Risk in the Norwegian settlement system 1995-2000.

• Author: Enge, Asbjorn

In recent years, there has been strong international focus on risk in the payment system and most countries have implemented measures to reduce this risk. In this article, we will discuss the main aspects of Norges Bank's and the Norwegian banking industry's efforts to reduce settlement risk in Norway's payment system. The establishment of Norges Bank's settlement system (NBO) in 1997 was a milestone in this work. A comparison of settlement risk today with risk before the establishment of NBO shows a considerable reduction, but there is scope for further reduction.

1 Introduction

Every day, large amounts of money are transferred between households, enterprises, the public sector and other economic agents. These transfers occur in connection with the purchase and sale of goods and services, different capital transactions such as loans and securities trading, as well as payments connected with returns on capital, eg interest and dividends. The parties involved in these transactions incur a degree of risk related to the counterparties' willingness and ability to fulfil their obligations. An individual who sells goods on credit risks, for example, that the buyer does not pay for the goods, and a lender risks that the borrower does not repay the loan. The focus of this article is not on this type of risk, but rather on risks incurred by banks when they transfer funds from payer to payee. Very often, such transactions also result in payments and obligations between the parties' banks, for example, in connection with the use of payment cards, giros and other instruments for transferring funds to and from customers' accounts. Several million transactions are sent through the Norwegian payment system every day. Most transactions are small, but extremely large transactions also occur. As payment intermediaries, banks may take on considerable obligations and claims in relation to other banks. A special feature of such inter bank exposure is that it is largely a result of customers' payments rather than the banks' own transactions. One bank's exposure to another bank can thus exceed the lines of credit that would otherwise be given. This makes risk in connection with the payment system unique.

2 Risk in the payment system and background for Norges Bank's involvement

Banks' risk connected with participation in the payment system is often divided into three categories: credit risk, liquidity risk and systemic risk.

Credit risk is the risk of losses due to the failure of another bank to meet obligations on time or at a later point in time. Credit risk arises because banks credit customers, ie individual and business customers as well as other banks, before they receive funds in settlement.

A bank that has credited a customer account will be exposed to risk until the final settlement has occurred in Norges Bank. If another bank becomes insolvent during this period, the size of the loss will depend on the legal status of transactions to and from the insolvent bank. Of course, the evaluation underlying a decision to credit the customer early will be very important to the risk involved. However, customer accounts have often been credited automatically in connection with payment transfers and explicit credit evaluations have been lacking. A somewhat simplified measure of efficiency might be the interval between customer payment initiation and funds accessibility for the recipient. There is a conflict between efficiency and risk since early crediting makes funds more rapidly accessible for banks' customers than crediting after settlement.

Liquidity risk is tied to the costs involved in liquidity shortfall due to delays in settlement. This may be due, for example, to insufficient liquidity planning at one of the banks or the failure or breakdown of computer systems or telecommunication services.

If a bank has large exposures to other banks, settlement problems may lead to a liquidity shortfall or losses that prevent them from meeting their own obligations. In this way, a bank's liquidity and solvency problems can spread to other banks through the payment system and at worst threaten financial stability. This type of risk is called systemic risk, and one of Norges Bank's primary objectives is to prevent this type of risk. Therefore, the possibility of systemic risk is of central importance to Norges Bank's evaluations of risk in the Norwegian settlement system.

3 Establishment of NBO

During the second half of the 1990s, the banking industry and Norges Bank have cooperated in a number of efforts to reduce risk in the payment system. The establishment of Norges Bank's Settlement System (NBO) in 1997 was a milestone in this work. First, we will describe settlements before the establishment of NBO. Then, we will describe the important changes that NBO has generated and how these changes have reduced risk.

Norges Bank was also the settlement bank for all major Norwegian banks before NBO was established. Banks' positions were settled once a day, at the end of the business day. This settlement included banks' positions from netting results in BBS (the Norwegian Banks' Payment and Clearing Centre) and transactions that were sent directly to Norges Bank. According to the rules, banks' positions at the end of the day should not exceed their limits for overnight loans in Norges Bank, but settlement could be completed even if a bank had a net obligation that exceeded borrowing limits (ie infringement of the rules was not controllable). Settlement could, however, be rejected if insolvency proceedings had been initiated against a bank, and in such a situation, the surviving banks would not receive payments from the insolvent bank.

In terms of risk, this solution entailed obvious drawbacks, both for the banks and for Norges Bank. Norges Bank's risk was due to the fact that lending to banks was unsecured. In addition, a settlement could be executed even though a bank exceeded the permitted loan limit.

At worst, such a bank could become insolvent and Norges Bank would only have a claim on dividends from the realisation of assets of the bankrupt estate and could incur a loss as a result of its role as settlement bank. Risk for banks participating in the settlements was tied to the possible reversal of net positions if insolvency proceedings had been initiated against a bank. With only one settlement daily, exposures could be considerable and the potential for loss or liquidity shortfalls great.

The establishment of NBO entailed a number of important changes in relation to the previous solution:

i) requirements for cover in connection with settlements in Norges Bank

ii) establishment of intraday liquidity information in real-time

iii) the possibility of continuous settlement through the day

The purpose of introducing requirements for cover was to remove Norges Bank's risk in its role as settlement bank and to clarify banks' responsibility for covering their positions in the settlement. This requirement means that a settlement is only made in Norges Bank if a bank's position does not exceed the bank's available...