metadata: authors: 0: author: Listfield, Robert
1: author: Montes-Negret, Fernando
docna: 0: docna: Modernizing payment systems in emerging economies
docty: Policy Research Working Paper
subtopic: Banks & Banking Reform,Financial Crisis Management & Restructuring,Financial Structures,Financial Sector Policy
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The authors address the following
            questions in this overview of payment systems: What is a
            payment system? How can efficient systems contribute to the
            development of modern, market-based financial institutions
            and markets? What elements are necessary for payment systems
            to operate efficiently? What are the operational
            characteristics of a modern payment system? What is the
            World Bank approach to selected payment system initiatives,
            design, and development? Effective, efficient payment
            systems, they conclude, are vital for the economic
            development of emerging economies. Efficient payment systems
            help promote the development of commerce, enhance economic
            policy oversight, control the risk inherent in moving large
            values, and reduce the financial, capital and human
            resources devoted to the transfer of payments. Many emerging
            economies lack the financial and technical resources to
            develop such systems. Many turn technical resources to
            develop such systems. Many turn to the World Bank and other
            international agencies for assistance. Unfortunately, some
            believe that the entire solution for an effective payment
            system rests in obtaining modern computer hardware and
            believe the World Bank's sole contribution is to
            finance hardware costs. Hardware procurement alone will not
            solve problems of payment systems. These countries need
            organizational plans and structure for national payment
            systems before they spend money on computer equipment. They
            often lack the expertise to design and operate modern
            payment systems, so they may need technical assistance from
            financial experts before they invest in systems development.
            The design of a new payment system should be kept simple.
            Many emerging economies lack the infrastructure and banking
            sophistication to leapfrog from basic to state-of-the-art
            payment systems. The first task is to fix the most serious
            problems. The second is to upgrade the current systems
            incrementally, to meet basic standards of timeliness,
            security, and reliability. As these improvements are made,
            the countries can turn their attention to long-term,
            advanced solutions. Each country's payments system is
            unique. To simply import another country's system
            without adjusting for the target country's geography,
            infrastructure, banking and legal structures, culture, and
            needs could lead to suboptimal solutions. Development of the
            system should follow a disciplined plan for defining the
            needs of users and for organizing the project team and
            project goals.
repnme: repnme: Modernizing payment systems in emerging economies
display_title: Modernizing payment systems in
            emerging economies
listing_relative_url: /research/1994/08/698096/modernizing-payment-systems-emerging-economies
topicv3: Commercial Banking m1326069 1236,Education, Skills Development and Labor
            Market m1326135 1484,Central Banks m1327453 1235,Financial Sector Development m1327681 1920,Credit Risk m1505083 3885
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Economics and Chief Economist
no_of_pages: 48
fullavailablein: node_id: 698096
model_extractions: POLIcy RESEARCH WORKING PAPER 1336

# Summary findings

Listfield and Montes-Negret address the following questions in this overview of payment systems: What is a payment system? How can efficient systems contribute to the development of modern, market-based financial institutions and markets? What elements are necessary for payment systems to operate efficiently? What are the operational characteristics of a modem payment system? What is the central bank's role? What problems do countries face when developing payment systems? What is the World Bank approach to selected payment system initiatives, design, and development?

Effective, efficient payment systems, they conclude, are vital for the economic development of emerging economies. Efficient payment systems help promote the development of commerce, enhance economic policy oversight, control the risk inherent in moving large values, and reduce the financial, capital, and human resources devoted to the transfer of payments.

Many emerging economies lack the financial and technical resources to develop such systems. Many turn to the World Bank and other international agencies for assistance Unfortunately, some believe that the entire solution for an effective payment system rests in obtaining modem computer hardware and believe the World Bank's sole contribution is to finance hardware costs. Hardware procurement alone will not solve problems of payment systems.

These countries need organizational plans and structures for national payment systems before they spend money on computer equipment. They often lack the expertise to design and operate modern payment systems, so they may need technical assistance from financial experts before they invest in systems development.

The design of a new payment system should be kept simple. Many emerging economies lack the infrastructure and banking sophistication to leapfrog from basic to state-of-the-art payment systems. The first task is to fix the most serious problems. The second is to upgrade the current systems incrementally, to meet basic standards of timeliness, security, and reliability. As these improvements are made, the countries can turn their attention to long-termn, advanced solutions.

Each country's paymint system is unique. To simply import another country's system without adjusting for the target country's geography, infrastructure, banking and legal structures, culture, and needs could lead to suboptimal solutions. Development of the system should follow a dis:iplined plan for defining the needs of users and for organizing the project team and project goals.

This paper-aproduct of the Financial SectorDevelopmentDepartment- is part of a larger effort in the departmentto examine factors constraining the development of countries' financial infrastructurc. Copies of the paper arc availablc free from thc World Bank, 18 18 H Street NW, Washington, DC 20433. Plcase contact FernandoMontes-Ncgret, room G8-133. extension 37832 (43 pagCs). August 1994.

_* The Policy resech Working Paper Series disseminaes the fndings of work in progress to encoge the exchange of ideas about devlopment issues. An obiective of the series isto get the fndings out quicily, cuen if the presetations ar kss than fldly polisbe Tahe papers cany the namsc of the authors and should be used and cited accordingly. he findings, interprfations4 and condusions are the autbors' oum d should nor be attributed to tec World Bank its Exutive Board of Dimtorsa or any of its nmmber countriesn_ Produced by the Policy Research Dissemination Ccnter
# MODERNIZING PAYMENT SYSTEMS IN EMERGING **ECONOMIES**

by Robert Listfield-and Fernando Montes-Negret<sup>1</sup> ' _L' Princpa, BEL GOLEUB (A Division of EDS.), Boson, and Princial Economist PMI, The World Bant Washington D.C_ _nuhi paper reflects only thw authors' views, and should be used and dited acicordinglr The ftndings, inr~prsauonu ad-concltwios are the sauthrs' own. They should not be atribmuted to. BE' Gokmzbe, the *World BanX their Board of Direcors, their management, or any of the World Bank membecr countries._
This paper presents an overview of payment systemns in developing countries and transitional socialist economies. The paper does not intend to make the reader an expert in payment systems. The paper intends to raise awareness of the challenges faced by central and commercial banks and the World Bank in developing or modernizing payment systems. The paper addresses the following questions:

1. What is a payment system?

2. What contributions can efficient payment systems make to the development of modem, market-based financial institutions and ma-kets?

3. What elements are necessary for payment systems to operate efficiently?

4. What are the operational characteristics of a modem payment system?

5. What is the Central Bank's role?

6. What problems do countries face when developing payment systems?

7. What is the World Bank approach to selected payment system initiatives and design and implementation?

# 1. What is a payment system?

A payment system is actually quite simple: it defines the procedures, rules, standards and instruments used to exchange fiancial value between two parties discharging an obligation. Although the purpose is simple, payment systems evolve over a period of years. The different conditions in each country (size, legal systems, business practices, communications, infrastructure, stages of development of insruments and institutions) make each payment system unique. Therefore, it is impossible to use one country's payment system as the sole model to be copied in emerging countries.

Emerging economies (former socialist republics or FSRs) do not have to "re-invent the wheel" to develop their own payment systems. They can adapt successful systems and practices from more developed countries to suit their own needs. Emerging countries can leam from the mmisukes made in other countries and avoid them by introducing preventive measures early in the development process. What are the key attributes of a successful payment system?

Payment transactions have two parts- the flow of information providing payment instructions and the flow of funds. These two flows are always related, but may follow different paths and have different timings. Each payment transaction has four .common elements: an obligation to discharge; a party to make the payment (payer) and a party to receive the payment (payee); a payment instrument, such as cash or a check, to corvey the information about the transactions; and one or more. financial intermediari'rs (usually banks) to transfer the value by drawing funds from the payer's account depositing funds intu de payee's account. Sometimes a third party (the central bank or a settlement bank) facilitates exchanges of value between the two participants banks. Each transaction has different requirements depending upon the customers (consumers or businesses), the natare of the financial obligation (bill payment or purchase at the point of sale) and the speed, security and cost required for the transaction. Developed countries (and many emerging ones) use several different payment instruments
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## and processing systems to satisfy the country's payment system needs.

Since either party in a transaction can be the payee or the payer, payment types are usually depicted by the following matrix: <!-- Start of picture text -->
- ~~~~~~iacil<br>Payee/Payer  Conesner  Business  Goveenuewt  Institutions<br>Cosmer<br>Business<br>Govrnment<br>Financial Instition<br><!-- End of picture text -->

# Payment Instrnmets

Each payment tanaction requires some form of payment instrument to supply.the term and conditions for the transaction. Each payment instrument must meet physical, legal and regulatory standards. Some of the-principal payment insnnents are descrbed below .Cash is the -simplest example of a payment, instrument. Cash is still used for most payment transactions (in number, not in value) in developed countries. The physical standards to protect cash from fogery vary by ouny and might have the following features: unique size and color, denomination, special paper and security features (k wateark, security thread, latent image, microtext, see-trough features,.silver-lustrous surface, protective line structures). The legal and regulatory-standards include bacding from the governent, conve-tbility into other cuecies and transferability to other parties. Because cash is transferable at full face value (within its country of issue), it discharges an obligation between two parties without futher action.

Nonpayme requiire the use of one or more banks to complete a transaction. Non-ch paynents are not accomplishedr merely by exchanging the payment instument between payer and payee, but by transferring deposit money between the payer's bank and the payee's bankY Noncash payment.instruments provide the mechanism for this bank-to-bank transferY Non-cash payment instruments, such as checks, must specify the payment amount, the names of the payer and the payee and their banks. Unlike cash, -non-as payment transactions have two process flows: the flow of the physical instrum t and the flow of funds. These two. flows can differ in timing and direction. Each payment instirment carries its own set of standards for the timmg and direction of the payment.

? _This ."clearing falcon include depositng, sorting, presenme and isecton. - This ¶selntlhentfzion consist of thie rafer of "good and final flids" to discharge the obligation._
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# Payment instruments can vary by:

<!-- Start of picture text --> PEsment Flow Patment Media Process Flow Settlement<br>Debit Paper Batch Immediate<br>Credit Electronic On-Line . Provisional<br>Telecommunications Net<br>Plastic Card Gross<br><!-- End of picture text --> These payment instruments can be combined to meet the users' needs. For example, time-critical payment applications require electronic media processed on-line. If the time-critical applicition transfers high value payments, the system is generally credit based and settled on a transaction-by-transaction (gross settlement) basis to provide immediate finality to minimize credit risk. Less time-critical applications may be processed in batches in paperbor electronic form to minimize costs.

c iaper-based -payments, such as checks or payment orders are processed manually or contain chine readable caracters for-high speed computer processing. The advantages of paper payments are that they do. not require the initiator to have access to a computer and they provide documentary evidence of proof of payment. The major disadvantage of paper payments is that they require physical handling and transportation to enable the exchange between the payer's and the payee's banks. This generally makes paper payments more cosdy and more time consumig than other payment instwets.

**Elecroic-** payments are instructions passed between banks without reliance on paper processing or shipment. These systems are ideal for high volume, repetitive payments such as wage and utility bills and for moving large; time sensitive payments. Electronic payments are not always cost effective for high volume, low value payments that are not time sensitive, particularly in emerging countries with limnited access to technology.

Card-based payments are used for consmer payments made at the point of sale (POS). Examples of card payments are ATM cards, credit cards and debit cards. The magnetic stripes on the back of the plastic cards provide information about the cardholder for security and processing efficiency. Teblmically, the credit card is not a consumer payment instrnuent. The consumer does not transmit funds when the credit card is used. The credit card transaction triggers a payment to the merchant supplying the service to the consumer. The consumer pays the bill later by another instrument, usually a check.

- There are-two types of payment flows debit and credit. In a credit transaction, the transaction and the payment flow through the banldng system in the same direction. An example of a credit transaction is direct payroll deposit. In a direct deposit transaction, the payment instrument flows from the paying corporation to the paying bank to the payee's bank to the payee. The flow of fimds follows the same path.

In a debit (cbeck) payment the check flows through the banking system from the payee to the payee's bank to the payer. The flow of funds moves in the opposite direction from the transaction.
-4 -

From a credit risk standpoint, the credit payment is generally superior because funding can be verified before the transaction is initiated (funds are in the customer's account before the payment is made). However, from a convenience standpoint, a debit transaction may be preferable in certain cases. All developed countries use a mix of debit and credit payments. In general, credit payments have increased in usage because they eliminate the risk of a payment made against insufficient funds and the cost and time delay that a returning for insufficient fund payment would entail. This is particularly important for high volume payments, for which almost all countries are using a credit transfer system.

Payment processing methodologies fall into two broad classes. On-line processing accesses the customer account for each transaction when the payment is processed making the entries to the customer account simultaneous with the processing of the transaction. Batch processing groups transactions and makes the posting to the custom account at a later time.

On-line processing tends to reduce the risk of payment failures and increases the speed of payments. However, on-line systems tend to be more expensive for high volume applications because each transaction is handled individually, rather than in bulk. On-line systems require sophisticated data communications, which can be a problem if a country's telecommunications -infrastructure is inefficient and unreliable.

Settlement finality (immediate or provisional) refers to the method and timing by which settlement takes place. Payments can carry immediate finality; that is, the funds are immediately and irrevocably available to the customer or the fumds can be provisional until a later date. Provisional payments are generally used with batch processing or with debit payments to allow time to confirm funding. mmediate payments are used most often with credit payments when the-funding can be validated before the transaction.

Immediate finality payments present less credit risk to the payer and payee, but more risk to the banking industry. Settlement is guaranteed with little opportnity for verification because of the speed at which these transactions take place. Notwithstanding the risk, immediate finality is a viruala requirement for high value systems where the ability to transfer (and retransfer) fluds rapidly is a necessity.

# 2. What contnrbutions can efficient systems make to the development of modern, market-based financial istitutiLons and markets?

There are many reasons why an efficient payment system is necessary in advanced and emerging countries: Promotion of economic adtivity. Payment systens promote economic activity, particularly domestic and international<sup>5</sup> ' commerce and trade. Without reliable, efficient and timely payment systems, companies cannot conveniently acquire raw materials, pay wages and promote economic growth. Payment delays (called debit or credit float) increase intermediation costs and reduce economic welfare. The problems increase if the country experiences high inflation. Tfhe more funds are tied up in clearing and settlement, the less funds are available for productive use.

_The discssion ofinter-republicanpaynusfas ouside die scope of thispaper._
_-5-_ Improved control of monetary aggregates. Large and unpredictable float levels (which add or subtract reserve money) influence short-term liquidity in the economy and introduce additional uncertainty in controlling monetary aggregates. Many countries counter the lack of available financial resources by printing more money, which leads to higher inflation and large swings in the money supply. An ideal payment system would mininnize delays (within economic reason) in the transfer of funds. The ability of central banks to manage and enforce reserve requirements efficiently and use indirect policy instruments to conduct monetary policy (through open market operations) depends on a nationwide integrated and reliable payment system.

Reduced transaction costs. Efficient payment systems minimize transaction costs. An expensive payment system only drains resources from more productive use. Thus the development of a national payment system must consider the total cost of labor and capital to operate the system.5 Capital resources in emerging economies usually have a higher oppormnity cost than in developed economies because of the scarcity of capital and hard currency. On the other hand, labor is plentiful and inexpensive in many emerging economies. Thus a nation's payment syste **r** 3_st be subjected to a costbenefit test. State of the art systems are not always the optimal solution, particularly in emerging economies.

Economists address the importance of an efficient payment system from two different perspectives and levels of aggregation. At the macroeconomic level their concern is the relationship between the payment system's efficiency (reflected in the velocity of the circulation of money) and the supply of money for a given level of aggrgate economic activity.- At the microeconomic level, economists look at the efficiency of the payment system indirecty as part of their broader interest in the welfare losses resulting from higher transaction costs (appendix 1).

Credit risk control. Unless the transfer of value is complete in a reasonably short time, outstanding obligations expose counterparties to the failure of others. An efficient payment system, which includes codified user rights and responsibilities, can reduce banldng and commercial risk.

Financial sector development The payment system is a basic component for a country's financial sector infrastructure and can facilitate the development of new financial instruments, products, institutions and markets such as debt and equity markets. This is particularly true for former communist countries where government ownership of businesses obviated the need for efficient payment systems.

Security and reliabSilty. Emerging countries (and developed ones) can be skeptical about new technologies and lack faith in financial instruments other than cash. New systems (non-cash or cash) must win the user's confidence by being dependable and reliable. Consumers must be protected against unauthorized access and fraud.

Products. An efficient payment system not only opens the door to increased competition through better service and cheaper transaction costs, but enables financial institutions to develop new products (card-based consumer systems, bank remittances) which can become important sources of fee income. The efficien **t** ransfer of funds combined with increased competition would eliminate or greatly reduce the incentive baniks in many transitional socialist economies have to delay payments and follow other rent-seeling behavior detrimental to the users of financial services.

_5 In many coounries, engraving and currency handling costs can be high. As a nation's payme system evolves, its reliance on cash as a payment instnrumen lessens._
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Institutions. Given how weak intrabank payment systems are in many emerging countries and socialist economies in transition, banks cannot manage their treasury operatiois efficiently. For example, bank branches must post reserve requirements in innumerable correspondent accounts at the central bank regional offices, creadng nightmarish management problems for the head offices ofthe central and commercial banks. Banks cannot compensate for excess liquidity in a branch with deficiencies in other branches.

Markets. An efficient payment system supports privatization efforts. It provides impetus to the development of the interbank and money markets facilitating the transfer of funds across highly comparunentalized economies (region and sectoral). These markets will improve monetary control, develop open market operations and rationalize liquidity and treasury management across the economy and institutions. A payment system would help develop the capital market and the Government Securities market. Money, bond and equity markets will benefit from a modem, reliable paymmt system. Business privatization requires that payment for goods and services be made promptly and accurately to enable them to operate profitably.

# 3. What elements are necessary for payment systems to operate efficiently?

Payment speed. Each payment need not be transferred between payee and payer instantaneously. While modem technology would permit such rapid movement, it would be cost prohibitive to move all payments in this way. Even in developed countries, few time critical payments are made in real time. However, the problem in many underdeveloped counties is that payments may take as long as 30 days to be made. These delays create uncertainty about the eventual completion of the transfer (risk), and limit the beneficiaries' ability to reinvest the funds in raw materials and capital expansion.

In developing a national payment system, final payment transfers must occur in no more than 3 **to** 5 days to make routine payment between two parties within the country. The system should transfer tine critical (often high value) payments no later than the same day.

Payment certainty. Users must be confident that once a payment has been initiated, it will be completed to the right party for the correct amount within a prescribed time. If users are not confident about the certainty of final payment, they will continue to use cash to make payments or demand cash for receipt of payments, rather than use non-cash payment instruments.

Payment certainty requires a structured operating capability with good controls. It needs rules and regulations governing not only the basic payment flows, but the resolution of errors and disputes. Finally, it requires an oversight body (the central bank or bank consortium) to enforce rules and resolve disputes between payment system providers.

Reiability. The systen must be reliable to obtain and retain user confidence. No system will operate as designed all the time, but it must have adeqate contingency provisions and controls to ensure reasonable access to historical records for audit trail. Systems must be designed with adequate back up capabilities if one or more major processing stations fail. This is critical in emerging countries where the reliability of basic infastructure needs (electricity, telecommunications, transportation for workers and physical documents and technical maintenance staff) may not reach developed country standards.
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# Safety and Security

Eraud control. The system must be designed with adequate controls to ensure against unauthorized access or tampering with payment system data. This requires the ability to identify the payee and payer properly and to ensure that amounts or beneficiaries of transfers cannot be altered to the benefit of either party to the transaction or to a third party.

Credit risk control. Payments systems move funds between two parties, often without the receiving party knowing whether the funds exist in the payer's bank. This creates credit risk between the two parties to the transaction, between the two banks and, perhaps, between the central bank and one or more banks. Credit risks should be understood and managed (if not eliminated) for each transaction.

Confidentiality. Payment system users must be confiden **t** hat their payment system data will not be available to unauthorized sources. Data should be protected from access during the transaction and after the payment is processed.

Record **maintenance.** Each party to a payment transaction must be able to prove their role in the transaction to prove payment has been made and provide tax information. The integrity of transaction records must be maitained, and te time frame for record retention must balance cost and access requirements.

### Convenience

The payment system must be convenient for users or they will use cash or other instruments. If the system requires automation for each participant or it requires one or more bank visits each time a payment is made, it may not be usable in developing countries.

### aosts

The design must be the lowest cost to all using parties subject limits on speed, certainty, reliability, safety and convenience and not just the lowest cost. These competing considerations lead to multiple systems to respond to the differen **t** ransaction needs. For example, a system for handling time critical, high value payment requires greater speed and security (at a higher cost) than a system for handling bill payments. It is often cheaper to develop multiple systems than to try to use the most functional system for each payment, regardless of need.

In emerging countries, these elements of an efficient payment system tend to be incomplete in one or more critical ways, be they too slow, lack certainty and reliability and/or have significant security and risk problems. In responding to these inadequacies may need short-term fixes to the current payment system to deal with the most serious problems before an entirely new system, which may take years to implement, is operational.

## 4. What are the operational **chara** of a modem payment system?

The foUowing elements are all necessary processing activities in a modem payment system: Originator processing. The originating bank receives payment instructions (debit or
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credit) from its customer and performs certain basic functions, regardless of the type of payment. The bank must verify the customer's and the item's authenticity, post the transaction to the customer's account (debit the customer's account for a credit item, credit for a debit item) and set up the appropriate offsetting accounting entry to the counterpart bank or clearing agent. The bank must sort the item by clearing agent and transport the item to the clearinghouse. The transpiortation can be physical for paper payments or telecommunications for electronic items. If items are sent in batches, a covering paper or electronic transmittal register provides control totals and listings for account reconciliation. With electronic items, security precautions must be taken to prevent access or alteration of the data. The originating bank must also establish archival records of the transactions for account reconciliation.

Clearing. Clearing includes the physical exchange of payinent instruments between the payer's bank and the payee's bank (or their agents). Clearing process can be centralized in a clearinghouse (participants exchange payment instruments among themselves on a multilateral basis). Alternatively, the clearing can be distributed (the originating and receiving banks deal directly with each other on a pair wise basis (bilateral clearing).

Clearinghouses simplify the exchange process.6 For paper payments (checks) there may be multiple clearinghouses, one in each major city within the country to minimize the document shipping time and costs. Electronic payments may be subject to a single nationwide clearinghouse or many geographic or competitive clearinghouses. Because payments (consumer payments) occur within narrow geographic areas, paper items are often processed locally or regionally to avoid lengthy transportation delays to and from a central point, or to reduce message traffic and telecommunications costs for electronic payments. Settlement. The setlement process transfers the transaction value between the originating and the receiving banks. To settle payment transactions, the two participating banks must have account relationships with each other, or each must have accounts with a comnon third party. Transaction accounts at banks on behalf of banks are called correspondent accounts or clearing accounts. If Bank A presents $100 in debit payment items to Bank B, and Bank A holds an account with Bank B, Bank B would credit A's account for $100 to setfle the item.

Pair wise settlement is cumbersome and can lead to systemic risk in the country's banking system. For example, if a country has 10 banks, and each bank holds a correspondent account with the other banks, a minimmn of 45 account relationships would be required.<sup>2</sup> ' This distributed settlement is operationally inefficient, requires large balances to be held until settlenent and can lead to systemic risk if a principal correspondent bank fails and cannot repay correspondent balances to the other banks.

Centralized settlement is often used for all or part of a country's payment settlements.

- _a A clearinghouse is an institaion established by a group of banlcs (with or. without the central bank's participation) to settle obligations. Each bank settles its obligations by paying the clearinghouse for the net amount owed to the rest of the members._

- _" To calcuate the number of permutions (P) of r objectsfrom a collecion of size n, denoted as P (r,n)_ = _[n! / (n-rJI!, where nI denotes a factorial fnr'= n. (n-I). (n-2) .... 2.11. Ifte order of selection is importan_ **_t_** _hen P (2, 10) = 10!1(10-2)! = 101/81= 90 (0 correspondent accounts would be required). However, if the order of selection is not importnt then there are r! ways to order r objects and the number of combinations (C) of r objects taken from n objects C (r, n) =ln/fr! (n-rJ]_ = _P (r, n)/ rI = 9012 = 45._
-9-

Under a centralized settlement operation, all banks maintain a clearing account with one bank. The settlement bank processes the settlement transactions between the originator and the receiver on its books. In the 10 bank example using centralized settlement, ten accounts rather than 45 would be requireclW and less money would be required for settlement because liquidity would be less fragmented. Centralized settlement has operational and liquidity advantages over distributed settlement. However, if the single settlement agent is a commercial bank, centralized settlement will increase the systemic risk of bank failure over a distributed system.

In most developed countries, the nation's central bank serves as the primary settlement agent for payment transactions. The central bank provides the operational and liquidity advantages of centralized settlement. Because the central bank cannot fail (unless the government fails), no systemic risk is inherent in central bank clearing balances. In most countries, banks and other financial institutions are required to hold balances with the central bank for monetary policy, liquidity, safety and soundness. Using these balances for settlement allows them to perform double duty, and minimizes the financial resources tied up in payment processing.

Central bank settlement can take place in one of two forms. Gross settlement happens when each item is settled separately. Net settlement happens when exchanged values are netted between participants and the residual balance is settled in the central bank's books. For example, assume three banks exchange payment and each has a single $100 debit against the other two banks. In a gross settlement, each bank would make four settlement entries - two $100 debits and two $100 credits or 12 entries in total. A net settlement would calculate each bank's single net position with the settlement agent and post a single entry (in this case zero) for each participant. This is also known as multilateral netting, an arrangement between three or more parties in which each member makes payments to a clearinghouse for the net payments due to the other members and receives the net amounts due from the other members from the clearinghouse. Multilateral netting has significant cost advantages over gross or even bilateral netting, but contains greater legal uncertainty in the case of failure of one of the settling participants.

Receiver processing. The receiving bank performs several tasks to complete the payment transaction. The bank must post the item to the receiving customer's bank account (credit to account for a credit item; debit to account for a debit item). The bank may have a requirement to notify the customer of the payment by phone, mail or regular periodic statement. The payment instrument (e.g. check) may accompany this notification. The receiver may have requirements to verify the item's authenticity (signature verification) before posting, verify the availability of funds (for a debit item) and archive the payment transaction record for reconciliation and error resolution.

The receiver may be the bank branch where the receiving customer has an account, any branch of that bank, or the bank's central or regional processing center. The receiver's physical location often depends upon automation within the bank and the presentment rules within the country.

Clearing and settlement must be organized cooperatively within the nation's banking industry, striking a difficult balance between cooperation and competition. Banks compete for customers based upon how they differentiate their originator and receiver processing. Payment instumments clearing and settlement standards and rules must be developed in concert. The embryonic state of development of private financial intermediaries in most transitional socialist economies argue strongly for the central bank to take a leadership role in payment system design and development. In more advanced market ' _C_ **_(r,_** _n) = lO!I,fl) (1lflJ10= ! = 10._
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_Tv.es of Paymert Systems in Mature Marker Econo:ies Bs 1 In mostdevefopedcounfrics, thes_ **_e_** _lements havebeen combinednhouseveralsystems, each sat Lingaparpieuarpoymetsystem need.. .- hep icipalpayment systems: T: are;..: * Ppeir BsBohSystem_ -,.~~~~~~~~~~~~~~ - _~Even_ **~** ~~~~ _given toay's mdem_ ~~~~~~~~~~~~~~~~~~~~ .. _itechnology,_ ;--... - _vinail.every'deve.lppedemmasill_ ..... _rleshavl on a paperbseddeblqcheek) spits. Ozetkvwne rangesfrom about 10% of all ashlaspamwen tnsaatons (i -Grmany and Sw: -;. erladtooerS0% -USA,Canada Frincaind.I an opse r n cntr :. -ab;o have apjpa_ **_-_** _-* aederedir:syte,n.(Giro which accm duta sig4ctpofionfpaymettranations. As tchnology-: ad--w ncshave permwted: some oslietormerl:.paper, trs to en c to elc, bsthe iget . influience -. ofteclologyhas beentoimproethe costandspedof processgpaperbdedisemas, rather t replcin oha -p s * .':-.' '.' ' a#'elcrnc.'- Ths L tnte for.,two .pr,uincereasns ,,, p'ebae pamns are g;nel thems ovnett orignorsospapers edpaymendo norequirehe originatorto be ausoinared. Thus, while lae businesssares now sil'.y '- able o origine 't" e-trrops and"mostcf ersarenot. Seco rmany ppcaons, most * notabl''-'--y checks, paperc items(conrainingshei-ongin:tosnature) provide grt tan eetronipaymen.P *.'- based: eectiprocessing.; credits, whichcnbes ec .. In . any eld ' signa v caia the orignatban, the samiese6 ogfr armc procasi reana ng paper debit and credite ets on and_ -: Y . -. . - :- .. _'tets nd_ . _heytheefoe crnbe considered_ . . : . . . . . .. .. _partof one_ . _-system._ ._ _.........................................................-f--, . .. . . .. . ...... ........... . - - i _Sertlement for. pper-based kewms isu..sually provisional and settled through clearing accounts held ar the central. or . - .... .correspondewcommercial boats. Cleanrnghouseypemrse in many deveped countr.es, whh: seikment. rakingpla-ce on a:nosr> * basi aythrough thecenltral bank. . . * * fleerene Batch Systems-I:n the last ten year or so, many formerlj pqper-based itms have been convernedto eectronic. payments. T7hese-baschedelearonicpaymerdsystems, often:referredro asautmared dearing houses e4s 1 are .p . directedebits and crediii, recurumispaymenu. truncared (naperitens convenedto electronicdte capturewish paper n :' : ' credisperymentssand orporatepoymners.' in coneepr;thesel_ **_e_** _ct s.stins ore very sitniaareto _ _r'.',rii except shot elictronic processing rkplacespaper-basedprocessing. and rtlecomunmications usuallyh but nor , e ',physical deliver. Setilement re andflniry for these systemsare verysimilar to paper systems.., , High. Valuer. ( e E Ciial)'Systems: Av,firandal markes mu re and technolog permits. "high volue.popmMtsy8sesrare: being implemented in many developedcountries. '7heuse of the term 'high value" is jsmewhata is)coding as the tr of these systems is speed reherthan rhe value.- Thesehigh.valuesys.temsare desifgnedro accomuowdasepayments that requisa .. .day trfsmisnon. settle fnaty.: Usually, thesesyste.s aeprocessedas ira Ioineopplicttionsrath_ - _* ''=.r cnsrod a rinsktrhcyaregenmrayiristrictedroacrd menzta areseated on a gr-assthraghs sckntrat nation -bankt Because sof he needfortt o hw:tehighest yer:sransacswn'cosboflnty *pymenrsystem. Thesehigher coss tend to restric c to trualytin.sensinvetranacts, 'ich are of hi hi value. Ewamples ofpayrents requiring this capabiliy arefnspurchasedto covrpotenal rshe -purchase and/orreturn offndi investedin overidghA or.other-owney marlcesfor cash.nmangementpurposes: orther.ateri. J:uudfibr JAr.edia yemnt,esuchas ro oseon-ainaionrac.In addiion thesesystim' often :supportthset.ein if transacions inade acr7ss otr noneialuwrkets. such as Siockor Money markets. These markets are oflenvis evelopmet oft_ *:~~~~~# _cou nt -u_ - * _::d. t there ore.'so ti the developmentof es orng paym rysuem_ pqynww........ **.** - ;''-i-i;e-'..... _:')._ .. . _-' .. ' Card-Bused (Consumer) Systems - Te,inat signficantcprywmt s;ystem is escard-based sstem usedforcredi 't-. , -Sale POS) debit cardstand AsomnaedTeller Madine (ATM) transacrions. These three appkicatianssho:f are many. .'-, fi cltud.gidcardobasdidecho ig nee foran .auth6iiisian systei to authenticarc the saer and wurtetrsacinand :' ' all low.trensactor. valuei-hich :reploed a c¢ash transactwn'. -Th;ere are also-seveal ;differencesetweennthesc appEcatians.. T'hemore sigo4tcar are:_ : . : .. .............. :.: . . . . .. : .................. : .: .. . .. ...... _Applications dor'al use h s se system :Card access devicei are notaiwaysidentical, Cardholder vication r-echniquaeareinotialrs: aenticalfeg., PIN numbers versus signature). -bdpias Despirt sk dfferences,- thebaisic requirenentsof_ **_a_** _lp rdlae onn and sysem needs are simjiar sough o cnsader -,t,hem one s,ystei Becausethese systems all involv the exchange of imniediosvazforrhe traentact:on ficash oAT{REs; kobds . .orsrdce far redit an dei rdit birisvital i oanidationrcepuaceenarealtmebasis. disrequiremet_ * . -.. _mdI c:Ude:of Oa real timet authorizsaiosystem essential, aiougli etl cu 63.carand ofern does .rakepace aft-rhsleact._ _ckirngacootav'ift_
0 ~~~~- **il.** economies opportunities for reducing transaction costs or risks are often identified by private participants in the payment system. Professional organizations can discuss transaction costs and recommend changes in current practices and systems to the regulatory authorities. Central banks are generally the custodians and lenders of last resort in the payment system.

Nature of payments. Payments can be interbank (payee and payer use different banks), intrabank (payee and payer use different branches of the same bank) or on-us (payee and payer use same branch). Interbank payments are cleared and settled through the interbank clearing and settlement mechanism. That is, a third party or parties provide clearing and settlement functions. Intrabank payments are sometimes processed, cleared and settled through the single bank. The more concentrated the banking system, the higher the percentage of intrabank transfers.

The interbank system requires cooperation among all users. The systems are joindy owned by the nation's banks or the central bank. By definition, intrabank systens are owned by the individual banks.- The banlcing industry must develop and invest in both interbank and intrabank payment systems to serve the customer needs for payment services.

# _5._ What is the Central Bank's **_Role?!'_**

The nation's central bank plays an important role in creating payments systems policies, coordinating regulations and standards and providing most of the nation's payment settlement services. Each central bank plays a different role in the degree to which it provides payment services other than settlements. In some-countries, the central bank is an active provider of payment services, often competing with the commercial banking industry (U.S., Germany, and Japan). In other countries, the central bank plays almost no operational role (U.K.). The central bank has a legitimate and important role in guaranteeing the safety, soundness, efficiency and fainess of the payment systemrn' The central bank as the lender of last resort mustthave the information and the means to oversee and, if necessary, assist the institutions participating in the payments system. Given the central bank's roles and its special responsibility to aLvoid systemic risk, any large-value payment mechanism requires the central bank's particular attention.

Central banks in transitional socialist economies and many developing countries have more responsibilities than central banks in market economies in- leading and coordinating payment-system reforms. Although the central bank's involvement in the operation system varies from country to country depending on the strength of its commercial banks, the central bank must play an entrepreneurial or facilitating role in all aspects of payment systems design and development."' The central bank's

- **!'** _Summers, Bruce. 1991. "Cearing and Payment Systems: 7he Role of the Central Bank", Federal Reserve Bulletin Washington D.C. pp. 81-91._

- A/ _Hook, Andrew T. 1992. 'Managing Paomt System Risk During the Transition from a Centrally Planned to a Market EConomy", IMF Worainz Papers, WP/92/95_

- _.1"In most cases, the long-tern scale nature of the transition to a mar*et-oriented system, the scarcity of resources_

- _in both public and private sectors, the shortages of skled personnel, lack of expeience in the private sector, and the potential costs of lagging behind other aspects of the reforms all support a major role for the central bank", on.dt., page 14. We could add two needs: to borrow from internationalfinancial instutions (Fks)_
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leadership in payment system development does not automatically qualify it to play the role of payment system operator. In some instances, the central bank might become part of the problem, rather than part of the solution when the bank ignores users' needs or adopts heavy-handed, top-down approaches with limited or no commercial bank participation.

An important component of the central bank's leading role is to create an organizational structure to coalesce domestic and external actors, functions and interests. This is critical for socialist economies in transition, given their history of severe compartmentalization in a centrally planned economy (CPE), top-down commands and poor cooperation among different agencies and different departments of the same agency or institution. The central bank must take the initiative and set up a national payments council (NPC) to lead payment systems reform. The NPC must:

- (i) be a forum (talking shop) for the central and commercial banks to discuss and agree on how to establish and oversee the functioning of the national payment system and how to coordinate cental and commercial banks' policies in the payment system (the harmonious development of inter and intrabank payment systems);

- (ii) channel and absorb external technical assistance.

A sample organizational structure and a charter outline for a hypothetical NPC are shown in chart 1 and in box 1. Each country might develop its own structure based upon its banking structure and capabilities.

_and to coordinate the necessary specalized tednical assistance which ai not avilable in nost countries._
<!-- Start of picture text -->
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<!-- Start of picture text --> CHART 1<br>NATIONAL PAYMENTS COUNCIL (NPC1<br>(Sample Organizational Structure)<br>NPC BOARD<br>CHAIRXW (CB)<br>EXECUTIVE DIRECTOR<br>............... ... CONSULTANT<br>(Full Time)<br>CB STAPF<br>(Full Time)<br>LEGAL AIWOPRTOSATOAINTIMM<br>REGULATORY CDTE omTE COMMITTEE IRNTE<br>CB CHAIRMA CO CRMAN CO CHAIRN CB CHAIR<br>-NPC RULES -INSTRNTS -HARDWAE -DOC<br>STANDARDS<br>-REGULATIONS ACCOUNING SOFTWARE -FORTS PAPER<br>STANDARDS & ELECTRONIC<br>CLEARINGHOUSE RULES -TRANSPORTATION TELECOM -TELECOM<br>PROTOCOLS<br>ACCESS SERVICES ELECTRONIC<br>MEDIA<br>LEGAL FRAMEWORK SECURITY<br><!-- End of picture text -->

**Note:** CB = Central Bank, and CO = Commercial Bank

The allocation of the Chair of the proposed Committees to CB or CO can vary from country to country.
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# NATIONAL PAYMENTS COUNCIL (Sample Charter)

Two classes of.membership will be open to all financial depository institutions: o **Fuji** Membership for the central bank, large (often state-owned) commercial banks, and savings banks and other significanit fiancial. depositories. Full members must originate or receive., more than a prescribed percentage (3%) of the paymentsvolume-or. value in the previous year. The:prescribed percentage limts the number of full members to between 7 and 10.

o Associate Membership for all other financial institutions.

*Governance. A Boaidlof Directors will govern the NPC. Permanent directors-will represent the centralbank,. the large-commercial banks, the savings bank, the Bankers-Asociation and other financial depositories and:* banks. Each board member.will have one vote. -The central bank wil- have veto power over the NPC's * decisions on nrles andregulations,the safety. and-soundness of the payment system and coi equaiity.

:- The associate members will elect directors eachyear for rotating two-year terms.. Directorsnmust be-governors -or deputy governors-fom. the d central bank and presidents, chairmen, vice-chairmen or -s-enorpolicy makers fr;om -commercial and- savings- banks-..

- s **.** ...-i ~~~~~~~~~~~~~~~~. . 'The board will appoint affull-timne Exetive Director.to'serve:as Staff Director and: Secretariat.- The exive director will-select and man-age -tm staff support the foreign c'-andlia with-esys 's *-partcipants. Other responsibiities includee'stablishinig an- anrnual: budget, o. commiat " ..-. arangng'boar and committemeetin s, - reglar ti.A core pof ful-tim'estaff 'wil coordinate.the work- performedy the C'-s. committees and senor stffothbgingsector.-

-Committees andSu-bcommxittees The.PC.wlLmintanforp..erm Ruiles andre-.gulationsoperanGins .-0 of S @-~~.Rul .. e a . f 0., - **--** -.. . .. . . -' **.** .. . . -:

e t co'i:e-es: o -Standards... -~ ~ ~ ~~ ~~~po - ;-:: to eachi::':'':---" ' -s A f -;=br. a- -:'-:: Each: ful memberw appoitone '' e t eto each committee. f: ors'.a 'p . - ..appointno less- thanone an-no.mor th.an-three rcpresentativestoecwh-' committee.Committee.nmbers 'must be senior, full-time bank empl-oyees wi direct reSpnibilities for in witn -tir baks-. If the: comittee member cannot attenda: me'eting, adiepty -repo dtingdirecly -'tote'h' c mieeer: may represent the institution.... - nay -t-t em son;. **..........** s **.** t5'- **: --** ~ ---0:; ' **...** ; **-** g **.** -. ... **. .** . f . .. **.** ... **..** ...

The central bank .vilL -:. chair the fl - Regulatidsn S:ta r committees. Ful m be will-; chr -ft. Operations and .Automationcomnumttees.--Chais willrepresent commercialp bk&afnd v'ill serve te-m-- ofuot .less thanone:yeao more **r** t thre years. -C ommittees 'ayrebcomt es-- -to snical miatters.... :: es. -0-- E -ff :-: -*; ::-- - :' - - ' t 5 - 0-' fSftf f 5 f S -- --- --f..

**UsrOrientatin. -Regulators.u.sers:and picti'pants:coor** tenys i in o -' Arrngements **ar-** more or le **o-5untryfo"** c - **-- orgaiizatioiL** may-be ai **eisting** htitutiin, such as -the N **atiol oinersion'** o r istitution **crtffie .s;pedifical1y to perform** -. to p 0:fi O **tis** ucin I .- 0~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~..... -

; t f~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

- . = .2.- . .: =: < xx=r **:- ..-=:** Sv{ **. ...:-** - **::** : **.** ...--: **;** .::-- .- **...** -: .... **.: -=.** . : **..** : :. **.** . **.** - **.** f:.::::.-
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Payment System Oversight. An efficient payment system requires the cooperation of all banks and their customers and an effective means of providing payment system governance. Governance must address these issues:

- Who provides prudential oversight to ensure the system's safety and soundness, including the standards for credit and liquidity risk?

- Who establishes the rules to ensure equitable access and conformity of interest among the participants?

- Who establishes the standards to permit the free exchange of payment data between participants?

- Who sets the financial terms to ensure that the system recovers capital and operation costs.

In most countries, the central bank and the commercial banks (or one or more commercial bank consortiums) define or provide oversight. No single commercial bank can provide oversight for competitive reasons.

Payment Systems Organization and Cost Recovery. Interbank payment systems can be organized in several different ways. Some methods differ by country; most countries employ several methods. Cooperative ventures between commercial banks and the central bank are needed to establish common nrles, formats and instruments. However, it is also common for large commercial banks to operate within a segment of the payment system for smaller, downstream correspondent banks.

A coordinating body provides governance. In-some-countries (Canada and the U.K.), the coordinaing body provides guidance for nrles and standards and operates the interbank system. In this model, the largest banks have equity ownership in the association and receive voting rights in return. Users may pay for services on a per usage (item fees) basis or annual assessment basis (often tied to prior year usage).

A second model establishes local associations (clearinghouses) to set- collection rules and procedures for the local area. Most payments tend to be cleared witbin a local commercial zone, although this is less true for commercial than for consumer payments. The organization and funding for local clearinghouses tends to be similar to national associations.

In the third model, the central bank operates a payment system (often in competition with the private sector.) Eligible fiancial depository institutions participate oay fees based on usage only (no outside equity partners). The method of establishing these fees varie. iom full cost recovery to partial subsidization.

The fourth model is the correspondent bank payment system. A large bank provides payment services (subject to rules and standards) to smaller banks. The correspondent bank provides such services to fully utilize capacity obtained for in-house purposes. The costs are usually recovered through item fees or compensating balance requirements.
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## 6. What problems do countries face when developing payment systems?

In developed countries, most recent payment system initiatives were built upon a mature base. Users and suppliers had non-cash payment system expertise and an infrastructure to support noncash payments. Interbank decision making bodies reviewed the practicality and acceptability of payment system initiatives. Mature accounting and intrabank settlement systems post customer accounts across branches of the same bank and with the Central Bank.

These conditions do not exist in many emerging countries. Although emerging countries may want to leapfrog past early developed country efforts into state of the art systems, the rapid change may not be practical from a financial, institutional or human resource standpoint. Early efforts in developing and transitional socialist economies should be implementable and practical. Once the initial efforts are in place and the country has a base of knowledge upon which to build, rapid advancement may be feasible. The critical payment design issue facing emerging countries is to identify the most important payment applications and develop a system that can be easily installed and used in commercial banks and central banks.

The most important payment application in most developing countries is the processing of commercial,payments for the purchase and sale of goods and services between two businesses because of trade's importance to economic development and because of the high dollar value of such transactions (compared to consumer payments). The second most important application is a time critical payment system to make large value transfers within minutes. A time critical funds transfer system becomes necessary for banks to manage their settlement positions with other banks or the central bank.

# Payment Development Priority

<!-- Start of picture text --> Financial<br>PaveelPayer Consumer If Business Government Instittions<br>Consumer Low Medium Low Low<br>Business Medium High Medium Medium.<br>Government Low Medium Low Low/Medium<br>Financial Institution Low Medium Medium Rgh<br><!-- End of picture text --> _1I Cash may satisfy the payment needs of most, if nor all, consumer payments in emerging economies. NOTE: These pnonties may vay slightly by countrv._ Other conditions that effect the payment system design in underdeveloped countries are:

- the lower wage scale of emerging countries and the higher technology. costs in the cost/benefit analysis of automation

- the lack of broad-based consumer transaction accounts limits the immediate iced for
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consumer based payment systems such as credit cards, debit cards and ATMs

- the need for project management skills necessitates outside assistance to implement system initiatives, such as payments processing

- the need for laws and regulations for payment systems

- the need for internal accounting and operation systems to support the customer accounting component of payment systems

- the need to rationalize central bank settlement services, including accounts consolidation by geography or type of account.

Each problem requires a unique solution based upon the country's infrastructure and banking culture. Payment system solutions cannot be imported. They must be adapted to meet the local environment by experienced experts.

7. What is the World Bank approach to selected payment system design, implementation and initiatives?

Why is-the World Bank involved in payment systems modernization projects in emerging countries and socialist economies in transition? The value transferred through the payment system by a country's economic agents is really a reflection or the dual image of the activity taldng place in its economyAR' The bank has a mandate to promote economic developmenit and has taken keen intereSL in developing and modernizing the aspects of a country's infrastructure that promote faster, productivityenhancing economic growth. Removing the bottlenecks for financial sector development must be one of its priorities. The bank is interested in:

- the payment system as a public utility (with externalities resulting from increased speed, reliability and safety in the transfer of value);

- the potential rates of return resulting from sharp reductions in transaction costs and from drops in float levels and costly delays in the transfer of funds (particularly in hyperinflationary enviromnents), which can be achieved with modest investments and improvement in existing practices;

- the potential for developing less distorting and more efficient indirect policy instruments for macro-control (open market operations);

- the potential to receive World Bank loans to finance technical assistance (design work and other consulting services), training and capital investments (hardware and software) for inter and intrabank payment system development, and grant financing provided by donor countries and cofinancing from other IFIs; and

_2' As economic development proceeds Labor specialization creares new demands for the trasfer of value witain and among countries._
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- the development of the financial sector, payment instruments, institutions and markets (money and capital markets).

World Bank assistance for payment system development and bank automation has expanded rapidly in the last two or three years. A list of countries and loans granted or tentatively planned are included in table 1.
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# Table 1 WORLD BANK LENDING FOR PAYMENT SYSTEMS DEVELOPMENT AND BANK AUTOMATION

_(Millions of US$)_

|Country|TA/Design|Hardware<br>Payment Systems<br>(Interbank)|Bank<br>Automation<br>(Intrabank)|
|---|---|---|---|
|Africa:||||
|Angola (||1.00|35_r4_|
|Egypt~"'"l-||||
|<br>Ghana||3.50|4.5|
|Asia:||||
|China:||||
|Phase 1|2.50(1)|40.00||
|Phase II (7)<br>Viet Nam|1.01)M|200 - 400<br>25 - 30 w|300 - 500|
|Eastem Europe:||||
|Hungary|0.40|13.50|4.1 2<br>40.0|
|Poland|-|-|42.0|
|FSU:||||
|Kazakhstan|_A_<br>0.40|29.65|23.4|
|- Moldova|T.D.|T.D.|T.D.|
|Russia (e|1.54|200-250|250.0 m|
|Turkmenistan|-|7.00|-|
|Ukraine .|0.85|1.90_"4_||
|Uzbekistan|_OAO_|3.50|0.9"2|

Notes:

- (1) Grant

(2)O Cenfral Bank automation (3) For 36 commercial banks (probably cofinanced with EBRD).

(4) Could be increased through reallocation of IBL funds.

(5) Limited to a check clearing system.

(6) Includes support for intmabank systems. (P), Planned. (T) Tentative. Possibly cofinanced. 'F.D. To be determined. Note: IBRD provided consulting services for a program of payment system modemizabon to be implemented and linanced by donors.
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# The Bank's Approach to Payment Systems Development

Objectives. Financial sector technical assistance (TA) in most payment systems operations tries to develop the host country's human resources and institutional ability to reform its sectoral and institutional policies.<sup>1</sup> '3 The Bank's TA finances the transfer of services, klowledge, skills, equipment and technology. The outcomes of this assistance could help policymakers analyze policy options and implement and monitor sectoral strategies, improve project preparation and implementation, and strengthen the country's institutioml abilities within targeted institutions or throughout the sector. The Bank's TA is an important and sometimes necessary component for development. However, TA is not by itself sufficient. An enabling environment and a critical mass of self-reinforcing reforms is required to maximize the benefits of any TA. The borrowers and the implementing agencies' commitment to the objectives is essential for success.

Design and delivery modes. With a highly educated work force technical assistance provides temporary substitutes in selected areas. The country can develop new skills to work toward selfreliance. Countries do not need to reinvent the wheel. They can adapt successful systems for their own needs and avoid mistakes and costly misallocations of resources. On the other hand in designing payment system TA loans, the Bank should be realistic about the beneficiaries' absorptive capacity and phase the assistance pragmatically to attain the objectives identified and agreed between the country and the Bank.

The Bank's TA can be delivered by financing short and long-term advisers, training (study tours) and equipment. The Bank can finance technical services in the field from inter-disciplinary teams from international consulting fmns. Complementary support can come from a resident advisor (at the central bank) or periodic visits from specialists from other central banks (as members of IMF missions). The latter assistance can be most useful in the early phases of payment system projects. During implementation -phase the central bank staff from advanced market economies can advise the recipient central bank and provide quality control to test the solutions proposed by the external consultant. One successful example of this approach occurred in the China payment system project in the form of an international advisory panel (IAP).

Developing terms of reference (TORs) **and** a local project msanagement structure. Detailed draft TORs for the payment systems sub-components are needed during the early stage of loan processing. The recipient should agree on the content and scope of the proposed activities. This discussion takes place between the Bank's mission and the central bank. Before the Bank reaches final agreement with the Central Bank, the Central Bank collects the views of all the participants, particularly the commercial banks. The central bank appoints a qualified coordinator for the proposed loan to centralize the activities, make decisions and act as the central contact point for external consultants.

# Other orgaonal requirements. The Central Bank must agree on:

- criteria and selection procedures for consulting services

- procurement and reporting procedures

_See "OperationalDirective 8.40: Technical Assistance, Tlhe World Bank OperationalManual Washington D.C_
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- a tentative financial plan based on similar activities in other countries. Realistic budgeting for local expenses will guarantee smooth project implementation.

# * implementation procedures and project supervision.

The Bank's experience shows that successful project implementation depends on the borrower's commitment to the project objectives, the institutional and administrative arrangements put in place and the agencies' capacity to monitor progress and introduce early and mid-term corrections. TA is labor and knowledge intensive and the agencies should appoint qualified and dedicated project managers.

# Payment System Design

Most countries already use rudimentary payment systems. The country's starting conditions determine the design strategy, but the approach to modernizing the existing system raises some questions. Should the country patch-up the current system or develop a new system? Should the country use a state-of-the-art system or a more labor intensive (but more cost-effective) system? Although these questions are important they do not address the real problems. One possible answer is to introduce shortterm improvements in the current payment system until the "optimal" system is ready. The country's dilemma will be whether the short-term improvements move away from the (still unknown) optimal system or move the system development. toward the final design. This points to the need to develop a multi-tracked approach to payment system reform.

Cases. A simple example of a multi-tracked approach to payment system reform might look like this. Country 1 is willing and able to follow an orderly centralized (top-down) approach to payment system reform (China). Country 2 is less willing or able to follow a centralized approach because the economy is in crisis. Country 2's banks and payment systems initiatives are outside the central bank's control. The availability of automation skills and equipment suggest a sub-optimal, homegrown approach (Ukraine, Russia).Y' Country I might not need short-term solutions. The preferred approach might be to develop and test a new payment system and design an orderly migration plan. Country l's vision of how the system should look dominates and drives the central bank's efforts from the beginning. In Country 2 the short-term, emergency solutions -might outweigh the need for long-term improvements. The challenge is how to control the process so that the short-term improvements do n6t derail the long-term solution.

The Central Bank in Country 2 runs the risk of letting the immediate need become the enemy of long-term reform. The central bank's first priority should be to create breathing space - time for the central bank and other financial institutions to design and implement a long-term strategy.'<sup>5</sup> . The challenge for Country 2 is to design and control a consistent two-track approach (short-term improvements and long-term system design) to payment system reformAl _In which the system engineers seem to be in the driving seat._

- _5' Hook A.T. on.cir. page 18._

_L° See appendix 2 for sample terms of reference from a two-trackcpayment system modernization project in Ukraine._
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Phase 1: Taking stock. The first task is to take stock of the country's existing system and identify the main problems (see appendix 3). Table 2 contains a sample checklist of characteristics that _vwill_ affect the payment system's design. Many activities in Phase 1 might take no less than four to six months to complete. Two to three months after the project begins it might be feasible to identify the areas needing immediate improvement and the remedial actions required.-'L The most important work in Phase I is to make short-term improvements while ensuring consistency with long-term improvements.

Table 2 SITUATlON ANALYSIS (STOCK TAKING PHASE: A CHECKLISI) <!-- Start of picture text --> County PAhysical<br>Chawckrsc, InJisrucure Thc Financial Systm The Current Payment System Inentve<br>Size PHYSICAL STRUCrURE INSIRUMEN7S CO-<br>Transpon Sysrem Central Bank Debit Relative Prices<br>Telecommunicaton FaciLities Commercial Banks Credit - 7abor/Capital)<br>mail System BI7S<br>Srork Exchange<br>Population LEGAL LAYOUT PROCESSING COMPEDTJON<br>Lawsltegulations Branches Ratch atwense<br>ContracrsiCodes Concentration On-Line Monopolistic<br>Juicial System Size Speed<br>Enforcement Functions Trraffc<br>Supervision<br>Terain INFORAIA1TON ACCOUArS CLEA4RNG BUSINESS NEEDS<br>Accosuwng Systens wiCunomersr : Bilateral flmeiness<br>Reliability Centralized Clearing House Interest Rates<br>limeliness Decentralized Inflation<br>wicCentral Bank<br>Reserve<br>leari-ng<br>Correspondent<br>INSI7T7TONAL 7ECHNOLOGY SEULAEMENT<br>Tradition Automation Immediate<br>Strengths Centradized Provisional<br>Organization Decentralized Gross/Rn<br>Efficiency IntrabanikPaynet Central Bank<br>Cooperation Settlenent Bank<br>Conflict Float (DiC)<br>Overdrafts<br>HUMAN DIVERSinFCA7ION PAYMEWN MEDIA<br>Education Money Market Paper<br>Skills Securities Market Electrnic<br>Know-How<br><!-- End of picture text --> _A useful technique to enhance the client's ownership of the project and to raise conscious amnong sensor staff is to hold an introductory_ **_paymt_** _systems workshop or a full seminuar to discus the preminry conclions of Phase I with the central bank_ **_and_** _the NPC._
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|_<br>_EHOLG_<br>_Hardware_<br>_Softwre_<br>_Malntenatnce_<br>.__<br>_<br>__<br>_<br>_<br>_<br>.__<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_.B.a_|PROCFS/<br>_Centrallzed_<br>_Decentralzed_<br>_Ownership_<br>_Operator_<br>_ckup__<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_<br>_|
|---|---|
|.|_~~~~~~~~~~~ORGANM7-47ON_<br>-<br>_.NPC_<br>_Command_<br>_Consensual_|
||_.E.'aodlng_<br>_Authorzoatlon_<br>_Audil_<br>_Superivlsion_|
||_M*IGR77ON_<br>_Two Track_<br>_Incremental_<br>_Convergence_<br>,,|
||_Weaknesses_<br>_.Srenghs._<br>_Risks_<br>_Widlingness to Change_<br>_Priorities_<br>_Short-term_<br>_Longer-tern_<br>_Costs/Fees_|

**Phase 2: The vision.** To- improve the chances of a consistent approach after the completion of the "first cut" diagnostic work in Phase 1, it might be advisable to develop the vision of how the system should evolve and what it should look like after the adoption of the long-term improvements (Phase 2). Overlapping between Phases 1 and 2 will depend on the central bank's ability to create breathing space. The vision should descrbe: (1) the user needs, (2) the payment instruments, (3) risk control features, (4) the system's requirements and procedures for processing, clearing and settling each instrument, (5) an implementation plan for each payment system, particularly the priority high value transfer system (HVTS).
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Table 3 _VISION:_ **_Conceptual Deign_** <!-- Start of picture text --> User Needs Payment Instruments Design<br>Business Paper<br>Consumers Electronic<br>Banks Card based<br>Central Rank Hybrid (truncated)<br>Government Credit transferdebi t ransfer<br>Otherfinancial insiltios . Guaranteed/provisionalfunds (kigh value/low value)<br>Batched/on line<br>JNsk Contol Design System Requirements<br>Settlement risk Capaciy (volumeforecasts)<br>Fraud risk Speed/timing<br>Security risk Costs<br>Reliability<br>Controls<br>Accoznting/seltment<br>Functionality<br>_____________________________________._______________ Interfaces<br>Ownership/Coat (beter owned by the pnvate sector) Cost Recovery<br>Equity/ownership Fees<br>Operationat ownership Full/partial (subsidized) recovery<br>Access<br>Stndard setting<br>Legal/Regulatory Requirements Other Issues<br>Stat-of-art<br>Offthe-she (turnkey)<br><!-- End of picture text --> The vision phase (driven by the users' needs) would be followed by the detailed conceptual design. The conceptual. design translate user requirements into technical requiremcnts and bidding documents to purchase equipment and additional technical services.LI Project **ManIgment** n most emerging countries the central bank lacks strong project management expertise. Project design and implementation must include:

- an institutional structure (establishing the NPC)

- a senior project manager with decision-making powers at the central bank, supported by staff from the relevant departments and able to ensure active involvement of all

- _'= We mention the technical requiremens and procurementfor conmleneness'sake, bu they fall beyond the scope of this paper-_
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# participants (within and outside the central bank)!'

- an experienced consulting firm with strong client orientation to transfer multi-disciplinary skills, with a project manager in the field ("traffic controller", sting in client education and good comnunications)

- early agreement on decision-making and conflict resolution processes

- an International Advisory Panel (IAP) of experienced central bankers to review and provide advice during project implementation

- thorough project supervision.

Some of the more common traps in developing payment systems are:

- not recognizing the countries starting conditions (identified in Phase 1)

- being seduced by technology

- over or under-stimating the client's absorptive capacity

- focusing on the means rather than the ends (the efficiency gains and the value added by the project)

- personalizmg rather than institutionalizing the process and the proposed solution

- poorly defined project scope (vague or overambitious).

Coordinadon. The World Bank is not the only player in payment system modernization. The IMF is an important contributor to payment system development from the central bank perspective. The Bank can complement these efforts by broadening its scope to include commercial banls and endusers and by providing financing for technical assistance and capital investment. The Bank can also mobilize grant funding to fiance the project design and trainng.

## Concuding Remarks

Efective and efficient payment systems are vital for the economic development of emerging countries. Efficient payment systems wi1l help promote the development of commerce, enhance economic policy oversight, reduce the financial, capital and human resources devoted to the transfer of payments and control the risk inherent in moving large values.

- BY _7he central banks of FSR should include these departments: conputer center, atomationlsystems (standdization), monetary poliy, currency issuance, accounting, treasury, payment methodology and bank supervsion. One task in the terns of reference for Phase I could be a reiew of thefunctional organization of the payment systems area. There seems to be fragmentation, undear delineation of responsibilites and accountability and poor communication or open rivalry between the departments. A reorgamnization would improve project implementation and payment operation-_
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Many emerging countries recognize the value of an efficient payment system, but lack the financial and technical resources to develop such systems. Many countries turn to the World Bank and other international agencies for assistance. Unfortunately, some emerging countries believe that the entire solution for an effective. payment system rests with obtaining modem computer hardware, and believe the World Bank's sole contribution is to finance the hardware costs. Hardware procurement alone will not solve the payment system problems in emerging countries.

Emerging countries need organizational structures and plans for national payment systems before they spend money on computer equipment. Because these countries often lack the expertise to design and operate modem payment systems, they may need technical assistance from financial experts for design before they make large investments in systems development.

The design of a new payment system should be kept simple. Many emerging countries lack the infrastructure and banking sophistication required to leapfrog from basic payment systems -to state-of-the-an systems. A two-tracked approach to project design is often the best way for payment system reform. The first task is to fix the most serious problems. The second task is to upgrade the current systems incrementally to meet basic minimum standards of timeliness, security and reliability. As these improvements are made, emerging countries can turn their attention to long-term, advanced solutions.

Although valuable lessons can be learned from other countries, each country's payment system is unique. To simply import another country's system without adjusting for the target country's geography, infrastructure, banking and legal stuctures, culture and needs could lead to a suboptimal solution. Payment systems development should follow a disciplined plan for defining users' needs, the organization of the project team- and project goals. The target country can adapt other countries' experiences for its own use; Thi requires design work by experienced experts before a new system can be implemented, even if the new system is adapted from another country.