The interbank fund settlement isa setup through which funds are transferred between banks. The settlementhappen on a periodic basis depending upon the agreed frequency.
Though thesystem has evolved over a period of time, there are inherent risks present inthe current methodology. The claims on these payments due are not commoditybased and are a form of a legal tender. It is the most reliable form of moneyin the financial system.The fund transfer is divided intosmall and large value fund transfer system. The large value ticket items aredistinguished as they are time critical and many market related activitiesdepend on it. The processing of funds transfersinvolves two key elements.
a. Information Transfer: It takes care of theinformation between the originator and the beneficiaryb. Settlement: This isthe actual transfer of funds between the two parties.
The system has been improvingitself over time but has few risks which makes it critical to the settlementpiece.a. CreditRisk: The risk arises if the originator’s bank is not able to meet itsobligation with the beneficiary bank in full value. It is a default of finalnature.b.
LiquidityRisk: This risk arises if the originator’s bank is not able to meet itsobligation in the short term.The situation under which thecredit and liquidity risk may arise are:a. SettlementLag: A settlement lag occurs ifthere is a time mismatch between the execution of a transaction and its finalclosure of the process. It occurs of the transfer of information and settlementof payment does not take place at the same time. This might further lead toLiquidity risk as it is not certain when the Beneficiary bank will receive thefunds. b. AsynchronousSettlement: It arises due to the design of the processes. A time lagbetween the completion of payment and delivery leads to the risk.
Most of thefinancial activities like foreign exchange, securities and cross borderpayments have asynchronous settlements. Though the Creditand Liquidity risk arise between two banks but can impact other banks in theeconomy. Multiple banks participating in the settlement will not be able tomeet its obligation due to failure of one bank to a meet its obligation. Thiswill further lead to other financial difficulties and in extreme cases impact thecomplete Banking system. It is a Systematic Risk.