Benefits and risks of Interconnectedness of Banks

Banks can be connected in several ways. The following are examples of the interconnectedness of Banks.

UPI live members:

A list of bank names live on UPI, whose customers can use UPI to transfer, pay, or collect money directly from one bank account to another bank account. This is the best example of the interconnectedness of banks.

Cheque clearing systems:

Cheque clearing systems of banks are an example interconnectedness of banks. The movement of money from cheque paying bank to cheque collecting bank is an example of the interconnectedness of banks.

The interconnectedness of banks in Cheque Kite flying:

Cheques are moved from the bank where it was deposited to the paying bank either in the traditional physical paper form or digitally under a cheque truncation system. This process is called the clearing cycle and normally results in a credit to the account at the bank of deposit, and an equivalent debit to the account at the bank on which it was drawn, with a corresponding adjustment of accounts of the banks themselves. When there is a time gap between cheque deposits in a bank and the effects of cheque clearance known to the bank, some unscrupulous customers try to misuse the delay in the clearing process by indulging in cheque kite flying.

Cheque kite flying is possible when a customer of the bank is allowed to draw money against uncleared balances. The kiter opens an account with 3-4 banks and keeps the Manager of those banks in confidence to allow him to draw the money from his account against pending clearance of cheques deposited by him. He then issues cheques to his customers without funds in his account. Further, he deposits the cheques for the equivalent amount drawn by him on the second bank and requests the manager of that bank to pass the cheque issued by him. So that cheque drawn on the first bank is paid. The same tactics are used in other banks without funds. He cashes cheques between them, although neither account has the clear funds to cover the cashed cheques. This allows the kiter to, in essence, gain interest-free loans from unsuspecting banks. However, when one bank returns the cheque issued by him with a reason ‘effects not cleared’ it will lead to domino effects on other banks that have passed his cheque against uncleared balance resulting in an overdraft in the account. However, the integration of advanced technology into banking operations has considerably reduced the time for cheques to clear and that has helped to reduce the incidence of cheque kiting.

The Interconnectedness of banks in network transactions:

The SWIFT messages or the latest version of ISO 20022 standard covers financial information transferred between financial institutions that includes payment transactions, securities trading, and settlement information, credit as well as debit card transactions, and Foreign Exchange transactions, among other financial information. Similarly, in domestic network transactions, we use NEFT, RTGS, ATMs, credit cards, debit cards, etc. which are mostly used for interbank transactions. A network of interbank exposures may lead to domino effects following the event of an initial bank failure to make the payment.

The Interconnectedness in the Interbank Call Money Market:

The interbank call money market is an essential element for the banking system because a bank with excess liquidity could lend its idle funds to a bank suffering from a liquidity shortage. Interbank call money market seeks short-term loans. Loans typically have a duration of one week or less. Banks often use the interbank call money market to meet reserve requirements. Other entities use short-term loans from the interbank call money market to manage various liquidity needs. When increasing numbers of U.S. consumers defaulted on their mortgage loans (familiarly known as the sub-prime lending crisis) in 2008, U.S. banks lost money on the loans, and so did banks in other countries. Banks stopped lending to each other, and a lack of market lending in these market types was a factor in the 2008 financial crisis.

Benefits of the interconnectedness of Banks:

The interconnectedness of banks offers better customer experience and operational efficiency. It allows financing to flow from areas where savings build up to others that seek funding, thus ensuring credit supply to the real economy. It also provides for diversification and risk-sharing between Banks.

Risks involved in interconnectedness:

Interconnectedness between Banking institutions –is an inherent characteristic of developed financial systems that adds flexibility to investment and the financing of the economy. However, at times of crisis, it may also contribute to propagating stress through the system. Large interconnections imply adverse shocks to banks rapidly and extensively across the financial system. Therefore, various regulatory initiatives have been introduced to mitigate financial stability risks arising from interconnectedness.

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