Volume 29 No. 1 January - March 2005

THE NEW SETTLEMENT FRAMEWORK: THE JOURNEY SO FAR

By Dr. (Mrs.) S. O. Alade* Dr. (Mrs.) S. O. Alade

1. INTRODUCTION In addition, effective transcends the individual implementation of mone- as illiquidity in one he improvement in tary policies has evolved in bank can create systemic system tandem with the evolution problems for other . To w e s m u c h t o and improvements in improvement in payments system, especi- Traditionally, Central instruments and infor- ally the use of paper-based Banks the world over have mation technology. From payment instruments and continued to evolve a viable cowries to and from improvement in informa- framework for the manage- silver to gold, from the tion technology. ment of settlement accounts primitive system of of banks, in line with exchange to the present Settlement system, as an international best practices. electronic system, the role important component of a This is aimed at ensuring and importance of efficient country's payments system, settlement finality at the payments systems have is an act that discharges given the been closely monitored and obligations in respect of important role that well- promoted by monetary funds or securities transfer functioning payments authorities in all countries. between two or more systems have on monetary In particular, advances in parties. Typically, in today's policy, financial stability a u t o m a t e d c h e q u e world, each bank involved and overall economic processing and the spread of in payments directly or activity. personal chequing accounts indirectly has an account have promoted to with the Central Bank, so Central Banks have tended the position of dominant that at the end of a settle- to play a more active role in payment instrument for ment process, payments due payments system since the medium to large value to and from various banks late 1970s because of rapid p a y m e n t s . T h u s , i n could be posted into the technological changes, advanced economies, banks' respective settlement d r a m a t i c g r o w t h o f cheques and other paper accounts. Liquidity is financial activity and the p a y m e n t i n s t r u m e n t s crucial to the survival of any consequent enormous accounted for about 98 per bank as illiquidity can have growth in both volumes and cent of total payment dramatic and rapid negative v a l u e s o f p a y m e n t i n s t r u m e n t s i n 2 0 0 0 consequences on even well- transactions. As a result, compared with about 33 per capitalized banks. The liquidity and credit risks for cent in Nigeria. importance of liquidity central banks, commercial

*Dr. (Mrs.) S. O. Alade is the Director, Banking Operations Department, CBN

46 Volume 29 No. 1 January - March 2005 banks and other participants i n t h e l i g h t o f t h i s for implementing a modern involved in payment experience that the Bank on system to enable efficient systems have increased 1st April 2004 installed a payments, and dramatically. Furthermore, new settlement framework, settlement is driven by payments and settlement which is the focus of this international standards and systems have become paper. The objective is to the desire to increase p o t e n t i a l s o u r c e s o f examine the new settlement international investor domestic and cross-border arrangement and its impact confidence in the national financial crisis. In this new on settlement and systemic market. environment, promoting risks. The paper is divided stability and efficiency of into five main sections. To automate the clearing payments and settlement Following the introduction and settlement processes, to s y s t e m s , d e v e l o p i n g is Section 2 which discusses reduce settlement cycles measures to reduce risk and the evolution of Clearing and to eliminate the risks, ensuring and Settlement System in the financial communities arrangements and changes Nigeria. Section 3 reviews are introducing modern if such arrangements do not the new settlement system, payment systems around the j e o p a r d i z e m o n e t a r y while section 4 appraises three key components of the management have become the new system. Finally, national infrastructure na- crucial Central Bank section 5 summarises and mely, high value payments, objectives. also concludes the paper. low value payments and securities clearing. Over the years, the Central 2. EVOLUTION OF Bank of Nigeria has CLEARING AND The Nigerian Clearing grappled with the problem S E T T L E M E N T And Settlement System- of clearing banks over- S Y S T E M I N Pre MICR Period drawing their accounts with NIGERIA the Bank, albeit by default, Subsequent to the establish- arising from the settlement The development of an ment of the Central Bank of arrangements. The Bank automated clearing system Nigeria in July 1959 and the had taken a number of is recognized as an essential gradual widespread use of measures to manage the and vital infrastructure cheques and other paper- problems caused by banks project in the development based instruments, the Bank overdrawing their accounts, of the banking sector within established the first bankers ranging from moral suasion, the country. Not only does it in 1961 for imposing penal interest provide improved banking the Lagos Clearing zone. rates, to outright suspension facilities, it also acts as a This was followed by Kano from , as a baseline for the develop- and Port Harcourt clearing last resort. Experience ment and integration of zones as well as clearing however, has shown that o t h e r p a y m e n t s a n d houses in each of the then w h i l e t h e o p t i o n o f settlement systems in the Regional Headquarters. suspension of a bank from area of electronic banking. the clearing house may be A m o d e r n p a y m e n t s The clearing house system, inevitable, its effects are infrastructure eliminates based on multilateral ex- usually grievous, and systemic risk and brings change of financial instru- c a p a b l e o f i n d u c i n g stability into the national ments, were directly systemic repercussions. It is banking system. The need operated and managed by

47 Volume 29 No. 1 January - March 2005 banks and other participants i n t h e l i g h t o f t h i s for implementing a modern involved in payment experience that the Bank on system to enable efficient systems have increased 1st April 2004 installed a payments, clearing and dramatically. Furthermore, new settlement framework, settlement is driven by payments and settlement which is the focus of this international standards and systems have become paper. The objective is to the desire to increase p o t e n t i a l s o u r c e s o f examine the new settlement international investor domestic and cross-border arrangement and its impact confidence in the national financial crisis. In this new on settlement and systemic market. environment, promoting risks. The paper is divided stability and efficiency of into five main sections. To automate the clearing payments and settlement Following the introduction and settlement processes, to s y s t e m s , d e v e l o p i n g is Section 2 which discusses reduce settlement cycles measures to reduce risk and the evolution of Clearing and to eliminate the risks, ensuring payment system and Settlement System in the financial communities arrangements and changes Nigeria. Section 3 reviews are introducing modern if such arrangements do not the new settlement system, payment systems around the j e o p a r d i z e m o n e t a r y while section 4 appraises three key components of the management have become the new system. Finally, national infrastructure na- crucial Central Bank section 5 summarises and mely, high value payments, objectives. also concludes the paper. low value payments and securities clearing. Over the years, the Central 2. EVOLUTION OF Bank of Nigeria has CLEARING AND The Nigerian Clearing grappled with the problem S E T T L E M E N T And Settlement System- of clearing banks over- S Y S T E M I N Pre MICR Period drawing their accounts with NIGERIA the Bank, albeit by default, Subsequent to the establish- arising from the settlement The development of an ment of the Central Bank of arrangements. The Bank automated clearing system Nigeria in July 1959 and the had taken a number of is recognized as an essential gradual widespread use of measures to manage the and vital infrastructure cheques and other paper- problems caused by banks project in the development based instruments, the Bank overdrawing their accounts, of the banking sector within established the first bankers ranging from moral suasion, the country. Not only does it clearing house in 1961 for imposing penal interest provide improved banking the Lagos Clearing zone. rates, to outright suspension facilities, it also acts as a This was followed by Kano from the clearing house, as a baseline for the develop- and Port Harcourt clearing last resort. Experience ment and integration of zones as well as clearing however, has shown that o t h e r p a y m e n t s a n d houses in each of the then w h i l e t h e o p t i o n o f settlement systems in the Regional Headquarters. suspension of a bank from area of electronic banking. the clearing house may be A m o d e r n p a y m e n t s The clearing house system, inevitable, its effects are infrastructure eliminates based on multilateral ex- usually grievous, and systemic risk and brings change of financial instru- c a p a b l e o f i n d u c i n g stability into the national ments, were directly systemic repercussions. It is banking system. The need operated and managed by

48 Volume 29 No. 1 January - March 2005

! ! clearing process was technology and make through cooperation by generally undisciplined, the clearing process those financial institutions rowdy, late in balancing faster and more accurate that participate actively in and prone to human and thereby reduce the the payments business. error, float. It would introduce networking between The major long term ! all the clearing banks, parties, and start to benefits include: irrespective of weakne- introduce the benefits of sses, maintained settle- electronic banking to all ! the membership will be ment accounts with the concerned. based on technical CBN. Many of the banks efficiency and ability to consistently retained Following the proposal by work in a controlled overdrawn position, the Governor, in conjun- environment, creating in the process, ction with the Bankers' systemic crisis. Committee, the CBN on 2nd ! MICR information can October, 1997 appointed be utilized, Four options were then Messrs Logica UK Ltd as proposed as follows: consultants for the Nigeria ! handwritten control A u t o m a t e d C l e a r i n g documents can be ! breaking the Lagos area System (NACS). A full replaced by a computer into zones. Spreading Strategy Report in July generated audit trail, the clearing process over 1998 recommended a a number of zones D e c e n t r a l i s e d D a t a ! human error can be would be quicker and Processing Solution for the eliminated through m o r e e f f i c i e n t . N i g e r i a A u t o m a t e d automated balancing However, it was felt that Clearing System (NACS). and reconciliation. duplication of infrast- ructure and personnel The Bank subsequently ! clearing cycle, and float outweighed the benefits, directed that the NACS could be reduced, should be private sector thereby reducing the ! reducing the number of driven, with shareholding opportunities for fraud. Clearing and Settlement open to all banks. Nigeria banks. This would make Inter-Bank Settlement ! CBN can examine the clearing process System (NIBSS) Plc was national net settlement more manageable, faster mandated to facilitate and figures that can be and efficient. coordinate the NACS consolidated from other project in Lagos Clearing payment systems and ! reducing the number of zone. The Central Bank i d e n t i f y p o t e n t i a l clearing days. This maintained the role of an problems. would bolster consumer umpire to provide the rules confidence and encou- and regulations of the entire The Nigeria Automated rage the use of non-cash clearing, settlement and Clearing System was instruments, payments system. The Bank therefore conceived to take was of the view that the advantage of state of the art ! automating the Clearing development of technology to improve the House. This would make clearing and settlement clearing and settlement u s e o f t h e M I C R arrangement should be processes. Specifically, the

49 Volume 29 No. 1 January - March 2005 the CBN. All the clearing domestic payments system. in the clearing house banks which were relatively In its report submitted in activities and each of them few directly participated at 1983, the company recomm- maintained account with the the clearing houses and ended the introduction of CBN with virtually no maintained accounts with Magnetic Ink Character clearing collateral. Thus by each branch of the Central Recognition (MICR) tech- 1995 over thirty banks had Bank. The clearing system nology into the payments their accounts with the CBN was manual in operation s y s t e m t o f a c i l i t a t e persistently overdrawn, and could take as much as document processing, thereby creating systemic eight hours after the shorter clearing duration crisis. commencement of the and boost confidence of the clearing house before banks banking public. In line with It is in consideration of could know their net the recommendation of the these, that in November, settlement positions and as consultant, a phased appro- 1995, the Governor of the long as twenty-seven days ach to the implementation Central Bank of Nigeria before customers of banks of MICR was adopted, stated that the Nigerian could take value for their starting with the CBN in clearing and settlement clearing cheques. 1988. The second phase system has to be drastically took off in 1991 with the overhauled. The challenges Although, the banks were implementation by First then were; not required to Bank, Union Bank and ! clearing collateral against United Bank for Africa. The efforts to convert the adverse net settlement full implementation of the public to use non-cash positions, there were low project in Lagos Clearing items was being hampe- i n c i d e n c e s o f b a n k s zone commenced on 1st July, red by the clearing and overdrawing their accounts 1994, when the exchange of settlement process, beyond 24 hours as there conventional cheques which was largely was market discipline. ceased at the Clearing manual, using hand- House. written control docu- MICR PERIOD ments. The introduction of the ! With the deregulation that MICR technology did little cheque usage and began in 1987, the economy to improve the clearing and settlement process were witnessed rapid increase in settlement system. In the prone to fraud and the number of deposit first instance, there were abuse. banks with the critical problems arising ! attendant sharp rise in the from lack of cheque long clearing cycle, - volume of financial instru standards. As a conse- taking between 9 to 15 ments being multilaterally quence of the problems, the days for customers to exchanged in the clearing MICR reject rate at 30% of take value on cheques house. Pursuant to enhan- the total clearing instru- ! cing the processing of ments remained high. too many banks directly clearing instruments, the Besides these problems, participating in clearing CBN in 1982 commissioned operation of the clearing house activities with all Messrs KOMPLEX Limi- system remained long. of them maintaining ted to carry out full There were over eighty accounts with the CBN, feasibility study on the banks directly participating

50 Volume 29 No. 1 January - March 2005

! risks in the banking 3.0 THE NEW CLEA- requirements. industry, particularly the RING AND SETT- ! CBN and customers' LEMENT SYSTEM Non-settlement banks exposure to the banks. The should maintain agency persistent overdrawn 3.1 Aims and Objectives a r r a n g e m e n t w i t h position of banks rebounded settlement banks and the with intensity, with unpre- The new clearing and cheque clearing balan- cedented large amounts. settlement system aims at ces plus the up-country Many of such banks had improving efficiency in transfers of the non- since been suspended from payments systems by elimi- settlement banks should further participation in nating settlement lag for be posted into the clearing house activities but high value and time sensi- settlement accounts of they left behind huge tive payments. It also the settlement banks at overdrawn position in their minimizes settlement risks. the CBN, under an accounts with the CBN and Agency arrangement. tremendous pains for their 3.2 Operational ! numerous customers as well Guidelines The operations accounts as a low confidence in the of the non-settlement use of cheques. Given the problems associ- banks shall be in credit at ated with the earlier cheque all times. In effect, while payments clearing and settlement risk increased because of system the Bank on 1st April Any bank applying for increased transaction flows, 2004 installed a new direct participation as a increased instruments and settlement framework. This settlement bank shall be shorter clearing and new arrangement included required to meet the settlement cycles; the the following: following conditions: settlement framework and ! institutional arrangements ! C l e a r i n g b a n k s Possess the capacity to were too weak to provide (seventy-five of them) provide the required the necessary tool for were classified into clearing collateral, payment and settlement risk settlement and non- which for a start was management. Given the settlement banks. fixed at N15 billion, and peculiarity of the domestic subject to periodic clearing and settlement ! Only settlement banks review. system, particularly the high should maintain settle- ! number of weak banks in the ment accounts with the Ability to offer agency system, the major flaw of CBN to meet settlement facilities to other banks the settlement arrangement obligations and for other and to clear and settle on under NACS was that all the transactions in CBN. their behalf. participating banks, direct ! and indirect banks, 80 of ! Non-settlement banks A d e q u a t e b r a n c h them, were all allowed to should maintain only network, in the CBN maintain settlement acco- operations account with twenty-two clearing unts with the CBN. Hence the CBN, for their areas. the persistent overdrawn foreign exchange, cash ! positions of banks. withdrawing operations Meet the volume and as well as cash reserve value criteria which

51 Volume 29 No. 1 January - March 2005

! clearing process was technology and make through cooperation by generally undisciplined, the clearing process those financial institutions rowdy, late in balancing faster and more accurate that participate actively in and prone to human and thereby reduce the the payments business. error, float. It would introduce networking between The major long term ! all the clearing banks, parties, and start to benefits include: irrespective of weakne- introduce the benefits of sses, maintained settle- electronic banking to all ! the membership will be ment accounts with the concerned. based on technical CBN. Many of the banks efficiency and ability to consistently retained Following the proposal by work in a controlled overdrawn position, the Governor, in conjun- environment, creating in the process, ction with the Bankers' nd ! systemic crisis. Committee, the CBN on 2 MICR information can October, 1997 appointed be utilized, Four options were then Messrs Logica UK Ltd as ! proposed as follows: consultants for the Nigeria handwritten control documents can be ! A u t o m a t e d C l e a r i n g breaking the Lagos area System (NACS). A full replaced by a computer into zones. Spreading Strategy Report in July generated audit trail, the clearing process over 1998 recommended a ! a number of zones D e c e n t r a l i s e d D a t a human error can be would be quicker and Processing Solution for the eliminated through m o r e e f f i c i e n t . N i g e r i a A u t o m a t e d automated balancing However, it was felt that Clearing System (NACS). and reconciliation. duplication of infrast- ! ructure and personnel The Bank subsequently clearing cycle, and float outweighed the benefits, directed that the NACS could be reduced, thereby reducing the ! should be private sector reducing the number of driven, with shareholding opportunities for fraud. Clearing and Settlement open to all banks. Nigeria ! banks. This would make Inter-Bank Settlement CBN can examine the clearing process System (NIBSS) Plc was national net settlement more manageable, faster mandated to facilitate and figures that can be and efficient. coordinate the NACS consolidated from other payment systems and ! project in Lagos Clearing reducing the number of zone. The Central Bank i d e n t i f y p o t e n t i a l clearing days. This maintained the role of an problems. would bolster consumer umpire to provide the rules confidence and encou- and regulations of the entire The Nigeria Automated rage the use of non-cash clearing, settlement and Clearing System was instruments, payments system. The Bank therefore conceived to take advantage of state of the art ! was of the view that the automating the Clearing development of cheque technology to improve the House. This would make clearing and settlement clearing and settlement u s e o f t h e M I C R arrangement should be processes. Specifically, the

52 Volume 29 No. 1 January - March 2005

! their funds. There has been increa- The Bank is addressing the sed confidence in the above problems along with Other achievement of the cheque clearing system. the on-going banking new clearing and settlement consolidation. It is expected arrangement, include: Despite the achievements in that after the consolidation both NACS and the current exercise, all banks would ! Overdrawn position of settlement arrangement, become settlement banks, as banks' accounts with the s o m e f u n d a m e n t a l they would possess the CBN, through the problems still remain, capacity to provide appro- cheque clearing beyond particularly the: priate discountable clearing 24 hours has been collateral. Currently under ! effectively eliminated. exposure of settlement review by the Bank is the In effect, CBN exposure banks to the non- guideline on clearing and to the banks and injec- settlement banks, as settlement systems to the tion of high powered some of them continu- extent that there may be a m o n e y h a s b e e n ously and persistently cap on the amount that can eliminated. overdraw their accounts be paid through the cheque with the settlement clearing system, so that ! Generally, the new banks. high-value payments are system has continued to handled by the RTGS ! instil discipline in many suspension of defaulting system which has been of the clearing banks non-settlement banks positioned to go live in from participation in August 2005. ! The new Settlement clearing house activities System is currently by their settlement 5 SUMMARY AND providing the platform banks, without follo- CONCLUSIONS for bank consolidation, wing the due process as as merger /acquisition specified and defined in This paper has examined the discussions are being the guidelines on the clearing and settlement driven by the current new settlement system. system since the intro- settlement/non-settle- duction of Nigeria Auto- ! ment relationship runs on some non- mated Clearing System settlement banks as a (NACS), which allowed all ! D e l i b e r a t e w r o n g consequence of the banks not only to participate delivery of cheques to crude method used by directly in settlement banks has been put their settlement banks to activities, but also maintain under firm control 'suspend' them from settlement accounts with the clearing house activi- CBN, without providing ! There has been effective ties. adequate collateral to monitoring of liquidity reduce the CBN exposure to ! and settlement risks, frequent changing from the banks and prevent leading to a significant one settlement bank to frequent injection of high reduction in panic borro- another, by non-settle- powered money into the wing, reduced pressure ment banks who see system. The paper also on the interest and their former settlement highlighted the problems exchange rates. b a n k s a s n o t t o o associated with the old accommodating. settlement system, particu-

53 Volume 29 No. 1 January - March 2005

OVERDRAWN POSITION OF BANKS THROUGH CLEARING YEAR (AS AT DECEMBER 31, ) 2002 2003 2004

NUMBER OF BANKS 12 32 -

OVERDRAWN AMOUNT ( N' MILLION ) 18,238.39 55,053.65 - Overdrawn position of the clearing banks declined to zero as at 2004 from N55.1 billion as at 2003.

Boosted by the NACS infrastructure and the new clearing and settlement arrangement, the efficiency of the payments system continued to improve as illustrated by the sustained growth in both volume and value of cheques cleared during the year 2004 as shown by the charts below:

V A L U E O F C H E Q U E S C L E A R E D (N ' M I L L IO N ) 1 9 9 4 - 2 0 0 4

1 2 , 0 0 0 . 0 0 1 0 , 0 0 0 . 0 0 8 , 0 0 0 . 0 0 6 , 0 0 0 . 0 0 4 , 0 0 0 . 0 0 2 , 0 0 0 . 0 0 -

94 95 96 97 98 99 00 01 02 03 04 19 19 19 1 9 19 19 20 20 20 2 0 20

V A L U E ( N ' M I L L I O N )

V O L U M E O F C H E Q U E S C L E A R E D 1 9 9 4 - 2 0 0 4

1 6 , 0 0 0 , 0 0 0 1 4 , 0 0 0 , 0 0 0 1 2 , 0 0 0 , 0 0 0 1 0 , 0 0 0 , 0 0 0 8 , 0 0 0 , 0 0 0 6 , 0 0 0 , 0 0 0 4 , 0 0 0 , 0 0 0 2 , 0 0 0 , 0 0 0 - 6 7 8 9 0 3 4 4 5 1 2 4 5 6 7 8 9 0 1 2 3 4 9 9 0 0 0 9 9 9 9 0 0 9 9 9 9 9 9 0 0 0 0 0 9 0 9 9 9 9 9 0 0 0 0 9 9 9 9 9 9 0 0 0 0 0 1 1 1 1 1 1 2 2 2 2 2 1 1 1 1 1 1 2 2 2 2 2 V O L U M E

CLEARING CYCLE FOR THE PERIOD 2000-2004

14

12 CLEARING CYCLE (DAYS) 10

8

6

4

2

0 2000 2001 2002 2003 2004 Up-Country 12 9 6 6 6 Intra-State 6 6 Local 4 4 4 3 3 YEAR

Source: Banking Operations Database, CBN Annual Report, and 2002 Banking Supervision Department Annual Report

54 Volume 29 No. 1 January - March 2005

larly liquidity, credit and account is funded. framework has brought to settlement risks. focus the need for a holistic The key objectives were to payments system reform to The new settlement frame- reduce clearing and settle- achieve a robust system, work which segregated ment risks, as well as to especially the establishment clearing banks into settle- improve macro-economic of an efficient and effective ment and non-settlement management. The achieve- legal and institutional banks was examined. While ments so far recorded under framework so as to reduce the settlement banks main- the new system though an settlement risk for all tained settlement accounts admixture is encouraging as stakeholders to a minimum to meet settlement obliga- the new system has succee- and further enhance the tions to counterparties and ded in eliminating the efficiency of the payment other transactions, inclu- incidence of banks overdra- system. While the CBN ding inter-bank large pay- wing their accounts with the continues to rely on S.41 of ments and foreign exchange CBN. However, while the the CBN Act in the transactions with the CBN, new arrangement elimina- regulation of the payments the non-settlement banks ted settlement risk from the system, it is pertinent to were required to maintain CBN, the risk was transfe- develop a comprehensive only operations account for rred to the settlement banks, legal framework for the limited transactions in which are carefully mana- payments system. In CBN, particularly, foreign ging it. addition, the Dishonoured exchange and inter-bank Cheques Act has to be fund transfers, provided the So far, the new settlement effectively enforced.

BIBLIOGRAPHY

O. J. Nnanna (1999): “Policy Options for Improving the Efficiency of the Nigerian Payments System”, CBN: Bullion, volume 23, No. 2, April/June.

M. O. Adeniran (1999): “Legal and Institutional Arrangements for a Payment System”, CBN: Bullion, vol. 23, No. 2, April/June.

MICR Technology in the Nigerian Banking Industry (1999), a publication of the MICR Technical Implementation Committee, CBN, Lagos.

Bank of Canada and the Department of Finance (1997): “The Payments System in Canada: An Overview of Concepts and Structures”, a background paper for discussion by the Payments System Advisory Committee, February.

C. O. Odiaka (2004): The Role of Payments System in Liquidity Management, a paper Presented at the Banking Operations Department retreat, December.

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