Interbank Funds Transfer Systems

Interbank funds transfer systems are arrangements through which funds transfers are made

between banks for their own account or on behalf of their customers. Arrangements for interbank settlement are far more uniform. Private Banks generally settle obligations between themselves over accounts at state-owned central banks. Claims on these state-owned central banks are no longer commodity-backed and typically have some form of legal tender status; they are the most reliable form of money in the economy.

Large value funds transfer systems (LVTS) are usually distinguished from retail funds transfer systems that handle a large volume of payments of relatively low value. The average size of transfers through large value funds transfer systems is substantial and the transfers are typically more time critical as the financial markets operate on it.

1. The first of these is the transfer of information between the payer and payee banks
2. The second key element is settlement - that is, the actual transfer of funds between the payer’s bank and the payee’s bank

Even though the interbank settlement process has evolved over a period of time there are few inherent risks in the system. As per our observation the system holds two types of risk and they primarily revolve around the settlement piece.

Credit Risk: It is associated with the default of a counterparty, is the risk that a counterparty will not meet an obligation for full value, either when due or at any time thereafter. It is permanent in nature.

Liquidity Risk: It is the risk that a counterparty will not settle an obligation for full value when due but at some unspecified time thereafter. It can be either short term or long term.

Further there are specific cases which leads to the above highlighted risks are:

1. 1. Settlement Lag in LVTS: Time mismatch between the execution of the transaction and its final completion.
   2. Settlement lags can result in credit risk if the transmission of information about the payment and the settlement of the payment do not occur simultaneously.
   3. Settlement lags may also result in liquidity risk. A bank may not be certain what funds it will receive through the payment system until settlement is completed, and thus it may not be sure whether or not its liquidity is adequate.
   4. Asynchronous settlement: A time lag between the completion of the two legs of the transaction (i.e. any lag between payment leg and delivery leg). This largest source of principal risk in the settlement of foreign exchange and securities transactions, or, more generally, in exchange for value systems.

These Credit and Liquidity risk arise between two banks but this further leads to a bigger risk and impacts all others banks in the ecosystem and is called Systematic risk. Central banks are particularly concerned with systemic risk. This is the risk that the failure of one participant to meet its required obligations when due may cause other participants to fail to meet their obligations when due. Such a failure could trigger broader financial difficulties that might, in extreme cases, threaten the stability of payment systems and even the real economy.

By their very nature networks, interbank payment and settlement systems are potentially a key institutional channel for the propagation of systemic crises. Central banks have a particular interest in limiting systemic risk in large value funds transfer systems because aggregate exposures tend to increase with the aggregate value of transactions and potential risks in large value transfer systems are therefore often significantly higher than those in retail funds transfer systems.