5 Payment System Reform in Formerly Centrally Planned Economies

Timothy Lane, D. Folkerts-Landau, and Gerard Caprio
Published Date:
June 1994
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David Folkerts-Landau, Peter Garber and Timothy D. Lane1 

A payment system capable of speedy settlement of transactions in goods, services, and basic securities is a linchpin of a functioning market economy. Measures to ensure the integrity of the payment mechanism and eliminate long and uncertain delays in settlement are therefore an essential part of financial system reform in formerly centrally planned economies.2

An effective payment system combines two vital elements. The first is trust among the participants, expressed as a willingness to postpone settlement of an obligation in good funds. For example, a seller of goods may be willing to accept a promissory note in payment and not insist on settlement in currency or bank deposits. Similarly, banks may extend credit to each other to meet payment imbalances rather than insisting on settlement in currency or bank deposits. Such arrangements expedite payments, allowing a greater range of mutually beneficial transactions to take place.

A second vital requirement of a payment system is discipline. Because credit may be extended automatically in the process of effecting payments, there is the potential for abuse: transactors could use the system to incur unsustainable imbalances between their payments and receipts. Discipline requires that settlement in good funds be made at sufficiently frequent intervals; other rules may also be needed to prevent an unbridled expansion of credit in the system.3

The failure of either trust or discipline can impair the efficiency of the payment system, and indeed of the financial system as a whole. If households and firms distrust each other but have confidence in banks, they will insist on settlement in bank deposits, and the consequent large holdings of deposits will allow banks to intermediate between borrowers and lenders on a large scale. If the banks distrust each other, they will insist on settlement in central bank deposits; banks will then hold large amounts of reserves or securities that the central bank will discount and will intermediate far less between private borrowers and lenders. More transactions will require settlement in central bank liabilities, and the central bank or the treasury will have to intermediate between borrowers and lenders. Such a system is usually characterized as being illiquid.

A failure of discipline can also undermine the payment system. The Achilles’ heel of financial discipline is the prospect of a bailout: if transactors ultimately expect to be indemnified for any losses resulting from bad debts, they have no incentive either to insist on settlement in good funds or to monitor the creditworthiness of their counterparties. In this case, arrears in payments will continue to mount, both within the banking system and elsewhere in the economy; when a bailout does occur, therefore, it will have to be huge. If the creation of credit through the payment system is unchecked, it frustrates the system’s purpose of facilitating the exchange of objects of value; it may instead become a mechanism through which transactors try to obtain a larger share of the eventual bailout.

Trust and discipline in the payment system are both serious concerns in economies in transition. Discipline has hitherto been deficient, as state-owned banks and enterprises have operated under “soft budget constraints” (Kornai, 1980) with the assurance that their debts are underwritten by the state. Even where the supply of credit provided by the banking system has been limited, there has been an explosion of interenterprise credit, typically in the form of arrears (Tyson, 1979). There have also been long delays in settlement within the banking system, as banks have taken advantage of the credit automatically extended through the payment mechanism.

This situation is expected to change. If the authorities in formerly centrally planned economies manage to distance themselves from the state enterprises—by privatizing them, or at least by making a credible commitment to limit bailouts—credit risk will become a much more important consideration. It is difficult to evaluate a counterparty’s creditworthiness in this setting, though, as this depends on the creditworthiness of that party’s debtors, and so on, which have never been put to the test. Moreover, many participants in the payment system may actually be insolvent, which could make transactors reluctant to accept credit and lead them to insist on payment in good funds. The result could be an illiquid system, resulting in high transaction costs and a consequent implosion of trade.4

This paper will focus on the wholesale, interbank payment system, bearing in mind the broader issues of payment system development. It is through interbank transactions that sizable payments among firms and households are intermediated. Transactions among banks are also central to bank liquidity management and money market development, which in turn are essential to any move toward market-based implementation of monetary policy.

The next section discusses in greater depth the importance of the wholesale payment system—not only in intermediating payments among enterprises and households, but also in enabling banks to engage in more rational liquidity management, and consequently in the development of money markets and the implementation of monetary policy. The following section describes the salient features of the existing state of payment systems in formerly centrally planned economies, explaining why this concern has only recently emerged. Then the policy issues involved in establishing a clearing and settlement system for interbank payments are discussed, especially the allocation of settlement risk, along with steps already taken or planned to reform interbank payment systems in various Central and East European countries.

Why Is the Interbank Payment System Important?

The establishment of an efficient system for payments among banks is important for several reasons: intermediating payments involving households and other firms; permitting active liquidity management; facilitating the development of security markets; and establishing the basis for implementation of monetary policy.

Clearing and Settlement

A payment system is a mechanism whereby financial institutions, other firms, or households can transfer funds to discharge their obligations. From the standpoint of firms and households, payments may be carried out in cash or by check or giro; the latter two media depend on an effective means of transferring funds among banks when payor and payee have accounts in different banks. This process can be divided into two parts: clearing—the transmission and recording of the instructions to make a payment; and settlement—the actual transfer of some medium generally acceptable in fulfillment of the payment instruction.

In most Central and East European countries, interbank payments are so sluggish that there may be delays of as much as several weeks during which neither payee nor payor has access to the funds. This results in the widespread use of cash, which is less convenient and secure in other respects.

In a complex financial system, in which payments in many directions take place on any given day, the risk of payment bottlenecks could be reduced by some form of netting arrangement (Bank for International Settlements, 1989). Under a netting arrangement, each participant needs to have reserves sufficient only to cover the net balance owed to the system, rather than enough funds at any moment to cover its gross payments. In this case, the large-scale payment system is used only to settle the net balance owed by or owing to each bank.

A clearinghouse often provides facilities for netting payments, as well as for the exchange of checks and other payment orders among its members to minimize operating costs. In advanced market economies, clearinghouses may be voluntary associations of financial institutions or they may be operated by a central bank. The clearinghouse rules specify conditions for membership and members’ rights and obligations and provide facilities to exchange checks drawn on each member institution, as well as standardizing other details such as the times by which checks must be presented to be made part of the settlement for a particular day’s business, and the standard format in which checks must be presented for clearing. Clearinghouses have also typically been active in developing methods of speeding the clearing and settlement of checks and reducing the operating burden on each member, fostering innovations such as automatic clearinghouses, electronic check presentment, and magnetic tape exchange. Another implication of clearinghouse rules is the allocation of settlement risk among the members, by specifying procedures to be followed in the unlikely event that one of its members cannot settle its net position at the final settlement. This procedure may require the unwinding of transactions made by the defaulting member, or it may include provisions for sharing of losses incurred in the day’s payments associated with the insolvency of any of its members.

An efficient interbank system is at most a necessary, not a sufficient, condition for an efficient retail payment system. Inefficiency in internal bank organization can also lead to slow payments, even when the banks can transfer funds readily among themselves. Banks may also have the incentive to delay payments in cases where they enjoy interest-free use of the funds in transit. The interest forgone is not the only resulting cost to the transactors in heavily distorted financial markets, where the payee who is deprived of the use of the funds may not be able to borrow at a market interest rate. The delay and uncertainty of payment thus impose a particularly heavy penalty on trade in an illiquid environment such as that of formerly centrally planned economies, and may discourage trade that is otherwise advantageous to the parties involved.

Bank Liquidity Management

If banks cannot readily transfer funds among themselves, it is difficult for them to engage in active liquidity management, for they lack means of investing funds for short periods or obtaining funds at short notice. The inadequacy of facilities for money transfer in Central and East European countries is reflected in banks’ typically large excess reserves, which constitute a drain on their resources. This may also make it more likely that an unexpected excess of payments over receipts may lead a bank to become illiquid, possibly generating a banking crisis.

The holding of large excess reserves as well as the risk of crises may be attenuated by the central bank’s acting as a lender of last resort. Central bank intervention may engender moral hazard problems, however; for example, banks on the verge of collapse may turn to the central bank for funds when other financial market participants quite rationally refuse to lend to it. It is harder for the central bank to scrutinize the creditworthiness of banks that turn to the discount window for funds where regulation and supervision of the banking system are in an embryonic state, as in Central and East European countries. These considerations also point to the desirability of reducing uncertainty in the timing of settlements, so that banks do not normally need to turn to the central bank for funds to deal with everyday fluctuations in their payments and receipts.

Funding Across Disparate Intermediaries

Another important function of the wholesale payment system is to provide facilities for longer-term interbank lending to promote a more efficient allocation of funds. At any moment, some banks may be experiencing inflows of deposits that exceed loan opportunities available, while for other banks the converse may be true. Such imbalances are structural in economies in transition, where the banking system is largely a relic of central planning. Typically, a state savings bank network specializes in collecting deposits from households, but has few outlets for lending, whereas other institutions, including commercial banks and particularly the specialized banks such as agricultural development banks or investment banks, have lending opportunities but little deposit base.

There are two ways to deal with this mismatch between deposit base and lending opportunities. One is to implement a general restructuring of the banking system and to bring about a more balanced portfolio structure for each of the banks. A more expedient alternative is to promote the development of an interbank market, through which banks with excess liquidity can lend funds to other banks more specialized in finding appropriate lending opportunities. Development of the wholesale payment system is essential for this interbank lending to deal effectively with disparities in the availability of funds and of opportunities for profitable use of funds.

Money Market Development

Similar considerations govern the payment system’s role in facilitating money market development. Assets’ liquidity depends on the speed with which “good funds”—the medium acceptable in final settlement—can be obtained by selling these assets: a bank will probably not invest excess funds in the money market if long delays ensue in reselling and receiving settlement for these assets when funds are again needed. Moreover, long and unpredictable delays in obtaining funds for securities sold or in borrowing funds at short notice increase the risk faced by market-makers; the bid-ask spreads needed to cover these risks may stifle budding money markets.

A money market provides a basis for developing the spectrum of financial markets that guide the allocation of savings in the economy. Active and deep money markets permit active liquidity management by securities dealers, which reduces their costs and risks of operation, and in turn enables them to make markets in securities of other maturities as well as in equities. These longer-term markets will themselves be more liquid and flexible, and thereby more effective as a means of allocating resources, to the extent that they are supported by a liquid money market, and more fundamentally by an efficient system of interbank payments.

Implementing Monetary Control

The effective market-based implementation of monetary policy is a medium-term goal of financial sector restructuring in Central and East European countries (see Khan and Sundararajan, 1991). Effective monetary control is essential in achieving the price level stability that is part of an environment in which market economic activity can flourish.

Payment system reform facilitates market-based monetary control in several ways. Most obviously, if sufficiently deep money markets do not exist, there is no way of carrying out meaningful open market operations: the instruments of indirect monetary control are simply unavailable. Moreover, if banks cannot engage in active liquidity management, they tend to hold large and variable excess reserves. This makes reserve money programming a difficult, perhaps nugatory, exercise. Moreover, if banks lack the means of obtaining reserves from other banks at short notice at market interest rates, tightening monetary policy will either risk making one or more banks illiquid or lead to an offsetting expansion of the monetary base through the refinance facilities.

Without a smoothly functioning payment system, short-term interest rates do not provide good indications of financial market conditions owing to transaction noise. Thus, the authorities cannot depend on interest rate signals to control quantities such as base money or reserve aggregates. Reducing this transaction noise by modernizing the wholesale payment system would increase the effectiveness of policy, as well as making interest rates a better guide for banks and other economic agents.

Finally, central bank float—credit extended by the central bank to the banking system pending settlement of payments—can be reduced with an improved payment system. In Central and East European countries, cash items in the process of collection or awaiting settlement have often been a substantial component on the balance sheets of the banks and of the central bank; this has added to the uncertainty of monetary programming, making it more difficult to forecast money, credit, and reserve aggregates.

Reform of the interbank payment system will therefore facilitate the market-based implementation of monetary policy both by adding the necessary tools to the central banks’ kit and by improving the quality of information the central banks can use in implementing monetary control.

Background in Central and Eastern Europe

Dissolution of the Monobanks

In characterizing the existing state of the interbank payment systems in the Central and East European countries formerly under central planning, it is important to consider the legacy of the monobank system. Under this system, a single bank carried out the functions of both central and commercial banking. It was therefore typically supplemented by specialized banks, including a national savings bank, a foreign exchange bank, and an agricultural development bank. Enterprises were often restricted to doing business solely with one particular bank.

This structure had the effect of limiting the volume of interbank payments. It also limited the amount of competition in the system. Enterprises were typically authorized to borrow virtually unlimited amounts from the bank to which they were assigned in making transactions authorized under the central plan. Enterprises were not required to have funds available in their accounts to make authorized expenditures. In general, enterprises’ decisions were constrained not by the funds available to them or by their overall solvency, but by the allocation specified in the central plan and the availability of raw materials and other inputs. Furthermore, central planning did not attach any time value to money, so enterprises were not particularly concerned about receiving funds promptly. These aspects of the central planning system—the limited number of banks, the lack of competition in the system, and the lack of urgency for banks’ customers to obtain speedy clearance of their payment orders—together with the underdeveloped telecommunications system, led to a payment system that was very slow.

The monobank system has been largely dismantled in many formerly centrally planned economies: in Hungary in 1987, in Poland in 1989, and in several other countries in 1990. The monobanks’ assets and liabilities together with their branch operations were devolved onto newly formed commercial banks. In general, these commercial banks were regionally concentrated: in Poland, for example, nine new commercial banks were established, each inheriting the National Bank of Poland’s commercial banking activities in a particular region of the country. In the former Czechoslovakia, one new commercial bank was established in the Czech lands and one in Slovakia. In Hungary, several new banks were established to take over the National Bank of Hungary’s commercial banking operations.

As the monobanks were broken up, what had been intrabank transactions became interbank transactions, making the establishment of an interbank payment system an important goal. Initially, the newly formed commercial banks were unequipped to carry out transactions among themselves; any interbank settlements were settled on the books of the national bank, with no netting or other arrangements to facilitate them. Commercial banks therefore had to hold large amounts of excess reserves, and the vagaries of the payment system resulted in large fluctuations in reserves. The clearing of payments was often very cumbersome. For example, in Poland in 1990, all payment orders below $10,000 were transmitted by ordinary mail, and even the establishment of the special interbank mail courier system was considered a major step toward making the payment system efficient. Anecdotal evidence suggests that lags in check clearing of three weeks or more were common.

Interbank and Intrabank Transactions

Because the newly formed commercial banks in formerly centrally planned economies were carved out of the branch networks of the monobanks, establishing an efficient interbank payment system entails some particular problems. One is the need for consolidation of each bank’s branch accounts to treat each bank rather than each branch as a unit. By contrast, for example, the National Bank of Poland until recently treated each separate branch independently so that each bank maintained multiple clearing accounts with it. Under these arrangements, a bank was concerned not only with its aggregate balance with the National Bank, but also with the balance of each of its branches. Each bank made an agreement with the National Bank about the amount of refinance credit available to it, and then allocated this refinance credit across its branches, informing the National Bank of the allocation. If a particular branch had a negative balance with the National Bank because of an imbalance of its settlement of payments, the National Bank automatically supplied that branch with refinance by providing payment credit at the minimum interest rate. If the branch exceeded its refinance credit allocation, it had to borrow at a penalty rate even if other branches of the same bank, which deal with the same branch of the National Bank, had excess reserves. As a result of the separate treatment of each bank branch, banks had to use the facilities of the National Bank to transfer funds among branches; this meant that intrabank payments occupied a large part of the telegraphic transfer facilities of the National Bank. Consolidation of bank branch accounts, implemented in 1992, was expected to lighten the traffic on the telegraphic transfer network and permit a larger proportion of interbank payments to take place through telegraphic transfers. It would also permit bank-wide liquidity management, which had hitherto been next to impossible.

Lack of Banking Skills and Techniques

A feature of the banking systems of many of the Central and East European countries that impedes the effective use of an interbank system is the inefficiency of the management of these banks. In many banks—particularly the state savings banks, in which the majority of household deposits are held—transactions are carried out by hand rather than electronically. In addition, procedures carried over from the days when banks were essentially record keepers for the central plan have exacerbated delays in processing payments.

Cumbersome procedures adopted by the central banks of these countries often aggravate the problem. For example, the development of a market in bills issued by the National Bank of Poland was hindered by National Bank rules in early 1991. If the bank wanted to purchase bills as a temporary repository for liquid funds but chose to leave these bills for safekeeping, it had to send an official to the National Bank to take possession of the bills and carry them to another window in the same office to place them in safekeeping. The absence of any mechanisms for carrying out such transactions over the telephone without physical transfer of paper, let alone a system of electronic “book-entry” transfers of government securities, impeded the development of the money market.

Telecommunications Facilities

Another important factor in most Central and East European countries is the primitive state of the telecommunications system. It has been extremely difficult to effect transactions by telephone, and the establishment of an interbank payment system involving the electronic transfer of funds between different banks would be impracticable with the existing facilities.

In the establishment of an interbank payment system, attention has typically been focused on the purely technical requirements for the electronic transfers of payment orders. Although this is an important condition for an efficient payment system, it is not the only one: attention also needs to be given to the economic policy underlying the transfer of funds through the payment system.


Credit from the central bank to the banking system also frequently plays an important supporting role in relation to wholesale payments. In formerly centrally planned economies, the issues are somewhat different from those in developed market economies, however. In the monobank system, credit from the central bank to other banks was hardly needed, because of the latter’s limited role. Within this system, the specialized banks could often run current account overdrafts at the national bank, and similar overdrafts could be run between different branches of the national bank.

After the dismantling of the monobank, central bank refinancing has often had two roles. Some refinancing—usually taking the form of overdrafts on current account—is associated with liquidity needs and in some cases even from a simple failure to settle accounts. The danger with this form of credit is that it may become open-ended. The central bank then cannot limit the credit it provides to some financial institutions, which continue to incur overdrafts. Any quantitative limits the central bank sets on these overdrafts are routinely exceeded and ratified ex post (as illustrated, for example, by the frequent overdrafts of the Bank for Food Economy in Poland). Some refinance credit is also closely linked to the provision of preferential credit to households and enterprises. For example, in Poland before 1990, refinancing was provided at preferential interest rates to subsidize the commercial and specialized banks’ provision of credit for agriculture, housing, and central (officially approved) investment. These different aspects of refinancing have often resulted in a plethora of different lines of refinance credit.

Supervision and Regulation

The weakness of the structure of bank regulation and supervision, with an attendant danger of manipulation and fraud, poses particular problems for the establishment of a wholesale payment system. When weak banks are allowed to have direct access to the interbank payment system, they create severe risks of nonsettlement. The challenge to the regulator when such banks are present is to prevent an insolvent institution from pumping a large proportion of its liabilities through the payment system so that the payee has access to the funds before settlement. Such access would spread a single bank’s insolvency throughout the system. This challenge exists both in high-volume electronic systems and in paper check-clearing systems. The problem needs to be controlled through strong regulations limiting the amount of credit implicitly extended through the payment system by requiring settlement before the payee is allowed access to funds. Supervision must be continuous to ensure that regulations are not circumvented, especially in an environment in which the quality of bank management is at best untested.

Poland’s 1991 Art B scandal provides an example of the potential for fraud that arises if the interbank payment system is inadequately regulated. Art B, a private company, was able to write certified checks on accounts in which there were no funds. If these checks were deposited in another bank, the company would immediately be credited with funds in that bank, while it would take several days before the check cleared and the account on which the check was written would be debited. With a certified check, the bank in which the check was deposited was immediately credited with the funds by the National Bank of Poland, while the bank on which the check was written was not debited until the check cleared. Art B would therefore have the use of funds until the check cleared. This check kiting scheme was possible largely because banking regulations at that time specified that settlements corresponding to transactions exceeding the equivalent of $10,000 had to go through the National Bank of Poland’s wire transfer system, while checks for less than that amount would be cleared by mail. Art B therefore wrote many checks for amounts slightly less than $10,000 so that the checks would be processed by mail and would take several days or even weeks to clear. Art B was allegedly able to do this because its bank, BSK, was prepared to certify checks written on accounts with zero balances, in return for a guarantee by the state savings bank, PKO-BP. An estimated $200 million of fraudulently obtained funds were taken out of the country. When the scheme was exposed, criminal charges were filed against officials of the National Bank, PKO-BP, and BSK.

The Art B affair had serious ramifications for Poland’s banking system. First, it resulted in an extension of the National Bank’s float by as much as 7 percent of narrow money, with a corresponding increase of the measured money supply. Second, the National Bank of Poland changed the regulations pertaining to interbank clearings, requiring that all interbank clearings associated with check transactions be handled by telecommunication methods. This measure was designed to help reduce the float and to aid in monitoring interbank transactions. This episode illustrates the potential for abuse when the regulatory structure is inadequate to discipline the extension of credit through the payment system.

Policy Issues in Payment System Reform

In designing payment systems for formerly centrally planned economies, some important policy issues must be addressed. These pertain to the allocation of risk among participants and the appropriate role of government in establishing and sustaining the system. It is important to address these issues and put the right set of arrangements in place from the start, to ensure the payment system’s ability to withstand the strains that will inevitably result from an increasing volume of transactions under conditions of massive restructuring of the financial sector and of the economy as a whole.

Allocation of Risk

The operation of a payment system involves two important types of risk. One is liquidity risk—the risk that a participant, even though solvent, might be unable to make a timely transaction because of a lack of readily available means of payment. A second is credit risk—a risk that in the event of bankruptcy of one of the participants, other participants would be faced with losses. These risks may be of particular importance to policymakers because they may become systemic—that is, they may spread throughout the system. For example, a default by one participant may lead to such large losses by other participants that they in turn may be unable to discharge their obligations, resulting in a chain of failures (Humphrey, 1986).

Associated with the issues of liquidity and credit risk is the notion of finality of settlement—that is, once a payment message is sent, it is certain that the payee will receive good funds that cannot be reversed, even if the payor subsequently becomes insolvent. Finality is generally a desirable characteristic of the payment system because it eliminates the risk faced by payees in the melee of the day’s payment operations. However, it comes at a price, since the risk associated with default cannot be eliminated in the system; it can only be shifted either to the central bank, the members of the clearinghouse, or other, unsecured creditors of the defaulting party. Finality can also be achieved at the cost of delays in carrying out payments, for example, by retarding the processing of payment messages until the payor has good funds available to make a payment. This might entail forgoing some of the benefits of netting arrangements.

Role of Government

Governments play a role in developing and regulating the payment system for several reasons. One relates to the behavior of the system in case of a financial crisis. If a bank is perceived as risky, other banks may refuse to engage in payment transactions with it for fear that the settlement will subsequently fail, leaving them highly exposed. A troubled bank may then find itself isolated from the payment system and be unable to continue to carry out transactions even if it is not actually insolvent. To avert this situation it may be desirable for either the members of the payment system as a whole or the government to share some of the credit risks. This is in large part the basis of the “lender of last resort” function of the central bank: to provide funds to financial institutions that are illiquid but not insolvent to prevent a liquidity crisis. It is also the basis of some central banks’ provision of “daylight overdrafts” to permit payments to be processed without the need for each payment system participant to assess the creditworthiness of other participants. There may also be moral hazard problems associated with the government assuming such a role, however. There may be some benefit to having banks take account of the creditworthiness of their counterparties, since in some cases they may have information on this creditworthiness that is not immediately available to the authorities. Moreover, the authorities may not be entitled to exclude a bank from the credit offered through the payment system unless they are convinced that the bank should immediately be closed; other banks, if their own money is at risk, may respond to available information in a more timely manner. A system in which the authorities extend credit through the payment system, by transferring risk from other banks to the government, removes banks’ incentive to monitor one another and to act on the information they obtain.

A second aspect of moral hazard pertains to the troubled bank itself. A bank that becomes insolvent may be able to pay off a substantial portion of its liabilities using the credit provided through the payment system, and thus shift losses from the bank’s other creditors onto the central bank. Such a shift, which amounts to an unintentional bailout of the failing bank’s creditors, has the same adverse incentive effects, and budgetary consequences, as any bailout.

These opposing concerns—systemic risk versus moral hazard—argue for the importance of making a policy decision about the appropriate division of risk among the individual banks in the payment system and the government.

Another possible role of government in the payment system is in assessing banks’ fitness to participate. As an extension of their general responsibility for regulating financial institutions, monetary authorities generally have a responsibility to scrutinize the accounts of the banks and protect against fraud and inordinate risk taking. In so doing, they typically have information about the soundness of particular banks that is unavailable to other banks that participate in the payment system. The authorities may therefore have a role in regulating banks’ right to participate in interbank payments. The judicious use of the information available to the central bank may aid in preserving the integrity of the interbank payment system.

Some Examples

These principles can be illustrated by considering some examples of payment systems in which these risks are dealt with in different ways (see Folkerts-Landau, 1991).


One example is the U.S. Fedwire, which is used for making a large proportion of interbank transactions. In this system settlement is immediate and final. If the payor has a positive balance with the Federal Reserve, its balance is debited by the amount of the payment. Participants in Fedwire are allowed to run daylight overdrafts—that is, their balances with the Federal Reserve may be negative during the course of the day. At the end of the day, however, they are required to obtain funds to cover these overdrafts, either by carrying out transactions with market players to move funds from other banks, by borrowing from other banks through the federal funds market, or by obtaining Federal Reserve credit through the discount window. If, however, a participant turns out to be insolvent during the course of the day, the risk associated with the transactions that have already been carried out on Fedwire are borne by the Federal Reserve. The payees in these transactions do not suffer any loss.


An alternative method of risk allocation is the Clearinghouse Interbank Payment System (CHIPS), a private mechanism for large-volume dollar transactions operated by the New York Clearinghouse. CHIPS transfers are primarily related to international transactions. In this system, the participants’ positions are netted continually through the day, and at the end of the day net obligations are settled through Fedwire transfers. If some participants are not able to meet their obligations, the participants in the CHIPS system share the losses according to a formal loss-sharing agreement backed by collateral. Of course, in the event of a large failure to settle, this amount may provide CHIPS insufficient resources to settle, so its promised “settlement finality” is not foolproof.


The Swiss Interbank Payment (SIC) system provides another example of how risk associated with interbank settlements can be allocated (Vital and Mengle, 1988). In the Swiss system there are no daylight overdrafts and no settling arrangements. Instead, a queuing system effects payments only when the payor has good funds available to transfer in settlement. The advantage of the Swiss system is that it ensures finality of settlement without requiring that any risk be borne either by the central bank or by the clearinghouse members at large. Its main drawback is the possibility of payments bottlenecks or even gridlock. In such a situation, gross payments in the system may be blocked entirely, even though net payments for the day for each bank are small relative to available reserves. This danger is particularly important if the payments being settled through the system are large.

Discipline Versus Speed of Payments

These various solutions to the wholesale payments operation underscore the trade-off between the allocation of risk in the payment system, which affects discipline, and the system’s efficiency in effecting payments; this tension always constrains the design of a payment system. Systems such as the Swiss system that carry out payments only when the payor has good funds available imply strict discipline—as they reduce the credit risk associated with a payment system—but are susceptible to occasional bottlenecks that disrupt the smooth flow of payments. Systems like Fedwire and CHIPS reduce the risk of bottlenecks by shifting some of the credit risk of the system onto the central bank or the collective members of the payment system, respectively, but this entails moral hazard problems. If the credit risk associated with the payment system is borne by the central bank, this may adversely affect participants’ incentives to monitor their exposures to credit risks associated with other participants. In the Fedwire system, the Federal Reserve has attempted to reduce the risk borne by the central bank and the attendant moral hazard problems by placing limits on members’ daylight overdrafts. But these limits in turn increase the danger that the system might be gridlocked under some circumstances.

Current Situation in Central and Eastern Europe

Considerations concerning the allocation of risk among the various participants in the payment system are only beginning to be of practical relevance in Central and East European countries. In these countries, the state-owned banks often have little sensitivity to risk considerations—in some cases because they are already insolvent owing to the legacy of bad loans on their books. Enterprises with soft budget constraints, which continue to exist, know that losses will be underwritten either by subsidies or by easy credit from the banking system. Other enterprises are therefore willing to extend credit to them or to allow them to accumulate arrears. In Central and Eastern Europe, few bankruptcies have occurred; in particular, few bank failures have occurred, despite the apparent insolvency of many of the major state banks in several of the countries. It is widely expected that at some stage the commercial banks will be recapitalized, and this may make market participants less concerned about the creditworthiness of their counterparties than they would otherwise be.

However, as market-oriented reforms progress in these countries, it is expected that budget constraints will harden. The banks are to be made independent joint-stock companies, and in many cases, plans for privatization of the banks are under way. Several of the reforming governments in Central and East European countries have declared the intention of establishing enterprise financial discipline. In a reformed environment, banks and other financial market participants would have to take account of counterparty creditworthiness. In sum, although the allocation of settlement risk in payments is not yet a major issue in the payment systems of Central and Eastern Europe, it will grow in importance as the other reforms of the financial system progress.

The enormous volume of transactions on the western large-scale interbank payment systems is accounted for largely by the importance of money market and foreign exchange transactions. Since such large-scale securities and foreign exchange transactions are not yet of practical relevance in Central and Eastern Europe, the volume of interbank payments will be much smaller in proportion to the volume of banking system assets and liabilities than in the large western economies. When money markets eventually develop, the large volume of transactions among dealers and large banks that characterize an advanced system of financial markets will emerge. Likewise, foreign exchange trading, which in most Central and East European countries has typically been the province of the central bank or of the specialized foreign exchange bank, is likely to become an area in which many financial institutions play an active role. Payment system design for the Central and East European countries should provide for the risk associated with the volume of transactions likely to emerge as other financial sector reforms take effect and as domestic financial and foreign exchange markets develop. It is important to establish a payment system that can deal adequately with the needs that ongoing financial system development will place on the interbank payment mechanism.

Reform Plans in Central and Eastern Europe

Reform of interbank payment systems has begun in several Central and East European countries. In many cases a priority is to upgrade the actual facilities for electronic transfer of funds. In some cases, this involves the establishment of completely new facilities. For instance, in Poland, a telex transmittal service for large-value payments was introduced in late 1990; then, in 1992, the National Bank of Poland wire network was developed, providing continuous settlement for interbank and other transactions. In the former Czechoslovakia, a fully computerized real-time clearing network began operations in early 1992. A system for large-value payments on the books of the National Bank of Romania was also introduced in the same year.

Transitional improvements can also be made with the existing technology, pending the introduction of new systems. These improvements include steps as mundane as requiring banks to use banking mail rather than regular mail service to transport paper documents and organizing efficient local physical exchanges of paper checks and other payment documents. Another important step is to link more banks with existing systems; for instance, a priority in Bulgaria was to link all the banks with the automatic payment system. Such upgrading requires both new hardware and the establishment of standards for the transmission of payments information, whether by paper or electronic means.

Clearinghouses with netting schemes to expedite clearing of transactions have also been organized. Clearing arrangements are often established on a regional basis; for instance, in Bulgaria, three regional clearing centers in addition to the one in Sofia were established. Such arrangements are often considered the responsibility of the commercial banks themselves. For instance, in Hungary, the new clearing and settlement system that began operations in mid-1992 is under the auspices of the Clearing, Settlements, and Transactions Company. In Poland, the task of establishing clearinghouses has been assigned to the Polish Payments Association, of which the commercial banks are members.

Although clearinghouses may not need government involvement in their establishment, they do require a clear legal and regulatory framework governing payments. Some components of this structure must include a clear definition of the rights, obligations, and liabilities of all parties in the payment system, a requirement that banks act promptly on payment instructions received, and a clear definition of the rights of consumers in the system. An appropriate legal structure is necessary to reduce uncertainty regarding the timing and finality of payments.

Several countries have made a priority of reducing the central bank’s involvement from its pervasive role under the monobank system. The central banks typically assume commercial banking risks. Also, they are involved in peripheral activities. For example, the national banks of several countries provide data processing facilities for the commercial banks, and only relatively recently did the National Bank of Hungary divest itself of customer account information.

The reforms of the payment system carried out thus far have often been successful in speeding up settlements, although in some cases the potential gains have not been realized. For example, in the Czech and Slovak Republics, despite a system that in principle allows clearing and settlement to take place in one day, in practice banks often drag their feet, leading to delays that may still amount to many days or even weeks. Similar delays have been noted in other countries despite improvements in technology.

The central bank refinance system needs to be reformed so that it can perform the function of lender of last resort—underpinning the payment system by providing credit to solvent commercial banks to enable them to deal with temporary shortfalls in liquidity (Goodhart, 1987). The legacy of the central planning system has typically been a patchwork of facilities for specific purposes, often at preferential rates. Priorities in this area are therefore to simplify the system, removing the preferential element and confining the role of central bank credit to very short-term (within-day or overnight) liquidity needs. One way of opening up refinancing to market forces, as well as fostering the development of money markets, is to establish a market for central bank repurchase agreements (repos), whereby the central bank purchases and agrees to resell qualified liquid assets (government and national bank securities, bills of exchange, etc.) at a specified price; a repo market was established in Poland in April 1991. However, if, as in Central and East European countries the money markets are not highly developed, it may only be possible to establish sufficiently deep repo markets for a limited number of maturities—as, for example, in Poland where National Bank of Poland bills were offered for one month’s maturity and repos on these bills for two weeks; in this case, the authorities may choose to supplement the repurchase facilities with other (non-market-based) credit facilities, perhaps by providing overnight credit to banks and other financial agents.


Reform of the wholesale payment system is an integral part of reform in Central and East European countries. The operation of an interbank payment system was not important under the system of central planning. The monobank system obviated the need for a large volume of interbank transactions; other aspects of the system reduced the urgency of ensuring swift and predictable settlements; and the official guarantee of bank solvency rendered the risk allocation issues irrelevant. The breakup of the monobanks, together with reforms designed to increase the autonomy of the banking system and to “harden budget constraints,” have made the design of an efficient system for interbank settlements increasingly relevant. Such a system is crucial because of the increasing importance of risk considerations and the lack of other mechanisms for controlling it, the influence of the banking structure on the need for interbank lending, and the anticipated development of money and eventually securities markets.

In addition to its importance to the banking system, an efficient wholesale payment system is an essential condition for market-based implementation of monetary policy. It is a necessary condition for the development of an active and liquid money market in which open market operations might be conducted. An efficient payment system also reduces the noise affecting the relationship between monetary targets and instruments, both by reducing the size and variability of central bank float and by permitting banks to engage in active liquidity management and thereby reduce their need to hold large and volatile excess reserves.

Payment system reform is not only essential but also includes some key policy issues. These issues are intimately related to the need to establish both trust and discipline in the system—a need that is reflected in the trade-off between achieving final settlement promptly and avoiding the moral hazard problems that arise when finality is guaranteed by the authorities. These policy issues are best addressed before new payment facilities and arrangements are established: it is best to get the right system in place from the start, anticipating the needs and strains that financial market development will place on the payment system.


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1The authors are grateful for country-specific information provided by V. Sundararajan of the IMF’s Monetary and Exchange Affairs Department. The views expressed here are those of the authors alone and do not necessarily represent the views of the International Monetary Fund.
2An overview of issues in financial sector reform in formerly centrally planned economies is provided in Lane (1994).
3The issue of market discipline is explored in a more general context in Lane (1993).

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