Credit Management and Cash Collections and Disbursements

Credit & Financial Management Review, First Quarter 2007 by Joyce, William B

Walter's regional bank account has two advantages. First, by choosing a remote location, the company has gained several days of float. Second, because the bank can forecast early in the day how much money will be paid out, Walter does not need to keep extra cash in the account to cover contingencies.

Electronic Funds Transfer

Throughout the world the use of checks is on the decline. For consumers they are being replaced by credit or debit cards. In the case of companies, payments are increasingly made electronically. Consumers also may receive and pay bills electronically via their personal computer. Currently Electronic Bill Presentment and Payment (EBPP) accounts for only a small proportion of payments but it is forecasted to grow rapidly. Electronic payments are relatively few in number but they account for the majority of transactions by value. Electronic payment systems may be of two kinds: a gross settlement system or a net settlement system. With gross settlement each payment is settled individually; with net settlement all payment instructions are accumulated and then at the end of the day any imbalances are settled.

In the United States there are two systems for making large-value electronic payments: Fedwire (a gross system) and CHIPS (a net system). Fedwire is operated by the Federal Reserve system and connects over 10,000 financial institutions in the United States to the Fed and thereby to each other. Suppose Bank Alpha instructs the Fed to transfer $1 million from its account with the Fed to the account of Bank Beta. Bank Alpha's account is debited immediately and Bank Beta's account is credited at the same time. Fedwire is therefore an example of a real-time gross settlement (RTGS) system. Most developed countries now operate RTGS systems or large-value payments.

Real-time gross settlement suffers from a potential problem. If Bank Alpha needs to pay Bank Beta, Beta needs to pay Zeta, and Zeta needs to pay Alpha, there is a risk that the system could gridlock unless each bank kept a large reserve with the Fed. (Alpha might not be able to pay Beta until it has been paid by Zeta, Zeta cannot pay Alpha until paid by Beta, and Beta in turn is awaiting payment by Alpha.) To oil the wheels, therefore, the Fed takes on the credit risk by paying the receiving bank even if there are insufficient funds in the account of the payer. Since each payment is final and guaranteed by the Fed, each receiving bank can be sure that it has the money and can give its customer immediate access to the funds.

Cross-border high-value payments in dollars are handled by CHIPS, which is a privately owned system connecting 115 large domestic and foreign banks. CHIPS accumulates payment instructions throughout the day, and at the end of the day each bank settles up the net payment using Fedwire. This means that, if the bank receiving payments makes the funds available to its customers during the day, it would be at risk if the paying bank goes belly up during the day. Banks control this risk by imposing intraday credit limits on their exposure to each other.