Liquidity-Saving Mechanisms and Bank Behaviour

Abstract

This paper investigates the effect of liquidity-saving mechanisms (LSMs) in interbank payment systems. We model a stylised two-stream payment system where banks choose (a) how much liquidity to post and (b) which payments to route into each of two ‘streams’: the RTGS stream, and an LSM stream. Looking at equilibrium choices we find that, when liquidity is expensive, the two-stream system is more efficient than the vanilla RTGS system without an LSM. This is because the LSM achieves better coordination of payments, without introducing settlement risk. However, the two-stream system still only achieves a second-best in terms of efficiency: in many cases, a central planner could further decrease system-wide costs by imposing higher liquidity holdings, and without using the LSM at all. Hence, the appeal of the LSM resides in its ability to ease (but not completely solve) strategic inefficiencies stemming from externalities and free-riding. Second, ‘bad’ equilibria too are theoretically possible in the two-stream system. In these equilibria banks post large amounts of liquidity and at the same time overuse the LSM. The existence of such equilibria suggests that some co-ordination device may be needed to reap the full benefits of an LSM. In all cases, these results are valid for this particular model of an RTGS payment system and the particular LSM.