The Importance of National Payments Systems in Reducing Market Risk S.W.I.F.T. Regional Conference in Central and Eastern Europe Prague, Czech Republic: March 24, 1999 Robert H. Keppler The World Bank

Market risk and risk reduction techniques Market risk and risk reduction techniques The Importance of National Payments Systems in reducing market risk Presentation structure Risk assessment from a commercial bank perspective Risk assessment from a commercial bank perspective World Bank role in financial sector development World Bank role in financial sector development

World Bank role in the financial sector  Convertibility of capital  Stability of exchange rates  Quality of information  Political uncertainties  Government borrowings from the banking system

World Bank role in the financial sector  Strengthen the legal and regulatory system  Improve basic banking skills  Clarify the role of the central bank  Commercialize / privatize  Improve quality of information  Strengthen the clearance and settlement systems

Payment System Reform  Active participation of all stakeholders  Satisfy needs of all users  Customer to customer perspective  Operational and strategic elements  Twin- track approach / short term problem solving consistent with longer term vision

Risk Assessment - Commercial Bank perspective The source and significance of payment system risk The source and significance of payment system risk Regulatory impact on commercial banks’ participation in payment systems - BIS initiatives (Lamfalussy Standards and SIPS Core Principles) Regulatory impact on commercial banks’ participation in payment systems - BIS initiatives (Lamfalussy Standards and SIPS Core Principles) Commercial bank response - undertake structured assessments Commercial bank response - undertake structured assessments

Risk Assessment - A Formal Approach System documentation System documentation Risk assessment worksheets Risk assessment worksheets Preparation of the risk assessment summary Preparation of the risk assessment summary

System Documentation  Description of an operating cycle of the system  Rules of the system  Legal opinion covering the system participation agreement  System membership  Money laundering implications - laws, policies and procedures

Typical Assessment Worksheets  Financial standing - owner / operator  Membership  Risk management  System settlement  Legal  System operations

Summary of key risks and mitigants 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 mitigants 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 payment risk  Controls for Receiver Risk  New account documentation  Establish emergency funding facility  Increase daylight overdraft facilities  Settlement limits for trading counterparties  Customer daylight overdraft controls - possibly discontinue customer payment service  Contingency system plan- operational considerations  Write to Central Bank/Bankers Association urging payment risk controls

Lamfalussy Report on Netting Schemes  Well-founded legal basis  Limits that permit participants to manage their credit exposure  Limits on the maximum level of exposure for a participant  Assurance of daily settlement if the largest debit position fails / defaults  Published criteria for membership / fair access  Back-up facilities capable of completing a day’s processing if a primary system fails

Core Principles - SIPS  Well-founded legal basis under all relevant jurisdictions  Participants should have a clear understanding of the system’s impact on each of the financial risks they incur through participation in it  Should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain such risks

Core Principles - SIPS  The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day  A system in which multilateral netting takes place should, at a minimum, be capable of ensuring timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation

Core Principles - SIPS  Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk  The system should ensure a high degree of security and reliability and should have contingency arrangements for timely completion of daily processing  The system should provide a means of making payments which is practical for its users and efficient for the economy

Core Principles - SIPS  The system should have objective and publicly disclosed criteria for participation, which permit fair and open access  The system’s governance arrangements should be effective, accountable and transparent