Financial Stability 2/2001
4 Risk in payment and settlement systems
4.1 Operational risk
4.2 Risk associated with banks' foreign exchange trading
Boxes:
Operational risk
Continuous Linked Settlement (CLS)
Large amounts are transferred daily between financial institutions, households,
enterprises and other agents. As a result of the transfers, banks have substantial
short-term claims on one another. The majority of Norwegian banks settle such
claims in Norges Bank through Norges Bank's settlement system (NBO). Average
daily turnover in NBO in the first ten months of 2001 was NOK 171 billion (see
Chart 4.1). This is an increase of a good 25 % compared with the same period
in 2001.
Chart 4.1
Banks are exposed to various types of risk in payment and settlement systems.
Credit risk and liquidity risk are regarded as the fundamental risk types. Analyses
show that under normal circumstances, and following a number of risk-reducing
measures by Norges Bank and the banking industry in recent years, there is limited
credit and liquidity risk associated with domestic payments.7
However, banks may be exposed to considerable liquidity and credit risk as a
result of factors such as operational failure or positions taken in foreign
exchange trades.
7 See
Economic Bulletin
1/01: "Risk in the Norwegian settlement system"and 3/01: "Do
Norwegian payment systems satisfy the new BIS recommendations?"
4.1 Operational risk
The disrupted operations at EDB Fellesdata earlier this year (see separate
box) is an example of how dependent the financial sector is on efficiently functioning
technological systems. The trend towards highly automated technology, the development
of electronic commerce and the integration of computer systems to exploit the
economies of scale offered by mergers and takeovers are all factors that may
add to the scale and complexity of operational risk. In consequence, operational
risk is increasingly defined and treated as a separate risk area, and more and
more attention is being devoted to it, both nationally and internationally.
The operational disruptions at EDB Fellesdata
On Thursday, 2 August, at 5.40 pm, all operations at EDB Fellesdata came
to a halt. The loss of service caused serious problems in relation to ATMs,
balance checking, internet banking, account information, telebanking and company
terminals.
The clearing and settlement system for a number of small and medium-sized
savings banks was also down. 114 savings banks and an estimated one million
users were affected. It was over a week after the problem arose before all
systems were back in normal operation on Friday, 10 August.
In this case, it proved possible to reconstruct transaction data, which helped
to contain the financial consequences of the disrupted operations. Incidents
of this type show that satisfactory contingency plans are important to prevent
banks from incurring substantial costs as a result of operational failure.
Pursuant to the Act relating to Payment Systems, Norges Bank is the authorising
and supervisory authority for interbank systems. The authorisation requirement
applies to systems of importance to financial stability. Authorisation is based
partly on information concerning measures to safeguard technical operations,
including contingency plans for disrupted operations if the ordinary system
does not function. Since March 2001, three interbank systems have been granted
authorisation pursuant to the Payment Systems Act.
As supervisory authority, Norges Bank is responsible for requiring that the
systems have an organisation that assures the necessary operational reliability,
and with respect to the event at EDB Fellesdata, has required more detailed
reporting on abnormal situations and follow-up of such situations from the bank
that is operator of the interbank system in question. Norges Bank and the Banking,
Insurance and Securities Commission are also investigating the cause of the
problems, while the banking industry itself is following up the event.
Operational risk
Operational risk is associated with factors such as inadequate procedures,
disruptions in IT systems, infringement of rules, fraud, fire and terrorist
attacks.
One of the reasons that methods for measuring and analysing operational risk
are still poorly developed is that operational risk is difficult to define
and quantify. The scale of operational risk will also vary between institutions,
depending on their organisation and internal control systems, which makes
data collection and comparison difficult. However, a survey carried out by
the Basle Committee estimates that operational risk comprises between 15%
and 25% of banks' total risk exposure.
An important goal in analysing operational risk is to decide how institutions
can best reduce the probability of operational disruptions, and the extent
to which institutions should have a buffer against such risk. Work is currently
in progress through the Basle Committee to formulate separate capital adequacy
rules for operational risk in the banking sector. As a starting point for
determining a minimum requirement for capital adequacy against operational
risk, the Basle Committee in collaboration with the banking industry has concluded
that a workable definition of operational risk is that it is risk of loss
as a result of inadequate or unsuccessful internal processes, human error,
systems failure or external events. In formulating the definition, it is important
to take into account that the capital requirement must as far as possible
reflect actual risk, and that measures to reduce risk must be "rewarded"
with a less stringent buffer capital requirement. The current proposal from
the Basle Committee presupposes that as they develop more sophisticated tools
and methods for measuring operational risk, banks will use more advanced models
to calculate the minimum capital adequacy requirement against such risk.
4.2 Risk associated with banks' foreign exchange trading
On average, Norwegian banks buy and sell foreign exchange for the equivalent
of about NOK 120 billion each day. In currency trading, the parties settle their
commitments in two independent national payment systems. This implies a risk
for banks, since they normally deliver foreign currency that has been sold before
receipt of the purchased foreign exchange has been confirmed. If one party does
not meet its commitment, the counterparty may at worst incur a loss equivalent
to the principal in the trade. Such risk is called Herstatt risk and means that
banks' foreign exchange positions can be regarded as unsecured loans. The share
of a foreign exchange position a bank ultimately loses if a counterparty becomes
insolvent will depend on the estate in bankruptcy's treatment of the bank's
dividend demands.
Norges Bank has obtained figures for banks' counterparty exposures in currency
trading (see also box in Section 5). Six of the largest Norwegian banks have
specified i) exposure to their ten main counterparties in various currency pairs
and ii) total exposure to all counterparties in the various currency pairs on
a given trade date. The study shows that banks' total exposure in connection
with currency trading was a little over NOK 140 billon on this date. The more
concentrated this exposure is to a few counterparties, the greater the risk.
The largest total exposure of the Norwegian banking industry to a single counterparty
was over 12 % of overall exposure. This means that the Norwegian banking industry
could have sustained a loss of about NOK 17.4 billion if this counterparty had
become insolvent (see Chart 4.2). The corresponding figure for exposure to the
10 largest counterparties combined was NOK 78 billion.
Chart 4.2
Exposure in currency trading
Settlement of currency trades can be divided into phases according to the
risk status of the settlement:
i) delivery of sold foreign currency
ii) deadline for cancellation of payment
iii) due date for purchased foreign currency and
iv) confirmed receipt of purchased foreign currency
Banks' exposure starts from the time when payment cannot be recalled, and
ceases with confirmation of receipt of the purchased currency. Banks' exposure
time depends on their own and their counterparties' routines for the execution
of currency trades, and on which currencies are bought and sold. If the exposure
period is more than 24 hours, a bank's exposure will exceed its daily foreign
currency turnover. Trading in the currency pair EUR/USD has the shortest exposure
period, at 11 hours, and trading in USD/JPY has the longest, at 37½ hours.
By comparing banks' exposure with their core capital, it is possible to assess
their ability to withstand a potential loss. In the most extreme case, a bank
had an exposure of 120% of its core capital to a single counterparty. However,
Norwegian banks generally have smaller exposures to their main counterparties
(see Chart 4.3). On average, the six banks would have lost a good 60% of their
core capital if the largest counterparty for each of these banks had been unable
to settle, and if they had not received any dividend payment from the estate
in bankruptcy. Such a loss would have made it difficult for some banks to fulfil
the authorities' capital adequacy requirements, while a few other banks would
still have complied with the requirements.
Chart 4.3
The probability of a counterparty being unable to settle its leg of a foreign
exchange trade must be regarded as very low. A review of Standard & Poor's
and Moody's ratings of the most important foreign counterparties shows that
Norwegian banks generally trade with banks with high credit ratings. The short
exposure time involved in foreign exchange trades also means that it is normally
possible for banks to avoid trading with financially unsound counterparties
(see separate box). There is therefore reason to assume that expected losses
are low, even though exposures may be very high. However, the possibility of
a major counterparty suddenly developing problems cannot be excluded, for example
because it has been unfortunate in its own choice of counterparties.
In the long term, it will be possible to virtually eliminate the credit risk
associated with banks' foreign exchange trading through settlement in CLS (see
separate box), which will make payment versus payment possible in foreign exchange
trading. According to plan, CLS will commence commercial operations in summer
2002. Initially, it will only be possible to settle trades in seven currencies
(AUD, CAD, CHF, EUR, GBP, JPY and USD), but CLS has given the final go-ahead
for the inclusion of the Scandinavian currencies as well. This will probably
take place in the first half of 2003. Even though NOK will not be included from
the start, Norwegian banks will be able to take part in settlements of other
currencies included in CLS. However, settlement in CLS is contingent on both
parties settling their leg of the trade in CLS, and since Norwegian banks' foreign
exchange trading normally involves NOK, the risk reduction for Norwegian banks
will initially be limited.
Continuous Linked Settlement (CLS)
Banks that take part in CLS will settle currency trades among themselves
over accounts in a common "multi-currency bank", CLS Bank (CLSB).
Between 7 am and 12 noon (C.E.T.), CLSB will i) receive payments, ii) settle
currency trades for which there is cover and iii) pay settled currency trades.
Incoming and outgoing payments will take place by way of CLSB's accounts in
national central banks, and settlement of banks' currency trading will take
place via their accounts in CLSB. One condition for settlement is that both
parties have paid a sufficient amount into CLSB's accounts in the national
central banks. CLS will thus virtually eliminate the credit risk a bank may
create for other banks in connection with currency trading. It is difficult
to say anything definite about what effect CLS will have on banks' liquidity
requirements. Banks' payments to CLS will take place on a net basis, thereby
reducing banks' liquidity requirements. On the other hand, payments must be
made within a shorter period than is the case at present. Moreover, banks
will not be able to settle currency trades over internal accounts in correspondent
banks to the same extent as previously, as CLS requires that incoming and
outgoing payments take place via CLSB's accounts in central banks.
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