New Directions for Understanding Systemic Risk A Report on a Conference Cosponsored by the Federal Reserve Bank of New York and the National Academy of Sciences (2007) / Chapter Skim
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4 The Payments System and the Market for Interbank Funds
4 The Payments System and the Market for Interbank Funds
Pages 55-67
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From page 55... ...
The fed funds market plays a critical role in allocating liquidity in the financial system as well as in supporting banks' ability to finalize the settlement of interbank payment obligations. The first paper, by Adam Ashcraft of the Federal Reserve Bank of New York and Darrell Duffie of Stanford University, explored whether trading frictions in the fed funds market affect the reallocation of excess reserves to banks requiring funds to complete their payments.
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From page 56... ...
Like every over-the-counter market, the fed funds market is subject to allocational frictions because trading is executed through bilateral negotiation. These frictions can be any sources of transaction costs or delays in identifying suitable counterparties, negotiating trades, or executing trades, and they can impact market efficiency. Existing theories of trading dynamics in over-the-counter markets have focused on "search" frictions, whereby traders locate each other with delays, to some extent by trial and error, and negotiate prices that depend in part on the difficulty of finding suitable alternative counterparties.
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From page 57... ...
Banks are motivated to end each day with non-negative balances in their reserve accounts at the Federal Reserve because overnight overdrafts are not permitted except in special circumstances. These institutions are also motivated to end each day with relatively small balances, in part because the Federal Reserve does not pay interest on overnight balances and in part because the institutions have other ways to meet their reserve requirements over their two-week maintenance periods, such as by holding currency in large ATM networks and by sweeping funds in reservable accounts into nonreservable accounts. By targeting its balances, a bank contributes to systemic stability.
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From page 58... ...
In addition, the authors raised the issue of, but did not resolve, whether precautionary balance targeting by banks in the fed funds market, coupled with a regime in which banks forecast the targeting policies of other banks, could have systemically destabilizing consequences. A potential systemic problem could arise, for example, if several large institutions during a day of extreme misallocation of reserves individually "hoarded" reserves, given the heightened risk of other banks doing the same or the institutions' forecasts that other banks are incapable of releasing excess reserves quickly to the market.
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From page 59... ...
When the authors applied the model to a liquidity market, they demonstrated that a reduction in market frictions can reduce this interdependence and thus the likelihood and size of congestive liquidity cascades. Network Topology of Interbank Payment Flows A payments system can be viewed as a specific type of complex network. In recent years, many fields of science have sought to characterize the structure of networked systems and the relationship between network topologies and stability, resiliency, and efficiency.
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From page 60... ...
In the Bech et al. model, interbank payments occur only along the links of a scale-free network based on the authors' analysis of Fedwire data; the model thus shows that only a very small fraction of the possible interbank exchanges tend to be active.
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From page 61... ...
The market creates a separate network of liquidity flows that, having a star topology, operates parallel to the network of payment flows. The inclusion of a liquidity market weakened the coupling between banks and reduced the size of settlement cascades.
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From page 62... ...
According to the authors, if the combined payments and liquidity market system is modeled with simple processes, the boundary between noncongested and congested states can be explained in terms of the relative values of three time constants: a liquidity depletion time, which is governed by the initial liquidity in the system; a net position return time, which increases with total deposits in the system; and a liquidity redistribution time through the market, which is associated with the market conductance parameter. An understanding of this boundary has significant practical applications because this understanding allows for direct consideration of the trade-offs between liquidity within the payments system and friction within the liquidity market, both of which are modified by central bank policies.
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From page 63... ...
The models do not have multiple equilibria because they do not yet include the anticipatory behavior that could produce feedback effects leading to system gridlock. In the combined payments system and liquidity market model, congestive liquidity cascades within the payments system are mitigated through transfers within the fed funds market.
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From page 64... ...
Thus, to what degree can anticipatory behavior and expectations of economic agents be realistically represented in simulation models, especially in simulations of systemic crises that are not modeling "business as usual"? While the issue has both conceptual and empirical dimensions, the empirical basis for this behavioral component is apt to be limited because systemic crises occur so infrequently.
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From page 65... ...
An important issue raised in this context was moral hazard. Whenever the central bank intervenes to mitigate or reduce the effects of a systemic shock, it can influence the future risk-taking incentives of private sector decision makers by weakening the perceived need to plan for the occurrence of extreme shocks.
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From page 66... ...
A shift has occurred from a bank-oriented financial system to a securities-market-oriented system in which a more diverse population of financial institutions interact. The diversity of investors in today's financial system -- such as pension funds, insurance companies, mutual funds, private equity and hedge funds, investment banks, and commercial banks -- makes for a more heterogeneous set of financial system participants than in the traditional bank-oriented models of the financial system.
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From page 67... ...
2006. "The Topology of Interbank Payment Flows." Federal Reserve Bank of New York Staff Reports, no.
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