Credit risk, as it pertains to ACH origination activities, is defined as the risk that a party to a transaction will be unable to provide the necessary funds for the settlement of that transaction. The transaction is an ACH origination Entry (debit or credit) and the party bearing the risk is the Originating Depository Financial Institution (ODFI). The ACH Rules dictate that ODFIs are responsible for all Entries originated through the ACH Network. That responsibility includes the settlement of ACH Entries originated through an ODFI when the funding is unavailable from Originators and/or Third-Party Senders. The potential obligation of an ODFI to have to fund originated ACH transactions is one of the greatest risks associated with being an ODFI. ODFIs should take the appropriate means to identify, mitigate, monitor and report credit risks in its ACH origination activities.
ODFIs are subject to credit risk in two ways. The primary and greatest risk from a financial loss perspective is through credit Entry origination. ODFIs are subject to credit risk for the period between the submission of an ACH credit File to the ACH Operator until settlement by the ACH Operator with all applicable RDFIs. The longer the period between delivery of the credit file to the ACH Operator and settlement of the funds, the greater the risk to the ODFI. This period of exposure is the equivalent of an unsecured, short-term loan. For most credit files this means the ODFI is financially responsible for one to two days until funds settlement. The impact of this risk exposure could vary from minor losses from delays in settlement to substantial losses should an Originator declare bankruptcy or otherwise be unable to provide the necessary funds. The quantity of these potential losses could be for the entire amount of the ACH File.
The second way ODFIs are subject to credit risk is through ACH debit origination. Due to the timeframes for the return of debit entries, incoming funds previously made available to an Originator could be potentially reduced subsequent to the settlement date. If the funds necessary to settle a Return Entry from an RDFI are no longer in the Originator’s account, settlement must be made by the ODFI. There are two distinct timeframes for the transmission of Return Entries. Most Return Entries must be received by the ODFI no later than the opening of business on the second banking day following the settlement date of the original File/Entry. Therefore, ACH debits originated on the settlement date are subject to return for up to two days. In addition, and specifically in regard to consumer ACH debit Entries, the RDFI has a longer timeframe to return Entries that are determined to be unauthorized. The exposure period for unauthorized Entries is 60 calendar days after the Settlement Date of the original ACH debit Entry. It’s important to note that while the exposure period for ACH credit risk from debit Entries may be longer, the quantity of the risk is generally not considered as great since returns pertain to individual Entries and not entire ACH Files.
Identification of Credit Risks in ACH Origination
Identification of credit risks should be addressed in an ODFI’s ACH Management Policy and risk management identification procedures related to individual Originators. Due diligence should be performed on every Originator and Third-Party Sender (TPS) to determine its ability to perform its obligations in conformance with the ACH Rules, including settlement of funds. Various due diligence procedures enable ODFIs to identify, understand and mitigate the risks of the relationship, including specific credit risks of the ACH activities. The ACH Rules and other regulatory guidance offer a framework that mirrors many practices of a commercial lending underwriting process to assist in the credit risk identification process.
Credit/Underwriting Department Participation
It is clear from the ACH Rules and other regulatory guidance (specifically OCC Bulletin 2006-39) that lending personnel should not be excluded from ACH origination activities. This is especially true in the analysis and identification of ACH credit risks pertaining to individual Originators/TPSs. An ODFI’s credit/underwriting department can provide a significant degree of assistance and expertise in this process. Involving credit/underwriting employees in the ACH Originator due diligence function makes for a more robust ACH risk management program. Also, since it has been demonstrated that the credit risk from ACH origination activities resembles short-term, unsecured lending, the financial institution’s loan policy should address that activity and set parameters, as well.
Conclusion
Credit risk related to ACH origination can expose a financial institution to real and, potentially, very significant financial losses. It is important for ODFIs to have effective processes in place to understand and identify the credit risks related to each Originator/Third-Party Sender. Involvement and participation of credit/underwriting employees in ACH origination activities are highly recommended by EPCOR.
If your financial institution has questions about how to best identify credit risks in your ACH origination portfolio and is seeking best practices in developing an ACH credit risk process or enhancing current procedures, give EPCOR a call (800.500.0100) or fill out our service request form for a free, no-obligation quote! EPCOR’s Advisory Services department is happy to create a custom engagement to meet your needs. |
