DEFINITION of Bilateral Credit Limit
A bilateral credit limit is an intraday limit that two institutions impose on each other in order to reduce their credit risk. When banks send large payments to each other, those payments may not clear until late in the day. Until that happens, the bank receiving the payment is at risk if the counterparty is unable to make payment. A bilateral credit limit reduces this risk by limiting the intraday amount that may be paid.
BREAKING DOWN Bilateral Credit Limit
The purpose of bilateral credit limits is to reduce the credit risk exposure of each member institution to another, and to ensure the stability of the payment system overall in case one institution fails to deliver on its obligations.
The Clearing House Interbank Payments System (CHIPS) is one large payment system in which bilateral credit limits are set by financial institutions. Payments in CHIPS are settled via netting. Another large payment system, Fedwire, also uses credit limits, although its settlement is known as real-time gross settlement, rather than netting.
In addition to bilateral credit limits, the payment systems usually have aggregate credit limits, which limit one institution's intraday obligation to all members of the system collectively.