Booklet: Retail Payment Systems
Section: Retail Payment Systems Risk Management
Subsection: Credit Risk
 

 

 

 

 

 

Credit risk is the risk that a party will not settle an obligation for full value. Each retail payment instrument has a specific settlement process that depends on the entities involved. Multiple financial institutions, third-party entities, as well as the payer and payee are involved with creating, processing, and settling the transaction. If a financial institution uses a third-party service provider, it is responsible for the credit risk exposure for the services performed. Financial institutions should have procedures in place to manage the credit risk of third parties using their accounts to settle transactions.

Non-cash retail payments, including the inter-institution settlement of cash withdrawals through shared ATMs, are usually settled on a deferred basis. With the deferred settlement, there is a risk that the paying institution or some intermediate party will fail before inter-institution settlement occurs. This deferred settlement, rather than real time settlement, mitigates but does not eliminate the credit risk.

When an institution supplies funds, it usually does not submit a payment for settlement unless the payer’s financial institution verifies that funds are available in the payer’s account. Otherwise, there is a credit risk exposure. When an institution receives funds in a retail payment transaction, it may suffer credit risk from granting funds availability for account transfers not properly authorized. In the ACH, NACHA has established rules requiring each ODFI to conduct appropriate creditworthiness monitoring, establish exposure limits, and periodically review the limits applicable to specific customers.

Returns are another source of credit risk. Checks and direct debit transfers can be returned if the payer’s institution chooses not to honor the presentment because of insufficient funds, forgery, fraud, or other payment irregularities. The return time frames vary for different payment instruments. For an ACH debit, the ODFI grants funds availability to the originator on settlement day. The credit exposure exists until the RDFI can no longer return the ACH debit. If not properly authorized, the return time frame under NACHA rules extends to 60 days from the settlement date.

Bankcards have specific procedures for chargebacks, which are amounts disputed by the cardholder and “charged back” or reversed out of the merchant’s account. The acquiring financial institution relies on the creditworthiness of the merchant, but if the merchant declares bankruptcy, commits fraud, or is otherwise unable to pay its chargebacks, the acquiring financial institution must pay the issuing financial institution.

The settlement of retail payment transactions, i.e., the transfer of funds between the parties, discharges the payment obligation. The risk that settlement of retail payment transactions will not take place as expected can result in both credit and liquidity risks. Financial institutions should understand and manage credit and liquidity risks related to the settlement of retail payments. This should include preparing for potential credit and liquidity issues resulting from incomplete settlement or operational problems.

Settlement lags occur when financial institutions, due to failure or the inability to fund their obligations, do not settle their obligations when due. Settlement lags result in credit risk until final settlement occurs. Any payment activity undertaken on the basis of “unsettled” payment messages remains conditional, resulting in risk. Settlement lags may also result in liquidity risk. Until settlement is completed, a financial institution is not certain what funds it will receive through the payment system. As a result, it may not be sure whether its liquidity is adequate. If an institution overestimates the funds it will receive when settlement takes place, it may face a shortfall. If the shortfall occurs close to the end of the day, an institution could have significant difficulty finding an alternate liquidity source.

Financial institutions often allow their corporate customers to incur intraday or “daylight” overdrafts. In principle, an institution engaging in this practice is extending credit to its customer. In most cases, the overdraft is eliminated with incoming funds transfers from other institutions (or outgoing securities transfers against payment) by the end of the business day. Daylight overdrafts constitute an extension of credit—no matter how long they remain unpaid. An institution’s credit policies should include provisions for approving and monitoring daylight overdraft lines to customers.