Loss Sharing in Theory and Practice

Over the past decade central banks and financial regulators have placed a heavy emphasis on ensuring that “National Payment Systems” are made as safe and secure as possible. We have seen the proliferation of Real Time Gross Settlement for high value payments and host of other arrangements for the “small ticket” systems. Generally these smaller systems settle on a multilateral net basis.

In the Bank for International Settlement’s “Core Principles for Systemically Important Payment Systems” there is the requirement that “A system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation”. Additionally there is the requirement that such systems should seek to exceed the minimum Core Principle requirements.

One way of structuring a “fail safe” arrangement is the use of Loss Sharing Arrangements.

A Loss-Sharing Agreement is defined by the Bank of International Settlements as an agreement between participants in a transfer (i.e. payment) system or clearing house arrangement regarding the allocation of any loss arising should one or more participants fail to fulfill their obligation/s. The arrangement stipulates how the loss will be shared among the parties concerned in the event that the agreement is activated.

The term itself is really a misnomer as depending on its structure, it is more of an arrangement to redistribute obligations rather than an apportionment of losses. It is often also referred to as an Additional Settlement Obligation.

The basic concept behind the arrangement is to apportion any shortfall in settlement obligations either on the basis that this is covered by the defaulting party (the Defaulter Pays Model) or by the surviving members of the clearing arrangement (the Survivors Pay Model).

The principles behind the models are fairly simple and are set out below.

Defaulter Pays Model

oEach participant in the payment system or clearing arrangement puts up collateral to cover its debit (i.e. obligation) position if it fails to pay.

oThis can be for full or only partial settlement of the defaulter’s obligation. If it is only partial then an additional arrangement will be needed to cover the residual shortfall. This could be a “survivor’s pay” model or it could be covered by another party such as the central bank.

oFor this model to work effectively a limit or “cap” needs to be placed on the maximum net debit position of each participant in the payment system or clearing arrangement. In some systems, such as the cheque system setting this sort of limit is almost impossible to do.

Survivors Pay Model

oThe survivors (i.e. the participants who are left) agree to cover the shortfall of the defaulter on some pre-agreed basis (formulae). This could be based on (1) equal shares (mutualisation), (2) proportionate shares as on the day before the default, (3) proportionate shares based on actual exposure over a period of time (such as a month, or a year) or (4) some other agreed basis.