Interbankfunds transfer systems are arrangements through which funds transfers are madebetween banks for their own account or on behalf of their customers. Arrangementsfor interbank settlement are far more uniform. Private Banks generally settle obligationsbetween themselves over accounts at state-owned central banks.
Claims on thesestate-owned central banks are no longer commodity-backed and typically havesome form of legal tender status; they are the most reliable form of money inthe economy. Large valuefunds transfer systems (LVTS) are usually distinguished from retail fundstransfer systems that handle a large volume of payments of relatively lowvalue. The average size of transfers through large value funds transfer systemsis substantial and the transfers are typically more time critical as thefinancial markets operate on it. Theprocessing of funds transfers involves two key elements. a.
The first of these is the transfer of informationbetween the payer and payee banksb. The secondkey element is settlement – that is, the actual transfer of fundsbetween the payer’s bank and the payee’s bank Even thoughthe interbank settlement process has evolved over a period of time there arefew inherent risks in the system. As per our observation the system holds twotypes of risk and they primarily revolve around the settlement piece.
a. Credit Risk: It is associated with the defaultof a counterparty, is the risk that a counterparty will not meet an obligationfor full value, either when due or at any time thereafter. It is permanent innature. b. LiquidityRisk: It is the risk that a counterparty will not settle anobligation for full value when due but at some unspecified time thereafter. Itcan be either short term or long term.
Further there are specific cases which leads to theabove highlighted risks are: a. Settlement Lag in LVTS: Timemismatch between the execution of the transaction and its final completion.Settlement lags can result in credit risk if the transmission of informationabout the payment and the settlement of the payment do not occursimultaneously. Settlement lags may also result in liquidity risk. A bank maynot be certain what funds it will receive through the payment system untilsettlement is completed, and thus it may not be sure whether or not itsliquidity is adequate. b. Asynchronoussettlement: A time lag between the completion of the two legs of thetransaction (i.e.
any lag between payment leg and delivery leg). This largestsource of principal risk in the settlement of foreign exchange and securitiestransactions, or, more generally, in exchange for value systems. These Creditand Liquidity risk arise between two banks but this further leads to a biggerrisk and impacts all others banks in the ecosystem and is called Systematicrisk. Central banks are particularly concerned with systemic risk. This is therisk that the failure of one participant to meet its required obligations whendue may cause other participants to fail to meet their obligations when due.Such a failure could trigger broader financial difficulties that might, inextreme cases, threaten the stability of payment systems and even the realeconomy.
By theirvery nature networks, interbank payment and settlement systems are potentiallya key institutional channel for the propagation of systemic crises. Centralbanks have a particular interest in limiting systemic risk in large value fundstransfer systems because aggregate exposures tend to increase with theaggregate value of transactions and potential risks in large value transfersystems are therefore often significantly higher than those in retail fundstransfer systems.