Financial Stability 1/2000

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4 Settlement risk

Norges Bank: Financial stability 1/2000

4.1 Clearing and settlement systems and risks that can arise in these systems
4.2 Measures for controlling risk in settlement and clearing systems

4.1 Clearing and settlement systems and risks that can arise in these

Considerable exposure may arise between banks participating in the payment system. In payment transmission services, transactions are generated by the customer, and the resulting interbank exposure is not the result of explicit credit assessments. This means that the risk that arises in the payment system is in a special position. In terms of total risk formation in the financial system, clearing and interbank settlement procedures are therefore important.
   Chart 4.1 shows the payment system in Norway. At the "bottom" of the system are banknotes and coins and systems for payment services allowing for the use of bank deposits and credit as a means of payment. At the "top" are systems for calculating positions and the transfer of funds between banks, ie clearing and settlement systems.

• Clearing systems include banks' joint system for interbank clearing (Norwegian Interbank Clearing System - NICS) and systems for clearing securities transactions (the Norwegian Central Securities Depository - VPS) and derivatives transactions (the Norwegian Futures and Options Clearing House - NOS).
• Settlement systems include Norges Bank's settlement system (NBO) and systems for settlement in private settlement banks. Banks can choose whether they want transactions to be settled directly in Norges Bank or indirectly via a private settlement bank.

Chart 4.1

   NBO was introduced in November 1997 and in 1999 average daily turnover through banks' accounts in Norges Bank amounted to NOK 146bn. Table 4.1 shows the distribution of transaction types that are settled in NBO:

• Large payments (over NOK 100m) and specially marked transactions are settled individually (gross) in Norges Bank. In principle, all banks have access to gross settlement in Norges Bank.
• Medium-sized payments are cleared in NICS in SWIFT netting, where 7 settlements are completed daily. 22 banks participate in these settlements.
• Small transactions, eg giro and ATM transactions, are sent via NICS retail clearing for settlement. 36 banks participate in this settlement.
• Payments connected to securities and derivatives transactions are sent to Norges Bank for settlement via VPS and NOS respectively. 19 banks participate in securities settlements, whereas 15 participate in derivatives settlements.

In systems with private settlement banks, credit risk is associated with claims on the settlement bank, whereas settlement in the central bank does not involve such risk. However, the total risk in both systems also depends on how the systems are constructed in order to reduce risk in connection with the settlement process. Settlement risk comprises credit risk, liquidity risk and operational risk. Credit risk depends primarily on the extent to which banks credit customers before funds are received in the settlement. Liquidity risk is linked to a shortage of liquidity due to delays in the settlement process. Operational risk is linked to the risk of breakdowns in data systems or telecommunications that involve costs for participants. The positions that banks assume through participation in the payment system will often result in exposures in excess of their equity capital, and in some cases, considerably more than their equity capital. In this sense, the payment systems can be a channel for spreading liquidity and solvency problems that could potentially threaten financial stability.

Table 4.1

4.2 Measures for controlling risk in settlement and clearing systems

In recent years, several measures have been implemented to reduce risk in the payment system. When NBO was established, a principle was introduced that all banks had to have cover in accounts in Norges Bank before settlement was carried out. NBO also entailed more frequent net settlement and the introduction of real time gross settlement. In gross settlement, transactions are settled individually and continuously, which means that banks must always have cover for their payments. In net settlement, the participants are exposed until settlement is completed, but as ingoing and outgoing payments are offset, the liquidity requirement is lower than for gross settlement. As shown in Chart 4.2, the share of gross settlements in total turnover rose sharply in 1999. This has reduced credit risk, but at the same time places greater demands on banks' liquidity management. In order to improve efficiency and reduce liquidity risk, measures have therefore been implemented to provide better information for banks and to enhance the efficiency of available liquidity.

Chart 4.2

   The Act relating to Payment Systems etc. entered into force on 14 April 2000, giving Norges Bank licensing authority for interbank systems. This provides Norges Bank with a new means of monitoring and ensuring the quality of systems which are external to the Bank's own settlement system.
   Netting has had an unclear legal position, and lays banks which are exposed in connection with a settlement to a bank under public administration open to the risk of being debited for outgoing transactions before being credited for incoming transactions. The new Act relating to Payment Systems etc. allows for agreements which legally safeguard clearing results, thereby reducing the credit risk associated with settlement.
   Norges Bank is also concerned about banks' risk exposure through participation in settlement systems for securities and foreign exchange transactions, and possible spill-over effects from such systems. In a foreign exchange transaction, the parties have to exchange payments in two countries at the time of settlement. The lack of synchronisation in such settlements is in part ascribable to different time zones, and in part to time-consuming procedures and routines for initiating and confirming payment. This risk is called Herstatt risk.³ Banks which are active in international foreign exchange trading will often have exposures in connection with these settlements which exceed equity capital. Foreign exchange settlement is therefore a channel for spreading risk that could potentially threaten financial stability. Foreign exchange trading has grown in recent years, which has increased the need for the implementation of risk-reducing measures in foreign exchange settlement systems (see Chart 4.3). Risk is primarily reduced through Payment versus Payment (PvP), whereby a foreign currency is paid out if, and only if, the matching amount is settled simultaneously. The private system, Continuous Linked Settlement (CLS), which is currently under development, will make PvP possible between the largest banks and currencies in the world. Norges Bank is working for the inclusion of NOK in the system. Banks can also reduce foreign exchange settlement risk by improving routines and settlement agreements with foreign counterparts. In spring 2000, Norges Bank started a project to assess foreign exchange settlement risk in Norwegian banks.
   Norwegian systems for securities and derivatives settlement are another important link in payment settlement. There is little credit risk connected to such settlements, as there are mechanisms to prevent a seller from handing over a security before payment has been received. VPS and Norges Bank are, however, working on measures to improve efficiency in securities settlement and to reduce the likelihood of liquidity problems.
   Operational disturbances in IT, telecommunications and power supply systems can involve costs for participants in the payment system that may result in instability in the financial system. In view of this, the authorities and market participants have implemented measures to reduce the vulnerability and ensure the continuous operation of the settlement and clearing systems. Special contingency plans were prepared in connection with the transition to the year 2000 and the leap year day on 29 February 2000.
   Norges Bank's objective is a system that prevents credit and liquidity problems in one bank from spilling over into other banks, thereby threatening financial stability. Improved settlement and clearing system structures do not necessarily remove all credit and liquidity risk, but do help to reveal risk and make it a reference for more explicit decisions among banks. In recent years, several measures have been implemented, both nationally and internationally, which have helped to reduce settlement risk. However, there is still work to be done in this area, and Norges Bank will continue to work closely with the industry to achieve further reductions in risk in the Norwegian clearing and settlement systems.

Chart 4.3

³Named after the German Bankhaus Herstatt which was placed under public administration at the end of the day in Germany in 1974. At that time, Herstatt's counterparty in a USD/DEM transaction had already paid in DEM and was still waiting for settlement in USD from Herstatt in the US payment system.

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