Models of foreign exchange settlement and informational efficiency in liquidity risk management

1. Models of foreign exchange settlement and informational efficiencyin liquidity risk management Joint Bank of England/ECB Conference on ‘Payments and monetary and financial stability’ Jochen Schanz, Bank of England

2. Overview • Background and policy questions • Model: Setup and Timing • Results

3. Overview • Background and policy questions • Model: Setup and Timing • Results

4. Background and Questions • CPSS Working Group on System Interdependencies • Globalisation and trend towards consolidation • One driver: centralised (‘global’) liquidity management. • Questions • Is global liquidity management here to stay? • What are the benefits and costs for financial stability? • Would a (further) change in FX settlement infrastructure design be desirable?

5. Local vs. global liquidity management • Local liquidity management: Payment outflows are financed • By using existing liquidity in home currency; • By borrowing in the domestic interbank market; • By selling assets against local currency. • Global liquidity management: In addition, • Exchange group-level liquidity surplus in other currency against home currency. • Not discussed: Cross-border collateral management.

6. Infrastructure design matters for risk CPSS FX Survey, 2007: • FX exposures to single counterparties typically exceed 5% of total capital in about one-fourth of the institutions on an average day (one half on a peak day). • One-third of transactions settle in ways that generates significant risks to financial stability. • One of the reasons: Absence of complete coordination of settlement for FX transactions which settle on the day on which they are traded.

7. Overview • Background and policy questions • Model: Setup and Timing • Results

8. Setup (1/2) • Two ‘countries’: East and West • One global bank with a subsidiary in each country; one domestic bank in each country; maximise end-of-day-2 payoffs. • Timing: Very short horizon (crisis scenario) • Date 0:Global bank invests deposits (risky asset / risk-free asset). • Day 1: Liquidity shocks hit. Liquidity outflow may be refinanced. If risky asset fails: bankruptcy. • Day 2: Risky asset pays off; healthy banks pay back interbank loans / reverse FX transaction.

9. Setup (2/2) • Global bank’s refinancing options: • Refinance domestically: unsecured interbank loan; • Refinance globally: FX transaction; • Do not pay today → fixed reputational penalty. • Lenders price loans to break even in expectation. • Distribution of information: • Within a banking group, information flows freely; • Between banks, there are barriers to the flow of information.

10. 24 hours of exposure from uninformed lending Distribution of information: Implications • Domestic refinancing (overnight interbank loan): • Local bank does not know liquidity-short subsidiary’s solvency risk.

11. Distribution of information: Implications • Global refinancing (via FX transaction): • Liquidity-short home subsidiary receives home currency from domestic bank • Foreign subsidiary pays (possibly later) foreign currency to the domestic bank’s foreign correspondent. • Before foreign currency is paid, domestic bank had exposure (uninformed lending); • After foreign currency has been paid, foreign subsidiary has exposure (informed lending).

12. PvP settlement: only informed lending. • Limit case for very low coordination: overnight loan. Distribution of information: Implications • Global refinancing (cont’d): • A sequence of Uninformed lending Informed lending • Better coordination → less uninformed lending, more informed lending.

13. Overview • Background and policy questions • Model: Setup and Timing • Results

14. Equilibrium refinancing decisions Proposition 1: Liquidity shortfalls will not be refinanced domestically when intra-group liquidity can be accessed. → Global liquidity management is here to stay. Refinancing decisions • Small solvency risk → refinance • Large solvency risk → don’t pay • Intermediate solvency risk → hold sufficient liquidity to be able to absorb liquidity shock

15. The influence of infrastructure design Proposition 2: Transmission of losses The better coordinated the settlement, the less likely losses are transmitted from the interbank borrower to the lender. • Domestic transmission of losses less likely; • Cross-border transmission of losses may be more likely. → Global liquidity management has benefits: Better informed lending means lower likelihood of transmission of solvency shocks.

16. The influence of infrastructure design Proposition 3: Failure to pay The better coordinated the settlement, the more likely bank will fail to make payment. • Better coordination means more informed lending; • Subsidiary can only refinance itself when its solvency risk is low; • In expectation (over solvency risk), subsidiary is more likely to fail to pay. → Global liquidity management has costs: failure to pay occurs more often.

17. Results - Summary • Global liquidity management is here to stay: Better informed internal lending crowds out uninformed external lending. • Global liquidity management has benefits: lower likelihood of transmission of solvency shocks. • Global liquidity management has costs: failure to pay occurs more often. The better the coordination in FX settlement, the more informed lending is, and the more pronounced these benefits and costs are.