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Use your browser's PRINT function to print this article. This article is located at: http://rbcglobalservices.com/corrbk/cmo_cbic.html When you are finished, click here. |
"It is interesting to contemplate an entangled bank," Charles Darwin once wrote. The biologist was referring not to financial institutions but to the edge of a body of water and its interdependency of life forms. As for the relationships among the other type of banks, well, Darwin probably could have written about that complex but cooperative evolution too.
For now we'll set aside the topic of biology to untangle the current characteristics of the correspondent banking system in Canada.
How are payments handled for the greatest efficiency and client benefits?
How is Canada working to manage large value transactions and control systemic risk, meeting the highest global banking standards?
What kind of factors influence credit decisions?
Where are Canada's strengths in trade financing?
What do interbank settlements managers and relationship managers value most from their Canadian correspondents? And what affects their selection of a correspondent bank?
The answers to these last two questions come from a revealing Canadian study of the world's largest correspondent banks. More on that later. First, a bit of history.
At the time of Canadian Confederation in 1867, when the British North America Act gave the new federal government exclusive jurisdiction over money and banking, Canada had 34 banks with 164 branches.
Today, Canada has 54 chartered banks (comparable to commercial banks in the U.S.), managing over CAD 1.3 trillion in assets. With some 8,200 branches between them, Canada's system provides a higher ratio of full-banking branches to population than any other major industrialized nation.
Those 54 banks include eight Schedule I banks and 46 Schedule II. Schedule I banks are majority Canadian owned and widely held. Schedule II banks, almost all foreign owned, have the same powers as Schedule I but tend to serve the financial needs of a specific geographic region or economic sector. The "Big Six" banks offer a truly national franchise, and operate internationally.
Canada has one of the most efficient and reliable clearing systems in the world. Paper items, such as cheques and drafts, are cleared nationwide with same-day value. Final interbank settlement occurs by noon Eastern standard time the next business day.
Electronic payments are cleared through our Real Time Gross Settlement System, the Large Value Transfer System (LVTS). Together the two systems clear more than 3.6 billion items annually, worth more than CAD 16.6 trillion.
Since 1980 Canada's clearing and settlement system has been operated by the Canadian Payments Association (CPA). Established by federal law, this organization comprises chartered banks, credit unions, trust companies, other deposit taking institutions, and the Bank of Canada (the country's central bank).
Together, the CPA's member institutions account for well over 95% of the transferable deposit liabilities of all Canadian deposit taking institutions. A member institution accounting for half of one percent of the total volume of transactions being cleared can be a direct clearer; there are 11 in Canada.
The clearing and settlement system has two objectives:
Information regarding the processing and settlement of interbank and commercial payments is included in the section on "The ACSS and the LVTS."
CPA bylaws and rules govern many facets of the clearing and settlement system:
The rules and bylaws only partly explain why the national clearing and settlement system runs smoothly. Just as important is the relationship between direct clearers and indirect clearers, all of whom are members of the CPA. Several additional factors also play a role.
First, every member of the CPA must also be a member of the Canada Deposit Insurance Corp., or the Credit Union Central of Canada, or have its deposits insured or guaranteed. Second, all direct clearers have operational relationships with the Bank of Canada, and access to central bank credit. Third, the clearing bylaw requires direct clearers to report to the relevant regulatory authority all cases of indirect clearers repeatedly borrowing large amounts for settlements.
Before examining the clearing and settlement process, what's the role of the Bank of Canada, which serves as the final settlement institution? It began operations in 1935, charged with regulating "credit and currency in the best interests of the economic life of the nation". While the Bank's role in the payments system is pivotal, it is also, operationally, quite limited.
The Bank does not accept deposits from individuals or corporates, nor does it compete with deposit taking institutions in the lending field. While the Bank of Canada has no specific statutory responsibilities regarding the regulation of financial institutions or clearing and settlement systems, it is responsible for the safety and soundness of the payments system. (In Canada the regulation of financial institutions is handled by the Office of the Superintendent of Financial Institutions.)
The Bank's control over the ultimate means of settlement is the key determinant of monetary policy. On its books, the Bank holds the accounts through which the direct clearers' gains and losses, in relation to the other participants, are settled daily. Controlling the means of settlement makes the Bank the lender of last resort, to cover a temporary deficiency in a direct clearer's settlement account.
A sketch of the system shows the CPA handling paper clearing through regional settlement points (RSPs), located in six major cities. Each day, at every branch of all deposit taking institutions in the country, paper payment items for clearing are bundled and totaled, collected by courier, and delivered to either the institution's nearest data centre (if it's a direct clearer) or to its agent (if it's an indirect clearer).
At each RSP, the paper clearings for all bank branches in the region are determined. These totals are transmitted to other institutions involved in the clearing process, and all paper items are transferred to the bank against which they are drawn. Each RSP establishes a cut-off time for the exchange of payment items.
Each bank verifies its incoming items and totals and their balance with the Bank of Canada is determined. If short of funds, the bank borrows from the central Bank.
Now, for some details on how this system works.
In Canada, the Automated Clearing and Settlement System (ACSS) is used to track and settle paper payment items. Beginning at around 18:30 EST, the ACSS records the net clearing gains and losses resulting from the exchange of items by each direct clearer. The next morning, the settlement process begins. At 9:30 EST, the ACSS makes available the preliminary net clearing gain or loss of each direct clearer. From then until 11:00, provided the direct clearers concerned agree, bilateral re-openings of the clearings can occur via the ACSS to handle corrections.
Shortly after 11:00, the ACSS provides final net gains and losses. The Bank of Canada obtains each direct clearer's standing and adjusts the balances of the clearer on its own books, under the previous day's date. At approximately noon, after final adjustments, the Bank establishes the closing balances of each direct clearer as of the end of the previous day.
The LVTS electronic payments system is used to process non-paper banking transactions, third party international transactions, large value third party domestic payments, and the settlement of transactions in the domestic interbank market.
The majority of the daily messages that flow through LVTS are from correspondent banks. Often these are third party payments for Canadian exports, and the purchases of securities by non residents. Let's run through a typical LVTS transaction.
Any CPA member who can demonstrate sufficient technical competence, and has a settlement account with the Bank of Canada, can be an LVTS participant.
The deadline for submitting payments via LVTS is 6:30 p.m.
The LVTS system has two main objectives. The first is to control systemic risk -- the risk that the failure of one participant to meet its obligations will make other institutions incapable of meeting their obligations.
How is this safeguard achieved? Underpinning the system is a real-time, transaction by transaction calculation of cumulative net credit and debit positions of all participants. A risk-proofing mechanism provides explicit and binding loss-allocation arrangements. These are backed by collateral, and involve all CPA members that participate directly in the system.
In other words, once a payment is sent and passes the system's risk tests, it cannot be returned or unwound -- settlement becomes certain. (In the very extreme possibility of the failure of more than one participant, during the same LVTS operating cycle -- where the sum of the exposures to the LVTS at the times of failure exceeded the available collateral -- the central bank has agreed to guarantee settlement in all circumstances.)
The second goal of LVTS is to provide final settlement on a same-day basis. This lets CPA member institutions offer their customers finality of payment. Members are assured of receiving funds that aren't subject to reversal if either the payer or its financial institution can't meet its obligation.
To give just a thumbnail sketch of how the LVTS accommodates payments, participants can use one of two methods: a defaulter-pays mechanism, or a survivors-pay mechanism.
On a daily basis, participants extend bilateral lines of credit to other participants. Each participant is subject to a cap, which is the sum of all the bilateral net credit lines they establish, multiplied by a constant percentage.
Each participant is subject to an additional settlement obligation (ASO), based on its pro rata share of the bilateral lines granted to any failed participant. This is subject to a maximum of the largest bilateral line it has granted to any participant multiplied by the constant percentage.
Participants each pledge collateral equal to their maximum ASO, and bilateral lines of credit can be changed same day. However, loss allocation procedures are based on the largest line of credit granted during the day to the failed participant, by each surviving participant.
For more information on LVTS, check out our "Guide to LVTS" or visit the Bank of Canada's Website.
In assessing the credit risk of dealing with other banks, Canadian financial institutions, like many other banks, use some form of a CAMEL analysis -- Capital, Asset Quality, Management, Earnings, and Liquidity.
CAMEL analysis is common since analyzing a bank is very different from analyzing a corporate -- a cash flow analysis of a bank just doesn't work. Furthermore, to be meaningful, any ratios have to be viewed in comparison to other banks in the same country.
Using a sliding scale that converts risk assessment to points, and factoring in the capital of the other bank (as well as their own capital base), Canadian banks set guidelines on the maximum amount they would lend.
The majority of exposure that the banks have with one another usually takes the form of derivatives -- mostly foreign exchange forwards and swaps. Derivative exposures add another layer to the existing symbiotic relationships between banks.
With Canadian exports exceeding C$360 billion in 1999, the export sector remains a dominant force in the Canadian economy. For this reason, all levels of government and financial institutions in Canada lend strong support to companies engaged in export activities.
Among exporters, the focus of many new government programs, and financial institution nitiatives, is to help small and medium-sized enterprises (SME) become export-ready. For example, Royal Bank of Canada recently redesigned its web site for international trade to focus on educating new and potential exporters and importers, and to provide an information portal from which they can easily gain access to a wide variety of export and import services.
The key market for Canada remains the United States, which in 1999 was responsible for C$309.6 billion in Canadian exports and C$249.1 billion in imports. Although the letter of credit is still the preferred financial instrument when trading with other parts of the world, open account trading has become the norm in trade with the United States. A similar trend is also developing in trade with Europe and parts of Asia.
To meet the demand for export financing in the SME market, many Canadian financial institutions have modified their lending policies to permit margining of foreign receivables in operating lines of credit, often supported by credit insurance by the Export Development Corporation or private insurers. New services are also being offered, where the banks purchase export receivables outright at a discount. In the manufacturing sector, companies such as Northstar Trade Finance Inc. are offering solutions to exporters whose foreign buyers are demanding medium-term financing.
In the coming months, Royal Bank of Canada anticipates a continued expansion of new product and service offerings to exporters and importers. We also see a growing trend in partnerships, alliances and joint marketing programs on the part of banks, governments and service providers, in an effort to reach a growing community of SME exporters and importers.
For more information on Royal Bank of Canada's international trade services, please visit us on-line at: www.rbcglobalservices.com/business/itrade
What are financial institutions looking for when it comes to selecting a correspondent bank? To find the answer, Royal Bank of Canada sponsored a survey in the spring of 1996, among the world's largest correspondent banks.
In all, 188 banks spoke out about the factors influencing their choice of a correspondent bank. The survey also secured statistically valid information on Canadian dollar interbank settlements and Canadian commercial payments markets.
The survey shows that Relationship Managers are willing to pay a premium price for three key attributes:
Incidentally, the Relationship Manager is rarely alone in selecting a settlement bank. Among the largest banks, less than one-quarter have the Relationship Manager make the choice alone. Two-thirds of the time, the decision is made jointly with the Interbank Settlements Department, or by the Interbank Settlements Department alone.
Unlike Relationship Managers, the Interbank Settlements Manager is willing to pay a premium price for superior service. The survey found that competitive pricing is important, but the most meaningful attribute is excellent service delivery.
Just what defines excellent service? Following are some of the components cited by Interbank Settlements Managers, ranked in order of importance:
The survey revealed today's market dynamics, by asking respondents about changes in their dollar and transaction volumes with their agent bank. Two out of five banks reported increases in both the number of Canadian interbank settlements and Canadian dollar volume over the previous year.
Broad-based market growth is indicated by the fact that three times as many banks said their activity is growing than said it's declining.
As with relationship managers, who are concerned with avoiding poor service, interbank settlement managers' dominant reason for selecting an interbank settlements agent, by a two-to-one margin, is service. One in five banks mentioned financial strength first, which tended to be more important to the top 100 banks.
As Darwin might observe, responses to the recent independent survey of correspondent banks indicate that among the "entangled banks", Royal Bank of Canada is fit indeed. And you know what he said about the survival of the fittest.
A recent survey of the world's largest banks revealed market share is an important consideration when selecting a correspondent. Yet over half the respondents didn't know which Canadian bank was the market leader. Do you know?
Royal Bank of Canada holds 46% of the Canadian dollar interbank settlements market, and 56% among the world's 100 largest banks. And, of the top 100 banks, 83% use us for their Canadian commercial payments. Not surprising when you consider Royal Bank of Canada is the largest bank in Canada!
With our market share, it's inevitable that a significant portion of interbank settlements (43% on average) are transferred between two customers who both hold accounts on our books -- a "book" transfer. Book transfers are free of charges (provided we receive fully qualified S.W.I.F.T. payment instructions) essentially offering clients "free" payments 43% of the time. We also have a global network of more than 3,000 correspondents in some 180 countries, supported by a team of account managers located in strategic markets around the world.
Other leaders within Royal Bank of Canada: Institutional & Investor Services (IIS) is Canada's largest custodian and among the 10 largest in the world with total client assets under administration of more than CAD 1.6 trillion (RBC Financial Group).
RBC Capital Markets, our fully integrated trading and investment banking division, provides comprehensive global services, including foreign exchange, money market, fixed income and capital market services. With trading hubs in Toronto, London, and Singapore, supported by 10 regional trading floors around the globe, we are the world leader in Canadian dollar trading and among the top 20 FX banks in the world.
Royal Bank of Canada was the first Canadian bank to establish an Internet website. We currently offer end-of-day statements and real-time balance and transaction reporting via the Internet, and have more services in the pipeline.
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