Bank Management Concepts

Risks Associated with Payment Systems and Risk Mitigation Measures

Risks in payment systems

In any payment transaction, there will be a time lag between the time payment instructions are issued and final settlement of these claims (either on gross or net basis). This time lag exposes the entire system to various risks which are given below:

  1. Credit Risk: the risk that a party within the system will be unable fully to meet its financial obligations within the system either when due or at any time in the future
  2. Liquidity Risk: the risk that a party within the system will have insufficient funds to meet financial obligations within the system as and when expected although it may be able to do so at sometime in the future
  3. Legal Risk: the risk that a poor legal framework or legal uncertainties will cause or exacerbate credit or liquidity risks
  4. Operational Risk: the risk that operational factors such as technical malfunctions or operational mistakes will cause or exacerbate credit or liquidity risks
  5. Systemic Risk: the risk that the inability of one of the participants to meet its obligations, or a disruption in the system itself, could result in the inability of other system participants or of financial institutions in other parts of the financial system to meet their obligations as they become due.
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Classification of Bank Payement Systems

Payment systems can be classified on the basis of the value of transactions being put through them, settlement modality or on the basis of timing of settlement.

  • Value of funds transfer: payment systems can be categorized into (a) Large-value funds transfer — where individual payments are of high value and therefore time sensitive and (b) Retail funds transfer — where the value of transactions are of relatively low individual value but the volume of transactions put through it large.
  • Settlement modality: payments systems can be classified into (a) Net settlement where payments are set off against receipts over a large number of transactions taken up for settlement.
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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”.… Read the rest

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Interest Rate Risk in Banking

The management of interest rate risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk.

Interest rate risk in banking is the potential negative impact on the Net interest income and it refers to the vulnerability of an institutions financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability, off-balance sheet items and cash flow. Hence, the objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off.… Read the rest

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Liquidity Risk in Banking

Liquidity planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompass the potential sale of liquid assets and borrowings from money, capital and Forex markets. Thus, liquidity should be considered as a defense mechanism from losses on fire sale of assets.

Liquidity risk in banking is the potential inability of a bank to meet its payment obligations in a timely and cost effective manner.… Read the rest

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Operational Risks in Banks

“Operational Risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and system or from external events.”

Generally, operational risk is defined as any risk, which is not categorized as market or credit risk, or the risk of loss arising from various types of human or technical error. It is also synonymous with settlement or payments risk and business interruption, administrative and legal risks. Operational risk has some form of link between credit and market risks. An operational problem with a business transaction could trigger a credit or market risk.

Indeed, so significant has operational risk become that the Bank for International Settlement (BIS) has proposed that, as of 2006, banks should be made to carry a Capital cushion against losses from this risk.… Read the rest

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