Efficiency and risks of netting

2.2 "Efficiency" of netting Incentives to reduce credit exposures and payment flows are coming from several quarters. First, there are transaction costs, including fees and communications expenses, for the settlement of foreign currency transactions; there are also implicit costs of holding balances and implicit or explicit costs of obtaining credit to effect settlements. As the volume of transactions continues to increase. banks are under pressure to reduce all these costs. Second, there is an increased awareness among bankers of the general desirability of reducing counterparty exposures. Third, and partly in response to the forthcoming implementation of the Basle Capital Agreement, ¹ bankers are attempting to reduce capital charges associated with their credit exposures wherever possible. At the same time, providers of communications and computer services are seeking to expand their business with the financial community, and perceive these incentives as an opportunity to do so.

2.3 Mechanisms for netting interbank contracts and payments can produce desirable efficiencies in the interbank markets and payment processes. However, narrowly defined efficiencies need to be balanced against the costs associated with the credit and liquidity risks that may be allocated or reallocated by a particular netting and settlement structure. The overall social efficiency of a netting arrangement cannot be judged solely on the basis of apparent reductions in communications expenses, or even on the basis of reductions in credit routinely required to settle a given volume and value of transactions. Judgments about overall efficiency should include consideration of the impact of netting arrangements not only on the level of counterparty risk to the participants but also on the overall level and allocation of financial risk to the banking system as a whole. "Externalities", often resulting from systemic risks, need to be evaluated. Moreover, if the shifting of risks between parties, and across borders, is not clearly defined and understood, interbank netting arrangements may create uncertainty by obscuring the actual allocation of risks.

2.4 The shifting of risks that can be caused by netting arrangements can be particularly troubling where the transaction cost efficiencies are enjoyed by banks located in one country, but the credit or liquidity risks associated with the settlement of payments resulting from that netting system may be experienced in the banking system of another country. This would be the case, for example, where the netting of payments between banks in a given currency is conducted outside the country of issue of that currency but the final settlement of the resulting net amounts occurs in the domestic payment system for that currency.

2.5 Risk assessment of netting structures. Several types of netting arrangements were analysed by the Working Party. Some were organised to effect bilateral netting, others to effect multilateral netting. Some rely on the netting of financial positions ("position netting"), but in such a way that parties remain liable for the settlement of gross amounts. Others contain or propose provisions that, if legally enforceable, would make participants liable for the settlements solely of netted amounts ("netting by novation"). One type of arrangement would establish a clearing house that would be substituted as the central counterparty in deals submitted for netting by participants in the arrangement, in order to effect a binding multilateral netting among those participants ("multilateral netting by novation and substitution").

2.6 Based upon the analysis in Section 6, the Payments Group believes that certain general conclusions can be drawn with respect to the allocation of credit and liquidity risks that are produced by different institutional forms of netting. Thus, assuming the legal enforceability of netting agreements, the Payments Group believes that arrangements which net outstanding financial or payment obligations can be ranked as follows, in comparison with the benchmark case, where no netting takes place:

1. bilateral position netting reduces liquidity risks to counterparties, and perhaps others such as correspondent banks, relative to the case of no netting; but it leaves counterparty credit risk unchanged, or may induce increases in risk if net exposuresare treated as if they were true exposures;

2. bilateral netting by novation reduces both liquidity and credit risks tocounterparties, and possibly to the financial system (other things being equal), relative to the cases of no netting and bilateral position netting;

3. lateral position netting may reduce liquidity risks relative to the cases of no netting and bilateral netting, under certain circumstances; if significant defaults occur, liquidity risks may be higher; credit risks are the same as, or may be larger than, in the case of no netting: credit risks are greater than in the case of bilateral netting by novation;

4. lateral netting by novation and substitution has the potential to reduce liquidity risks more than any other institutional form, but this depends critically on the financial condition of any central counterparty to the netting; if the liquidity of a central counterparty is weak, the liquidity risks of this institutional form may be greater than in the case of bilateral netting by novation; the credit risks of this institutional form are generally less than in other forms that have been considered, subject again to the identity and condition of any central counterparty.

2.7 Validity of netting agreement. A key assumption in arrangements to effect a binding netting of payments or obligations is that the netting agreements are legally valid and enforceable. This assumption undoubtedly extends to many other netting arrangements developed or proposed in the last several years. If the assumption is incorrect for arrangements governed by the laws of various financial centres, then credit and liquidity risks can be much larger than otherwise believed. Moreover, in order to evaluate the risks of any actual or proposed netting system, central banks and bank supervisors will need to examine the totality of operational, financial, legal and other institutional details relating to the system.

Broader policy issues

2.8 The Payments Group believes that, in addition to the allocations of credit and liquidity risks produced by different netting arrangements, attention needs to be focused on additional policy questions which may be raised by the development and operation of these systems.

2.9 Monetary implications. Instead of the exchange of individual financial obligations for payment in money, most netting systems operate so that one financial obligation is exchanged for a similar, offsetting obligation, and only the net difference is settled in money. In essence, two counterparties, or a whole netting group, can achieve the same financial position through netting that would otherwise have required a large number of payment instructions and accompanying money flows to settle those instructions. Thus systems for the binding netting of foreign exchange and other financial obligations provide a service that is a very close substitute for the function of money as a medium of exchange.

2.10 Over time, the large-scale development of these netting arrangements may produce both a quantitative and a qualitative change in interbank payment processes. Bank demand for both intra-day and overnight balances held at central banks, and possibly credit from central banks, may be affected. The spread of netting arrangements may also affect the prospects for the development of formalised intra-day interbank credit markets, which are discussed from time to time in several countries. Moreover, central banks will need to look beyond payment systems in order fully to assess questions of integrity and efficiency in key monetary arrangements.

2.11 Financial implications. A widespread development of clearing house or similar multilateral arrangements will have the potential to change significantly the structure of interbank credit relationships. To a degree, banks are already substituting trading in organised futures markets, such as the Euro-dollar futures markets, for interest and exchange rate positioning in "cash" or deposit markets. To this extent, netted claims on clearing organisations have already replaced gross interbank credit exposures in the deposit markets.

2.12 The interbank foreign exchange markets, and other markets such as the swap market, are "over-the-counter" markets rather than organised exchanges. However, the development of multilateral clearing houses for those markets, along the lines currently being proposed, will affect credit exposures in a manner similar to a shift towards organised exchange trading. The ultimate counterparty will become a clearing house or clearing corporation, and credit exposure and risk must then be judged in the light of the financial resources of the clearing house.

2.13 The Basle Capital Agreement attaches a zero risk weight to bank claims on a clearing corporation associated with an organised financial exchange, provided that they are subject to daily margining. Claims on any clearing house which was established to net foreign exchange, or other over-the-counter, interbank transactions would not qualify for this treatment, at the very least because they would not be associated with an "organised" exchange. However, some believe that, in principle, although not necessarily in practice, such clearing houses could have similar risk characteristics to clearing corporations for organised exchanges.

2.14 Implications for supervision and central bank oversight. A long-standing concern of central banks has been to ensure that the foreign establishments of multinational banking organisations are adequately supervised. The Basle Concordat ² allocates responsibility for the supervision of banks' foreign establishments between home-country and host-country authorities. However, cross-border or offshore multilateral netting arrangements present several complications for the allocation of supervisory responsibility, and indeed they may currently escape supervision or oversight by any authority.

2.15 First, formalised netting arrangements and offshore payment systems are qualitatively different from individual banking organisations. Such arrangements can best be thought of as groupings of individual banks with closely interrelated credit and liquidity risks, and which have common rules and operating procedures. Because of the inherent systemic risks created by the shifting of risks among participants, providers and settlement agents in multilateral systems, it may be necessary to consider whether supervisors should examine the credit, liquidity and operational risks at the level of each system as a whole.

2.16 Second, the international sharing of supervisory responsibility for such systems may be problematic. For example, the host-country authorities for an "offshore" system are likely to have important interests in overseeing credit, liquidity and operational risks in respect of the institutions and markets within their jurisdiction. The home supervisors from various countries for the multinational participants in that offshore system will also have interests in any system that affects the solvency and liquidity of institutions they oversee. At the same time, the central bank for the country of issue of any currency cleared on that offshore system will have various monetary or supervisory interests in the efficiency and integrity of the markets which use its currency. In a multi-currency clearing house arrangement there will be more than one relevant "country of issue". Moreover, offshore clearing need not be provided by a banking institution at all, and participants in such arrangements need not be banks. For example, the netting function of a multilateral arrangement could be provided by a communications carrier which may not be based in either the country of the participants or the country of issue of the currency, while, in principle, participants could include both banks and other kinds of financial institutions, or even non financial companies. The appropriate division and sharing of supervisory responsibilities in such cases will be extremely problematic.

2.17 A further problem for the supervision of clearing house or similar arrangements would be raised in some countries by the overlapping jurisdiction of domestic supervisory authorities. As stated above, such clearing houses are likely to have characteristics that are similar to clearing corporations for organised securities and futures exchanges. Thus, in countries where the authority to supervise banking, securities and futures activities is divided between two, or more, official bodies, jurisdictional questions may arise. In addition, if different supervisory standards or methods are applied by different bodies, then different regulatory solutions in different countries may imply differences in oversight and risk across otherwise similar clearing houses in different countries.

2.18 Central bank services. A number of proposals to establish multilateral foreign exchange netting arrangements are in the course of development. Part of these proposals could be that central banks should provide settlement and other services to facilitate the development and operation of such arrangements . Requests for such services would raise a variety of issues for individual central banks, including, among others, the legal rights of special clearing institutions to obtain services; the legality and propriety of establishing central bank accounts for non-residents; night-time settlements; night-time funds transfers to accommodate settlements; access to central bank credit; and the use of collateral.

Footnote:

1. International Convergence of Capital Measurement and Capital Standards. Committee on Banking Regulations and Supervisory Practices, Basle, July 1988.

2. Principles for the supervision of banks' foreign establishments, Committee on Banking Regulations and Supervisory Practices, Basle, May 1983.