Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: International Experience
Payment and Settlement System

Credit and liquidity risks inherent in payment and settlement system have the potential to contribute to systemic problems if not properly managed and controlled. A robust payments and settlement system is essential to maintain integrity of the financial system. Accordingly, central banks tend to have a key role in the oversight of payment and settlement systems. Central bank involvement is greatest in the core inter-bank large value funds transfer systems, which central banks in many cases own or operate. While all central banks have an oversight role, the degree of operational involvement differs widely, largely reflecting the development of their financial systems.

In industrial economies, central banks have increasingly withdrawn from operational involvement in payment and settlement systems in order to focus on ensuring the maintenance of an effective service and protection against systemic financial risk. For example, Fry et al. (1999) found that for industrial countries, operational involvement did not fully reflect strong formal oversight responsibilities, even in the large value funds transfer systems. On the other hand, the oversight responsibilities of central banks generally tend to be more formal in transition and developing economies than in industrial countries, either under the authority of the central bank law and/ or banking laws. Not surprisingly, there is considerably more central bank ownership and operational involvement in transition and developing countries. Fry et al. (2000) documented that around 60 per cent of central banks in industrial countries own or part own their country's Real Time Gross Settlement (RTGS) system, compared with 100 per cent in transition and developing economies.

These differences are not surprising given the relative development of financial systems. In particular, transition economies have been faced with the challenge of building new payment systems and developing competitive market-based financial sectors. Although the starting point may be different in emerging economies, the challenges may be large if the financial sector is relatively closed and the commercial banking sector may not have the resources, skills or incentives to develop new payment and settlement system on their own. Given their concern to reduce risk and promote the efficiency of a country's payment system, central banks in transition and emerging economies often play a prominent role in the development of these systems.

In the context of payment and settlement system, an emerging issue is the use of electronic money (e-money) and its implications for financial stability. E-money can facilitate the process of transactions for the parties involved (Box VIII.3). Implications of e-money for monetary transmission have been discussed in Module 6. This Section briefly touches upon the implications for financial stability. Notwithstanding the recent progress, the use of e-money as a means of payments remains fairly modest, with a notable exception of Singapore.

At this point of time, it looks unlikely that demand for e-money will be widespread. Risks of e-money to financial stability could possibly arise from an e-money issuer becoming reckless in its issuances. Excessive issue of private e-money, apart from being inflationary, could lead to a run on the provider and introduce gridlocks into the payment system if private e-money payments are refused. Bailouts by a central bank to preserve financial stability could create moral hazards. Regulation of e-money would, therefore, need to be undertaken to minimise such systemic risks. One possibility is to impose prudential requirements such as capital adequacy, ratings and standards on e-money issuers, akin to the banking system. Another option could be to require e-money issuers to redeem their private e-money for government money in large quantities. At the organisational level, institutional mechanisms can be designed in order to review policies, practices, measures, and procedures to review e-security regularly. There is also a need to understand threats and dangers and the steps that need to be taken to mitigate the vulnerabilities. In addition, understanding access control systems and methodology, telecommunication and network security, as well as security management practice assume importance.