Liquidity saving mechanisms and bank behavior in payment systems

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 mechanism have recently been implemented and proposed in many major interbank payment system. The chapter applies a novel methodology combining Agent Based Modeling (ABM) and game theory. We 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 a LSM stream. We simulate the systems using realistic settlement processes and solve equilibrium choices for the amounts of liquidity to post and the fraction of payments to settle in each stream. We 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 achieve 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. The views expressed in this paper are those of the authors, and not necessarily those of the Bank of England. The authors thank participants in: the 6th Bank of Finland Simulator Seminar (Helsinki, 25–27 August 2008); the 1st ABM-BaF conference (Torino, 9–11 February 2009); and the 35th Annual EEA Conference (New York, 27 February-1 March 2009). The authors are also indebted to Marius Jurgilas, Ben Norman, Tomohiro Ota and other colleagues at the Bank of England for useful comments and encouragement. Kimmo Soramäki gratefully acknowledges the support of OP-Pohjola-Ryhmän tutkimussäätiö. * Corresponding author: e-mail: [email protected], www.soramaki.net