Financial Stability 2/2000

Print

4 Settlement risk

Norges Bank: Financial stability 2/2000

4.1 Measures pertaining to the domestic payment system
4.2 Credit risk in foreign exchange settlement

4.1 Measures pertaining to the domestic payment system²⁾

Banks' participation in the payment system exposes them to risk in the form of:

• Credit risk, which is the risk of loss if another participant fails to meet his obligations. The cause of credit risk in the payment system is that banks credit private and corporate customers' accounts and other banks before the banks themselves have received settlement from the bank responsible for making the payment.
• Liquidity risk arises as a result of the loss of anticipated incoming payments, owing to settlement delays.
• Systemic risk is the risk that liquidity or solvency problems at a bank may cause liquidity problems or insolvency at other institutions. The probability that solvency or liquidity problems at one institution may spread to other institutions figures prominently in the central bank's assessment of the settlement system.

Continuous settlement has led to a considerable reduction in risk

The introduction of Norges Bank's settlement system (NBO) in 1997 made it possible to have continuous settlement of individual transactions (gross settlement) and to complete several netting settlements each day, rather than a single settlement at the end of the day as was previously the case. In connection with the introduction of NBO, a system for liquidity information was also set up which allows banks simpler access to information about exposure to other banks. NBO also embraced the principle that all banks must have sufficient funds in their accounts in Norges Bank before settlement is carried out. In 1999, RTGS was introduced, along with an upper limit of NOK 100 million per transaction in SWIFT netting, which means that all transactions above this limit are settled gross. As a result, gross settlement now accounts for the bulk of settlement volume in Norges Bank (see Chart 4.1).

In the case of gross settlement, the duration of a bank's exposure to credit risk is shorter. Moreover, banks can choose to delay crediting customer accounts until settlement has been received, without this causing any significant delay in payment to the customer. In addition, gross settlement simplifies risk management since banks can decide when to send transactions for settlement. In this way they can influence exposure to counterparties in the payment system, for instance by holding back payments to counterparties to which they already have high exposures. The transition to RTGS and more frequent net settlement has thus reduced credit risk. This is illustrated in Chart 4.2, which provides a rough estimate of exposures in SWIFT netting this year compared with corresponding netting in 1995. On average, the largest exposures which were observed were more than halved. This is an 80% reduction in relation to the capital base in banks. Analysis of the distribution of all identified exposures in SWIFT netting shows that in more than 95% of cases, exposures constitute less than 5% of banks' core capital.

Chart 4.1     Chart 4.2

New crediting procedures in the netting of retail transactions have reduced risk

The bulk of normal customer payment transfers (giros, card payments, cheques) is settled in the Norwegian Interbank Clearing System (NICS) for retail settlement. Daily turnover in this system averages NOK 20-25 billion, divided among two to three million transactions. As in SWIFT netting, the positions between banks in retail netting are generally small. However, exposures can potentially be substantial since there is no upper limit on the size of transactions processed in this system, nor any ceiling on the size of exposures between banks. In order to eliminate this credit risk, the banking industry introduced procedures eliminating the use of advance crediting for most transactions, with effect from June 2000. This eliminates credit exposure in the range of NOK 20-25 billion each day from the Norwegian settlement system. The transition to crediting after settlement could have negative consequences for the efficiency of payment transmission services. However, this has been counteracted by the introduction of an extra settlement in Norges Bank which enables banks to maintain early updating of customer accounts.

Further risk reduction for large payments

As mentioned, the figures generally show small exposures for individual banks in SWIFT netting and short exposure durations in RTGS. However, this provides little information about possible exposures in periods of market turbulence. The full risk reduction potential will therefore not be realised until the system for crediting customer accounts prior to settlement has also been abandoned for this type of transaction. Ongoing work in the banking industry's organisations means that during 2001 banks will probably also abandon this procedure, thereby substantially reducing credit risk in SWIFT netting and RTGS. Given the considerable volume of transactions channelled through these systems, this means that little credit risk between banks will be generated in the Norwegian settlement system.

Greater demands on liquidity management and operational factors

Real-time settlement places considerable demands on banks' liquidity management, and has tightened the requirements for operational factors which may affect the stability of data systems and telecommunication systems. Serious liquidity problems have so far been avoided, mainly for three reasons. First, Norges Bank offers unlimited intraday liquidity to participants in the settlement, provided that they can furnish collateral. Second, banks have coordinated the exchange of gross transactions, preventing banks from creating liquidity problems for others by holding back their own transactions until the end of the day. Third, NBO has a built-in function which automatically calculates the positions in any queues of outstanding transactions banks may have against each other. If there are sufficient funds for the net position, these are combined for settlement.

4.2 Credit risk in foreign exchange settlement

In the spring of 2000, Norges Bank carried out a survey of foreign exchange settlement risk in Norwegian banks.³⁾ This type of risk stems from the lack of synchronisation between the various national payment systems involved where a bank risks effecting payment in the sold currency without receiving an equivalent value in return in the currency bought. This lack of synchronisation is in part ascribable to different time zones, and in part to time-consuming procedures and routines for initiating and confirming payment. This type of risk is often referred to as Herstatt risk⁴⁾, and is a form of credit risk. The probability of such an event is assumed to be very small, although the sums exposed to this risk are large.

Daily turnover in foreign exchange settlement in which Norwegian banks were involved during the time in which the survey was carried out amounted to approximately NOK 168 billion, corresponding to daily payment obligations of NOK 84 billion. Chart 4.3 shows the distribution between currencies. The exposure duration associated with foreign exchange (FX) settlement is usually measured as the time between the bank relinquishing the sold currency and confirmed receipt of the currency bought. Table 4.1 shows the FX settlement exposure durations (in hours) for Norwegian banks in connection with trades in various currency pairs. The results compare favourably internationally. On the basis of knowledge of the settlement cycle and market weighting, the average exposure duration for Norwegian banks throughout the day can be estimated at just over 1½ times the daily volume outstanding. This means that the banks which took part in the survey have FX settlement exposures of NOK 130-140 billion, corresponding to more than three times their total core capital. These positions remain open during weekends and public holidays, and are for the most positions against foreign banks. The exposures are therefore far larger and of longer duration than the exposures of banks through participation in the Norwegian payment system. The survey showed wide variations in how banks manage FX settlement risk. The largest banks appear to have working practices in this area on a par with sound international practice. In terms of financial stability, however, it is important for banks to have equally firm control over this type of risk as they do over other types of credit risk. One important measure for reducing FX settlement risk is the private initiative Continuous Linked Settlement (CLS), which will introduce simultaneous foreign exchange settlement, thereby in theory eliminating credit risk in such transactions. Norges Bank is working for the inclusion of NOK in CLS in the course of 2002.

Chart 4.3     Table 4.1

© 2000 Norges Bank webmaster@norges-bank.no