A new settlement system at Norges Bank.

Author:Watne, Kjetil
  1. Background

    Norges Bank is responsible for promoting robust and efficient payment systems as part of its work to ensure financial stability. The payment system is an important component of the financial infrastructure and efficient, stable and accessible systems are essential for a smoothly functioning economy. Norges Bank may be viewed as the bankers' bank in that banks can make deposits in and borrow from the central bank and execute payments with settlement in central bank money. These functions are performed in a settlement system, the primary function of which is transferring funds from the account of any participant bank to that of any other bank. An essential precondition for financial stability is that the interbank systems are designed in such a way that banks' settlement risk is manageable and that any problems in one bank do not spread through the system to other banks (cf. CPSS (2000)).

    Like a number of other central banks, Norges Bank introduced a real-time gross settlement system (RTGS) in the 1990s, enabling fund transfers between participant banks and to and from the central bank on a continuous basis with final settlement. Previously, all transactions were accumulated over the course of the day and funds were only transferred between banks' accounts after end of opening hours. This entailed some uncertainty as to whether settlement would be executed, as there was always a possibility that a bank might become insolvent while payments were in transit before settlement.

    The core of the first settlement system, developed in the 1990s, was a standard banking system for keeping accounts and payment services for ordinary bank customers. The system was purchased for use in connection with Norges Bank's function as the government's bank. Subsequently, private banks took over the task of providing payment services to government agencies.

    In the same period, greater attention was paid to the risk inherent in financial infrastructures, with international recommendations for risk-mitigation measures, including introduction of real-time functionality in central banks' settlement systems. Norges Bank's in-house IT department incorporated real-time functionality into the system as well as arrangements for balance checking before payment orders were posted.

    The system's functionality was thus in line with international best practice and complied with international recommendations (cf. CPSS (2000)). System users were also generally very satisfied with its user-friendliness. Nevertheless, several factors suggested that Norges Bank would eventually have to find alternative system solutions. Continued use of proprietary software appeared to be too risky in the long run. For that reason, Norges Bank decided to prepare the introduction of alternative operating and system solutions before the existing systems became outmoded and the risk of disruptions became too high.

    Section 2 below describes the rationale for the choices Norges Bank made in establishing its strategy to outsource the settlement system. Section 3 describes the process for selecting an external operator for the system and the background for outsourcing the operation of the system before the software was replaced. Section 4 is a review of the main activities of the project to replace the settlement system software and a description of a framework for collaboration with the banking industry. Section 5 summarises Norges Bank's experience of outsourcing, the changes replacing the software has entailed and how this has affected the operational stability of the settlement system. Section 6 outlines some of the challenges we faced during the procurement processes, while section 7 describes a number of issues arising when multiple external providers were involved. Section 8 concludes the article with some observations on how operational risk in the settlement system is affected by the outsourcing.

  2. Norges Bank's strategic choices and clarification of principles

    Since the 1990s, Norges Bank has increasingly focused on its core activities: financial stability and monetary policy. A major restructuring has taken place and non-core tasks have been phased out or outsourced. Even though promoting an efficient and robust payment system is a core activity by virtue of Norges Bank's function as the ultimate settlement bank, the actual IT operation of the settlement system need not be performed by Norges Bank. The operation and development of the settlement system can, for example, be provided by external IT companies on commercial terms.

    However, independently of the organisation of the technical IT operations of the system, Norges Bank must make sure that the system is updated in accordance with best practice and needs and designed for high operational reliability. An external company with IT operations as its core business might be in a better position to build up and maintain broader technical expertise than a relatively small in-house IT department within the central bank. Outsourcing can thus improve operating stability and reduce costs. On the other hand, it will be more difficult to control external providers' resource use and priorities with regard to troubleshooting and upgrades compared with an in-house IT department. The risk of being treated as a low priority customer may be greater, the smaller the share of the provider's overall business the service required constitutes.

    Regardless of operational solution, it is essential to be able to monitor stability, control products and services and secure expertise for dealing with non-conformance. This may be more of a challenge in an outsourcing model. These are factors that must be addressed in contracts with and ongoing follow-up of the external services provider.

    Considerations of "a bank-based model"

    In line with the policies of other central banks, Norges Bank has been charging banks for settlement services since July 2001. Prices have been raised gradually so that they now fully cover Norges Bank's estimated costs for settlement services. As banks are charged for settlement services, Norges Bank is of the view that they should also be involved in discussions on functionality and development of the system. In 2002, before work commenced on outsourcing the settlement system, Norges Bank invited the banking industry to participate in a task force to consider adjusting the definitions of responsibility between banks and the central bank. The task force considered a "bank-based" model, in which banks, through NICS (Norwegian Interbank Clearing System), could perform more of the functions connected with transaction processing that are normally executed by the central bank settlement system. The actual account keeping of bank deposits and loans and related control routines remain the responsibility of the central bank also in a bank-based model. To learn more about bank-based models, Norges Bank examined how settlement services were provided by the Bank of Canada and the Swiss National Bank. At these central banks, settlement functions are organised in collaboration with commercial banks, with settlement executed in systems owned or controlled by banks. However, the central banks have influence through representation on the boards of the entities responsible for the systems.

    Following a thorough examination by the task force of various alternatives for a bank-based model, the banking industry stated that the banks would not be interested in assuming more responsibility for interbank settlement. One argument was that it was not substantiated that such a model would entail overall cost reductions, and that the model might increase banks' liability and hence risk. The changes involved in implementing a bank-based model required changes in the private clearing system that would be substantial and costly. On this basis, Norges Bank concluded that a bank-based model would not be given further consideration.

    Upgrading strategies

    Starting with the principle of maintaining the existing lines of responsibilities between Norges Bank and the private banks, Norges Bank examined various alternatives for replacing IT systems and establishing external operational solutions. Simultaneously replacing the settlement system and moving operations was deemed too risky for such a critical and complex activity. Thus, two primary alternatives remained for carrying out the strategic decision to outsource the settlement system:

    --First outsourcing operations from Norges Bank to an external service povider, then replacing the software

    --First installing new software at Norges Bank, then outsourcing operation of the new system to an external service provider

    Norges Bank placed particular emphasis on each alternative's ability to maintain high operational stability during the entire changeover phase. The conclusion was to first outsource IT operation of the existing system to an external provider, and then replace the software after the outsourcing process was completed. To reduce the risk of disruptions and failures in the system, and thereby ensure stable operation, only absolutely necessary modifications to the systems were made during the outsourcing period.

  3. Selecting the external service provider

    Tendering processes of this kind in Norway are subject to public procurement rules, which emphasise transparency and a level playing field for relevant service providers. However, for reasons of system security, Norges Bank could not publicly disclose all the system specifications. Therefore, Norges Bank sent a request for proposal containing an overall description of the tasks and functions covered by the outsourcing contract directly to selected IT service providers. Five service providers were considered potential bidders based on the following criteria:

    --Expertise in operating business-critical systems on the settlement system's technology platform (IBM mainframe).

    --The possibility of implementing a transfer of...

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