How a liquidity saving mechanism affects bank behavior in interconnected payment networks

Abstract

AbstractA surge in banks’ liquidity needs increases settlement costs that could burden the functioning of the real economy through its impact on banks’ lending behavior. A liquidity saving mechanism (LSM) can help reduce banks’ liquidity needs, but it could also affect banks’ strategic behavior. To understand how an LSM affects banks’ behavior in a real-time gross settlement system, this study models settlements in a day as a timing game in which banks decide when to make payments, thereby trading off the cost of delaying payments against the cost of borrowing liquidity. An LSM provides a partial offsetting service, whose direct effect is to decrease the cost of liquidity associated with payments that are offset. The study’s stylized analyses reveal that an LSM indirectly affects banks’ strategic behavior in a network context. Without an LSM, a positive strategic spillover effect can arise through the network of payments, which an LSM can dismiss by cutting off the underlying payment network. To demonstrate its welfare impact along with the network structures, this study theoretically analyzes a class of core-periphery networks. The density of the network is shown to have implications on the welfare consequence of adding an LSM. From a policy perspective, the implications on a policy mix between an LSM and the fee setting for intraday lending are discussed.