Credit Cap

A credit cap is a ceiling on the credit a participant may use inside a payment or settlement system. Depending on the system, it can limit an intraday overdraft on a central bank account, the net debit position a participant may build up before settlement in a netting system, or the amount any one participant may owe another. The system operator or the settlement agent sets the cap, and payments that would take a participant over it are rejected or held in a queue.

Credit caps exist because payment systems naturally create credit. In a deferred net settlement system, receiving banks are exposed to sending banks until settlement. In a real-time gross settlement system, the central bank is exposed when it lets participants overdraw. A cap limits that exposure. It differs from a counterparty credit limit, which a firm sets internally for its own risk management, rather than one imposed by the system.

A club runs a bar where members can sign for drinks and settle up at closing time. Without a rule, one member could run up a huge bill and then slip out. So the club sets a cap: once your tab reaches a set amount, you pay something off before the barman pours again.

A credit cap is that bar rule for banks in a payment system. It lets payments flow smoothly through the day on credit, while making sure no single bank can build up a debt so large that its failure would hurt everyone else.

A cap is typically linked to the participant's financial strength, its capital, its collateral, or a combination. The system checks each new payment against the cap in real time. If the payment fits, it is accepted and the participant's position is updated. If not, the payment waits until incoming funds create room, or is rejected. Systems often support payments held in a queue with a liquidity-saving mechanism, so that capped payments can be released as soon as offsetting payments arrive.

Common forms include:

• Net debit caps. The maximum net debit position, outgoing minus incoming payments, a participant may hold at any moment.
• Bilateral credit limits. Limits each participant sets on the net amount it will accept from another specific participant before settlement.
• Sender net debit caps. A system-wide limit derived from the bilateral limits other participants have granted to a sender.
• Overdraft caps. Limits on intraday overdrafts on accounts at the central bank, often requiring full collateral.

The Federal Reserve applies net debit caps to institutions that use daylight overdrafts in their master accounts, which settle Fedwire transfers. Under its payment system risk policy, an institution's cap is linked to its capital and a self-assessed or default cap category, and overdrafts can incur fees, with collateralised overdrafts treated more favourably. Many other central banks provide intraday credit in their RTGS systems only against eligible collateral, so the collateral pledged effectively becomes the cap.

Private netting systems use caps too. EURO1, the euro large-value system operated by EBA CLEARING, uses bilateral and multilateral limits to control each participant's position, backed by a collateral pool that supports settlement if a participant fails. Before it moved to a prefunded real-time design in 2001, CHIPS used bilateral credit limits and sender net debit caps in its end-of-day netting.

Caps limit credit risk to the settlement agent and to other participants, and limit systemic risk by keeping any one failure manageable. For netting systems, international standards require that settlement can complete even if the participant with the largest obligation fails; caps help keep that largest obligation within the resources available. The Principles for Financial Market Infrastructures list limits of this kind among the tools FMIs should use to manage credit exposures.

Caps that are too tight slow payments, as banks wait for incoming funds before they can send, which can cause gridlock late in the day. Caps that are too loose leave the system exposed. Operators therefore combine caps with collateral, throughput rules, queuing and liquidity-saving features, and review cap levels as participants' finances and payment volumes change.

Participants manage caps actively. Treasury teams monitor their position against the cap throughout the day, schedule large outgoing payments to follow expected incoming ones, and pledge extra collateral when a busy day is expected. A bank that repeatedly hits its cap may face questions from the operator or the central bank about its liquidity planning, and in some systems may have its cap reduced.

• Federal Reserve: Payment Systems