Credit risk arises when 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, the institution 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 the institution's accounts to settle transactions.Insured depository institutions are subject to Regulation F (Limitations on Interbank Liabilities, 12 CFR Part 206) which requires institutions to monitor and limit their exposures to correspondents.
Credit risk with retail payment systems is evident in ACH, merchant card, and remote deposit processes where the financial institution supplies funds on behalf of a merchant and provisional settlement does not occur for several days. Returns are another source of credit risk for all forms of retail payment systems. Checks and direct debit transfers can be returned by the payer's institution because of insufficient funds, a closed account, a stop payment order, forgery, fraud, or other payment irregularity. The return timeframes 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 for consumer debits under NACHA rules extends to 60 days from the settlement date.
Financial institutions that accept large volumes of retail payments from merchants should understand the nature and degree of credit risk from those relationships. Financial institutions should manage those relationships in the same manner as any credit, subjecting the customers to credit administration processes for due diligence and ongoing monitoring. The risk in large volume relationships, and the institution's legal lending limit and capital position should be recognized in establishing exposure limits for each customer. Financial institutions may mitigate credit risk by requiring pre-funding for credit originators and adequate risk- based reserves for debit originators.
For the ACH system, NACHA rules require each ODFI to conduct appropriate creditworthiness monitoring, establish exposure limits, and periodically review the limits applicable to specific originating customers. Both ODFIs and RDFIs are exposed to credit risk. However, an RDFI's credit risk is minimal because it has the right to return items it is unable to post to customers' transaction accounts within NACHA guidelines and timeframes. ODFIs are ultimately responsible for all transactions entering the payment system regardless if the transaction is a credit or a debit. ODFIs that generate credits have a typical credit exposure of three days, which represents the gap between the submission of the ACH credit file and the funding of the file by the file originator. Such credit risk may be mitigated by requiring pre-funding of the credit file. ODFIs that generate debits have a credit exposure of 60 days due to the potential for returns.
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. 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.