Legal Aspects of Payment Systems²

Consumer EFTs and Applicable Rules⁵

Wholesale EFT Systems and Applicable Rules

The topics considered above have focused on retail transfers by consumers. Wholesale transfers between banks, for their own account and for the accounts of their corporate customers, however, account for a very sizable proportion of the value of funds that are handled.

UNCITRAL Model Law on International Credit Transfers Compared with Uniform Commercial Code Article 4A

With the notable exception of the United States, most countries do not have legislation dealing with electronic funds transfers as such. As has previously been noted, the United States has adopted the Electronic Fund Transfer Act that governs consumer transfers. Moreover, all states in the United States have adopted Article 4A, an amendment to the Uniform Commercial Code, in order to deal with wholesale large-value fund transfers. With the volume and value of international electronic funds transfers increasing each year and only the incomplete rules of particular systems to govern the rights and liabilities of parties to the transfers, the United Nations Commission on International Trade Law set about creating a model law to govern international transfers.

It was the hope of some that, in the interest of uniformity, the model law would resemble UCC Article 4A.³⁴ As the drafts of the model law progressed, the later drafts did evidence a tendency to draw closer to the provisions of UCC Article 4A. However, despite this tendency, a number of differences remain. In order to understand the issues, it may be appropriate to compare certain key points of UCC Article 4A and the UNCITRAL Model Law.

In a typical example of an electronic funds transfer, an originator who wishes to transfer funds to a beneficiary will order the originator’s bank to send to the beneficiary’s bank a transfer of funds through one or more intermediary banks. In the terminology of UCC Article 4A, the complete transfer is called a “funds transfer,” and each segment of that transfer occurs by way of a “payment order.” In the terminology of the UNCITRAL Model Law, the complete transfer of funds is called a “credit transfer,” and each segment thereof is effected by a “payment order.” Both laws deal with consumer transactions and neither deals with debit transfers. The UNCITRAL Model Law deals with consumer transfers (although it does not deal with issues related to consumer protection). While UCC Article 4A could apply to a transfer effected for a consumer, it does not apply to a transaction if any part thereof is covered by the Electronic Fund Transfer Act.

The basic approach of UCC Article 4A is to place the burden of responsibility on the originator or any sender, while the UNCITRAL Model Law seeks to fasten a measure of responsibility on the receiving bank, as well, for the completion of the transfer. Thus, the UNCITRAL Model Law requires a receiving bank that detects certain errors or inconsistencies in payment orders that are received to give its sender notice of errors or inconsistencies (Articles 8(4), 8(5), 10(2), 10(3), and 10(4)). Such errors might, for example, indicate that the payment order has been misdirected or that it contains inconsistencies in its terms and instructions. By contrast, UCC Article 4A does not require the receiving bank to give its sender notice of such errors. The significance of this difference is that receiving banks may, pursuant to the agreed procedure between the parties, be subjected by the UNCITRAL Model Law to a duty to examine incoming payments orders. The duty may be determined under a subjective test (Articles 8(5), 10(3), and 10(4)) or an objective test (Articles 8(4) and 10(2)). The proponents of UCC Article 4A maintain that such a duty would impede and make more costly a high-speed automated system of fund transfers that is required in the modern commercial world.

Another difference between the two laws is their approach to the issue of whether or not consequential damages may arise if a bank is at fault for an incomplete transfer. Both laws attempt to circumscribe the liability that may attach to a bank by way of consequential damages. UCC Article 4A envisages the possibility of consequential damages arising under certain circumstances—that is to say, if the beneficiary’s bank has received notice of special facts and, nevertheless, refuses after the beneficiary’s demand to make payment (Section 4A-404(a)).³⁵

Both UCC Article 4A and the UNCITRAL Model Law make the originator’s bank and subsequent intermediary banks responsible for the arrival of a fund transfer at the beneficiary’s bank. They do this through what, in effect, amounts to a “money-back guarantee.” According to this guarantee, a receiving bank is required to refund with interest an amount that has not properly arrived at the beneficiary’s bank. Thus, if the beneficiary’s bank does not accept a payment order for the benefit of the beneficiary, the originator need not make payment and, if he has done so, is entitled to get the money back. The manner in which Section 4A-402(d) deals with this money-back guarantee is similar to that of Article 14, but the latter allows the originator’s bank to vary the obligation by agreement under circumstances involving a significant risk.

Both UCC Article 4A (Section 4A-209 and 210) and the UNCITRAL Model Law (Articles 7 and 9) contemplate that a receiving bank may either accept or reject an incoming payment order. Both laws (Section 4A-210(a)) (Articles 7(3) and 9(2)) require a receiving bank, in the event that it chooses to reject the payment order, to give notice of such rejection to the sender. (Under Section 4A-210(b) of UCC Article 4A, and Article 7(3)(a) and Article 9(2)(a) of the UNCITRAL Model Law, this duty is subject to the assumption that there are sufficient funds of the sender on deposit with the receiving bank or, in the case of the UNCITRAL Model Law, that payment is made by other means.) The consequence of not giving notice varies under the two laws. Under UCC Article 4A, the liability brings into play an interest penalty. Under the UNCITRAL Model Law, the failure to give notice of rejection may lead to acceptance of the payment order under Article 7(2)(e), in the case of a receiving bank that is not the beneficiary’s bank, and under Article 9(l)(h), in the case of the beneficiary’s bank.

Under UCC Article 4A, the nature of acceptance depends on whether the acceptor is a beneficiary’s bank or another bank. In the case of the originator’s bank or an intermediary bank, acceptance occurs when that bank issues its own payment order so as to implement the originator’s payment order (Section 4A-209(a)). At this point, the sender is obligated to pay the amount of the payment order to the receiving bank (Section 4A-402(b) and 4A-209 Official Comments 1 and 4). In the case of the beneficiary’s bank, acceptance occurs when it pays the beneficiary, notifies the beneficiary of receipt of the payment order, receives payment by the sender, or in certain cases, fails to reject the payment order (Section 4A-209(b)(l),(2) and (3)). By way of comparison, under the UNCITRAL Model Law the originator’s bank or an intermediary bank accepts the sender’s payment order, among other ways, when the bank issues an implementing payment order, when it debits an account of the sender, or when the time for rejection has elapsed without notice having been given (Article 7(c)-(e)). In the case of a beneficiary’s bank, acceptance occurs, among other ways, when the bank gives notice to the sender of acceptance, when it debits an account of the sender, when it credits the beneficiary’s account, when it gives notice to the beneficiary of the right to the funds, or when the time for giving notice of rejection has elapsed (Article 9(1)). A sender’s obligation to pay the receiving bank arises when the receiving bank accepts the payment order (Article 5(6)). In most cases, execution of the payment order by the receiving bank is simultaneous with its acceptance of the payment order, and payment is due from the sender upon such execution. If the sender maintains an account with the receiving bank, payment may be made by debiting that account (Article 6(a)). Alternatively, if the sending bank maintains an account in favor of the receiving bank, payment may be made by crediting that account and becomes effective when used by the receiving bank (Article 6(b)(i)). Other means of payment involving accounts in third-party banks or at a central bank and pursuant to the rules of a fund transfer system are also authorized (Article 6(b)(ii)-(iv) and (c)). Similar means of payment are set out in UCC Article 4A (Section 4A-403).

Both laws provide for what is called a “security procedure” in UCC Article 4A (Section 4A-201) and an “authentication procedure” in the UNCITRAL Model Law (Article 2(i)). The implications of such a procedure are that a sender may be bound by a payment order purportedly sent by him or by his agent if the payment order complies with a commercially reasonable method of security against unauthorized payment orders even if, in fact, it has been sent by a wrongdoer without authority.

UCC Article 4A requires, by way of Section 4A-302(a)(l), that the instructions of an originator be strictly followed concerning any intermediary bank or funds-transfer system to be used in effecting the funds transfer. However, the UNCITRAL Model Law (Article 8(3)) permits an intermediary bank to inquire of the sender for additional instructions if it determines that it is not feasible to follow the original instructions or that they would cause excessive costs or delay. Both UCC Article 4A and the UNCITRAL Model Law provide for the cancellation and amendment (Section 4A-211) or revocation (Article 12) of payment orders, provided that these are received within a reasonable time before a receiving bank has executed a payment order or, in the case of the beneficiary’s bank, before the transfer is completed and the funds are placed at the disposal of the beneficiary.

Finally, it should be noted that the scope of the UNCITRAL Model Law is limited to transfers where the sending bank and the receiving bank are in different countries (Article 1),³⁶ while Article 4A may govern national and international transfers. As has been noted, both laws are intended to govern credit transfers (rather than debit transfers) and, while Article 4A excludes consumer transactions if they are in any part governed by the Electronic Fund Transfer Act (Section 4A-108), the UNCITRAL Model Law includes consumer transfers (although it does not deal with issues related to the protection of consumers) (Article 1, footnote). Both UCC Article 4A and the UNCITRAL Model Law contain conflicts rules in order to determine which law will govern a given transaction. The provisions of these conflicts rules, however, differ. Moreover, the conflicts provision of the UNCITRAL Model Law is independent of the other provisions and, accordingly, may or may not be adopted by a state that adopts the UNCITRAL Model Law. (Compare Article Y of the UNCITRAL Model Law with UCC Section 4A-507.) Both Article 4A and the UNCITRAL Model Law (Article Y (1)) provide that, unless otherwise agreed, the law of the receiving bank will govern the relations between the sender and that bank (Section 4A-507(a)(1)) (while Section 4A-507(a)(2) also provides that, in a dispute between the beneficiary and the beneficiary’s bank, the law of that bank will govern). While Article 4A expressly recognizes that system-transfer rules may select the law of a particular jurisdiction (Section 4A-507(c)), the UNCITRAL Model Law is silent on the matter.

UNCITRAL Model Law on International Credit Transfers Compared with the EC Council Directive on Cross-Border Credit Transfers

Following the issuance of a Commission recommendation³⁷ and a proposed directive,³⁸ a Council Directive on cross-border credit transfers was issued in 1997.³⁹ It is a somewhat abbreviated set of rules that deals with particular issues. It is limited to credit transfers of amounts less than ECU 50,000 in line with its objective of allowing individuals and small and medium-sized businesses to be able to make credit transfers rapidly, cheaply, and reliably within the European Community in the currencies of the member states.⁴⁰ It requires credit institutions to provide clear information about their credit transfer services concerning the time needed to effect payment, the manner of calculation of fees and charges, the value date, the reference exchange rates, and the complaint and redress procedures available to customers,⁴¹ as well as relevant information subsequent to the execution or receipt of a transfer.⁴²

In orientating itself toward consumer protection, it differs from the UNCITRAL Model Law in which an optional footnote to Article 1 states that the UNCITRAL Model Law does not deal with consumer protection issues. In this regard, the UNCITRAL Model Law has no comparable provisions requiring the information stipulated by Articles 3 and 4 of the Directive. In the absence of an agreement between the originator and his financial institution, the funds called for must be credited to the account of the beneficiary’s institution by the end of the fifth banking business day following the date of acceptance of the credit transfer order by the originator’s financial institution.⁴³ The beneficiary’s institution then must make the funds available to the beneficiary by the end of the business day following the day on which the funds were credited to the account of that institution.⁴⁴ While the obligation of the originating bank under Article 6 of the Directive thus corresponds to the obligation of such a bank under Article 11 of the UNCITRAL Model Law, Article 10 of the latter, which deals briefly with the obligations of the beneficiary’s bank, refers only to the governing law for guidance.

The UNCITRAL Model Law, it should be noted, obligates any sending bank to execute a payment order within two days, while the obligations of an intermediary bank to act in a timely manner are only inferred in the Directive from its obligation to compensate the originator’s institution if the delay in making payment within the applicable five days (or otherwise agreed period) is attributable to it.⁴⁵ An important difference between the UNCITRAL Model Law and the Directive is that the former allows one or more of the receiving banks in a credit transfer to deduct charges notwithstanding that this may result in the amount of the payment order that is ultimately accepted by the beneficiary’s bank being less than the amount of the originator’s payment order.⁴⁶

By contrast, the Directive requires that the originator’s institution, any intermediary institution, and the beneficiary’s institution execute the credit transfer for the full amount (unless the originator has specified that the costs of the credit transfer are to be borne by the beneficiary who demands the full amount specified in a contract). (The Directive reflects in this regard section 4A-302(d) of the Uniform Commercial Code.) In the UNCITRAL Model Law, there is an obligation to refund (“money-back guarantee”) that arises from several scenarios: (i) a credit transfer is not completed,⁴⁷ (ii) the amount transferred exceeds the amount of the order received,⁴⁸ or (iii) an order is executed in disregard of an effective revocation order.⁴⁹ In the Directive, the obligation to refund is limited to amounts not exceeding ECU 12,500 in the event that the account of the beneficiary’s institution is not credited.⁵⁰ This amount is supplemented by interest and charges.⁵¹ Each intermediary institution that has accepted the credit transfer is liable to the institution that instructed it to carry out the order, and the originating institution must recredit the account of the originator. (Interest is also payable on the remaining amount of funds that have not been credited within the applicable time period—to the originator by the originator’s institution⁵² or to the beneficiary by the beneficiary’s institution.)⁵³ It should be noted that while the UNCITRAL Model Law permits revocation of a payment order if it is received by the receiving bank in time to allow it a reasonable opportunity to act,⁵⁴ no provision for revocation is provided in the Directive. By way of comparison, UCC Article 4A provides that a sender may cancel or amend a payment order if notice thereof is received by the receiving bank before it accepts the payment order and in time to allow it a reasonable opportunity to act upon it.

Netting

Banks have long used systems of netting transactions between them. Derived from check collection, the practice has been introduced to payment orders in electronic funds transfers and to various types of contractual commitments as well. An example may serve to illustrate this development. Suppose that during the course of a day, two banks issued payments orders to each other in response to their customers’ requests. If Bank A issued 12 orders to Bank B and the latter issued 6 orders to Bank A, there would be a total of 18 payment orders issued. Instead of making payments at the time of each transaction, it is possible to net this number if the two banks agree. The banks might agree to wait for the end of the business day, at which time the amounts of the payment orders would be set off against each other and a single payment made from the net debtor bank to the net creditor bank. Risks of error and fraud could be reduced, and the costs of payment and settlement reduced.

In the example posed, but two banks were involved. However, it is possible to extend the concept to a multilateral system of banks as well. To understand this concept, it is helpful to consider and differentiate between three basic systems: (i) gross settlement without intraday credit, (ii) gross settlement with intraday credit, and (iii) net settlement.

In a gross settlement system, payment orders are expected to be honored on a transaction-by-transaction basis. Funds are held on deposit so that the order can be effected by the operator of the system (ordinarily the central bank or other manager of the system). If funds are not so available, the operator will return the order to the originating bank or will hold it in queue until sufficient funds accumulate in the account of the originating bank to allow its payment order to be executed. The norm in the system is characterized as a real-time gross settlement. An example of such a system, where there is no facility for the extension of credit, is the Swiss Interbank Clearing System.

An alternative gross settlement system can be constructed in which the operator may extend credit on an intraday basis in the event that the account of the originating bank lacks sufficient funds to effect its payment order. In this kind of system, the operator (ordinarily a central bank) will have assigned limits to the amount of credit that it is willing to extend to each of the participating banks, perhaps based on the capital of each. The operator will expect the required funds to be put into the accounts of banks to which credit has been extended before the close of the day. An example of this system is FedWire.

In the third system (the net settlement system), settlement is not intended to be carried out on a transaction-by-transaction basis. Instead, it will be effected at designated times during the course of a day. In such a system, it is anticipated that the payment orders of the participating banks will be netted at such times. In these systems, credit is extended by the participating banks to each other rather than by the operator. The operator of a net system may be the central bank, as in BOJNET, or an association of banks, like the New York Clearing House that operates CHIPS. Since the participating banks are responsible for the extension of credit, each may be required to calculate the credit limit that it will extend to each of the other participants. The proponents of such net settlement systems point out that they reduce the amounts that participating banks would otherwise have to take from the operation of their business in order to fund their accounts with the operator of a gross settlement system. In addition, net settlement systems are less likely to give rise to gridlock situations, in which banks must wait for other banks to perform on a transaction-to-transaction basis before they, themselves, will be funded sufficiently to enable the operator to proceed to implement their own payment orders.

A consideration of the various aspects of netting systems has given rise to a set of minimum standards for the design and operation of cross-border and multicurrency netting and settlement systems. These standards are called the Lamfalussy standards after the Chairman of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries that proposed them. The first of these standards is that such netting systems should have a well-founded legal basis under all relevant jurisdictions. A significant legal issue that may arise is that in some jurisdictions the insolvency of one of the participating banks may result in a situation in which the netting envisioned by the system may be negated by the legal rules of the jurisdiction of the insolvent bank participant. This could occur through a process known as “cherry-picking” if, pursuant to such rules, the receiver of the insolvent bank could confirm the performance of transactions already executed by a counterparty while simultaneously disaffirming the insolvent’s obligations in favor of that counterparty. In order to clarify such situations in favor of the netting principles that are at the heart of their systems, some countries have sought legislative amendment of relevant statutes. Thus, in the United States, the Bankruptcy Code and the Federal Deposit Insurance Corporation Act have been amended, and further changes have been made by the Federal Deposit Insurance Corporation Improvement Act of 1991.⁵⁵

Regulation and Contracts

Rights and obligations of the parties to various payment systems can be regulated by law, by contract, or by some combination of the two. As will be appreciated from the foregoing analysis, the older forms of payment, such as cash and checks, are largely governed by law, although at least in the case of checks, some of the statutory provisions may be varied by contract.⁵⁶ Moreover, in the case of newer forms of payment, where a statute is applicable, the power of the parties to vary some of its provisions may be expressly recognized.⁵⁷

Payment card systems are governed by contract in most countries, although banks and other card issuers may issue nonbinding codes of practice (frequently under government stimulus). In the United States (and in Denmark),⁵⁸ statutes have been passed and regulations issued to establish a legal framework for payment cards, and the contracts between the issuer, its agents, merchants, and consumers have reflected that framework and amplified its provisions. In the United States, as discussed above, there is also a statute that governs wholesale electronic funds transfers. In the European Community, increasing recognition is being given to the need to establish a legal framework for the purpose of providing uniform payment systems that may be used to make payments throughout the European Community. Accordingly, recommendations and directives are being issued to provide such frameworks, and a consensus is emerging that, if banks and other sponsoring parties of these systems fail to come up with adequate codes of practice and contracts that embody their terms, then what had been the subject of recommendations may need to be addressed by directives. This approach has been adopted both for payment cards as well as for electronic funds transfers (below a threshold amount, as explained above).

With the exception of the United States, wholesale electronic payment systems are governed by a hodgepodge of rules (public and private) and contracts that do not provide for a comprehensive and transparent legal regime. It is instructive in this connection to read the prefatory note of the National Conference of Commissioners on Uniform State Laws and the American Law Institute, which accompanied the official version of Article 4A of the Uniform Commercial Code. After asking why Article 4A is needed, the note states:

There is no comprehensive body of law that defines the rights and obligations that arise from wire transfers. Some aspects of wire transfers are governed by rules of the principal transfer systems. Transfers made by FedWire are governed by Federal Reserve Regulation J and transfers over CHIPS are governed by the CHIPS rules. Transfers made by means of automated clearing houses are governed by uniform rules adopted by various associations of banks in various parts of the nation or by Federal Reserve rules or operating circulars. But the various funds transfer system rules apply to only limited aspects of wire transfer transactions. The resolution of the many issues that are not covered by funds transfer system rules depends on contracts of the parties, to the extent that they exist, or principles of law applicable to other payment mechanisms that might be applied by analogy. The result is a great deal of uncertainty. There is no consensus about the juridical nature of a wire transfer and consequently of the rights and obligations that are created. Article 4A is intended to provide the comprehensive body of law that we do not have today.

The conclusion that a statutory framework is necessary for a payment system has not, however, been accepted by all observers. Many have argued that, especially in the case of new and evolving systems, imposing a legal framework at too early a stage may result in constraining the development of a preferred technology and a system based on it. Others, however, have pointed to anomalous results when a system is left solely to be governed by contract.

An analysis of such anomalous results has indicated several important areas where government standards may be needed in payment card systems. These areas are as follows:⁵⁹

• Banks and other card issuers may engage in the unsolicited issuance of electronic payment cards and/or personal identification numbers or PINs. This practice has led in some cases to cards and PINs being sent by a bank to the wrong address and their fraudulent use by a stranger.

• Adequate disclosure of the terms and conditions of the contracts that will bind a cardholder may not be made available to him prior to his entering the arrangement.

• Consumers may not receive a printed record of each electronic banking transaction. This makes it difficult or impossible to reconcile a bank statement with a withdrawal or debit that is in question.

• Changes in the contract terms and conditions may occur without adequate notice to the cardholders.

• The consumer’s liability for unauthorized use of his payment card may be left for the card issuers to decide instead of being regulated by statute.

• In some countries, the burden of proof in the event of a dispute may be put on the cardholder instead of the card issuer.

• When the electronic payment system goes wrong (e.g., stopping for a period of time, providing the wrong amount of cash, or debiting an account incorrectly), should the card issuer that maintains the system be liable in damages?

• Should a procedure be required by which the cardholder who loses his card may notify the issuer at any time?

• Should error resolution procedures be left to card issuers, or should they be specified by statute?

There is a legal rationale for concluding that in the payments area it may be necessary for the government to establish standards that must be reflected in the contracts that govern the relations between the parties. This rationale is based on the consideration that payment contracts are not likely to be ordinary contracts based on the consensus of the parties, but are far more likely to represent the adhesion of one or more of the parties to the stipulations of a single party (the bank). Such contracts are called adhesion contracts and share five principal characteristics:

The adhesion contracts may be distinguished from commercial standard form contracts (like building contracts), which may serve as a model between parties of relatively equal bargaining power. Commercial standard form contracts have been widely adopted because they facilitate trade. Moreover, these contracts may be varied in their particulars by the parties. In contrast, adhesion contracts are often associated with monopoly power. The weaker party is merely presented with a form that he is requested to sign, or he will forgo the benefit that would otherwise accrue from entering into the contract. Adhesion contracts are not drafted with individuals in mind, but for the public in general; it is in this light that society has distinguished them from ordinary contracts, which are the product of bargains entered into through a meeting of minds based on the process of offer and acceptance.⁶¹ It is submitted that, in most instances, contracts offered by banks and other sponsors of payment systems are in the nature of adhesion contracts.

The response of many societies to adhesion contracts is to remove them from the area of private contracts and to subject them to guidelines and standards that are believed to reflect the public interest. That the countries of the European Community and the United States have chosen to set standards through legal frameworks for payments contracts is not mere coincidence. It proceeds naturally from the nature of payments contracts. It is submitted that it is likely that this approach will increasingly be adopted elsewhere in the world.

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The subjects treated in this volume attempt to place the central bank in the context of rapidly changing developments. After surveying developments at the international financial institutions, the volume treats three main areas of interest: payments issues, dealing with banks in distress, and the resolution of sovereign liquidity crises. A final section explores several matters of special interest: the regulation of derivatives activities of banks, bank secrecy, and financial services in the General Agreement on Trade in Services.

This volume is the fifth in a collection of revised proceedings of seminars that have been sponsored by the International Monetary Fund’s Legal Department, in conjunction with the IMF Institute, for general counsels of central banks. The volume, which reflects topics originally addressed at the 1996 seminar, contains the collected views of many of the foremost thinkers and actors in the field of banking having particular reference to the legal aspects of the matters discussed. Following the main papers of the proceedings are the remarks of a number of distinguished commentators. Each of these commentators offers a distinct perspective on a given subject. The main areas of interest are set out with forewords by way of introduction and afterwords by way of conclusion. Hypotheticals are introduced by a number of commentators to serve as illustrations of the issues. The views expressed in the various papers and commentaries are those of the authors and should not be interpreted as reflecting the views of the International Monetary Fund or any other institution.

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Mr. Gianviti surveys the history of special drawing rights (SDRs), describes their purposes, reviews the conditions for an allocation of SDRs, and analyzes proposals for such an allocation. He explains that SDRs were created by the First Amendment of the International Monetary Fund’s Articles of Agreement for the purpose of supplementing existing reserve assets. He notes that they were not explicitly recognized as reserve assets. Their main use was to be exchanged for currencies among Fund members. At the time of the Second Amendment, however, SDRs were made the unit of account of the Fund’s General Resources Account (instead of gold), and it was expressly stated that they were intended to become the principal reserve asset of the international monetary system. He notes that a country’s reserve assets now include four categories of assets: gold, foreign currencies, its reserve position in the Fund, and SDRs. Mr. Gianviti compares and contrasts these four categories of assets. In his analysis of SDRs, he explains that the creation of SDRs was the result of protracted discussions. Various proposals were put forward to create a new source of liquidity, additional to existing reserve assets, which could be created by a deliberate action of the world community and injected into the world economy in order to avoid a general deflation, although subject to some strict conditions to avoid a general inflation. He states that, at first, the creation of the SDR appeared to be a complete success: SDR 9.5 billion were allocated by the Fund in 1970-72. Thereafter, unexpected economic developments cast a doubt on the continued need for SDR allocations. Nevertheless, further allocations of SDR 12 billion took place in the 1979-81 period. From that time until 1997, there had not been an allocation of SDRs. Mr. Gianviti introduces the subject of the debate over whether there was a need for a new SDR allocation. He then provides an example of how the SDR system operates. Moreover, he describes the process of an allocation of SDRs, the applicable accounting rules, and the cancellation of SDRs. Mr. Gianviti explains the two functions of the SDR—as a unit of account and as a reserve asset. Thereafter, he discusses the substantive conditions for an SDR allocation. In conclusion, Mr. Gianviti reviews and analyzes various proposals for such an allocation. The Board of Governors of the IMF has now approved the proposed amendment of the Articles of Agreement to allow for a special one-time allocation.

Mr. Holder examines the role of lawyers in the International Monetary Fund, an organization possessing international legal personality. First, he spells out the objectives, structure, and functions of the IMF, noting that its legal activities reflect these features. He states that the Fund is an intergovernmental, international organization, whose authority and power derive from its constitutional document, the Articles of Agreement. He details IMF functions as set out in the Articles and describes how the Articles expand on their execution. Second, he describes the gamut of tasks that are performed by the Legal Department. Mr. Holder comments that, since 1946 when the Legal Department was first established in the IMF, it has become a necessary part of decision making, and, consequently, the Department has contributed to practically all of the Fund’s activities. He goes on to describe how the work of the Department falls generally within four functional categories—general legal issues, country-specific issues, administrative affairs, and technical assistance—and examines each category in detail. Third, he answers the following questions: Who are the clients? What form does legal advice take? Where is the law found? Finally, Mr. Holder makes some general observations about the lawyer’s role in the IMF. He concludes that IMF lawyers are primarily dealing with member states and are caught up in the historic shift of authority from exclusive national authority (“sovereignty”) to that of cooperative international authority.

Mr. Shihata considers the role of the World Bank and its affiliate institutions, the World Bank Group, in the 1990s and contends that the World Bank is the most qualified institution to meet the challenges of global development. He addresses the changes that have occurred within the World Bank relating to its membership, operations, internal structure, and related matters. He points out that the growth in the World Bank’s membership has paralleled the widening and intensification of international linkages in trade and finance, termed “globalization,” and that such developments have greatly influenced the types, scope, and modes of operations of the World Bank. Mr. Shihata examines the greater emphasis being placed on private sector development, social development, governance, the environment, and debt reduction. Regarding governance, he notes that the lending for improvement in this area has supported legal, judicial, and civil service reform, including the introduction of measures to enhance public accountability and greater transparency in government actions. He also describes the World Bank’s new lending instruments and business practices, and its internal structure and culture, noting that the main purpose of recent organizational changes was to transform the World Bank into a more result-oriented institution. Mr. Shihata maintains that the World Bank’s demonstrated readiness to adapt itself to meet world needs, its ability to continuously improve its strategies and operational practices, and its dynamic new leadership are the factors of promise that should help it meet new challenges.

Ms. Aizawa reviews developments at the International Finance Corporation (IFC), which marked its fortieth anniversary in 1996. She points out that the IFC is now the world’s largest multilateral source of direct investment for private project financing in developing countries and describes its roles as an investor in the private sector and a mobilizer of resources (through its “B” loan program). Ms. Aizawa focuses on the IFC’s privatization and advisory services, financing of infrastructure projects, and capital markets development. She also describes the IFC’s assistance to small and medium-scale enterprises and its focus on the environment. She concludes that the IFC’s activities reflect the belief that market forces must play a greater role in the economies of developing countries if sustained growth is to be achieved.

Ms. Tibbals Davy, in a paper she presented, considers the risk associated with the settlement of foreign exchange transactions. She points out that, given the estimated $1 trillion plus of foreign exchange trades arranged daily, the resulting large exposures raise significant concerns for individual banks and the entire international financial system. These concerns include the possible effects of such risk on the safety and soundness of banks, the adequacy of market liquidity, market efficiency, and overall financial stability. Ms. Tibbals Davy describes how the collapse of Bankhaus Herstatt in 1974 brought foreign exchange settlement risk into sharp focus and then turns her attention to Settlement Risk in Foreign Exchange Transactions. This report, which was issued by the Committee on Payment and Settlement Systems of the Central Banks of the Group of Ten Countries, analyzes the existing arrangements for settling foreign exchange trades and offers practical approaches for reducing foreign exchange settlement risk. Ms. Tibbals Davy goes on to identify legal issues raised by the Committee’s specific findings and recommendations, including finality and choice of law, netting, and cross-border issues (especially regarding insolvency legislation). She concludes that (i) individual banks can control their foreign exchange settlement exposures by applying appropriate credit control processes to their foreign exchange settlement exposures, (ii) industry groups can develop well-constructed multicurrency services that contribute to the risk-reduction efforts of individual banks, and (iii) central banks in cooperation with the relevant supervisory authorities can foster private sector action.

Professor Bhala examines cross-border electronic banking and focuses on the systemic risk and sovereignty issues that it raises. He begins by defining the concept of cross-border electronic banking. Thereafter, he elaborates on two challenges. First, he considers whether cross-border electronic banking has rendered the international banking system inherently more volatile. His affirmative answer is based on an examination of six components of systemic risk: credit, market, market liquidity, payment or settlement, operational, and legal risks. Second, he suggests that the electronic technology employed in cross-border electronic banking has eroded the autonomy of central banks to conduct their own banking policies. Professor Bhala examines the conflicts that arise from the process of determining what law applies to a cross-border electronic banking transaction. He notes that never before has the difficulty of central banks to keep pace with change been so obvious. This difficulty raises a significant issue concerning the appropriate role of a central bank that finds itself perpetually behind the curve of developments. For example, should it promote market-based self-regulation? Professor Bhala contends that cross-border electronic banking highlights the need for central banks to redouble their efforts to reach agreement on supervising such transactions.

Mr. Baxter addresses the legal uncertainty surrounding stored value products and the dilemma it has produced. On the one hand, legal uncertainty may undermine public confidence in a nascent payments system and stifle its development, but on the other hand, premature adoption of rigid legal rules can hamper competitive product development. Mr. Baxter defines a happy balance in this situation as sufficiently clear legal rules to assess liability and risk, without being so costly and constraining that they become an iron cage. He provides an overview of stored value products—what they are and how they work—and discusses their credit feature. Then, through an example, Mr. Baxter considers the evolution of a stored value product from creation, through its transfer, to final settlement and discharge. He points out that, by focusing on each of these stages, it becomes clearer when commercial law issues can be resolved by a written contract between the parties to the transaction or when a special legal rule is necessary. He emphasizes the importance of adopting a finality rule. Finally, Mr. Baxter examines some issues of particular relevance to central bankers, such as choice of law, lost or stolen obligations, and foreign exchange risk. He concludes that central banks can help foster the development of appropriate rules, thereby permitting stored value products to act as an efficient payment mechanism for consumers without unnecessary or uncontrollable risk.

Professor Guest compares the common law and the Geneva systems in their treatment of the legal incidents of checks and their collection. First, he compares the definitions of checks found in the United Kingdom’s Bills of Exchange Act and the United States’ Uniform Commercial Code with that found in the Geneva System’s Uniform Law on Cheques. Second, he examines a host of issues related to these definitions, including the definitions of bank, postdated check, assignment of funds, and transferability. Other issues examined are certification, presentment, countermand of payment, and the effects of a drawer’s death or of a “crossing” of the check. Professor Guest describes annotations sometimes found on checks, such as “not negotiable” and “account payee,” and checks defined as payable through a bank and payable in account. He surveys the liability of parties to forged or stolen checks. Finally, he considers the collection of checks, focusing on the liability and protection of the collecting bank, the effect of delays, and truncation of the check collection process.

Mr. Feldberg surveys approaches to bank supervision. He notes that technological advances, product innovation, globalization, structural changes, and deregulation—together with a wave of broad-scale banking problems in a number of countries—have fundamentally altered the business of banking. These trends, he contends, have produced major new challenges for bank supervisors and have raised questions in many countries about the adequacy of bank supervisory techniques and overall performance, as well as about the need for fundamental changes in supervisory approaches. Mr. Feldberg first describes the different types of supervisory models in use among the Group of Seven countries, concentrating on the role of on-site examinations and the supervisors’ relationships with external auditors. He identifies common themes, one of which is a noticeable shifting of emphasis in supervisory practices from detailed transactional reviews to a more risk-based and process-based focus. Second, he details the U.S. supervisory approach and discusses its emphasis on developing and administering prudential policies. In addition to describing the supervisory tools used in normal circumstances, Mr. Feldberg examines the U.S. approach in times of stress. Finally, he surveys the work of the Basle Committee on Banking Supervision, including its efforts in the area of prudential risk-based capital requirements; its work on risk management and derivatives; its efforts to establish the principle of comprehensive consolidated supervision; and its efforts to achieve close collaboration among bank supervisors and other financial regulators.

Mr. Ireland describes the central bank’s role in bank closures and focuses on its role as lender of last resort. He notes that the classic lender of last resort provides liquidity to solvent banks when they are unable to meet their liquidity needs from other sources. A critical element is whether the bank needing liquidity assistance is a viable entity. Mr. Ireland reviews U.S. legislation designed to reduce the costs to the deposit insurer of resolving troubled banks, and against this background, he considers two examples of bank “failures.” The first is Continental Illinois National Bank, which was rescued on a basis that was probably not “least cost” out of concerns for systemic consequences, and the second is the Ohio thrift crisis, a series of failures that might be characterized as systemic, at least in a particular geographical area. Regarding Continental, he examines why it was “rescued” rather than liquidated. As to the thrift crisis, he notes that it highlights the limitations inherent in the classic lender-of-last-resort function when good supervisory information is not available. Mr. Ireland suggests that the central bank’s powers as lender of last resort can serve as a vital source of funds to borrowing institutions but, if used inappropriately, these same powers can result in preferring creditors and encouraging their early flight from troubled banking institutions.

Mr. Josefsson examines bank failures that occurred in the Nordic countries, focusing on the severe banking crises in Finland, Norway, and Sweden. In these countries, authorities took drastic actions to support problem banks, and, in order to safeguard the banking system’s stability and to protect depositors’ money, spent large amounts of taxpayer money to rescue insolvent banks. Mr. Josefsson examines these crises to elicit lessons regarding the complex process of bank rescue operations. First, he identifies the causes of the crises: bad banking, the international recession, and bad economic policies. Second, he considers the role of deposit insurance and government support in each of these countries. Additionally, Mr. Josefsson describes special organizations that were set up to manage the support system for the bank restructuring and to decide on the measures to be taken. He also reviews the types of support provided and the public cost of bank restructuring. Mr. Josefsson concludes, among other things, that (i) government authorities need to take action immediately once there are indications of an imminent bank crisis, (ii) a deposit protection scheme cannot solve a systemic bank crisis, (iii) the government should be responsible for restructuring through a special government agency, (iv) bad assets should be transferred to an asset management company outside of the banks, and (v) banks should not be allowed to operate unless they meet the requirements of the Basle capital standards.

Mr. Feldman considers bank failures that occurred in Latin America. He begins by noting that systemic banking crises have occurred in the past several years in Argentina, Bolivia, Mexico, Paraguay, and Venezuela, while important cases of bank failures—without reaching systemic proportions—affected Brazil, Costa Rica, and Ecuador. With respect to crises of systemic proportions, he analyzes the causes of the bank failures and deposit runs, and examines the responses of government authorities. He compares the banking crises of Venezuela and Argentina, noting the difference between the deposit runs in those two countries. As to nonsystemic bank failures, Mr. Feldman describes cases in Costa Rica and Brazil. He points out that several lessons can be drawn from the bank failures in Latin America, including (i) the need for authorities to introduce and maintain comprehensive strategies to address problem banks and (ii) the need for authorities to strengthen prudential regulation and banking supervision in order to protect the soundness of their banking systems and, indirectly, their countries’ macroeconomic stance.

Mr. Barton maintains that risk management is more important today than ever before. He explains that bank regulators must respond to the increased potential for risk in a way that is the least intrusive and least costly so that banks can thrive in today’s competitive environment. In this chapter, Mr. Barton focuses on the method being employed to achieve this goal by the Office of the Comptroller of the Currency (OCC) through its “Supervision by Risk” program. His discussion of the program considers the following questions: What is Supervision by Risk? Is Supervision by Risk a change? What are the benefits of this philosophy for banks? What do bankers need to do in light of the OCC’s changes? What still needs to be done by the OCC? He points out that Supervision by Risk focuses the banker and examiner on the identification and evaluation of risks across all product lines and activities. Mr. Barton notes that the OCC has defined nine risk categories: credit, liquidity, interest rate, price, foreign exchange, transaction, compliance, strategic, and reputation risk. It has also developed a common framework for evaluating risk known as the Risk Assessment System. For each bank that it evaluates, the OCC develops a supervisory strategy based upon the evaluation, and documents and communicates its findings to the bankers. He concludes that the Supervision by Risk program will continue to evolve and that the OCC is committed to focusing on this process.

Mr. Hoffman describes a joint program used by the U.S. agencies to supervise U.S. operations of foreign banking organizations. He examines the program’s main components and details the enhancement of the examination process that is embodied in the new “ROCA” rating system. This system focuses on risk management, operational controls, compliance, and asset quality. He then goes on to explain how the program enables the bank supervisory agencies, as host country supervisors, to identify supervisory concerns for communication to the banks and their home country supervisors. Mr. Hoffman contends that implementation of the program should lead to the prompt resolution of those concerns and ensure the continuance of strong overall risk management and internal control processes in the U.S. banking system. Using the case of Daiwa Bank as an example, he examines what can happen when a bank does not have adequate risk management and internal control processes in place throughout the organization. He points out that the cases of Daiwa Bank and Barings Bank exemplify the consequences of failure to observe relatively simple, “low-tech” elements of risk management and internal controls. He also emphasizes that these cases illustrate the importance of the worldwide coordination of supervisory efforts. Mr. Hoffman concludes that, given the greater likelihood that the problems of one internationally active bank will affect others, bank supervisors must have effective supervisory methods and must vigorously coordinate them.

Mr. Mattingly examines the importance that information sharing between banking supervisors has acquired in the wake of the increase in cross-border business by international banks. Noting that even the most comprehensive system of consolidated home country supervision may not be sufficient to deal effectively with internationally active banks, he reviews the cases involving the Bank for Credit and Commerce International (BCCI), Daiwa Bank, and Barings Bank. He also considers the Basle Concordat, which is a set of common principles for the supervision of banks’ foreign establishments adopted by the Basle Committee on Banking Supervision. An important aspect of information sharing concerns bank secrecy or customer confidentiality (the expectation of customers that financial information will be kept confidential). To illustrate some of the legal issues raised by the sharing of confidential supervisory information, he summarizes provisions of U.S. laws relating to the collection and dissemination of information, including the Trade Secrets Act, the Right to Financial Privacy Act, and the Freedom of Information Act. In addition, he analyzes the statutory basis on which the Board is able to share information with other supervisory authorities. In this chapter, he describes experiences of the Board of Governors of the Federal Reserve System in sharing information and the ways in which the Board has sought to balance the competing interests in this area. Mr. Mattingly also describes two multilateral initiatives concerning the sharing of information between supervisors of different industries: a joint initiative undertaken by the Basle Committee on Banking Supervision and the International Organization of Securities Regulators (IOSCO), and the Joint Forum, a working group composed of representatives of the Basle Committee, IOSCO, and the International Association of Insurance Supervisors.

Mr. Gianviti discusses basic concepts and issues relating to the resolution of sovereign liquidity crises. He begins by noting that the expression “sovereign liquidity crisis” refers to a situation where a government is unable to service the country’s debt. If the debtor is a sovereign state, as a subject of international law it cannot be subjected to bankruptcy procedures or other normal legal remedies applicable to national subjects, because of its sovereign immunities. As a consequence, the only remedies available will be those that can be negotiated between the sovereign debtor and its creditors. Mr. Gianviti then analyzes several key concepts: sovereign debtor, liquidity crisis, and external debt. He distinguishes between three categories of debtors: private debtors, official debtors other than sovereign states, and sovereign debtors. Turning to the concept of a liquidity crisis, he distinguishes it from insolvency and considers the notion of solvency in the context of sovereign debtors. Thereafter, he notes that the distinction between external and internal debt is not based on the currency of payment and does not necessarily correspond to a difference between payment in local currency and payment in foreign currency. In this connection, Mr. Gianviti stresses the primary significance of the residence of the parties. He explains why attention is often given to the currency of payment in discussions on sovereign external debt. He states that the resolution of sovereign liquidity crises involves a number of different, and sometimes conflicting, considerations. He points out that, while greater attention has been given to foreign creditors and to the problem created by the shortage of foreign exchange, a sovereign liquidity crisis cannot be resolved by ignoring the situation of local creditors and the impact of local currency payments both on the budget of the sovereign debtor and on the availability of foreign exchange for all creditors, foreign or local.

Mr. Morais cites the 1994 Mexican financial crisis as a wake-up call to the international financial and political community to urgently consider improved procedures to deal with sovereign liquidity crises. He goes on to identify and analyze the deficiencies in the existing “traditional” legal framework for rescheduling sovereign debt. He addresses the essential features, relevant contractual provisions, and overall adequacy and effectiveness of the legal framework governing each of the main categories of sovereign debt—multilateral credits, bilateral credits, syndicated loans, and international bonds. Mr. Morais also examines two proposals for dealing with future sovereign liquidity crises: (i) strengthening the legal framework for negotiating with bondholders and (ii) establishing an international debt adjustment facility patterned in part on the domestic bankruptcy model.

Mr. Gordon, in a paper he presented, considers the legal remedies available to creditors in the event of a sovereign debt default. He begins by considering the meaning of the concept. He goes on to note that in order to secure an effective legal remedy against a defaulting borrower, a creditor needs two things: (i) a judgment providing that damages of a specific amount are due and (ii) sufficient assets of the borrower to attach or seize to secure the judgment. Mr. Gordon examines some of the hurdles a creditor has to clear in order to secure a judgment and have its claim satisfied, such as the applicability of the doctrine of sovereign immunity. After examining the effect of this doctrine on property of the state located in the country or abroad or on account with a central bank, he concludes by considering whether these immunities should be restricted. Mr. Gordon’s discussion draws upon the statutory and case law of different countries.

Mr. Buchheit considers the process of rescheduling sovereign debt. Regarding the rescheduling process in 1982 and 1983, he recalls the then-prevailing notion that countries’ external debt problems could be resolved quickly. He surmises that this refusal to acknowledge the depth of the problem was costly because temporary solutions were fashioned for what were wrongly believed to be “temporary” problems. Consequently, debt reduction (as opposed to simple debt rescheduling) was not generally used until the Brady Initiative in 1990. Mr. Buchheit draws a lesson from this state of affairs: if a solution is to come from renewed market access, then remedial measures that appear adequate to the market should be implemented to restore a country’s medium-term creditworthiness at an early stage. Additionally, he addresses the impracticality of requiring unanimity of consent from all creditors to any amendment of the repayment terms. This leads him to consider creditors that are unwilling to accept a proposed debt reduction. Mr. Buchheit points out that, in some Brady-style reschedulings subject to English law, the sovereign borrower has been asked to covenant that it will not voluntarily enter into any arrangement with a nonparticipating creditor on terms more favorable than those offered in the Brady deal unless the same terms are made available to its other lenders. Mr. Buchheit also examines the borrower’s options for dealing with nonparticipating creditors. He surmises that if debt problems recur in some countries, the litigation risk to the sovereign debtors will be greater than a decade ago because of the many noninstitutional investors that are currently holding such debt.

Mr. Patrikis, in a paper he presented, surveys initiatives of the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) to supervise and regulate banks’ and other financial institutions’ derivatives activities. He begins his discussion by examining the Federal Reserve Board’s examiner guidelines and manual relating to derivatives activities. These address such issues as customer appropriateness, netting agreements, senior management oversight, and risk measurement and management. He discusses the requirements imposed by the guidelines on both examiners and financial institutions. In the latter connection, he considers the role of the board of directors and senior management, and adequate internal controls. After reviewing changes in risk-based capital guidelines and the Board’s regulations, he reviews the treatment of the OCC’s banking circular on derivatives activities (under the OCC’s Supervision by Risk program) and the FDIC’s guidance on derivatives activities. In the chapter, Mr. Patrikis highlights the Principles and Practices for Wholesale Financial Market Transactions, as well as initiatives of the Derivatives Policy Group, the Federal Financial Institution’s Examination Council, and the Bank for International Settlements to promote enhanced disclosure and supervision of derivatives activities. He also discusses other significant federal initiatives carried out by the U.S. Government Accounting Office and the President’s Working Group on Financial Markets.

Mr. Wood provides an in-depth look at how countries balance their own need to know about banking activity in order to prevent criminal activity or to properly perform their regulatory role against the privacy rights of individuals. He begins by noting that nearly all countries with developed legal systems respect bank secrecy and explains that the differences between the countries’ laws focus on degree rather than substance. In essence, while there is little divergence from the rule that a bank may not disclose information about its customers to other private persons, there is significant divergence regarding the extent to which banks must disclose such information to government authorities. Mr. Wood concludes that compulsory disclosure by the banks is the primary issue in bank secrecy law. Mr. Wood goes on to provide a summary description of international attitudes on bank secrecy and disclosure, investigating the motives for maintaining and the main reasons for piercing the veil of secrecy. He classifies individual countries on a scale of low to high secrecy and identifies various sources of the law of bank secrecy, including constitutions, codes, special statutes, and case law. He elaborates on the well-known English case of Tournier v. National Provincial & Union Bank of England, which is followed in a large number of countries with English-based legislation, and also observes that many jurisdictions have modeled relevant codes after the original French Penal Code provisions. Mr. Wood elaborates on recognized principles regarding the scope of the secrecy duty and analyzes various exceptions to the duty, including the need to disclose information in cases of money laundering. He illustrates the concern with criminal conduct involving banking activities and the efforts to combat it on both international and national levels. In addition to discussing disclosure to bank supervisors, Mr. Wood considers disclosure to securities supervisors and tax authorities, as well as in civil litigation. In the course of the chapter, he cites national legislation and the case law of countries around the world.

Mr. Low, in a paper he presented, reviews the General Agreement on Trade in Services (GATS) financial services negotiations, which took place in 1995, and assesses their results. He begins by explaining the GATS framework within which the negotiations took place, emphasizing that a fundamental feature of the GATS is the principle of progressive liberalization. Mr. Low discusses the agreement’s main obligations of the most-favored-nation principle and transparency commitments, and examines the national treatment provision. He goes on to consider the relationship between commitments to liberalize trade in financial services under GATS and policies relating to prudential regulation and to financial flows on the current and capital accounts of the balance of payments. Against this framework, Mr. Low traces the progress of the 1995 financial services negotiations and examines their results. He concludes that, in order to remove existing distortions and create a truly efficient and well-functioning global marketplace for financial services, further work is necessary in a multilateral context. Mr. Low believes that the GATS provides a unique tool for achieving the goal of providing the foundation for a liberal trading system for financial services that would benefit all countries. In an addendum, Mr. Low explains that the 1995 negotiations produced an interim agreement that remained in force until December 1997 and discusses the new, permanent set of agreed-upon commitments, which is expected to enter into force by March 1, 1999.

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I would like to express my gratitude to Pamela Bickford Sak, formerly of the Legal Department, and Gail Berre, of the Fund’s External Relations Department, for expert editorial assistance. Thanks also go to Clare Huang, my former assistant, who contributed both to the seminar and to the publication of its proceedings. Several members of the Fund’s Graphics Section also made important contributions. Philip Torsani and Massoud Etemadi designed the cover, and John Federici typeset the text. Additional assistance was provided by Miriam Camino-Wolosky and Carmen Tirbany, my assistants, Rachel Ray, and A. Touami, the Legal Department Librarian. Finally, I am indebted to Francois Gianviti, General Counsel of the International Monetary Fund, as well as to David Cheney, of the Fund’s External Relations Department, and to members of the IMF Institute, who, through their guidance and support, made this project possible.

Robert C. Effros

April 1998