1. Intraday Liquidity in Gross Payment Systems Francisco José Callado Natalia Utrero Universitat de Girona Universitat de Girona XXXIII Simposio de Análisis Económico, Diciembre 2008

2. INTRODUCTION No intraday liquidity Intraday Liquidity with Collateral Intraday Liquidity with Flexible Collateral Intraday Credit with cost Maximum level of liquidity Lower level of liquidity No Credit Risk Existence of Credit Risk (Illiquid assets) Existence of Credit Risk Gross Payment System: settlement of each payment order usually in real time. Gross Payment System: settlement of each payment order usually in real time. Preference of Financial Authorities Preference of Financial Authorities Introduction of intraday liquidity provision mechanisms in gross systems. Introduction of intraday liquidity provision mechanisms in gross systems.

3. INTRODUCCIÓN Design and implementation of a payment system in a given country affects its financial and economic development (Humphrey, 1995; Shoenmaker, 1995.etc.) Design and implementation of a payment system in a given country affects its financial and economic development (Humphrey, 1995; Shoenmaker, 1995.etc.) Money Demand.Money Demand. Monetary Policy operationsMonetary Policy operations Financial Markets StabilityFinancial Markets Stability Financial authorities are concerned with the way in which large amounts of money are processed. (Rochet y Tirole, 1996, Greenspan, 1996). Financial authorities are concerned with the way in which large amounts of money are processed. (Rochet y Tirole, 1996, Greenspan, 1996). The payment system can play an important role in the event of a financial and liquidity crisis. The payment system can play an important role in the event of a financial and liquidity crisis.

4. OBJECTIVE Comparative analysis of gross payment systems taking into account the different mechanisms of liquidity provision actually in use Model § § Diamond-Dybvig (1983), Freixas-Parigi (1998). § § Two investment possibilities: § § Eligible assets § § Non Eligible assets § § Possibility of default. § § Intraday Credit Risk

5. MODEL § §Two identical islands, three periods and one good. § §Consumers are endowed with one unit of the good at t = 0, that can be consumed or stored. § §There exist three kinds of consumers, § §impatient that consume at t = 1 (fraction  of consumers) § §patient that consume at t = 2 (1-). § §A fraction (1-) of the patient consumers (non strategic) can consume only in the other island (they have real payment needs). § §The remaining fraction (strategic) can consume in any of the two islands

6. MODEL Banks are risk neutral with two investment opportunities: Banks are risk neutral with two investment opportunities: collateral assets: rf, with rf 1.collateral assets: rf, with rf 1. other assets. R, that can take two values: RH and RL (L for low return and H for high return) with probability pH and pL respectively.other assets. R, that can take two values: RH and RL (L for low return and H for high return) with probability pH and pL respectively. E(R) > r f > 1.E(R) > r f > 1. Return at t=1 of any investment: k. with k < 1. Return at t=1 of any investment: k. with k < 1. It is assumed that It is assumed that Banks know the volume of payments they usually process but they are not able to identify the kind of consumer that arrives to the bank.Banks know the volume of payments they usually process but they are not able to identify the kind of consumer that arrives to the bank. This volume is equal to the amount of consumers with real payment needsThis volume is equal to the amount of consumers with real payment needs

7. MODEL How money is transferred in each system: With no Intraday Liquidity: Banks can transfer money by liquidating assets. With no Intraday Liquidity: Banks can transfer money by liquidating assets. Intraday Liquidity with Public Debt. Banks can transfer money by liquidating assets or by obtaining credit from the Central Bank backed up by public debt as the only eligible asset. Intraday Liquidity with Public Debt. Banks can transfer money by liquidating assets or by obtaining credit from the Central Bank backed up by public debt as the only eligible asset. Intraday Liquidity with Flexible Collateral. Banks can transfer money by liquidating assets or by obtaining credit from the Central Bank backed up by eligible assets (some of them are illiquid) Intraday Liquidity with Flexible Collateral. Banks can transfer money by liquidating assets or by obtaining credit from the Central Bank backed up by eligible assets (some of them are illiquid) Intraday Liquidity with cost. Banks can transfer money by liquidating assets or by obtaining credit from the Central Bank with a cost and no collateral. Intraday Liquidity with cost. Banks can transfer money by liquidating assets or by obtaining credit from the Central Bank with a cost and no collateral.

8. TIMMING OF THE MODEL T=0 Investment Decision Investment in Eligible assets: Gross with collateral: Proportion of consumers with real payment needs. Gross with no collateral: No investment T=1 Impatient consumers consume and patient consumers simultaneously decide wich action they take. K  (L, H), L low return and H high return. Independently distriuted in each island. Set of Strategies: S = { T, W, R } S’ = { T, R } T=2 Banks liquidate investment and share them among depositors.

9. RESULTS Equilibrium under certainty Equilibrium under certainty Proposition 1. assume p H = 1, Proposition 1. assume p H = 1, (i) Equilibrium in all systems is (W SC, T NSC ); (ii) Ordering of systems: Intraday credit with cost. Intraday credit with flexible collateral. Intraday credit with collateral. No Intraday credit. Difference among them comes from investment portfolio composition. Difference among them comes from investment portfolio composition.

10. RESULTS § Equilibrium under uncertainty Proposition 2 Equilibrium in all systems is [(W SE, T NSC ) (R SC, T NSC )] § With high return signal agents behave as in the certainty case. § With low return signal consumers with real payment needs transfer their money and strategic withdraw. Although these later would prefer to transfer there is no sufficient collateral or the limit established by the central bank prevent them from doing so. §This limit is similar to the suspension of convertibility mechanism characterized in Diamond and Dybvig (1983)

11. RESULTS  With no Intraday Liquidity. There is no risk for the central bank.  Intraday Liquidity with Public Debt. There is no risk for the central bank.  Intraday Liquidity with Flexible Collateral. There is a risk for the central bank. If banks do not meet their commitment financial authorities could end up holding illiquid assets.  Intraday Liquidity with cost. There is a risk for the central bank if banks do not meet their commitment

12. RESULTS Comparative Statics. Comparative Statics. Proposition 3 (i) The model with no collateral is better than the one with collateral the greater the return spread between eligible and non eligible assets and the lower the probability of default (ii) The greater the payment volume the better the model with no collateral. (iii) For return on eligible assets sufficiently high, the greater the proportion of consumers with liquidity needs the better the model with non flexible collateral

13. WELFARE ANALYSIS § Utility function: Data EU-25, Canada, USA, Japan, Hong Kong, Singapore, Switzerland, Bulgaria and Rumania. Parameters t = proportion of notes and coins in (M1 +payments) λ = 1- proportion of payments over (payments + M1 – t) R = money market rate + 2.25 r = money market rate pl = Probability of Default (Moody’s)

14. WELFARE ANALYSIS Results 1.The best model is the intraday credit with public debt as collateral 2.Two groups of countries: a)EU-15, new entrants of EU (except Malta and Latvia), Singapore, Canada, Japan and Switzerland with the following order: 1.Collateral Public Debt 2.No intraday liquidity 3.Flexible Collateral 4.Intraday credit with cost §Singapore, Canada, Switzerland and UK agree with their model. §EU does not agree. The increase in expected cost of financial authorities would not justify the gain in flexibility for participants of the system.

15. WELFARE ANALYSIS Results b) USA, Bulgaria, Rumania, Latvia, Malta and Hong Kong. 1.Collateral Public Debt 2.No intraday liquidity 3.Intraday credit with cost 4.Flexible Collateral §USA presents a different order being the best model (3) the one established by the Federal Reserve.

16. USA Hong Kong. WELFARE ANALYSIS (+)Notes and Coins(-) (+) Return(-) (-)Payment Volume(+) (+)Probability of Default(-) EU-15, new entrants EU Singapore, Canada Japan, Switzerland Bulgaria Rumania Latvia Malta USA USA Hong Kong. EU-15, new entrants EU Singapore, Canada Japan, Switzerland Bulgaria Rumania Latvia Malta

17. CONCLUSIONS § In this paper Comparative analysis of gross payment systems taking into account the different mechanisms of liquidity provision currently in use § Equilibrium in each of the systems is characterized. § It is shown how the preference for each system crucially depends on some of the parameters of the model, such as the usual volume of payments, the probability of default, the return on the eligible assets and the return of the bank investment portfolio.

18. CONCLUSIONS § The intraday credit with no collateral is preferred to the other models the greater the difference between the return on the list of eligible assets and the other assets, the lower the probability of default and the greater the payment volume §Besides, under the intraday credit model with no collateral it is possible to establish an optimum policy for the amount of credit granted by the central bank. §Welfare analysis with real data for EU-25, Canada, USA, Japan, Hong Kong, Singapore, Switzerland, Bulgaria and Rumania.

19. CONCLUSIONS §Results indicate that the best model for the majority of countries is the intraday credit with public debt as collateral followed by the model with no collateral. §Countries like Singapore, Canada, Switzerland, UK and USA are in agreement with the model established by their financial authorities §The election by the European Central Bank (flexible collateral) would be more difficult to justify according to the model results. §The increase in expected cost of financial authorities would not justify the gain in flexibility for participants of the system.