Liquidity Saving Mechanisms and Bank Behavior in Payment Systems

Liquidity Saving Mechanisms and Bank Behavior in Payment Systems

Marco Galbiati (Bank of England, UK & European Central Bank, Germany) and Kimmo Soramäki (Aalto University, Finland)
DOI: 10.4018/978-1-4666-2011-7.ch006
OnDemand PDF Download:
$30.00
List Price: $37.50

Abstract

Interbank payment systems form the backbone of the financial architecture. Banks need to hold costly funds at the central bank to process interbank payments. Each bank would individually like to hold a low amount of funds and finance its outgoing payments from payments received by other banks during the day. Collectively, however, all banks cannot “free ride” on other banks’ liquidity, which makes bank behavior in interbank payment systems a complex and interesting topic. This chapter investigates the effect of Liquidity Saving Mechanisms (LSM) in interbank payment systems. LSM mechanisms have recently been implemented and proposed in many major interbank payment systems. The chapter applies a novel methodology combining Agent Based Modeling (ABM) and game theory. The authors model a stylized two-stream payment system where banks choose a) how much liquidity to post and b) which payments to route into the each of two “streams”: an RTGS stream and an LSM stream. The authors simulate the systems using realistic settlement processes and solve equilibrium choices for the amount of liquidity to post and the fraction of payments to settle in each stream. The authors find that, when liquidity is expensive, the two-stream system is more efficient than the vanilla RTGS system without LSM. This is because the LSM achieves better co-ordination of payments. When liquidity is inexpensive, the second stream does not add value, as banks find it convenient to ignore it and use the plain RTGS stream. For an intermediate range of cost of liquidity, several equilibria may emerge. Besides a corner equilibrium where all payments are settled via the LSM stream, there are equilibria where both streams are used. Interestingly, some of these may be inefficient, as they involve a (somewhat paradoxical) mix of intensive use of the LSM and high liquidity usage in the RTGS stream. The appeal of the LSM resides in its ability to ease (but not completely solve) strategic inefficiencies stemming from externalities and free-riding.
Chapter Preview
Top

Introduction

Interbank payment systems form the backbone of the financial architecture. They are the ultimate method of settlement of obligations between banks, and provide final settlement for a number of ancillary systems: retail payment systems, securities settlement systems, fixed income and foreign exchange systems. Given the value of payments transacted there - typically around 10% of a country’s annual GDP each day (Bech, et al., 2008). Due to the fact that interbank payment systems provide the ultimate means of settlement, their safety and efficiency are is of great importance to the whole economy and a pre-requisite for the effective implementation of monetary policy.

Up until a few decades ago, the interbank payment systems predominantly operated on the basis of net settlement. The payment to and from each bank would be processed over the course of the day and the net amounts due would be transferred from net debtors to net creditors on the books of the central bank. Due to the credit risks that this could cause if the payments were credited to customers before final interbank settlement, central banks began introducing Real-Time Gross Settlement (RTGS) systems. In such systems, the funds are credited in gross value together with the payment instructions so that intraday credit positions between banks do not arise.

The main cost faced by the banks operating in these systems is related to the provision of liquidity, which is needed to settle the payments. Indeed, most interbank payment systems use a Real-Time Gross Settlement (RTGS) modality, whereby a payment obligation is discharged only upon transferring the corresponding amount in central bank money. While this eliminates settlement risk, it also increases the amount of liquidity required: if two banks have to make payments to each other, these obligations cannot be ‘offset’ against each other. Instead, each bank must send the full payment to its counterparty.

RTGS systems, however, require much more liquid funds than net settlement systems. These settlement funds are normally provided free but against eligible collateral by the central banks. Even so, the collateral pledged may have alternative uses creating an opportunity cost.

As the amounts are very high, the costs are real and banks have an incentive to economize on liquidity usage. Each bank would individually like to hold a low amount of funds and finance its outgoing payments from payments received by other banks during the day. The RTGS structure may therefore incentivize free-riding. A bank may find it convenient to delay its outgoing payments (placing it in an internal queue) and wait for incoming funds which it can ‘recycle.’ By so doing, a bank can avoid acquiring expensive liquidity in the first place. Collectively, however, all banks cannot ‘free ride’ on other banks liquidity, which makes bank behavior in interbank payment systems a complex and interesting topic.

There are three main reasons why such ‘waiting strategies’ are in practice limited to a level that allows payment systems to function smoothly. First, system controllers may detect and penalize free-riding behavior. Second, system participants typically agree on common market practices and may punish non-cooperative behavior1. Third, banks themselves have an interest in making payments in a timely fashion. The cost of withholding a payment too long may eventually exceed the cost of acquiring the liquidity required for its execution.

However, it is a well-known fact that a certain volume of payments is internally queued for a while. These payments do not contribute to any liquidity recycling as they are kept out of the settlement process. A tempting idea is therefore to coordinate these pending payments according to some algorithm which may allow saving on liquidity.

These algorithms are called ‘Liquidity Saving Mechanisms’ (LSMs), and systems employing them are generally termed hybrid systems. There are many kinds of hybrid systems; the simplest type combines two channels for settlement: one, which works by offsetting queued payments, and one, which works in RTGS mode. Banks may then use the first for less urgent payment, and the second for transactions that need to be settled instantly.

Complete Chapter List

Search this Book:
Reset