Introduction to Payment Systems in Banking System

Payment Systems encompass a set of instruments and means generally acceptable in making payments, the institutional and organizational framework governing such payments and the operating procedures and communications network used to initiate and transmit payment information from payer to payee and to settle payments. Payment system facilitates the exchange of goods and services between economic agents using an accepted medium of exchange. A modern payment system typically has a range of specialized subsystems developed to serve particular sets of customers; some of these clear and settle small payments, some large payments, while some cover both large and retail settlements.

The Bank for International Settlements defines payment systems as “a set of instruments, procedures and rules for the transfer of funds among system participants”. The proposed Payment System legislation in our country defines a ‘payment system’ as “a system that enables payment to be effected between a payer and a beneficiary and includes clearing, settlement or payment service”.

A payment system, therefore, comprises – (a) a means by which the payer gives authority to his bank for funds to be transferred (b) a means of transmitting and exchanging the payment instruction and (c) a means of settlement between the banks involved.

Significance of payment systems

Over the last decade and a half, operation of payment systems has generated considerable interest for the policy makers due to the increasing turnover of the payment systems, both in terms of volume and value, as well as due to the rapid technological advances in this area. It is now understood and appreciated that payment systems play a pivotal role in the financial infrastructure of the economy, is a necessary channel for monetary policy transmission and an agent that promotes economic efficiency. We can briefly examine these roles of payment systems.

  • Payment systems and financial stability: Any major payment system failure could result in failure to meet payment obligations by the system participants leading to erosion of confidence of the markets and financial structure. Similarly, adverse development in a financial market or institution will have a disruptive impact on the payment system operations. There is, therefore, a two-way interaction between stability in financial and banking markets and stability within the payment system. Bank and financial market supervisors need to communicate closely with the payment system overseers so as to ensure that, as far as possible, such problems can be anticipated and resolved at an early stage.
  • Payment systems and monetary policy implementation: In the course of maintaining monetary stability, central banks generally operate in the money market by influencing the short term interest rate which in turn would influence other rates. Alternatively, some central banks use the option of manipulating the statutory reserve requirements to achieve their monetary policy objectives. Both methods represent a market-orientated approach to monetary policy implementation thereby necessitating an active inter-bank money market and efficient forecast of liquidity conditions / requirements in the economy by the central bank. A reliable large-value payment system with same-day settlement is very much a requirement for meeting both of these conditions.
  • Payment systems and economic efficiency: If a payment system is inefficient and unreliable, it may take weeks rather than days for a payment instruction to move from the payer’s bank to the payee’s bank and for the final recipient’s account to be credited. Such inefficiencies in the payment system are not just an inconvenience to the users, but can have an adverse impact on how the economy works. If money is “tied-up” in the payment system, then it is not available for other, productive, purposes.