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An important element of the payment process is the risks to which its participants are exposed. This section will address the key financial risks of PS, such as liquidity risk, credit risk, and systemic risk. Special attention will be paid to operational risk. Other, including non-financial, risks that are associated with the functioning of the PS, for example, currency, legal risk, reputational risk, etc., require a separate analysis. These risks are not considered in this manual.
Credit risk management is of particular importance, since the functioning of most PSs is associated with obtaining an overdraft loan from the central bank and with mutual lending of participants in these systems. Credit risk lies in the fact that the monetary obligation will not be fulfilled in full either at the time of maturity or during the entire subsequent period of time [BIS, 2001]. This type of risk is often associated with the default of one of the settlement participants and includes the risk of losing money and the risk of not realizing the benefits due to non-fulfillment of the contract. In payment systems, attention is focused on the risk of default on payment obligations, mainly in interbank settlements, although credit risks can arise at any stage of the payment process. Thus, the credit risk of PS can be closely intertwined with the general credit risks of transactions in the financial markets.
Liquidity risk - the likelihood that the payment of the obligation by the counterparty (or participant in the settlement system) in full will take place not within the time period specified in the contract, but at some unspecified moment later | BIS, 20011. However, the counterparty (or participant) remains solvent, since there is a possibility that he will be able to pay off the arisen obligations at an indefinite moment. Although the lender of the transaction will ultimately receive the amount due, a delay in payment can negatively affect its financial position, lead to the use of additional sources of liquidity or default on its obligations on time, which is fraught with economic losses.
Liquidity risk differs from credit risk because, in credit risk, default is a loss that must ultimately be shared in some way among those dealing with defaulting participants. When characterizing payment systems, the term “settlement risk” is often used as a “synthetic” concept that combines the two types of risks mentioned above - credit and liquidity.
The main source of financial risks in payment systems is the presence of a time lag between the moment the settlement operation is initiated and the moment the settlements are finally settled and the money is credited to the beneficiary's account. Naturally, the risk is especially high in net systems (systems with deferred payment), where transactions performed by settlement participants during the day are “conditional”, and the final settlement and recording of transactions occurs in bank accounts at the end of the billing period.
The risk of net systems arises from various factors. First, the current practice leads to the fact that many banks participating in net settlements credit money to customer accounts based on information about the initiation of a payment (receipt of a payment order in the settlement system), without waiting for the final settlement of the final phase of the settlement period. If at the same time it turns out that the bank that sent the payment order is not able to pay off its obligations at the end of the day, then the bank that paid the money to the client will have to demand it back, and in case of refusal it will suffer a loss. Secondly, the payment risk may also be associated with an incorrect assessment by the bank of the need for liquid funds, which will be revealed at the end of the billing period.
In addition to financial risks, PS participants are also exposed to operational risk.Operational risk can be viewed from two perspectives. On the one hand, operational risk is the risk that deficiencies in information systems or internal procedures could lead to unforeseen losses. On the other hand, operational risk is the risk of human error, fraud, or the failure of any component of hardware, software, or communication systems. Summarizing the above, operational risk can be defined as the risk of system failure due to failure of information technology or due to natural / man-made disasters and accidents or human factor, fraudulent schemes | BIS, 2001]. In the light of the active introduction of computer technologies into the settlement system observed in recent years, the value of operational risk is growing sharply.
KP PC recommends improving the liquidity and operational risk management mechanism as a top priority. To improve liquidity risk management in PS, stress testing and assessment of the situation in which the bank is unable to settle due to failures or complete failure of the system should be carried out. This scenario assumes widespread failures and multiple / one-time system failures. Global banks must have robust liquidity management procedures throughout the day to process key payments on a priority basis and be prepared to execute key payments in the event of a sudden liquidity shortage across multiple systems | Shirakami, 2008].
To manage operational risk, system operators, financial institutions and service providers should:
The main factor in the accumulation of systemic risks is the magnitude and duration of the credit and liquidity risks to which the transactions of individual settlement participants are exposed. The more intense these risks, the more likely the onset of a general systemic crisis in the field of settlement transactions. In this regard, in recent years, the international banking community and central banks of individual countries have been actively monitoring payment risks and strive to introduce changes in settlement practices that would minimize and even completely exclude the possibility of systemic violations of the payment process.
The publication of a special report by the CP PC entitled “Basic Principles for Systemically Important Payment Systems” | BIS, 20011 is evidence of the serious concern of international financial institutions about the increased financial risks. The report emphasizes that a healthy payment system is the main condition for maintaining financial stability. In this regard, ten "basic principles" of organizing the operation of payment systems and four points of responsibility of central banks for the observance of these principles in banking practice are formulated. Some of these rules are listed below.
Thus, the document states that the rules for the operation of payment systems should give their participants a clear understanding of the financial risks that they assume when carrying out payment transactions (Principle II). Further, the system should have clearly developed procedures for managing credit and liquidity risk, indicating the areas of responsibility of the system operator and all of its participants (Principle III). It is extremely important to ensure a high degree of security and operational reliability of the system and the availability of additional mechanisms to carry out daily processing on time (Principle VII). This principle was originally formulated in the Lamfalussy report, commissioned by the central banks of the G10 countries in 1990. It was formulated for the settlement of cross-border multicurrency transactions,
Special attention in the KP PC report is paid to the risks in net-systems with multilateral offset. They must “as a minimum ... ensure that daily settlements are completed on time in the event that the participant with the highest settlement obligation fails to make a final settlement” (Principle V).
Central banks are advised in the guidelines to publicly explain their role and policies in relation to COP and ensure that these systems operate in accordance with the core principles outlined in the report. These principles relate mainly to systems for payments of large amounts, but many provisions of the document are applicable to other PSs, with a smaller volume of payment transactions.
Note that insufficient development of the legal framework can additionally create a significant legal risk in the PS. Legal risk can be defined as the risk of incurring a loss due to an unexpected change in law or regulation, or because a contract cannot be enforced [Vanjelisti, 2008]. This risk arises if the rights and obligations of the parties involved in a payment transaction are not clearly defined (which creates uncertainty). To minimize this type of risk, it is required that the PS activities are based on a well-developed system of rules and procedures.
Credit risk management is of particular importance, since the functioning of most PSs is associated with obtaining an overdraft loan from the central bank and with mutual lending of participants in these systems. Credit risk lies in the fact that the monetary obligation will not be fulfilled in full either at the time of maturity or during the entire subsequent period of time [BIS, 2001]. This type of risk is often associated with the default of one of the settlement participants and includes the risk of losing money and the risk of not realizing the benefits due to non-fulfillment of the contract. In payment systems, attention is focused on the risk of default on payment obligations, mainly in interbank settlements, although credit risks can arise at any stage of the payment process. Thus, the credit risk of PS can be closely intertwined with the general credit risks of transactions in the financial markets.
Liquidity risk - the likelihood that the payment of the obligation by the counterparty (or participant in the settlement system) in full will take place not within the time period specified in the contract, but at some unspecified moment later | BIS, 20011. However, the counterparty (or participant) remains solvent, since there is a possibility that he will be able to pay off the arisen obligations at an indefinite moment. Although the lender of the transaction will ultimately receive the amount due, a delay in payment can negatively affect its financial position, lead to the use of additional sources of liquidity or default on its obligations on time, which is fraught with economic losses.
Liquidity risk differs from credit risk because, in credit risk, default is a loss that must ultimately be shared in some way among those dealing with defaulting participants. When characterizing payment systems, the term “settlement risk” is often used as a “synthetic” concept that combines the two types of risks mentioned above - credit and liquidity.
The main source of financial risks in payment systems is the presence of a time lag between the moment the settlement operation is initiated and the moment the settlements are finally settled and the money is credited to the beneficiary's account. Naturally, the risk is especially high in net systems (systems with deferred payment), where transactions performed by settlement participants during the day are “conditional”, and the final settlement and recording of transactions occurs in bank accounts at the end of the billing period.
The risk of net systems arises from various factors. First, the current practice leads to the fact that many banks participating in net settlements credit money to customer accounts based on information about the initiation of a payment (receipt of a payment order in the settlement system), without waiting for the final settlement of the final phase of the settlement period. If at the same time it turns out that the bank that sent the payment order is not able to pay off its obligations at the end of the day, then the bank that paid the money to the client will have to demand it back, and in case of refusal it will suffer a loss. Secondly, the payment risk may also be associated with an incorrect assessment by the bank of the need for liquid funds, which will be revealed at the end of the billing period.
In addition to financial risks, PS participants are also exposed to operational risk.Operational risk can be viewed from two perspectives. On the one hand, operational risk is the risk that deficiencies in information systems or internal procedures could lead to unforeseen losses. On the other hand, operational risk is the risk of human error, fraud, or the failure of any component of hardware, software, or communication systems. Summarizing the above, operational risk can be defined as the risk of system failure due to failure of information technology or due to natural / man-made disasters and accidents or human factor, fraudulent schemes | BIS, 2001]. In the light of the active introduction of computer technologies into the settlement system observed in recent years, the value of operational risk is growing sharply.
KP PC recommends improving the liquidity and operational risk management mechanism as a top priority. To improve liquidity risk management in PS, stress testing and assessment of the situation in which the bank is unable to settle due to failures or complete failure of the system should be carried out. This scenario assumes widespread failures and multiple / one-time system failures. Global banks must have robust liquidity management procedures throughout the day to process key payments on a priority basis and be prepared to execute key payments in the event of a sudden liquidity shortage across multiple systems | Shirakami, 2008].
To manage operational risk, system operators, financial institutions and service providers should:
- - be prepared for business continuity measures that will enable rapid recovery and resumption of critical operations;
- - have alternative channels for making the final settlement;
- - constantly maintain its readiness for measures to ensure the continuity of operation;
- - apply complex, complex testing methods - with the inclusion of aspects of interdependence at the national and international levels.
The main factor in the accumulation of systemic risks is the magnitude and duration of the credit and liquidity risks to which the transactions of individual settlement participants are exposed. The more intense these risks, the more likely the onset of a general systemic crisis in the field of settlement transactions. In this regard, in recent years, the international banking community and central banks of individual countries have been actively monitoring payment risks and strive to introduce changes in settlement practices that would minimize and even completely exclude the possibility of systemic violations of the payment process.
The publication of a special report by the CP PC entitled “Basic Principles for Systemically Important Payment Systems” | BIS, 20011 is evidence of the serious concern of international financial institutions about the increased financial risks. The report emphasizes that a healthy payment system is the main condition for maintaining financial stability. In this regard, ten "basic principles" of organizing the operation of payment systems and four points of responsibility of central banks for the observance of these principles in banking practice are formulated. Some of these rules are listed below.
Thus, the document states that the rules for the operation of payment systems should give their participants a clear understanding of the financial risks that they assume when carrying out payment transactions (Principle II). Further, the system should have clearly developed procedures for managing credit and liquidity risk, indicating the areas of responsibility of the system operator and all of its participants (Principle III). It is extremely important to ensure a high degree of security and operational reliability of the system and the availability of additional mechanisms to carry out daily processing on time (Principle VII). This principle was originally formulated in the Lamfalussy report, commissioned by the central banks of the G10 countries in 1990. It was formulated for the settlement of cross-border multicurrency transactions,
Special attention in the KP PC report is paid to the risks in net-systems with multilateral offset. They must “as a minimum ... ensure that daily settlements are completed on time in the event that the participant with the highest settlement obligation fails to make a final settlement” (Principle V).
Central banks are advised in the guidelines to publicly explain their role and policies in relation to COP and ensure that these systems operate in accordance with the core principles outlined in the report. These principles relate mainly to systems for payments of large amounts, but many provisions of the document are applicable to other PSs, with a smaller volume of payment transactions.
Note that insufficient development of the legal framework can additionally create a significant legal risk in the PS. Legal risk can be defined as the risk of incurring a loss due to an unexpected change in law or regulation, or because a contract cannot be enforced [Vanjelisti, 2008]. This risk arises if the rights and obligations of the parties involved in a payment transaction are not clearly defined (which creates uncertainty). To minimize this type of risk, it is required that the PS activities are based on a well-developed system of rules and procedures.
