National Payment Policy in Nepal- A concept paper

Payment Systems in Nepal - Vision 2009-2012

Submitted to: Nepal Rastra Bank

Mission Statement:

To develop an effective, efficient, reliable, accessible and secure payment system that is relevant to Nepal’s environment and fully supports customer and the country’s needs:

1. Introduction

Payment & Settlement System plays crucial role in effective and efficient circulation of money in the economy thus giving boost to trade & business. It is recognized world wide that an efficient and secure payment system is an enabler of economic activity. It provides the conduit essential for effecting payments and transmission of monetary policy. Role and functionality of Payment systems have been changing gradually with advancement in products & technologies.

More recently, the proliferation of electronic payment mechanisms, the increase in the number of players in the financial arena and the payment crisis in quite a few countries and regions in the 1990s have focused attention on public policy issues related to the organization and operation of payment systems. Following three main areas of public policy have guided payments system development and reform:

-       Protecting the rights of users of payment systems,

-       Enhancing efficiency and competition, and

-       Ensuring a safe, secure and reliable payments system.

Electronic commerce and finance are growing rapidly. New payments mechanisms designed to aid electronic commerce have become routine. Predictions abound about the capabilities of the information and communication technology to bring forth important tools for conducting electronic commerce and payments. We are in the very beginning of a wave of innovation and change.

In a dynamic economy, markets need to play a key role in guiding the development of infrastructure, including mechanisms like payments systems. This means that innovation and competition will be central to the future development of the payments system - as they are in other areas of the economy. Strategic planning and investments by market participants will be shaped by views about the future. Public policy should assist them in shaping their views by pronouncing its vision and intentions clearly and well in advance so that the market participants can face the challenges and take advantage of opportunities. This Vision helps in charting out a course to purposeful and orderly change.

For such policy pronouncements, a country can opt for a strategic approach, where the state of the payment system is established, its weaknesses and strengths determined and a way forward charted, giving due regard to the country’s environment and the strategic direction of the payment technologies and practices. This approach enables one to have a holistic vision of the entire payment system, and leads to the development of a Strategic Implementation Plan that is well structured, appropriately phased, properly sequenced and convergent in perspective.

Nepal being in the very primitive stage of implementing Electronic Payment Systems, this document will create ground level approach towards understanding entire payment systems, its components, operating modules and its stakeholders. This document will also cover best practices of Payment Systems being implemented in other countries and their experiences.

2. Components of the Payment Systems Mission Statement:

The major components of the Payment System mission statements are Safety, Security, Soundness and Efficiency. Called the ‘Triple-S + E’ principle in short, each of the principles, which have a synergistic inter-relationship, would specifically address the following:

i.         Safety will relate to addressing risk, so as to make the systems risk free or with minimal risk.

ii.        Security will address the issues relating to confidence, with specific reference to the users of these systems.

iii.      Soundness will be aimed at ensuring that the systems are built on strong edifices and that they stand the test of time.

iv.     Efficiency will represent the measures aimed at efficiencies in terms of costs so as to provide optimal and cost effective solutions.

3. Payment Systems – Current Status

There are diverse payment systems functioning in the country, ranging from the paper based systems where the instruments are physically exchanged and settlements worked out manually to the most sophisticated electronic fund transfer system which are fully secured and settle transactions on a gross, real time basis. They cater to both low value retail payments and large value payments relating to the settlement of inter-bank money market, Government securities and Forex transactions.

The retail payment systems in the country comprise both paper based as well as electronic systems. They typically handle transactions which are low in value, but very large in number, relating to individuals, firms and corporate. These transactions relate mainly to settlement of obligations arising from purchase of goods and services. In Nepal there are 10+ cheques clearing houses located regionally as well as at district levels. These clearing houses clear and settle transactions relating to various types of paper based instruments like cheques, drafts, payment orders etc. Nepal Rastra Bank manages all these clearing houses which still run with 100% manual system.

The other types of electronic clearing systems functioning in the retail payments area in the country are currently limited to internet banking transactions for within bank transactions whereas through ATM & POS terminals using plastic cards for intra bank transactions. Nepal still lacks Electronic Clearing Systems (ECS in India) and Automated Clearing Houses (ACH in other countries) for catering to bulk payments. Nepal also lacks The Centralized Electronic Funds Transfer (EFT) System which is operated by Central Banks/ National Level Institutions in other countries to facilitate within country Electronic Fund Transfer between financial institutions. This is typically for individual / single payments. These systems are governed by their own respective rules. Currently in Nepal different banks and other institutions are running shared/ standalone Electronic Funds Transfer (EFT) System facilitating cash withdrawals and purchase transactions between different financial institutions. Those operators are operating entire systems at their own and are not governed by any regulations from central bank. All these electronic fund transfer systems settle on different mechanism as per rules set by respective operator.

4.         Following are the significant inadequacies in certain critical areas of the existing Payment & Settlement Systems in Nepal:

i.         Payment Instruments: There is a narrow payment instrument base that is dominated by cash, with cheques as the most widely used non-cash instrument. Credit instruments are minimally used, while direct debits are virtually non-existent. Existing non -cash instruments are not standardized. They vary in content, format, physical characteristics and security features, which undermine the introduction of automated processing, and constrain the efficient detection and control of fraud and forgery.

ii.        Legal and Regulatory Framework: The legal and regulatory framework relevant to payment system development is either outdated, inadequate or does not conform to new payment practices and trends.

iii.      Payment Technology: The use of payment technologies, including Automatic Teller  Machines (ATMs), payment  cards, SWIFT, Electronic Fund Transfer at Point of Sale (EFTPOS), Electronic Commerce and Internet Banking is either at very primitive stage or non -existent.

iv.      Clearing and Settlement Systems: Clearing systems are manual, with the local clearing cycle taking three days from the date of presenting the instrument to the clearing house, and upcountry clearing taking more than seven days. In areas with no clearing houses, it can take up to 30 days to clear an instrument. The payment and settlement legs of securities transactions are not yet synchronized to provide for Delivery Versus Payment (DVP), while foreign exchange transactions do not provide for Payment versus Payment (PVP). There is no fast track clearing of high value instruments in the payment system. In particular, the absence of high value clearing for debit instruments, coupled with the absence of instrument value limits and bank exposure caps, increases the risk of inter bank exposure.

v.       Risk Management:  Lack of amount limits for certain payment instruments and exposure caps associated with certain banks may constrain cost-effective risk management, and even potentially expose the clearing house to systemic risk. Although a collateralized lending facility for banks with inadequate funds on their settlement accounts to meet clearing obligations exists at the central bank, a dynamic collateral management system to mark and book securities for collateralized lending to commercial banks is non-existent.

vi.      Institutional Framework:  The institutional framework is both narrow and shallow. Important payment system institutions like credit rating agencies, factors, autonomous clearing house(s) and third party processing organizations to process payments initiated at EFTPOS (Electronic Fund Transfer at Point of Sale) points, do not yet exist. Most of the commercial bank branches are situated in urban areas and district capitals, leaving the upcountry and rural areas significantly under banked.

vii.    Physical Infrastructure: The existing power and communication infrastructure is still inadequate to effectively and efficiently support the requirements of a modern payment system.

viii.   Regional Co-operation: There is room for more co-operations at the regional level. For instance, certain risk management measures, payment technologies and electronic processes, and payment system laws should be harmonized to promote the inter -operability of regional systems within SAARC.

From the foregoing, it is clear that the payment system must be deliberately and systematically reformed, developed and modernized with a view to building its capacity to meet the challenges and expectations of modern business and economic management.

5.  Specific objectives of the National Payment System Modernization Project are to:

(i)             Provide a variety of adequate payment instruments, and put in place mechanisms and processes that can safely and cost-effectively support the transfer of monetary value from payer to payee.

(ii)            Facilitate a quick transfer of funds between transacting parties, with a view to minimizing float and improving efficiency in the circulation and transmission of funds.

(iii)           Manage and minimize risk in a cost-effective manner so as to enhance and strengthen the clearing and settlement efficiency.

(iv)          Develop and put in place an adequate legal and regulatory framework that can sufficiently regulate payment system activities, and provide for expeditious and cost effective conflict resolution procedures.

(v)           Enhance the country’s macroeconomic management capabilities through the availability of timely and accurate information on the stock and flow of funds.

(vi)          Work closely with Government and other infrastructural providers to upgrade the existing infrastructure and processes to levels that can adequately and efficiently support modern Payment practices, delivery channels and trends.

6.         Strategic Vision 2012:

It is envisioned that by the year 2012, Nepal should have in place a developed and modern Payment system that is effective, efficient, reliable, accessible and need -driven.

6.1        Payment System Development and Modernization Strategies

In order to achieve the mission and objectives of the payment system modernization project, the following strategies are proposed:

6.1.1     Payment Instruments Strategies: In order to redress the identified weaknesses in the payment instrument base, the following strategies will be implemented:

(i)             Introduction and promotion of new payment instruments (e.g. direct debits) to serve as significant and credible alternatives to cash and cheques. Direct debits are particularly suitable for utility payments.

(ii)            Retail payment instruments, which are basically low value, but high volume, should emphasize convenience and speed so as to effectively serve the personal and retail sectors.

(iii)           Wholesale payment instruments, which are basically high value, but low volume, should emphasize both speed and safety, leading to same-day finality and irrevocability.

(iv)          In order to encourage a risk-reduction propensity in the composition of the payment instruments, credit instruments should be promoted.

(v)           Standing orders (regular and periodic credit transfers) and direct debits should be promoted by both the banking industry and the utility companies.

(vi)          Users should be sensitized on the different features and strong points of the existing and new payment instruments.

(vii)         Standards for payment instruments should be developed and promulgated as both an efficiency enhancement and risk management measure.

6.1.2     Clearing and Settlement Systems:

Three basic clearing and settlement systems are being proposed for Nepal’s payment system:

(i)            Paper Based Transfer System (PBTS):    

The PBTS will be used to process paper-based retail debit and credit instruments, through the    Automated Clearing House (ACH). The system will give credit transfers same day finality and next day finality for debit instruments. Participating banks will settle their obligations to each other on a multilateral net basis, through their settlement accounts at the central bank, which is the settlement agent. Paper-based processing technology like the Magnetic Ink Character Recognition (MICR) or Optical Character Recognition (OCR) will be used to automate and improve the efficiency of a Paper Based Transfer System.

(ii)           Bulk Electronic Transfer System (BETS):

In this system, payment initiation and the exchange of payment instructions and related data will be in electronic form, either through electronic media or along communication lines, through to the clearing house. The BETS will be restricted to credit transfers (including standing orders), and direct debits (preauthorized debits). Inputs into the system will only be in electronic form, and the system will be designed to handle and process high volume, low to medium value payments. Bilateral or multilateral settlement will be allowed and a settlement instruction will indicate the settlement date, and whether bilateral or multilateral settlement is to be used.

(iii)          Large Value Transfer System (LVTS): Large value, time critical credit payments will be cleared through a Large Value Transfer System (LVTS) , which may be a Real Time Gross Settlement (RTGS) System or a Designated Net Settlement (DNS).

(iv)          Complementary Systems: In addition to the above systems, it is envisaged that there will be a   number of complementary systems, which include:

(a) Payment Cards Processing Systems (PCPS):  This is the systems that use payment cards at        points of sale will be built to facilitate authorizations, clearance and settlement. Automated Teller Machine (ATM) Network(s) will be built to facilitate verification, authorization, clearance and settlement among users and their banks or participants. The cleared net amounts will be transmitted to the settlement agent for entries to be effected on their settlement accounts.

(b) Electronic Banking and Internet Based Systems (EBIS): There is no reliable data on the volume and value of electronic and Internet-based payment transactions. Nevertheless, this payment area is set to grow. Institutions that venture into this area, including the establishment of Internet service providers, will be encouraged. The NPS Project will closely follow and monitor developments in this area, with a view to developing an Electronic Banking and Internet Based System (EBIS) at an appropriate time, when it is both cost-effective and prudent.

(v)        Foreign Currency Clearing: As the number and activity of foreign-currency denominated accounts increases, coupled with the need to reduce foreign exchange outflows arising, foreign currency clearing will be introduced. The clearing financial institutions will have to agree with their settlement agent on how to treat the credit balances on their settlement accounts.

(vi)       Management of Clearing Houses:  In order to enhance the supervisory and oversight role of the central bank over the payment system, and also to encourage the development and consolidation of self-discipline within the banking and financial services industry, it is proposed that the management of clearing houses should be autonomous. These autonomous clearing house(s) would then be run on a cost recovery basis, with full-time professional managers and auditors. There should be a transition period of five years, during which the central bank will gradually ease itself out of the management of the clearing house(s).

vii.       Document Truncation: As a way of enhancing clearing and settlement efficiency, cheque and other paper truncation should be introduced and promoted. This truncation should be gradual, starting with partial truncation, and then proceeding to full truncation. The laws must be amended to accommodate the document truncation technology.

6.13.     Management of Payment System Risk:

Adequate mechanisms and features need to be built in the country’s payment system so as to control the precipitation of credit, liquidity, settlement, operational, foreign exchange and   systemic risks. Measures must also be put in place to check the perpetuation of forgery and fraud and other criminal behavior, in both papers -based and electronic systems. Different payment system risk management measures, as spelt out below, will be put in place to control risk among the payment instruments and in the clearing and settlement systems.

(i)   Risk Management in Paper Based Transfer Systems (PBTS) and Electronic Bulk Transfer System (EBTS): The risk management measures for the Paper Based Transfer System (PBTS) and the Electronic Bulk Transfer System (EBTS) will include:

(a) Control of bilateral flows of payment messages.

(b) Establishment of a dynamic collateral management system to provide liquidity to cover intra-day exposure to liquidity shortages

(c) Reaching agreement on the nature and type of securities or instruments that will be accepted as collateral.

(d) Establishment and implementation of multilateral and individual caps with regard to settlement obligations.

(e) Only clearing banks having settlement accounts with the settlement agent shall have access to collateral facilities

(f)   The BIS (Bank for International Settlement) Core Principles for Systemically Important Systems (CPSS)), shall be observed and adhered to in the operation of netting systems.

(g) The tools and related measures to identify assess and monitor the different risk profiles, will be put in place

(h) All settlement accounts will be pre-funded

(i)   Risk management measures will be periodically reviewed

(j)   The functionality of the clearing and settlement systems will provide for the achievement of Delivery versus Payment (DVP) and Payment versus Payment (PVP).

(k) All foreign exchange bureaus must trade spot, and not forward.

(ii) Large Value Transfer System (LVTS)-Real Time Gross Settlement -RTGS: In an LVTS-RTGS, the major risk types are the credit and liquidity risk associated with the sending bank. These risks will be primarily managed through:

(a) Pre-funding of settlement accounts

(b) Existence of collateralized intra-day credit facilities to take care of liquidity shortages

(c) The amount and frequency of use of intra-day credit facilities will be carefully monitored and analyzed

       (iii) Electronic Banking and Electronic Money Activities: The risk management measures contained in a report entitled Risks Management for Electronic Banking and Electronic Money Activities, which was prepared by the Basle Committee on Banking Supervision, will be considered during the design of the Electronic Banking and Internet System (EBIS).

(iv) Standardization and Consistency with Regional and International Practices: Payment instruments, in both the electronic and paper-based form, must be standardized. Such standards should be consistent with both regional standards and international best practices.

(vii) Payment System Oversight: A set of performance benchmarks, along the lines of the Early Warning System (EWS) Model used in the supervision of banks, shall be developed, to be applied in the periodic assessment of payment system efficiency and effectiveness. A comprehensive checklist to be used in payment system audits will be developed.

6.1.4 Payment Technology:

The level and scope of the country’s payment technology needs to be improved and upgraded if we are to enhance the efficiency, reliability, convenience and security of the payment system.

(i) Use of SWIFT:  Banks should be encouraged to procure SWIFT and electronically transfer funds using SWIFT. The possibility of forming a national SWIFT User Group to take advantage of collective     bargaining power should be explored. Efforts to form an SAARC SWIFT Users Group should also be explored.

(ii) Promotion of Automatic Teller Machine (ATM) Use/ ATM Network:

Owing to the flexibility and convenience afforded by Automatic Teller Machines (ATMs), Banks with ATMs should be encouraged to build an ATM Network, which could be called NEPALSWITCH. The switch will enable participating members to clear and settle ATM withdrawals that are done at such banks where the drawer does not hold an account.

(iii) Use of Payment Cards

Institutions that can issue payment cards, including credit, debit and smart cards should be encouraged to start operations. A bank or a consortium of existing banks could start issuing cards and operating payment card businesses, in return for a set of incentives. Nepal Rastra    Bank has to issue guidelines on the operation of payment card schemes.

(iv) Internet Banking and Electronic Commerce:

Institutions that can spearhead the establishment and structured promotion of Internet banking and electronic commerce should be encouraged. Internet payment system providers should be encouraged to open and operate business.

(v) Third Party Processing Companies:

Independent third party processors who can set up infrastructure to operate Electronic Fund Transfer at Point of Sale (EFTPOS) should be licensed to operate.

6.1.5 Institutional Framework:

As part of strengthening payment system risk management and widening the country’s financial system, the following institutions should be established:

(i)    Credit Reference Bureaus: These would assess the risk profiles of some important players in the payment system, including commercial banks and other financial institutions. Nepal Rastra Bank should, as a matter of urgency, work closely with stakeholders and other relevant authorities to put in place a unique identifier for each individual/citizen in Nepal, so as to prevent bad debtors from using different names when borrowing from different banks.

(ii)   Factors: These are institutions that buy loans, including those that are not performing well, at a discount, and then proceed to recover the loans themselves. They should be introduced in the country to check the deterioration of borrower discipline.

(iii)  Provision of Rural Payment Services through Microfinance Institutions (MFIs): Owing to the high overhead costs, banks find it difficult to extend payment services to the rural areas in a cost-effective manner. Microfinance institutions should therefore be encouraged to extend payment services to the rural areas. However, the MFIs must be properly licensed and regulated.

6.1.6 Government Payments:

Some of the existing Government regulations and policies should be reviewed so as to improve payment system efficiency.

6.1.7 Legal and Regulatory Framework Strategies

Adequate laws and regulations must be put in place to regulate the payment system. The existing laws related to the payment system should be comprehensively reviewed, and formulate amendments where necessary. Legislation to accommodate modern practices like cheque truncation should be put in place.

6.1.8 Sensitization of the Public on Payment System Issues:

The public (both individual and corporate), through seminars, workshops and print, electronic and broadcast media should be sensitized with regard to the different aspects of a payment system.

6.1.9 Physical Infrastructure:

The country’s physical infrastructure needs to be upgraded if it is to efficiently and effectively support modern payment system activities. Yet infrastructural provision is one area where the Payment System Project does have little influence. It therefore has to largely depend on the capacity, goodwill and commitment of the major infrastructure providers that include Government, power and communication companies.

Nevertheless, several strategies are also proposed in this area:

1. Lobby Government to liberalize infrastructural provision through the expeditious

amendment of monopolistic laws. In this regard, the Communication and Electricity laws that have liberalized the provision of telecommunication services and the generation and distribution of electricity are efforts in the right direction.

2. Work closely with telecommunication companies to modernize and upgrade the telecommunication infrastructure

3. Lobby Government to improve on the transport infrastructure, which is used to transport payment instruments

4. Reduction in duty and tariffs in application, equipments and services being used for automating payment and settlement process.

6.1.10 Building Technical Skills in the Payment Area:

Banks, other financial institutions, communication companies and other stakeholders should draw up and implement capacity building programmes that are intended to build core Competencies in the critical and technical areas of payment system development.

6.1.11 Synchronization of Strategies

Because of the multidisciplinary nature of the payment system area, the proposed payment system strategies need to be synchronized with those of other key stakeholders, including Government and Telecommunication Companies.

6.1.12 Financing the Payment System Development Process:

It is envisaged that the payment system development costs will be shared among some of the stakeholders. For instance, depending on circumstances, capital expenditure to procure    certain hardware and software may be borne collectively or individually. In some cases, cost recovery principles may apply either on the basis of full recovery or partial recovery. However, the details of financing and cost recovery will be discussed and agreed on by all the stakeholders.

7.         Implementation Plan- Road Map

 7.1 Short Term Projects (2009-2011)

It is proposed that the following projects should be embarked on immediately or in the near future:

                        1. Standardization of Payment Instruments

2. Automation of MICR-based Cheque Clearing

3. Formulation of Adequate Legal and Regulatory Framework

4. Creation of an Autonomous Clearing House.

5. Promotion of Credit Transfers and Direct Debits.

6. Establishment of Credit Rating Agencies and Factors.

7. Sensitization of the Public on Payment System Issues.

7.2 Medium/Long Term Projects (2009--2013)

                  These should include:

                  1.  Establishment of a Bulk Electronic System

                  2. Construction of an ATM / Payment Card Switch (NEPALSWITCH)

                  3. Operation of Payment Card Schemes, including EFTPOS

                  4. Establishment of a Large Value Transfer System

5. Establishing of Electronic Payment Gateway to facilitate E-commerce transactions

                        6. Facilitate to start Mobile Commerce

8.         Conclusion:

It is expected that implementation of the above strategies and the     corresponding projects     should lead to a payment system that can effectively meet modern business expectations, enhance the country’s resource mobilization capacity through improved customer convenience and flexibility, and efficiently contribute to sustainable and positive macroeconomic performance.

Disclaimer:

While preparing this document references/ text/ quote/ research findings have been taken from the available sources through internet.