Precautionary Demand and Liquidity in Payment Systems

Authors


  • We are grateful to Charles M. Kahn, Gabrielle Demange, and Fabio Castiglionesi for constructive discussions of the paper and to Valeriya Dinger, Todd Keister, James McAndrews, Stephen Morris, Rafael Repullo, Jean-Charles Rochet, Jochen Schanz, Pierre-Olivier Weill, and participants at the 8e Journées of the Foundation Banque de France, Bank of Mexico, Bank of France, Bank of Japan, Bank of Korea, Korea Institute of Finance, the 2009 Meeting of the Association for Public Economic Theory, IESE Business School, Bank of Spain, the 2009 Financial Intermediation Research Society Conference on Banking, Corporate Finance and Intermediation (FIRS), the Workshop on Payment Economics: Theory and Policy at the Bank of Canada, the JMCB Conference on Liquidity in Frictional Markets at the Federal Reserve Bank of Cleveland, the 2007 European Meeting of the Econometric Society, and the Workshop on Money and Payments at the Federal Reserve Bank of New York for useful comments, and to Andrew Howland for outstanding research assistance. We also thank the Fondation Banque de France for financial support. The views expressed in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.

Abstract

In large-value real-time gross settlement payment systems, banks rely heavily on incoming funds to finance outgoing payments. Such reliance necessitates a high degree of coordination and synchronization. We construct a model of a payment system calibrated for the U.S. Fedwire system and examine the impact of realistic disruptions motivated by the recent financial crisis. In such settings, individually cautious behavior can have a significant and detrimental impact on the overall functioning of the payment system through a multiplier effect. Our results quantify the mutually reinforcing nature of greater caution, and allow comparative statics analysis of shifts in key parameters.

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