What is a payment system?

By Stanley Epstein - Principal Associate, Citadel Advantage

What is a payment system? I am reminded of lengthy debates around the office on just this question - and the heated and, at times, passionate discussion that ensued. My antagonist, who is also my partner, took one view and I took the other. The thrust and parry of the dialogue ebbed and flowed … long into the night over innumerable cups of coffee.

The Bank for International Settlements (BIS) definition of a payment system states; “A payment system consists of a set of instruments, banking procedures and, typically, interbank funds transfer systems that ensure the circulation of money”. (From “A glossary of terms used in payments and settlement systems”, Committee on Payment & Settlement Systems. BIS, Basel, Switzerland).

Armed with this definition we can examine the components that make up what we so glibly refer to as a “payment system”. This examination will help us see what a payment system really is.

The BIS definition focuses on “... instruments, banking procedures … interbank funds transfer systems”. Let us examine each in a little more detail.

Instruments – a mere half century ago this was easy to define. Payment instruments were basically cash and cheques. Today however there is a vast range of payment instruments. Apart from the cheque and cash we now have giro-payments, electronic transfers, internet payments, debit orders, standing orders, credit cards, debit cards, electronic “cash”, mobile payments and so on. And the nature is each is vastly different from the other.

Banking procedures – these cover a huge area. Anything that is not an instrument or that does not relate to how that instrument is moved, must, by definition, be related to a banking procedure. Here there are internal bank procedures (such as how a branch initiates payments), payments systems rules, the agreements (such as those between banks, between banks and their customers, between banks and the clearinghouse), national and international payment laws and payment regulations. We must also not forget the actual operational procedures, either manual or technology driven within individual banks that are used to initiate, verify and process the payment. All of these procedures are simply to get the payment ready for the next step, to move it to a transfer system.

Interbank transfer systems – this covers local and national clearinghouses (for physical instruments such as paper), ACHs (automated clearinghouses for the electronic ones), message carriers (such as S.W.I.F.T. – Society for Worldwide Interbank Financial Transactions), switches for ATM transactions, the national and international credit card networks and so on. Missing from the BIS definition is the intrabank systems that give effect to payment instrument transfers within the same bank. These are transfer systems too.

The key word in the definition is “set” - for all these components have to be combined to make up a complete unit which achieves the desired outcome – just like a tea set with its cups, saucers, tea-pot, strainer (or perhaps a tea-bag holder), milk jug and sugar bowl are just the thing for carrying out correct ritual for brewing and serving tea.

Sure, one can have tea without all this but it’s not really the same.

The analogy, while useful as a description ends here - in a payment system the missing components give rise to a serious problem – Risk.

Risk takes on many forms; credit risk, liquidity risk, legal risk, operational risk, settlement risk, systemic risk and put the whole fabric of the payment system in danger.

Despite this we often associate the word “system” with only the technology; the bits and bites, the hardware and the software. We tend to forget that there is a lot more that goes into making up a payment system.

So the next time that you write out a cheque or take that credit card from your wallet, or casually use you smartphone give a thought to the process that you are initiating in a complex structure that we take so for granted - the payment system.

Corporate Governance in the Banking Industry

By Stanley Epstein

Broadly speaking corporate governance can be best described as a system of rules, practices and processes by which a business enterprise is directed and controlled. In essence corporate governance involves balancing the interests of the many stakeholders in a firm. These stakeholders include its shareholders, management, customers, suppliers, financiers, government and the larger community.

Corporate governance has become firmly entrenched on the world business scene over the past three decades. Today it is a key component in the operation of all manner of firms around the globe. Even more important is the need for corporate governance to be effective, not only for business firms but for the economy as a whole.

Banking is an important component of the economy, be it national or global. Banks play a very important financial intermediation role in this space. Clearly any difficulties arising from corporate governance shortcomings at banks will also result in a very high degree of nervousness in both the public and the market.

Some very fundamental deficiencies in bank corporate governance became very apparent during the 2008 financial crisis adding to the general distress that the crisis itself generated.

So in 2010 the Basel Committee on Banking Supervision published a set of principles for enhancing sound corporate governance practices at banking organizations. These principles set out best practices in corporate governance for banks.

The Basel Committee has since revised its original set of principles. This revision was published in July 2015, after consultation with the international banking community.

The revised guidance stresses the vital importance of effective corporate governance and promotes the importance of risk governance as part of a bank's overall corporate governance structure.

There are in all thirteen principles, which range from the bank board’s responsibilities, composition, structure; senior management, governance, risk management, compliance, audit compensation, disclosure right through to the role of bank supervisors.

So what major changes have taken place over the past five years?

The following five broad themes are evident in the revision.

1. The guidance has been expanded as regards the role of the board in overseeing the implementation of effective risk management systems.
2. Additional stress is placed on the need for the board to be competent as a group and for individual board members to devote enough time to their role on the board and to keep up-to-date of current banking developments.
3. Reinforces the guidance on risk governance. This also covers the risk management roles played by bank business units, risk management teams and internal audit. The importance of a sound risk “culture” is also addressed.
4. Bank supervisors are provided with guidance on how to evaluate the processes that banks use to select not only their board members but their senior management as well.
5. The guidance also recognizes that compensation schemes are a key part of the governance and incentive structure by which the bank board and its senior management transmit acceptable risk-taking behavior and strengthen the bank's operating and risk culture.

The Basel Committee stresses that these principles are relevant irrespective of whether or not a jurisdiction chooses to adopt the Committee’s regulatory framework. The board and senior management at each bank still have an obligation to pursue good governance.

As regards Systematically Important Financial Institutions (SIFIs), these organizations are expected to have the corporate governance structure and practices appropriate with their role in and potential impact on national and global financial stability.

The full document covering the revised principles can be downloaded directly from the BIS at http://www.bis.org/bcbs/publ/d328.pdf

Principles for financial market infrastructures – New consultative report published

The BIS’ Committee on Payment and Settlement Systems (CPSS) has just published, in conjunction with the Technical Committee of the International Organization of Securities Commissions (IOSCO), a new consultative report on financial market infrastructures.

The report “Principles for financial market infrastructures” contains new and more demanding international standards for payment, clearing and settlement systems. Issued for public consultation by the CPSS and, the new standards (called "principles") are designed to ensure that the essential infrastructure supporting global financial markets is even more robust and thus even better placed to withstand financial shocks than at present.

The report contains a single, comprehensive set of 24 principles designed to apply to all systemically important payment systems, central securities depositories, securities settlement systems, central counterparties and trade repositories (collectively "financial market infrastructures" or "FMIs"). These FMIs collectively record, clear and settle transactions in financial markets.

When finalized, the new principles will replace the three existing sets of CPSS and CPSS-IOSCO standards,

• the Core Principles for Systemically Important Payment Systems (2001)
• the Recommendations for Securities Settlement Systems (2001), and 
• the Recommendations for Central Counterparties (2004).

The CPSS and IOSCO believe that a single set of principles will provide greater consistency in the oversight and regulation of FMIs worldwide.

Robust and efficient FMIs help to ensure that markets continue to function effectively even in times of crisis and are an essential prerequisite for financial stability. Although FMIs have generally performed well, there are nevertheless lessons to be learnt both from the recent crisis and from the years of more normal operation since the current standards were issued.

Compared with the current standards, the new principles introduce more demanding requirements in many important areas including;

• the financial resources and risk management procedures an FMI uses to cope with the default of participants
• the mitigation of operational risk, and
• the links and other interdependencies between FMIs through which operational and financial risks can spread.

There are also principles covering issues that are not fully addressed by the existing standards. These include new principles on segregation and portability, tiered participation and general business risk.

Published along with the report is a cover note which sets out some specific issues on which the committees are seeking comments during the public consultation period.

Comments on the principles have been invited from all interested parties and should be sent by no later than 29 July 2011 to both the CPSS secretariat (cpss@bis.org) and the IOSCO secretariat (fmi@iosco.org). The comments will be published on the websites of the BIS and IOSCO unless commentators request otherwise.

After the consultation period, the CPSS and IOSCO will review all comments received and publish a final report in early 2012. As set out in the cover note, the proposal is that relevant authorities will then strive to include the principles in their legal and regulatory framework by the end of 2012 and to apply the principles as part of their regulatory, supervisory and oversight activities as soon as possible. FMIs will be expected to take appropriate and swift action in order to meet the principles.

The consultative report as well as the covering note may be downloaded from the BIS website - http://www.bis.org/publ/cpss94.htm

Long-Term Issues in International Banking: New report from the Committee on the Global Financial System

The Committee on the Global Financial System (CGFS) has just released “Long-Term Issues in International Banking”, a report prepared by a Committee on the Global Financial System (CGFS) Study Group chaired by Hans-Helmut Kotz, former Executive Board member of the Deutsche Bundesbank.

International banking has been an important driver of financial globalization and integration, so contributing to welfare gains over time and across countries. During the recent crisis, however, the plight of many internationally active banks epitomized the fragility of the financial system. This underscored the importance of a proper understanding of the drivers and effects of cross-border intermediation.

The report addresses structural issues in international banking from three angles: a historical perspective, what the drivers have been, and what might happen next.

• The development of international banking: the report documents its evolution over the last 30 years in terms of size, form and geographical coverage.

• The factors behind the development: the report provides a critical review of the literature on the various drivers of international banking. A noteworthy conclusion is that the fast growth of internationally active banks, which contributed to the vulnerability of their business model, is difficult to explain on efficiency grounds, at least at an aggregate level. This suggests that institutions' incentives might have been distorted, which warrants further investigation.

• Potential future developments: in addressing this more speculative question, the report pays particular attention to the regulatory reform environment, the pattern of economic growth worldwide and the rapidly evolving interactions between markets and banks.

You can download the full report HERE