstances surrounding the particular payment. This use of multiple payment instruments in different circ*mstances, along with the specialization of payment systems, is fully consistent with the principle that payment systems should be efficient from the standpoint of users of such systems. Thus, the possibility of multiple instruments and systems should be part of the conceptual framework of designers of payment mechanisms.

Efficiency from Suppliers’ Standpoint (Supply Efficiency)

Efficiency in the payment system also requires that payment services be produced and distributed efficiently by banks and other suppliers of such services. A particular concern for suppliers is that the real resources devoted to making payments, such as labor, capital, and technology, be deployed so that the benefits from using the resources are greater than or equal to their costs.

The analysis of supply efficiency can be somewhat complex because payment systems involve the provision of services by individual banks to nonbank customers as well as the interbank clearing and settlement process. Interbank clearing inherently involves one or more of the institutional forms of interbank activity described earlier—correspondent, clearinghouse, or central bank arrangements. Thus, the analysis of supply efficiency extends to all of these arrangements.

In general, individual banks in a market economy expect to recover the operating and capital costs of their activities, including a return on invested capital. This policy extends to the payment system activities of banks. In many countries, the experience is that banks competing with each other will attempt to reduce the costs of providing payment services as they attempt to increase the efficiency of their operations. These efforts often lead to the automation of traditional labor-intensive payment practices, when bank managements consider capital and automation technology to be relatively inexpensive compared with labor.

An important issue in developing countries is the extent to which state-of-the-art automation technology should be installed in individual banks and in the payment system generally. As suggested above, in developed countries, competitive pressures have led to the widespread application of automation to payment processing, as payment volumes have increased and the capital costs of automation have fallen dramatically. Further, the automation of payment processing and accounting functions within commercial banks is often undertaken, in part, because it is closely related to the automation of general banking activities and the development of new services.

The same competitive pressures will influence banks in developing countries. The relative benefits of installing advanced automation equipment, however, should be analyzed in light of the particular characteristics of payment volumes, labor costs, and equipment costs in each country. For example, scarce capital and foreign exchange resources may raise the relative cost of installing advanced technology, with the possibility of diverting scarce financial resources from more highly valued commercial uses. Thus, recent experience in developed countries with payment system automation provides important information about choices but should not be viewed as an absolute indicator of the benefits of technology that must be followed regardless of cost.

As noted above, interbank clearing and settlement is a key feature of payment systems in economies with large numbers of banks. In principle, the installation and operation of interbank systems should economize on labor, capital, and technology resources, as would individual intrabank systems.

In correspondent banking, at least two situations are possible. First, a single bank may act as correspondent to two other banks, for example, bank A and bank B. In this case, the provision of interbank payment services to banks A and B involves processing transfers of funds between the accounts of A and B at the correspondent. Supply efficiency by the correspondent entails the efficient employment of capital, labor, and technology in providing services to customer banks such as A and B as well as to other customers.

Second, a series of correspondent banks may be involved in completing the interbank processing and settlement of a payment. If a payment is to be made by bank A to bank B, but these banks do not share a common correspondent, assume that they use two different correspondent banks, C and D. Banks C and D, in turn, have a common correspondent, E. In this example, bank E can be visualized as the top of a correspondent banking pyramid, with multiple layers of correspondent banks. Clearly, a large number of banks could become involved in the payment process as it operates through the correspondent banking system. Experience suggests that both benefits and costs are involved in complex correspondent banking arrangements. On the one hand, correspondent banks can provide an important service at relatively low cost by specializing in payment processing, particularly for relatively low-volume users of particular payment services. On the other hand, additional costs and other inefficiencies may be associated with a relatively long clearing and settlement chain, including long and variable delays in completing payments. The process of returning payment items and resolving errors or other problems can also be extremely complex and lengthy. These problems result partly from the inefficiencies in making payments through the processing systems of different banks, which may include manual as well as automated message handling. In addition, as discussed in Chapter 10, individual banks in a payment chain may be tempted to slow down processing to obtain the benefits of one or two days’ extra use of customer funds.

Large numbers of payments flowing between banks, particularly involving paper instruments, generate potentially large inefficiencies in interbank clearance and settlement. In such cases, clearinghouses are often introduced to speed interbank clearance and settlement, with savings both in processing costs and settlement resources. Clearinghouses typically introduce centralized processing and accounting procedures with strict operational deadlines applying to all members. The multilateral netting of the monetary value of payments is also typically introduced, and can reduce the value of settlement obligations by 50–90 percent.5

Central bank arrangements may have characteristics of either correspondent banking or clearinghouses, or both. In some countries, the central bank owns and/or administers interbank clearinghouses similar to those that are operated privately in other countries. Net settlements are conducted using balances in central bank accounts. In other countries, the central bank collects paper instruments and/or operates an electronic payment system that relies on the crediting and debiting of its account holders in a manner similar to a private correspondent, with the important exception that funds in central bank accounts are free of default risk. In still other countries, including the United States, the central bank may offer both types of interbank clearing and settlement procedures.

Both private clearinghouse and central bank arrangements can introduce important efficiencies into interbank clearing and settlement, although care needs to be taken in analyzing the benefits of these arrangements. For example, both clearinghouses and central banks may be able to exploit economies of scale and scope in clearing and settlement. Traditional economies of scale may exist in the communication, processing, clearing, and settlement of either electronic or paper-based payments. In this context, economies of scale mean that as processing volumes increase over a relevant range, marginal and average unit processing costs decline.

Economies of scale may also exist in the sense of “network economies,” in which the addition of participants to a clearinghouse or central bank arrangement reduces the marginal and average unit costs of communications and processing for the group as a whole. The concept of network economies covers efficiencies attributable to the identities of the additional participants who exchange payments with others in the clearing group, and not simply owing to an increase in processing volumes. In some cases, “financial network economies” may also exist in the sense that as members are added to a multilateral clearing group, the aggregate value of net credit extended within the clearing group may increase less than proportionately with the aggregate value of payments to be cleared and settled. Again, this effect is partly associated with the identities of added members, not simply that additional payments are to be cleared and settled.

Further economies of scale may exist with respect to interbank settlement if increases in the value of payments processed result in a less than proportional increase in the value of the settlement media, including central bank money, needed to conduct settlements. In all of the above situations, “supply efficiency” increases because interbank clearing and settlement can take place at lower unit costs than they would do otherwise.

Both clearinghouses and central banks may also experience so-called economies of scope, also known as “synergies,” in interbank clearing and settlement. Economies of scope would be said to exist if payment communications and processing can be coupled with credit operations so that the marginal and average costs of providing the services jointly is less than the respective costs of providing them separately.6 For example, it may be much less expensive to receive implicit credit through a multilateral clearing arrangement than to “prefund” settlement obligations on an ongoing basis throughout a daily clearing cycle, using a separate credit facility to raise the money to meet prefunding requirements. Economies of scope may also exist in the joining of settlement and processing operations in real-time gross settlement systems typically run by central banks.

Care needs to be taken in analyzing economies of scale and scope for at least three reasons. First, the presence or absence of economies of scale is essentially an empirical question for specific clearing technologies and organizations. For example, in the case of check clearing, the statistical evidence from Federal Reserve experience suggests that check clearing does not have such large economies of scale that to achieve an efficient use of clearing resources, all checks cleared on an interbank basis in the United States should be processed by a single check processor or, indeed, at a single processing site.7 Even with electronic technologies, it should not automatically be assumed that the fixed costs of acquiring computers will create economies of scale so large that all payments should be processed by a single clearing organization or at a single computer center. Economies of scale, or the lack thereof, in communications technologies will have a bearing on the overall scale economies in interbank clearing, particularly of electronic payments.

Second, although clearinghouses and central banks may help to focus attention on promoting efficiency in interbank clearing operations, they may also at times face internally conflicting objectives. Private clearinghouses are likely to have multiple owners who have somewhat different objectives for the clearinghouse based on their differing commercial interests. Central banks may have multiple responsibilities that transcend payment activities and may, by law or custom, be responsive to a wide range of public policy objectives in administering payment services. As a result, both private clearinghouses and central banks may at times find it difficult to take “entrepreneurial steps” to increase efficiency in the interbank clearing process.

Third, major private clearinghouses that are important institutions for clearing payments may also be a focal point of credit and liquidity risk in the payment system. When payment and credit volumes are relatively large, systemic risks may arise that generate external “diseconomies” for institutions in the financial system. These diseconomies may offset, at least to some extent, the net benefits associated with economies of scale and scope. In such cases, as discussed below, key risk controls may be needed to manage or avoid risks. A full analysis of the efficiencies such clearinghouse arrangements offer to the financial markets, as well as to society generally, must take into account any major financial risks, along with the costs and results of installing and operating key risk controls.

Overall Efficiency in the Market for Payment Services

Overall efficiency in the market for payment services requires that both users and suppliers of payment services behave efficiently. Users will choose among payment instruments and methods based on the benefits and costs associated with the attributes of different payment methods. Suppliers will supply instruments, communications and delivery systems, and clearing and settlement systems to optimize the use of resources needed to handle payments.

The presumption is that over the long run, competition among the providers of banking and payment services is the most effective way to ensure that the services produced are wanted by their users, and that those services are produced at the lowest cost possible, at fees commensurate with the cost of production. Accordingly, central banks will want to promote competition in the provision of payment services. The starting point for such policies may be the recognition at the philosophical level that private banking organizations, clearing associations, and similar participants all have an important role to play in an efficient payment system. This role is to provide both the institutional framework for the payment system and, at times, to compete directly with the central bank and other official bodies that may participate in the operation of the payment system. As discussed further below, regulatory policies are available, when needed, to help limit risks in the payment system.

Policies to Stimulate Payment System Efficiency

There are at least five broad areas in which central banks, together with other public authorities, can stimulate improvements in payment system efficiency. These include the setting of standards, competition policy, legal policy, monetary regulations, and the provision of central bank services. Positive steps that can be taken in each of these areas are identified below.

Standards

In the area of standards, central banks and other authorities can encourage the use of, and even issue, in consultation with banks, payment instruments and electronic message formats. The setting of standards, however, inherently touches on the interests of banks and payment system users broadly, and should balance the needs of each group. Further, as explored earlier, different payment instruments will be used for different purposes. Thus, problems are likely to arise if attempts are made to design one payment instrument or system for all uses in a country.

Technical standards that allow efficient processing of instruments or messages are also very important. The adoption of common standards can greatly simplify and speed up processing. A uniform system for identifying and routing paper documents or electronic messages, for example, is vital for reducing mistakes and delays in processing.8 Standard message formats are also very important for the automated processing of payments, particularly if multiple banks or payment systems are involved.

Competition Policy

In competition policy, the central bank and anti-monopoly authorities should encourage wide access to essential clearing arrangements. Clearinghouse arrangements, for example, may pose temptations to exclude competitors, which can affect the quality of, and charges for, interbank clearing services. Certainly, those that form clearinghouses may underwrite the costs and risks of such arrangements, with late entrants receiving benefits but not bearing a full share of costs. But there are creative mechanisms that can be used in many circ*mstances to help control such situations and their associated adverse incentives, if needed.

Financially weaker participants in clearinghouses may create systemic credit and liquidity risks for other members, particularly in multilateral netting. As discussed in Chapter 7, these risks can be controlled to some degree through risk management techniques set up to protect the clearinghouse and other participants. Although it will presumably be necessary to exclude some potential members from a clearinghouse because of the technical or financial risks they represent, clearinghouses should not be designed to rely on exclusionary practices as the chief means of risk control. Less restrictive means should be found, particularly for clearinghouses that are an essential part of the payment system.

A further issue is whether a country’s thrift institutions and so-called near-banks should be excluded from direct participation in key clearing arrangements. This issue often generates frictions in both banking and political circles. From the standpoint of the provision of efficient payment services, it is not clear a priori why such institutions should be excluded from key payment arrangements, if they qualify for membership on other grounds.

Legal Policy

In the area of legal policy, the central bank and legislative authorities should strive to make payments law as clear as possible. The rights of parties involved in making and receiving payments, including intermediary banks, should provide a sound foundation for payment system design, risk management, and use. It may be particularly important to design both a statutory and regulatory framework that facilitates the automation of payments processing, to stimulate gains in payment system efficiency. The issue of legal risks is discussed further in the next section.

Monetary Regulations

With monetary regulations, central banks may need to consider the effects of reserve requirement rules and related regulations on the liquidity of banks and the use of central bank money for the settlement of payments. For example, as discussed in Chapter 4, if required reserves must be held in segregated accounts and cannot be used to settle payments, the monetary costs of settlement may be increased substantially. This may unnecessarily increase the costs of providing payment services for a country’s banking system, with no offsetting public policy benefits. The objective of all payment systems is the transfer of money balances; monetary regulations that interfere with the money transfer process, or increase its cost, will increase the costs to banks of supplying payment services and therefore to bank customers of using bank payment services.

Central Bank Services

Finally, in the broad area of central bank services, central banks have a number of choices on their degree and type of involvement in the payment system. As noted above, central banks may choose to operate interbank clearinghouse arrangements directly. They may also choose to provide correspondent banking services. As discussed in Chapters 6 and 11, a very important payment service that central banks can offer is a large-value interbank funds transfer system.

Another vital and unique service is net settlement. A cornerstone of interbank clearing and settlement, particularly involving clearinghouses, is settlement in central bank money. Funds held on deposit at central banks are free of default risk and are provided by a neutral, public institution. Moreover, when interbank money markets are used to adjust the reserves of the banking system, settlement in central bank money is necessary to effect desired adjustments of reserve positions. Thus, particularly if a central bank does not provide other payment services, net settlement is fundamental to the establishment of money markets for adjusting banking reserves.

When central banks offer payment services, one important policy, as discussed earlier regarding clearinghouses, is the degree of access permitted to services. The objective of an efficient payment system suggests a policy of wide access by banks or other institutions offering deposit-money accounts used for payment purposes. Along these lines, the Federal Reserve is required by law to provide access to standardized payment services on a nationwide basis to “depository institutions,” including banks, thrift institutions, and U.S. branches and agencies of foreign banks.9

In theory, the market would ensure the efficient provision of clearing and settlement services through correspondent banking channels if access to central bank services were more limited. As noted above, however, there are potential frictions in correspondent banking arrangements, along with conflicting incentives regarding the provision of speedy clearing. Furthermore, since payment services and general banking services are often closely linked, smaller banks that face payment services with higher cost or lower quality obtained through the correspondent banking system, may be at a disadvantage in general banking markets vis-à-vis larger banks. This, in turn, may affect the degree of market concentration and economic efficiency in banking markets generally. Thus, direct access to central bank services may help significantly not only to speed up payments and reduce their cost but also to maintain a more competitive banking system.

When a central bank provides payment services, however, it must also be careful not to subsidize these services in a way that suppresses the development of efficient private clearing arrangements. For example, if the central bank provides payment services free, as some central banks in developed economies have done in the past, it is likely to attract a very large share of the interbank clearing business. If it processes payments inefficiently, the general efficiency of the payment system will be reduced, perhaps substantially.

To take the United States, before it began charging fees for its payment services in 1980, the Federal Reserve collected a large share of the checks written in the United States. Studies show that some Federal Reserve check processing centers processed too many checks in proportion to the clearing resources employed at the centers, driving up the unit cost of check processing beyond the economically efficient level. Following the imposition of fees for check processing, the total volume of checks processed by the Federal Reserve declined, and processing loads were more rationally distributed across processing sites, lowering processing costs per item and increasing efficiency.10

A further effect of charging cost-based fees for central bank payment services is that, if and when private sector alternatives exist to central bank clearing, significant incentives are created for managers of central bank payment operations to provide services efficiently. This effect should not be underestimated. For example, competition for business may provide the impetus for central banks to improve services and introduce new technologies earlier than they would do otherwise.

If a central bank does choose to recover the costs of providing its services through fees, what costs should be recovered? For example, should a central bank recover only the variable costs of providing payment services, or should it also recover fixed costs? If fixed costs are to be recovered, how are costs associated with a central bank’s other functions to be separated from costs attributable to payment services? In general, carefully designed cost accounting systems are needed when production inputs such as buildings, computers, and other equipment are used both for processing payments and for processing other data. Another question is how much management time should be attributed to payment services when management has both policy and operational responsibilities.11

One principle is clear. Unless a central bank recovers at least its variable costs of providing payment services through fees, it will almost never be economical for private banks to compete with the central bank for interbank clearing business. Moreover, in theory, central banks should recover their capital costs, including a market-oriented rate of return on capital, along with imputed taxes, in setting fees. This type of cost recovery helps to ensure that resources at the central bank’s disposal are put to the most valuable uses and to promote overall efficiency in the provision of payment services.

The appropriate level of central bank cost recovery for particular payment services has been discussed for a number of years in the United States and is currently under discussion in Europe.12 The development of new payment systems or the availability of payment services in geographically distant places may somtimes argue for some level of subsidy. In the United States, the Monetary Control Act of 1980 recognized this possibility. The presumption, however, is that a central bank seeking to stimulate efficiency in the payment system would resist a policy of providing large-scale subsidies to all of its services. The Federal Reserve follows a general policy of recovering the full costs of providing payment services.13

An interesting issue is whether unique services such as those provided by large-value interbank payment systems that provide real-time settlement in central bank money should be subsidized. Such systems form the basic standard for final electronic interbank settlement and, in many cases, form the fundamental settlement infrasturcture of interbank money markets. Such systems can also be crucial to the continuing liquidity and stability of the financial system. Whether these systems should be subsidized because they provide broad public benefits, beyond those to the immediate users of such systems, is not a settled question.14

Risks of Human Interference and Error

The risks of improper human interference in the payment process through activities such as counterfeiting, theft, and fraud may be dealt with in many ways.15 Indeed, there have been a number of highly publicized cases of fraud involving the payment systems of developing countries in the past few years. Prevention, detection, prosecution, and punishment are relied upon for protection against these risks. In cases where swift apprehension is not possible, however, the deterrence value of threatened prosecution and punishment may be quite low. Further, law enforcement authorities often note that theft or misapplication of money and securities through the payment system is the result of highly organized criminal activity.

The most important strategy for addressing counterfeiting, theft, and fraud is to take cost-effective steps to prevent them from occurring. Mechanisms to verify the identity and authority of the individuals signing paper instruments or initiating and receiving electronic payments are essential. Simple precautions can involve increasing the security of processing centers and communications channels used for payment information. Physical security of premises and machines is very important, as is the protection of data, both in storage and during transmission. Furthermore, security should not be limited to banks and processing centers but should extend to the premises and computers of users of payment services. These ideas are explored fully in Chapter 12.

When multiple parties are involved and paper instruments are used to make payments, it can become quite complex and costly to set up sophisticated mechanisms to prevent fraud. In both paper-based and electronic payment systems, added security features may slow payment processing and, possibly, settlement operations. Some security measures, particularly those involving central bank or government activities, may raise public concerns about the privacy of payment and financial data.

In a market-oriented economy, the costs of theft and fraud as well as the cost of security relied upon to prevent these activities will be borne largely by payment system users. At some point, of course, trade-offs involving costs and benefits, as well as privacy concerns, will determine how much security is economical. Nonetheless, to maintain confidence in the main payment systems for an economy, it is likely to be necessary to make significant investments in security.

Operational Error and Failure

A key issue in the design and maintenance of automated systems is the management of the risks of operational error and failure. Indeed, the integrity of payment system operations, during both normal and unusual processing conditions, is critical to the functioning of a modern financial system. The tolerance level of errors and failures may be key parameters in the design of systems. These issues are discussed more fully in Chapters 10 and 12.

When a payment instrument or message is handled by multiple communications and processing systems in a sequence of communications, banking, and clearing organizations, failures at any one of a number of organizations can delay or misdirect a payment message. Thus, general policies on operational risks may need to consider a quite complex mix of organization types and processing risks.

An important policy decision with very practical cost effects concerns the type of arrangements that authorities will encourage to back up the primary processing elements in critical payment systems. A number of operational arrangements are possible, as discussed in Chapter 12. These arrangements are in the nature of an insurance policy. Unfortunately, until system failures actually occur—and they tend to occur rarely for well-designed and well-maintained systems—institutions may feel that investments in backup systems are a waste of money. Thus, it may be beneficial for a central bank to encourage attention to backup arrangements in the context of the long-term costs and benefits of investing in such arrangements.

Legal Risks

Uncertainty about laws and regulations can also be an important risk in the payment system. Clear payments law, typically embodied in statutes or regulations, can help bring certainty to the payment process and avoid general disruptions of payment activities because of concerns about the status of legal rights. For example, clear definitions of the rights of parties to a payment, clear requirements for creating payment instruments or messages, and a definition of rights and responsibilities in communications, clearing, and settlement are very important. The location of different operational, financial, and other risks goes along with the definition of rights and responsibilities.16

One interesting issue in the creation of payments law is whether the government should define the rights and responsibilities of all parties to payments (including those of correspondent and intermediary banks) or whether the authorities should permit the parties to individual payment transactions, along with their banking organizations and clearinghouses, to negotiate rights and responsibilities. On the one hand, market principles and the need for flexibility in financial and payment transactions may argue, in some cases, for individual negotiation. Clearinghouses, for example, have often adopted important rules affecting rights and responsibilities that are binding on their members, including rules covering sharing of financial losses. Correspondent banks “regulate” parts of their payment operations through private contracts. On the other hand, the legal definitions and standards for a unified, nationwide payment system would argue for uniform statutory or regulatory standards. To an important degree, each country must deal with this issue in the context of its own standards for commercial and payments law, its general legal principles, and the practicality of different legal strategies.

In formulating payments law, it is necessary to balance the interests of a variety of participants in the payment system. For example, suppliers of payment services, including banks and clearing organizations, will want commercially reasonable laws and regulations that are not costly to comply with. End users of the payment system will presumably also want low-cost rules. Some end users, however, may also have an interest in relatively expensive consumer protection measures that entail high implementation costs. A balancing of interests is therefore necessary.

Both suppliers and end users of payment services may seek legal provisions that will allow risks or losses to be shifted to the other group. Again, some balancing of interests is likely to be necessary. Legal provisions that do not clearly allocate risks and leave the resolution of legal uncertainty until after payments have been initiated have little value. Indeed, in large-value payment systems, legal uncertainties can generate serious systemic risks for the financial system.

Although a full discussion of all types of law that touch on payments is beyond the scope of this chapter, many types of law may be relevant. For example, bankruptcy laws may determine whether a payment that has been made by one party, who subsequently goes bankrupt, to another party, can or cannot be reversed. A country’s laws governing the bankruptcy of banks may have a profound effect on the status of payments that have been initiated but not finally settled before such a bankruptcy. In addition, general banking laws may govern the terms and conditions of accounts offered by banks, rights in deposit money, and the credit-granting process. In multicurrency and cross-border transactions, a host of laws governing foreign exchange and cross-border transactions may come into play and affect the process of making payments.

Perhaps the legal issue of overriding importance in the payment system concerns the definition of when a payment is final. Finality occurs at the time at which a payment is complete and cannot be reversed. Some payments, such as those made over the Fedwire funds transfer system in the United States (as described in Chapter 6), are final as they are being processed. Indeed, a Fedwire funds transfer is both irrevocable and unconditional between the depository institutions sending and receiving the transfer, so that a payment cannot be reversed even owing to mistake and error. (Such problems must be dealt with outside the Fedwire payment system by private negotiation.) Thus, when a depository institution receives a payment directly over Fedwire, it has received final payment in central bank money.17 Other privately or publicly operated payment systems, including large-value multilateral netting systems, may have less stringent finality rules than real-time gross settlement systems such as Fedwire. For example, there may be a period of time on some systems, during which checks, payment orders, or certain types of electronic payments may be returned, if the payments contain errors or are thought to be fraudulent. The terms of finality are also likely to differ between debit transfer systems and credit transfer systems, owing to the different operational nature of the two types of systems. All payment systems, however, define a time after which payments cannot be reversed.

Stringent finality rules do not come without cost. For example, if electronic funds transfers are final as they are processed, making a transfer is equivalent to making an irrevocable and unconditional delivery of cash. Indeed, an important reason why many payment systems do not adopt the rule that all payments are irrevocable and unconditional when they are processed is the added cost of arrangements that would be required to ensure the very high security and integrity of payments. At the same time, as discussed below, reliance on payment reversals, particularly same-day reversals, to manage financial risks in large-value interbank transfer systems would potentially entail very large systemic risks.

Credit, Liquidity, and Systemic Financial Risks

Credit risk enters payment system analysis because the operation of most payment systems involves extensions of credit, either explicitly or implicitly. Many central banks extend credit directly to commercial banks in connection with the provision of payment services. Commercial banks typically extend credit to one another in the course of payment operations, either as part of correspondent banking relationships or through clearinghouse arrangements. Moreover, banks also normally use money markets to borrow or lend reserves of central bank money that are gained or lost through payment, clearing, and settlement. Commercial banks also extend credit to their customers as part of normal commercial operations, of which one part is the handling of payments.

Credit risk is the “risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter.”18 In the payment system context, the focus is on the risk of default in the settlement of payment obligations, particularly in interbank settlements. There are, however, often credit risks at every stage of the payment process. Banks or bank customers that borrow funds in the payment process may be unable to repay those funds for reasons wholly unrelated to their payment activities. For example, the value of customer or bank assets held in the form of securities, commercial loans, or real estate may decline sufficiently to bankrupt the holder of the assets, who, in turn, may be a borrower of funds at some stage in the payment process. Thus, credit risk in the payment system may be closely intertwined with general credit risks in the banking and financial markets.

Liquidity risk is the “risk that a counterparty (or participant in a settlement system) will not settle an obligation for full value when due. Liquidity risk does not imply that a counterparty or participant is insolvent since it may be able to settle the required debit obligations at some unspecified time thereafter.”19 An important implication of liquidity risk for the payment system is that, although a participant in the payment system may hold insufficient central bank money to settle payments at a particular point in time, payments can be settled for full value given sufficient time to convert assets into central bank money. The same point is also true for settlement media other than central bank money. Liquidity risk contrasts with credit risk, since with credit risk, a default at settlement represents a loss that must ultimately be shared in some way by those that have dealt with the defaulting payment system participant.

Systemic risk is “the risk that the failure of one participant in a transfer [payment] system, or in the financial markets generally, to meet its required obligations will cause other participants or financial institutions to be unable to meet their obligations (including settlement obligations in a transfer system) when due. Such a failure may cause significant liquidity or credit problems and, as a result, might threaten the stability of financial markets.”20 Systemic risks can result from the extension of credit between banks in either the payment process or the interbank markets. Indeed, systemic risks in the financial markets are not confined to banks, but may include other major financial institutions. One particular form of systemic risk in private clearing arrangements is the risk that a settlement default by one participant in a clearing arrangement will trigger defaults by other participants.

As discussed in Chapter 11, central banks are concerned about credit, liquidity, and systemic risks in the banking and payment system from their perspective as supervisors of financial institutions, monetary authorities, and operators of payment systems. As supervisors, central banks are concerned about the credit and liquidity risks to the individual institutions they supervise. As monetary authorities, central banks are concerned about the demands for central bank money and credit, both in general and at specific times when important interbank settlements are conducted. As payment system operators, central banks are concerned about providing efficient and low-risk payment services. In all three roles, central banks are concerned about the systemic stability of the payment and financial system and the important connections between various financial markets and the payment systems that provide the infrastructure for settling transactions in the financial markets. Thus, official payment system risk policies typically have their roots in the combination of functions performed by central banks.

Private Sector Clearing Arrangements

Central banks may directly supervise private sector clearinghouses, may provide money or credit to facilitate settlements by participants in these arrangements, and may be directly involved in settlements through net settlement or other services. Thus, central banks often have important public policy interests in the operation and management of clearinghouse arrangements for payment and other instruments, including securities. Policies toward private clearing arrangements are currently under review and development in a number of countries. An important issue is how extensive should be credit, liquidity, and systemic risk safeguards in relation to the risks presented by a particular system.

The organizers and members of private sector clearing arrangements also have concerns about risks to their participants, ultimate users, and to the viability of the arrangement itself. As noted above, one of the major systemic issues for a clearing arrangement is the possibility that one member not meeting its obligation on a given day may cause other members not to be able to settle their obligations, so-called knock-on effects. To reduce the risks of catastrophic failures involving many institutions, and to ensure the integrity of clearings and settlements short of catastrophic failure, clearinghouses should, and often do, adopt risk control procedures. These risk control procedures, which are described more fully in Chapter 7, may include membership standards; inspection programs; credit limits both on bilateral and multilateral positions; and loss-allocation procedures backed by pools of funds or collateral, committed bank lines of credit, and guarantees. Operational risks may be managed through operational requirements for membership, backup processing arrangements, and other techniques.

For central banks overseeing clearing arrangements, it is important to bear in mind that the greater a system’s credit and liquidity safeguards, the greater is the probable cost to the private sector of establishing and using such facilities. In countries in which clearing arrangements fall into categories that lie on a spectrum from lowest to highest in systemic risk, it may be possible and desirable to give greater attention to, and to demand stronger risk controls and liquidity safeguards from, arrangements that present greater degrees of systemic risk. For example, small-value systems in which multilateral net positions are small in relation to each user’s assets, capital, and ability to finance settlement failures may require a somewhat lower degree of risk controls and liquidity safeguards than large-value payment netting systems. In contrast, large-value systems would ordinarily need to have the strongest controls.

In the past in many developed countries, clearing arrangements were not subject to requirements that explicit credit and liquidity risk management arrangements be in place. For example, clearing arrangements for checks or other paper instruments often allow these instruments to be returned to a bank attempting to collect the instrument through a clearinghouse if a bank on which an instrument is drawn is unable to settle the instrument. Credit risk, and even liquidity risk, is essentially managed by returning payments that cannot be settled.

This type of risk management system, which relies on the “reversing” or “unwinding” of payments, may be adequate to manage risks associated with clearing systems that process and settle relatively small values. Risk management based on unwinds, however, has sometimes been adopted by clearing arrangements for large-value payments, including electronic interbank funds transfer systems. In general, central banks have discouraged the use of reversals or unwind procedures as a method for managing credit and liquidity risks, particularly by electronic same-day settlement systems for large-value payments. First, such procedures have the potential to cause serious systemic liquidity problems in financial markets, if they are ever used. Second, settlement failures in clearing arrangements could occur as part of a larger financial crisis, and reversals could significantly amplify, through the payment system, a problem originating elsewhere. Third, a central bank may want to avoid any implication that it might provide the credit or liquidity necessary to avert the disruptive effects of a large-scale reversal of payments. Instead, central banks may insist that private sector participants in clearing arrangements directly take the necessary precautions to deal with credit and liquidity risk as part of the normal cost of operating a clearing system.

In the international setting, the central banks of the Group of Ten countries have developed a set of minimum common standards for “netting schemes,” including clearing arrangements that rely on the principle of multilateral netting and settlement.21 Moreover, the European Union central banks have endorsed similar minimum standards for domestic clearing arrangements in Europe that rely on multilateral netting.22 Among other things, these minimum standards require a clear definition of credit and liquidity risks in clearing arrangements, along with adequate credit and liquidity risk management systems. To avoid the systemic risks of multiple defaults in a clearing arrangement, the standards require that large-value systems be able to settle the single largest net debit position on the system in the event of a default. The standards also require other measures such as a strong legal foundation for netting systems, objective and public admission criteria, and reliable operational backup systems. Whereas policies toward domestic clearing arrangements may well depend on the particular circ*mstances in each country, the minimum standards provide an important starting point for analyzing risks in a wide range of netting systems as well as policies designed to manage these risks.

Correspondent Banking Arrangements

Correspondent banking arrangements may be as important, or even more important, than clearinghouse arrangements in the payment system in some countries. Specific payment system risk policies may or may not be aimed at these arrangements, depending on the country and the particular features of the arrangement. Operational and credit examinations conducted by bank supervisory authorities should cover key interbank settlement activities, along with other activities, as noted in Chapter 11.

Central Bank Payment Systems

One means of reducing credit and liquidity risks within the private sector is for a central bank to supply jointly payment services and supporting credit to the banking system. In the arena of large-value payment systems, some central banks provide multilateral netting systems, others provide real-time gross settlement systems, and some provide both. By offering credit with payment services, as amplified below, central banks tend to absorb credit and liquidity risk. Some central banks, of course, choose not to provide credit in connection with payment services, following a policy that places the private sector in the position of generating any credit needed to make payments. Even when a central bank does not provide credit in connection with its payments operations, however, it may monitor risks and be prepared to assist in liquidity management, in the event of potential settlement difficulties.

An emerging trend is for central banks to emphasize the advantages, from a risk perspective, of systems that provide for real-time gross settlement, particularly of large-value payments.23 A central bank would at least provide real-time settlement for a payment system, and might well own and operate the entire system, depending on the country. As explained in Chapter 7, real-time gross settlement systems do not necessarily eliminate credit and liquidity risks. When central bank credit is granted in connection with real-time settlement systems, for example, risk is essentially transferred to the central bank, which must then adopt means to manage the risks. Real-time settlement systems, however, do have the crucial advantage of eliminating the possibility that if one bank in the financial system defaults on its payments at settlement, others will in turn default. Thus, real-time settlement systems can potentially help to reduce systemic risks associated with large-value payment systems.

Whether a netting system run by a central bank has less credit and liquidity risk than such a system run by private banks is an open question. For its own systems, a central bank may be in a more favorable position to insist that strong risk controls be adopted. A countervailing point, however, is that a clearinghouse run by a central bank may be regarded as failsafe by participants, and there may be even less incentive than in private sector arrangements to agree to sound risk controls.

Central banks have designed specific tools to help manage the credit and liquidity risks in the payment systems they operate.24 Credit limits placed on users of the system, including limits of zero, are one way to limit risk. In addition, real-time monitoring and control mechanisms have been devised for credit extensions made through payment operations. In the strongest of such arrangements, credit transfers over a payment system may be rejected, or placed in queues, until sufficient balances are available, possibly from central bank credit extensions, to complete payments without exceeding relevant credit limits. Credit limit programs also exist that rely on payment system users to stay with limits as payments are made, and rely on after-the-fact detection and penalties for breaching these limits.

Central banks may take collateral to protect themselves against credit risk in the operation of the payment system. Indeed, some collateralized overnight central bank lending facilities were first developed to provide the credit needed to settle debts arising from the clearing of paper instruments. Thus, the basic idea of a central bank taking collateral to protect against credit risk, while providing needed liquidity to the banking system, is a very old concept.

Charging a fee for daylight overdraft credit is a technique that has been adopted by the Federal Reserve Board to influence the demand for daylight overdraft credit in accounts at Federal Reserve Banks. Charging a fee for daylight credit is analogous to the widely used practice of charging fees for overnight or longer-term central bank credit. As of this time, however, the Federal Reserve is the only central bank that has implemented a program of charging fees for daylight overdrafts, which it began in April 1994.

Other tools for managing risk to the central bank, and to the payment system generally, may depend on the role of a central bank in banking supervision. If a central bank has the power to supervise and examine banks or other payment system users, examinations that touch on the creditworthiness, liquidity, operational controls, contingency procedures, and related areas of a banking organization may provide information on risks to both the central bank and the payment system generally.

1

The author wishes to thank Diana Hanco*ck and Bruce Summers for helpful comments on this chapter.

2

In certain countries, the monetary liabilities of thrift or savings institutions may be used.

3

Paper currency may also take the form of a liability of a country’s treasury or another government entity. Coinage is also an important liability of either a central bank or another government body.

4

See Chapters 6 and 8.

5

Under multilateral netting procedures, each member of a clearinghouse group typically will pay or receive one net amount of money per clearing cycle, which represents the multilateral net value owed to, or to be received from, all other members with respect to the instruments cleared in that cycle. There are many variations on this basic theme. Multilateral netting is discussed further in Chapters 3 and 7.

6

Credit extensions may be either explicit or implicit. Implicit credit extensions, for example, may take place through the multilateral netting of payments.

7

See P. Bauer and D. Hanco*ck, “The Efficiency of the Federal Reserve in Providing Check Processing Services,” Journal of Banking and Finance, Vol. 17 (April 1993), pp. 287–311.

8

The standardization of check sizes and the use of the “magnetic ink character recognition” (MICR) line on checks, which contains machine-readable routing and account information, was critical in automating check processing in the United States.

9

The term “depository institution” is defined in Section 19(b)(1)(A) of the Federal Reserve Act and is similar to the concept of deposit-taking financial institutions.

10

See David B. Humphrey, “Resource Use in Federal Reserve Check and ACH Operations After Pricing,” Journal of Bank Research, Spring 1985, pp. 45–53.

11

Further issues are whether and how to separate policy and operational functions to avoid any potential conflicts of interest between central bank policy formulation and market activities. These questions are explored in Chapter 11.

12

For a discussion of cost recovery objectives in the European Union, see Working Group on EC Payment Systems, “Report to the Committee of Governors of the Central Banks of the Member States of the European Economic Community on Minimum Common Features for Domestic Payment Systems,” November 1993, pp. 6 and 28 (Principle 9).

13

For background material on the Federal Reserve’s policy of recovering the costs of providing payment services and charging fees for priced services, see Section 11A of the Federal Reserve Act, “The Federal Reserve in the Payments System,” and “Principles for Pricing of Federal Reserve Bank Services,” Federal Reserve Regulatory Service, sections 7–128, ff. (March 1994).

14

The Federal Reserve does not subsidize the provision of Fedwire services.

15

For the purposes of this chapter, the forgery of signatures on paper instruments and the unauthorized making of electronic payments using various computer-assisted techniques are variations on the theme of theft and fraud.

16

See Chapter 5 for a discussion of the legal foundations of large-value transfer systems.

17

The legal framework of the Fedwire system is discussed more fully in Chapter 5.

18

See the Glossary to Payment Systems in the Group of Ten Countries (Basle: Bank for International Settlements, December 1993), p. 536.

19

Ibid., p. 539.

20

Ibid., p. 544.

21

See “Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries” (Lamfalussy Report) (Basle: Bank for International Settlements, November 1990), p. 5. These standards, which are shown in Table 2 of Chapter 7, also apply to foreign exchange contracts and certain other instruments traded “over-the-counter” in interbank markets.

22

See Working Group on EC Payment Systems, “Report to the Committee of Governors of the Central Banks of the Member States of the European Economic Community on Minimum Common Features for Domestic Payment Systems,” November 1993, p. 5 (Principle 5).

23

Ibid., p. 5 (Principle 4).

24

See, for example, “Overview of the Federal Reserve’s Payments System Risk Policy,” Federal Reserve System (October 1993).

25

These comments also apply when central banks provide accounts to foreign governments.