Liquidity Saving Mechanisms and Bank Behavior in Payment Systems

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.