The interbank fund settlement is
a setup through which funds are transferred between banks. The settlement
happen on a periodic basis depending upon the agreed frequency. Though the
system has evolved over a period of time, there are inherent risks present in
the current methodology. The claims on these payments due are not commodity
based and are a form of a legal tender. It is the most reliable form of money
in the financial system.
The fund transfer is divided into
small and large value fund transfer system. The large value ticket items are
distinguished as they are time critical and many market related activities
depend on it.
The processing of funds transfers
involves two key elements.
Information Transfer: It takes care of the
information between the originator and the beneficiary
b. Settlement: This is
the actual transfer of funds between the two parties.
The system has been improving
itself over time but has few risks which makes it critical to the settlement
Risk: The risk arises if the originator’s bank is not able to meet its
obligation with the beneficiary bank in full value. It is a default of final
Risk: This risk arises if the originator’s bank is not able to meet its
obligation in the short term.
The situation under which the
credit and liquidity risk may arise are:
Lag: A settlement lag occurs if
there is a time mismatch between the execution of a transaction and its final
closure of the process. It occurs of the transfer of information and settlement
of payment does not take place at the same time. This might further lead to
Liquidity risk as it is not certain when the Beneficiary bank will receive the
Settlement: It arises due to the design of the processes. A time lag
between the completion of payment and delivery leads to the risk. Most of the
financial activities like foreign exchange, securities and cross border
payments have asynchronous settlements.
Though the Credit
and Liquidity risk arise between two banks but can impact other banks in the
economy. Multiple banks participating in the settlement will not be able to
meet its obligation due to failure of one bank to a meet its obligation. This
will further lead to other financial difficulties and in extreme cases impact the
complete Banking system. It is a Systematic Risk.