Fall 1984

An assistant vice president with the in large-dollar transfer systems was an Federal Reserve Bank of Cleveland, Risk in Large-Dollar unfamiliar topic until quite recently. Even the author is re­ today, people who are not banking profession­ sponsible for Fed­ Transfer Systems als probably have little notion of what these eral Open Market systems are, what they involve, and why Committee briefings by E.J. Stevens those risks should be investigated. and other monetary In a nutshell, large-dollar transfer sys­ policy advice. The author has benefited tems in the United States are telecommuni­ from the comments cations networks (currently including Fed wire, of Donald Hester, CHIPS, CashWire, and CHESS) almost entirely Ernest Patrikis, dedicated to same-day handling of multimil­ David Humphrey, lion dollar payments among banks (see box 1). James Hoehn, Roger Hinderlitcr, These payments may be for a bank itself, as Kim Kowalewski, it buys and sells money, or for the accounts of John Carlson, and the bank’s customers, especially financial Mark Sniderman. institutions, active in world money and capi­ tal markets, and nonfinancial corporations. The risk being discussed is risk: that, at the end of a day, a participating bank will not be able to pay the net amount (pay­ ments minus receipts) it owes to the other banks on one of the systems for that day’s transactions. How to deal with this risk may be viewed differently by banks, their custom­ ers, and the Federal Reserve System. Nev-

Box 1 Large-Dollar Transfer Systems CashWire is operated by the Payment and Administra­ tive Communication Corporation owned by a consortium of 180 U.S. banks. Service is currently provided to 17 of these banks, which send approximately 350 payments daily with an average value of about $700,000. CHESS, or Electronic Settlement Sys­ tem, is operated by the Chicago Clearing House Associa­ tion with service available to members, who must be in the 7th Federal Reserve District. Service is currently pro­ vided to six banks, which send approximately 450 mes­ sages daily with an average value of about $1.0 million. CHIPS, or Clearing House Interbank Payments System, is operated by the New York (City) Clearing House Asso­ ciation with service available to its members. Service is currently provided to over 120 institutions, which send approximately 75,000 payments daily with an average value of about $3.0 million. Fedwire is operated by the 12 Federal Reserve Banks and their branches with service available to any depository institution with an account relationship with a Reserve Bank. Service is currently provided to over 7,000 insti­ tutions, which send approximately 150,000 payments daily with an average value of about $2.4 million.

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1. For example, see “Risks in Elec­ ertheless, there is a common concern that the phone and other devices can be employed. tronic Payments Systems, ’ ’ Report risk be recognized and methods of risk man­ Fledgling debit card and home banking sys­ of the Risk Task agement be understood.1 To that end, the Board tems exist, some automated clearinghouse Force, Association of Governors of the Federal Reserve System transactions are now made on a computer-to- of Reserve City Bank­ has formally asked for industry comment on computer basis, and electronic check collec­ ers, October 1983. a number of proposed methods of risk man­ tion is contemplated. Nonetheless, small pay­ agement and control.2 ments typically are not completed on tele­ 2 . See Board of Gov­ ernors of the Fed­ The purpose of this article is to examine the communications systems. eral Reserve System, concept of settlement risk (section II). This Large-dollar transfer systems should also “Proposals to Re­ requires, in addition, a background description be contrasted to inter-bank message systems duce Risk on Large- of the institutional basis for making large- that, standing alone, do not necessarily effect Dollar Transfer dollar payments in the United States (section I) payments. SWIFT and Bankwire II, for exam­ Systems,” Docket and an explanation of why concern about set­ ple, are technologically sophisticated tele­ No. R-0515. tlement risk has only recently come to the communications systems; however, they are 3. Automated Fed- fore (section III). only capable of conveying messages. Those wire payments, for messages may be—frequently are—instruc­ example, involve tions authorizing a bank to remove funds from a fee of 55C to each I. Large-Dollar Payments of the sending and the account of one depositor and place them receiving banks. and Settlement in the account of another. When both deposi­ The banks them­ tors maintain accounts at the bank receiving selves would have Payment Systems the message, only follow-up internal book­ to charge substan­ keeping is required to complete the process. tially more than this The nature of large-dollar transfer systems to cover the 55C fee However, if the account to which the payment plus inhouse costs. in the United States is best understood by con­ is directed is at any other bank, then no pay­ Non-pecuniary trasting them with small-dollar systems on ment has been made until a follow-up inter­ costs may loom just the one hand and, on the other, with nonpay­ bank payment has been initiated via one of as large. Specifically, ment message systems. Small-dollar transfer the large-dollar transfer systems. In this sense it is sometimes ar­ systems—cash, checks, automated clearing­ gued that small-value SWIFT and Bankwire II, despite restricted wire transfers are houses (e.g., for direct deposit of Social Secu­ access, standardized formats, and a sophisti­ more likely to go rity or salary payments)—are familiar to most cated telecommunications vehicle for trans­ astray. A bank that people. Whereas an average cash transaction mission, are closer to telex, telephone, and fails to receive a is for considerably less than $100, and even the mail service than to large- or small-dollar transfer, standing average check (including business checks) to gain only the over­ transfer systems. What distinguishes large- night return on the is for less than $1,000, the average wire trans­ dollar transfer systems from these message value of the payment, fer (the generic name for payments made on systems is the ability of one participant to has little incentive large-dollar systems) is in the million-dollar transfer cash in the form of immediately to initiate a search range. This is not to imply that wire transfers available bank balances to any other partici­ fora missing$ 1,000 are somehow restricted to such large sums: payment; other par­ pant by a single message. In the jargon of ties to the transaction small payments can be made as readily as payments, these large-dollar transfer systems may be relied on to large. However, routine wire transfer of small make payments because they include settle­ do the job. The incen­ payments is usually un-economic because the ment—the irrevocable transfer of ownership tive is a thousand­ value of gaining interest for a day or so by of bank balances from one participant to fold greater on a completing a same-day payment is not worth million-dollar trans­ another. This transfer is analogous to pay­ fer, which is there­ the additional cost of a wire transfer.3 ment in cash in the form of legal tender cur­ fore likely, if lost, to Wire transfers typically are completed on rency and is brought about by the transfer of be sought assiduously a telecommunications system, although tele­ deposit balances at Federal Reserve Banks until found. from the account of the paying bank to that of the receiving bank.

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Settlement Risk The circumstances under which this might happen are extreme. Inability of a bank to The risk that is the major concern in large- settle would be the symptom not just of a dollar transfer systems is settlement risk, bank failure but of an unexpected bank fail­ reflecting the possibility that the recipient’s ure. Indeed, it might be argued that, at least bank will not be paid by the payor’s bank. for very large banks, such an event could This risk should be distinguished from the not happen. After all, in the event of trouble, more familiar risks confronted in ordinary wouldn’t the supervisory authorities be sum­ payments, including the simple risk of non­ moned immediately to arrange a last-resort payment of a debt and the risk of being paid loan from its Reserve Bank? In this way, every with a bad check (see box 2). Settlement other participant in a large-dollar transfer risk is the risk that a bank, despite a paying system would be paid; no settlement failure customer’s adequate balance or credit line, would occur. This argument ignores two vital will be unable to cover payments it has initi­ matters. First, as explained in the next para­ ated on various payment systems during the graph, settlement risk would not disappear; banking day. it would simply be transformed into of the Federal Reserve or other creditors of the troubled institution. Second, as explained Box 2 Three Kinds of Risk in section II, the supervisory authorities and the Federal Reserve might be well-advised to adopt a “hands-off” policy in the case of an incipient and isolated settlement failure, allowing other participants in a network to absorb the losses occasioned by settlement failure. Settlement risk is, therefore, the risk that no other bank, supervisory authority, or government lender of last resort will lend enough to a bank to cover its debit position vis-a-vis another institution before the end of the day. Exposure to settlement risk may be borne by A and B are banks. the recipient of a payment or by his bank, A' and B' are customers of those banks. depending on which payment system is util­ ized. Settlement risk for Fedwire payments is 1. Nonpayment A'owes money, but may fail to do any­ thing about it. B' is exposed to a credit risk: A' may be borne by the Reserve Banks, which stand as a deadbeat. the bankers (B in box 2) for the depository 2. Bad Check: A' pays B' by check, but has insufficient institutions receiving payments (B' in box 2). funds in his account with A to cover the check. A'gives Notification of a payment sent by a Reserve the check to B\ who deposits it in B. B sends the check Bank to a recipient bank is an irrevocable to A for payment, receiving provisional credit in B’s ac­ count at the Federal Reserve Bank, where A's account notice that immediately available funds have is provisionally debited. A then finds A'has insufficient been credited to its account. If the Reserve funds and returns the check to B via the Federal Reserve, Bank discovers at the end of the day that the which reverses the previous entries. paying bank has insufficient funds to cover 3. Settlement Risk: Upon instruction from A\ A wires its Fedwire payments, the Reserve Bank can­ funds to B for credit to B'. At the end of the day, A has insufficient funds to pay B the amount it owes for this (and other) payments, even after subtracting other payments made by B to A.

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4. These matters are spelled out in the not recover the funds from the recipients.4 reported so that each participant has an oppor­ Federal Reserve’s The location of settlement risk exposure in tunity to verify all of its bilateral net debit Regulation / Sec­ tion 210.36, Final CHIPS is different from Fedwire. This large- and credit positions and its aggregate net debit Payment and Use dollar system is not a bank, but a clearing­ or credit (“net net”) position. Then, settling of Funds: (a) Final house with net settlement. Participating banks must indicate their readiness to settle, Payment. A transfer banks receive notices of payment during the before which they have had an opportunity item is finally paid day from each of the other banks and send to confirm that their non-settling respondent when the transfer­ ee’s Reserve Bank notices of payments to the other banks. The participants in debit positions either have sends the transfer clearinghouse records all of these payments, a sufficient balance with the settling bank, or item or sends or tele­ but no transfer of assets between partici­ are able to borrow a sufficient amount from phones the advice of pants takes place. At day’s end, each bank the settling bank, to cover the debit. When all credit for the item then is in a net debit or credit position with settling banks have signaled their readiness to the transferee, whichever occurs respect to each other bank, reflecting the net to settle, those in debit positions send the first, (b) Right to Use balance of payments to, relative to payments amounts they owe from their Federal Reserve Funds. Credit given from, each of those other banks. Of course, Bank deposit accounts via Fedwire to the by a Reserve Bank the sum of all these bilateral net debit and CHIPS settlement account at the Federal Re­ for a transfer of credit positions is always zero because what serve Bank of New York. When all payments funds becomes avail­ able for use when each bank owes is what each other bank is are received, the balance in the settlement the transfer item is owed. This accounting identity makes clear account is dispersed via Fedwire to the Fed­ finally paid, subject why settlement of the day’s payments can be eral Reserve Bank deposit accounts of the to the Reserve Bank s such a simple matter. Each bank in net debit settling banks in credit positions. right to apply the position with respect to the aggregate of all Settlement risk in CHIPS, then, refers to transferred funds to an obligation owed other participants might pay what it owes into the possibility of two different kinds of failure to it by the trans­ a pool from which each bank in net credit to pay. One would be the inability of a non­ feree. See “Regula­ position could be paid. In this way 120 partic­ settling participant to cover its debit position, tion J: Collection of ipants would be able to settle 7,140 bilateral either by funding its account with the settling Checks and Other positions [(120 X 119) -r- 2] with a total of only bank or by a loan from that bank. The other Items and Wire Tra nsfers of Fu nds, 120 payments, some into and some out of the would be the inability of a settling bank to Federal Reserve clearinghouse settlement account (see box 3). fund its account at the Federal Reserve Bank. Regulatory Service, The facts of CHIPS settlement are both Locating the risk of loss in these hypothet­ vol. Ill, section 210, more and less simple than these few sen­ ical situations involves identifying how settle­ as amended, effec­ tences suggest. CHIPS participants include ment is handled if one of the participants is tive April 2, 1984, both settling and non-settling banks. Non­ unable to make settlement. CHIPS’ Rule 13 p. 7-043. settling banks both send and receive pay­ specifies the series of steps for operating under ments in their own names. However, at the such circumstances. First, more time can be end of the day, they pay or receive the net granted, in effect extending the end of the day balance due from or to them through one of beyond the appointed settlement time (nor­ the settling banks rather than directly with mally 5:45 pm). This extension may be granted the settlement account at the Federal Reserve by the clearinghouse because a settling bank Bank of New York. A settling bank agrees to notifies the clearinghouse of its unwilling­ receive the net credits or pay the net debits ness to settle for one of the non-settling par- attributable both to its own activity as well as to that of each of its non-settling respondents. Settlement then proceeds in several steps at the end of the day. First, net positions are

Economic Review • Fall 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Fall 1984 5. Deletion of trans­ actions does not re­ ticipants for whom it would otherwise be The possibility of deleting payments helps lieve the participant obligated to settle, or because a settling bank of its obligation to clarify the difference between provisional to make those pay­ notifies the clearinghouse that it is unable and final payment. Payments made via inter­ ments, according to to cover its own debit position by settlement bank net settlement networks for large-dollar Rule 13. time. The extra time would allow a non-settling payments are provisional until settlement participant to seek funding and/or an alter­ is complete. This comes at the end of the day, native settling bank, or would allow a settling when funding of the settlement account by participant to secure funds. If, despite extra net debit position banks is complete and pay­ time, a participant is still unable to settle, ments have been sent from the settlement the day’s transactions of that participant account to the banks in net credit positions. (both payments and receipts) can be deleted Between the morning opening of a network from the settlement.5 This means that the and evening settlement, payments are provi­ aggregate net debit or credit position of each sional in the sense that the receiving bank remaining participant will change by the may not actually receive credit to its deposit amount of its bilateral net credit or debit for account at a Reserve Bank. Those who use the day’s transactions with the deleted insti­ the proceeds of such payments without any tution. The remaining participants might other guarantee are exposed to the risk that then settle, if those with increased net debit the payment will not become final because of positions have or can acquire sufficient funds settlement failure. to cover their new, larger settlement obliga­ Settlement risk is more narrowly focused in tions. The deleted institution would then be­ CashWire and CHESS. All participants in come the legal quarry of a host of unhappy these systems are settling banks using their customers, other banks and their customers, own accounts at Reserve Banks to pay to the clearinghouse, and regulatory authorities. or receive from the settlement account. Also, at least as an interim matter, all CashWire participants guarantee irrevocable availabil­ Box 3 The Benefits of ity of funds to their receiving customers. Set­ a Net-Settlement System tlement risk is thus absorbed by the partic­ Suppose 120 banks agree to send and receive payment ipating banks in CashWire, while it is shared messages among themselves during the day and to settle with the customers of participating banks only the net amounts due to and due from one another at the end of the day, using deposit balances at Reserve in CHIPS. Banks as the medium of settlement. At the end of the day, each of the 120 banks either owes or is owed by each of the 119 other banks. Thus, there II. The Nature of Risk Exposure will be 7,140 (half of 120 X 119) pairs of net credit and debit positions, or bilateral net positions, to be settled. Bilateral Risk Exposure In the absence of a net-settlement system, settlement of these 7,140 positions would involve a payment by each Identifying how losses might be realized in of the debit position banks to each of the corresponding large-dollar transfer systems is not the same credit position banks. as evaluating the extent of risk exposure of With a net-settlement agreement, settlement requires any individual participant in those systems. only 120 payments, some into and some out of the set­ tlement account at a Reserve Bank. Those owing more Bilateral settlement risk exposure may be than they are owed (at least one bank) pay that “net- thought of as the expected value of the cost to net” amount to the settlement account; those that are a participant of a settlement failure by a par­ owed more than they owe are paid that “net-net” amount from the settlement account. When settlement is com­ plete, the settlement account is exhausted because the sum of all banks’ positions is precisely zero: what each bank owed was what another bank was owed.

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6. The discussion here proceeds as ticular counterparty bank. Aggregate settle­ linking it to another bank. Further, it seems though credit is being extended by ment risk exposure of a bank is the sum of plausible that these estimates are not made the receiving bank the expected values of the cost of settlement with certainty, but are better imagined as to the paying bank, failure evaluated across all counterparties being distributed across a potentially wide rather than to the in a large-dollar transfer system. Conceptually, spectrum of values, ranging from just above customers of the then, a bank would measure its bilateral set­ zero (complete recovery) to more than 100 per­ receiving bank. This initial presumption tlement risk exposure as the expected value of cent (no recovery plus costs of waiting and is relaxed in the the unrecoverable portion of its bilateral set­ litigation). The probability of any particular next section. tlement position (net credit) with respect to percentage, j, actually being realized from the *th other bank. This risk exposure of one the ith bank could then be stated as A bank to another, ignoring any interdependence whole spectrum of such probabilities of per­ among all banks, has two ingredients.6 One centage unrecovered would exist, with their is the actual dollar value of the bilateral net distribution tightly clustered near zero for credit extended by B to the ith bank in a par­ counterparty banks of good repute and long ticular payment system during a day; the relationship, and less tightly clustered, more other is the expected value of the percentage evenly spread above zero for less reputable, of this position that will not be recovered. less well-known counterparties. Consider first the dollar value of the bilat­ Combining the bilateral net credit position eral net credit extended by B to i. This amount and the probability of percentage unrecovered, will vary each day and during the day with settlement-risk exposure of bank B to the the ebb and flow of payments to and from one ith counterparty bank can be represented by another, and can be represented symbolic­ the weighted average of all possible outcomes, ally as $Bi. Next, consider the unrecovered percen­ E(XBi) = tage of the bilateral net credit extended by j> 0 one bank to another. That a bank is unable to Lest this characterization of risk exposure settle at the end of a day would impose a cost seem too remote from the real world, recognize on its net creditors in the form of interest that something like this risk-exposure calcu­ foregone on the unsettled position for the lation must be employed by any bank that period of time the position remained unset­ makes loans. The on a loan tled. Of course, this cost might be recovered, must incorporate both the explicit yield and the in effect writing an ex post loan and then being likelihood of costs on nonrepayment. In the repaid, but costs of negotiating and litigation large-dollar transfer system case, there is credit would remain. Alternatively, if the bank had extended (the net bilateral credit position, $Bi) failed, there might be some delay before its but no explicit yield because the credit is to obligations were settled, involving both admin­ be repaid before the end of the day and, with istrative and waiting costs. Finally, the un­ few exceptions, interest is charged only on settled position might turn out to be unrecov­ loans with maturities of overnight or longer. erable in part, in total, or (including litigation For this reason the net bilateral credit posi­ and waiting) more than total. tion is often referred to as daylight credit All of this potential write-down is what extended by B to i, or as Vs daylight over­ is imagined to underlie each participant’s esti­ draft with B. mate or expectation of the percentage unre­ covered of each net bilateral credit position

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Sharing one or a few isolated alarmists among its Risk exposure of B to i is affected by some­ many customers, only some of whom may thing in addition to the bilateral credit posi­ switch to a more sound bank. Less likely is tion and the creditworthiness of i as per­ a bank to be able to ignore the qualms of one ceived by B. This additional matter involves or a few counterparty banks representing the degree to which others share B’s exposure the interests of many customers. Banks are to i. The more widely shared an exposure is, in a better position to profit from, and there­ the better for B in two distinct ways. The fore would likely be more aggressive in seeking, first would be the extent to which funds, $b information about the creditworthiness of are at risk. As in a case in which B is receiv­ counterparty banks. Similarly, the power ing payments from i for the accounts of a num­ of information to constrain risky behavior is ber of customers, B’s exposure is reduced to likely to be greater when in the hands of a the extent that its customers might both share bank than in the hands of a customer. It is the litigation and collection costs as well as bear credit judgments of other banks that provide the burden of amounts that are ultimately the foundation of a bank’s liquidity, deter­ unrecoverable. In a more limited way, some mining its ability to obtain short-term fund­ cost sharing might be possible among a num­ ing in the interbank money market. Counter­ ber of banks all of whom were in net credit party banks would be more likely to maintain position when i failed to settle. a truly less risky posture, including smaller The second way would skew the spectrum aggregate daylight overdrafts, when other of probabilities of percentage unrecovered banks have continuing daily incentive to dis­ toward zero. More widespread sharing of cover their creditworthiness. exposure may benefit B in that more numer­ ous sources of independent scrutiny of fs creditworthiness may reduce the chances of i s pursuing imprudent courses of action. This All of the foregoing discussion of risk expo­ is no more than the fooling-all-of-the-people- sure implicitly has assumed that a settlement all-of-the-time impossibility theorem at work. failure is an isolated event; that losses because In this application, the theorem reflects the of a settlement failure would be small enough increasing likelihood that (true) adverse infor­ that banks could absorb the resulting unex­ mation will become available to counterpar­ pected loss of funds without themselves being ties as the number of counterparties increases. unable to settle. Upon investigation, this is The power of information in constraining an overly strong assumption that ignores the behavior and reducing risk exposure depends interdependence of participants in a payment in part on who gets the information. A single system and the resulting vulnerability of customer of a bank, receiving adverse infor­ many banks directly or indirectly to a single mation about another bank from which pay­ counterparty’s failure to settle. ments might be received, can simply refuse to Vulnerability to counterparty failure re­ do business with customers of the suspect flects both the speed with which a bank bank or request payment in some safer means. must gain access to cash and the likely scar­ While this may be a prudent course of action city of cash. An unexpected settlement failure for the payee, it has only limited power to would occur at the end of a day when most force constructive change in the suspect bank, which may be able to ignore the qualms of

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banks have finished matching their sources is unlikely to help, being of limited amount, with uses of cash through purchases and sales cumbersome denomination, dispersed location, of funds in the money market. Unexpected and probably sealed in time-locked vaults. non-repayment of a daylight credit then Deposit balances at correspondent banks removes one expected source of cash, which would be useful to a single bank, but their must be replaced before the close of Fedwire use would merely relocate the cash shortage prevents further transfers of cash that day. to the correspondent bank. In this sense, the Even though the Fedwire facility might be search for end-of-day cash is one of musical kept open beyond the normal 6 pm close if there chairs in which the cash needs (players) are were trouble, emergency financing arrange­ no larger than the available stock (chairs), but ments would have to be made in an hour or matching need with available stock will be so, or before the next morning. accompanied by pandemonium, and the pan­ Speedy access to cash might be sought in a demonium may last longer than the few hours bank’s own balance at a Reserve Bank. This available to settle. Clearly, there is almost would require no action, because the cash no excess cash in the system to be mobilized already would be on deposit and, for reserve on short notice if by excess we mean excess requirement purposes, the unexpected drain reserve deposits. Excess reserves are widely might be offset by larger cash holdings distributed as “small change” across the over future days. However, for many of the entire banking system; if they were available nation’s largest money center banks, the size to be mobilized into sellable quantities, the of daylight overdrafts is many times larger federal funds rate would already have induced than their own or any counterparty bank’s their owners to bring them to market before normal overnight reserve deposit position. the end of the day. For this reason, cash balances would be inad­ The total reserve deposits of banks with equate in preventing vulnerability to a coun­ cash may be available to lend to those with­ terparty failure. If insufficient cash is avail­ out cash to the extent that reduced holdings able in the bank’s own account, then steps one day can be offset by enlarged holdings (or might be taken to sell liquid assets. However, reduced requirements) later in a two-week many banks would have difficulty doing this reserve maintenance period or by carry-over because liquid assets would already have been of deficiencies into the next period. Further, serving as collateral for other purposes and just as one bank must cover an unrepaid therefore be unavailable. Their alternative daylight credit in the event of a settlement would then be to borrow. Whether borrow­ failure, so, too, other banks will have un­ ing or, in exceptional cases, selling unpledged expected cash surpluses because of unsettled liquid assets, the challenge is both to find payments to the failed institution. On balance, other banks with the required amount of cash the surpluses are less than the deficits only as well as to convince them to make the cash in the amount of the funding gap that triggered available. Which of these hurdles—finding the initial bank failure. In general, then, suf­ cash or acquiring it—would be the more trou­ ficient cash will exist in the aggregate, but blesome is a debatable matter, for neither its redistribution must be accomplished very would be easy. quickly, after the time at which most mar­ Finding banks with cash may be difficult, kets have begun to close, and subject to the given the limited stock of cash on which perceived creditworthiness of deficit banks. the U.S. financial system operates. The rele­ The difficulty arises, therefore, not just vant concept of cash is, again, in the form of in the scarcity of total cash but in the distri­ deposit account balances at Federal Reserve bution of unexpected cash deficits and sur­ Banks (because they can be transferred via Fed­ wire before the end of the day). Vault cash

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pluses across banks. If a bank with an unex­ icy, involving the degree to which risk expo­ pected deficit does not have established credit sure is concentrated on banks in the pay­ lines with a surplus bank or the surplus banks ment system. do not have management authorization to | sell funds to the deficit bank, then a speedy redistribution of cash would be very difficult— Concentration of Risk perhaps impossible—by transactions among There is a fundamental tension between these banks late in the day in the money mar­ two means of managing settlement risk in a ket. Intermediary banks, having authority payment system. One would seek to concen­ to lend to the deficit bank and to whom the trate risk exposure on banks; the other would surplus banks will lend, would then be required seek to distribute exposure more broadly to complete the process that would prevent a over banks, their customers, and the lender wave of systemic failures. The reliability of of last resort. these market mechanisms would presumably Concentrating risk exposure on banks is depend importantly on the degree to which promoted, as we have seen, when banks guar­ confidence in normal credit judgments about antee irrevocable availability of funds to their deficit banks could overcome a prudent incli­ customers. The result should be incentives nation of surplus banks to seek safety in cash for banks to monitor carefully the condition in the midst of waves of market talk occa­ of counterparty banks and to manage day­ sioned by an unexpected bank failure. light credit extensions to those counterpar­ Of course, this is just the setting—a “liquid­ ties. At the same time, banks would have ity crisis”—in which a central bank lender incentives to monitor their own market rep­ of last resort might play a constructive role. utations and to protect those reputations Systemic risk—of a cascade of settlement fail­ through prudent banking practices, including ures—can be eliminated by isolating the ini­ management of their use of daylight credit. tiating settlement failure, preventing it from Concentrating risk exposure could also be forcing unexpected cash deficits on other promoted by the lender of last resort through banks, which in turn could force unexpected a “hands-off” attitude toward systemic risk. deficits on still other banks, and so on. The This would require a credible policy of unwill­ lender of last resort might isolate the prob­ ingness to be pressured into eleventh-hour lem in one of several ways. It might lend to a lending even to otherwise sound institutions bank that would otherwise initiate a settle­ suffering the repercussions of a settlement ment failure, or to second-round banks with failure. Knowledge that the lender of last unexpected deficits produced by the settlement resort would not intervene should create failure, or to banks that would be willing to incentives for sound banks to manage care­ lend to the second-round banks. However, the fully their bilateral net credit extensions central bank may face constraints on its lend­ across all payment networks as well as their ing. For example, it may be prevented from net debit positions across networks. Scrupu­ making loans to foreign institutions or to lous management of these daylight credit banks without adequate collateral or to in­ extensions would aim at narrowing the size solvent banks. Such constraints would influ­ of possible unexpected end-of-day financing ence which set of banks became the focus of needs to levels commensurate with access to last-resort-lending activity in isolating settle­ cash available in the system to meet them. ment failure and eliminating systemic fail­ ures. Beyond these institutional considerations, however, is an important issue to be faced in designing settlement-risk-management pol­

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This management might involve minimizing detected and uncorrected. In combination, both daylight credit extensions by careful control effects will increase the probability that the of the timing of payments relative to receipts, lender of last resort will have to intervene. by lengthening the maturity of bank financ­ ing to reduce daily payments and receipts, and by increased holdings of cash to act as III. The Current Concern a buffer stock. Both banks and the Federal Reserve are con­ Distributing, rather than concentrating, cerned about risk exposure on large-dollar risk exposure can be promoted if banks hold transfer systems. What is not clear is whether customers liable for funds provisionally cred­ this reflects a recent discovery of a longstand­ ited to their accounts but not delivered be­ ing and stable exposure, or an awareness of cause of settlement failure. Perhaps more recent growth in that exposure. The evidence important, distributing risk exposure can be presented in what follows argues that it is promoted if the lender of last resort follows the latter, the awareness of significant growth a policy of lending freely to banks in circum­ of settlement-risk exposure, that underlies stances that might otherwise threaten sys­ the current concern. temic settlement failures. Degrees of settlement-risk exposure cannot There are important differences between be measured. Creditworthiness cannot be concentrating and distributing risk as a means modeled by an exact science; the expected of managing settlement risks in a payment value of the unrecovered percentage of a network, although both may be effective in bilateral net credit position necessarily lies achieving a low incidence of settlement fail­ in the eye and mind of its beholder. Bilateral ures. Concentration of exposure relies primar­ and aggregate net credit and debit positions ily on market pressures within the banking on a payment system during a day may be industry. Banks will wish to conserve their own recorded by individual banks, but have only liquidity by shunning normal reliance on recently begun to be recorded by operators volatile sources of funds, maintaining a good of the payment systems. Therefore, any his­ ability to borrow should unexpected settle­ torical evaluation of exposure must rely on ment problems arise. This may also serve to inferences drawn from indirect evidence bear­ economize on their daylight overdrafts by ing on creditworthiness, bilateral and aggre­ reducing the need to repay overnight funds gate net credit and debit positions of indi­ each day before fresh funds have been received. vidual banks, and systemic risk. Liquidity conservation will be encouraged by other banks that will be carefully manag­ ing daylight credit extensions and the quality Individual Bank Risk of the banks to which such credit might be The dollar volume of daylight credit extended extended. Distributing exposure relies more apparently has been growing rapidly since heavily on bank customers and supervisory at least 1970. The dollar volume of large- authorities to promote prudent banking prac­ dollar payments grew at a 24 percent com­ tices, and ultimately on the intervention of pound annual rate from 1970 through 1983, the lender of last resort to prevent settlement almost 2M> times the rate of growth of the failures. Clearly, distributing exposure cre­ value of national income and output over the ates a moral , in the sense that a cred­ same period. All but 3 percentage points of ible commitment by the lender of last resort to prevent systemic settlement failures will make redundant many management and mon­ itoring efforts of banks. This will reduce the liquidity of the banking system and raise chances that imprudent practices will go un­

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this volume expansion was in the number of eral net credit extensions during a day to transactions rather than in their average make payments. value. This was quite different from national Sequencing—delaying payments until re­ income and output, where inflation-adjusted ceipts arrive—is an alternative to daylight output grew only 3 percent, while the aver­ overdrafts in covering payments. It is an age value (price) of output grew 7 percent. In approximation of a “realtime” accounting itself, growth in the number and value of system in which payments could only be transactions does not necessarily require made if a sufficient balance were on hand at growth in daylight credit extended. It is pos­ the instant the payment were ordered. Pay­ sible that, with increasingly careful control of ments accounting is not typically “realtime,” the timing of payments relative to receipts, but “batched” overnight. Daylight overdrafts banks could have accommodated a larger arise if payments are ordered before the re­ value of payments with no increase in day­ ceipts come in that will leave a positive cash light credit—that is, without using larger bilat­ balance. In principle, the total stock of cash in the banking system could be as little as a single dollar, as long as that dollar were used Fig. 1 Large-Dollar Transfers Made or and reused over 500 billion times during the Settled through Reserve Deposit Accounts day. In practice, with a total stock of deposit balances at Federal Reserve Banks of a little Billions of dollars more than $20 billion, the average dollar would bUU have to turn over only about 26 times daily 1 1 Fedwire to be used and reused in completing over fijjl CHIPS $500 billion of large-dollar transfers. This is up from only IV2 times daily as recently as 500 1--- 1 CashWire 1970 (see figure 1). Nonetheless, the feat of 1____ | and CHESS turning over the stock of cash 26 times daily mmmm Reserve deposit would indeed be prodigious if each payment H H account balances were made against an adequate cash balance 400 in “realtime,” so that dollars were actually used and reused 26 times. Sequencing would require that initial payments be made up to the limit of the opening cash balance, but 300 further payments be delayed until sufficient receipts accumulated to fund them. Alterna­ tively, the feat of 26 times per day turnover is not at all prodigious if daylight overdrafts 200 can be used. Payments far in excess of open­ ing cash balances could be made with the expectation of covering them with offsetting receipts later in the day before settlement. Increasingly powerful computer and tele­ 100 communications technology might have made it possible for banks to sequence payments carefully as the volume of transfers grew,

0 1970 1983 SOURCE: Board of Governors of the Federal Reserve System.

Federal Reserve Bank of Cleveland Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Fall 1984 7. The Federal Re­ serve Bank of New thereby avoiding increased daylight overdrafts. before competing uses of people and equip­ York maintains Corporate cash management became a so­ ment intervened, would be to activate the an on-line monitor of positions of Edge phisticated science during this period. Indeed, system to transmit the string of repayments. Act customers and the spread of cash management had as a The result would be efficient work flow and restricts their day­ by-product some of the rapid growth in wire a routine drawing down of the bank’s Federal light overdrafts. transfer volume. Moreover, computerized Reserve deposit account balance at the open­ Starting in 1984, telecommunications for wire transfer, inte­ ing of business each morning. If overnight an ex post monitor was put in place for grated with realtime accounting systems, did sources of funds normally exceeded reserve all Fedwire users. make it possible to build into banks’ systems deposit balances (reserve deposits of all banks preset limits on daylight credit extensions amounted to about $20 billion in mid-1984), to customers. This had a counterpart in then the result would be an immediate day­ the “store and forward” environment of the light overdraft that would last until fresh over­ CHIPS system. Banks could store payment night funding had been bought and received. messages in the system until such time as The incentive structure in CHIPS has been they were prepared to authorize a payment, somewhat different. Settling banks have when the payment would be released and the had an interest in the amount of daylight credit transaction completed. Beyond this, how­ provisionally extended to their respondent ever, there is little to suggest the application banks participating in CHIPS. Indeed, the of sophisticated technology to the problem “store and forward” mode of operation made of sequencing inter-bank payments traffic to it possible to set dollar limits on the net credit enable banks or networks to control their extended to a customer by a bank, whether net bilateral or aggregate daylight credit or the customer were a large nonfinancial cor­ debit positions. poration making trade payments or a respon­ Lack of evidence of attempts to sequence dent bank paying for money or foreign ex­ inter-bank wire payments is not surpris­ change market purchases. Another indication ing. Investing resources in managing the of settling participants’ interest in control­ sequencing of payments would be likely only ling risk exposure may be found in the change if there were some clear incentive to do so. in CHIPS finality from 1:00 pm of the next In fact, incentives to manage daylight credit day, first to 10:00 am of the next day (in 1979) positions have been weak in the large-dollar and then to 6:30 pm of the same day (in 1981). transfer systems. Shortening this time gap had the effect of Fedwire, until recently, had no systemwide substantially reducing the duration of set- mechanism for monitoring daylight credit tlement-risk exposures. extended to banks.7 With no restrictions on These efforts by settling banks to control their daylight overdrafts, efficient manage­ their own potential credit-risk exposure to ment of commercial bank operations had every customers might also be viewed as efforts to incentive to use large daylight overdrafts to control settlement risk. Any limitation on reduce other costs. For example, large banks credit extended through payments made for a routinely finance themselves by buying over­ customer is also a limit on daylight indebted­ night funds from many other banks and fi­ ness of the paying bank to other participants nancial institutions (aggregating over $100 bil­ in the network. Until recently, however, these lion daily in mid-1984). Just as routinely, the incentives were not reflected in any network banks can prepare the necessary list of repay­ limit on bilateral credit or debit positions, ment messages at the end of a day for auto­ or in a bank’s ability to set a limit on bilateral mated telecommunications transmittal on the or aggregate credit extended on the system. following day. The first job each morning,

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CashWire and CHESS do have both bilateral institutions, supervised by a more diverse set net credit limits and sender net debit caps, of regulatory authorities, entering new mar­ but these cannot be attributed to any incen­ kets and (for some) entering the twilight of tives operating within the group of partic­ viable operation during 1981-82, surely could ipants, because they are an interim require­ have reduced the average creditworthiness ment of the Federal Reserve for net settlement of the set of institutions eligible to use Fed­ of the networks. CashWire also requires cus­ wire. How much Federal Reserve risk expo­ tomer guarantees. sure actually increased as a result is impos­ The conclusion that one draws is that the sible to quantify. Actually, it may not have bilateral and aggregate net credit positions been a substantial increase. Most of the newly generated on large-dollar payment systems eligible institutions did not avail themselves have been growing rapidly over the years of access to Fedwire or any of the other large- since at least 1970. Payments volume grew dollar payment systems. rapidly; the cash position of the banking A more important increase in risk exposure system using these payment networks did was the result of growing international inter­ not grow at all; incentives for participating bank volume. The 1970s first saw U.S. banks banks to sequence their own transactions to follow U.S. multinational corporations abroad avoid reliance on daylight credit were weak, at and then become immersed in recycling petro best. If risk exposures were not growing, it dollars through the world banking system. could only have been because the creditworthi­ CHIPS dollar volume was growing at a 35 per­ ness of participants was improving enough cent annual rate starting in 1970. Between to offset growing daylight credit usage. mid-1978, when current data reporting began, The creditworthiness of system partici­ and the end of 1983, U.S. banks’ own claims pants probably was not improving. In addi­ on foreigners were growing at a 30 percent tion to a general weakening in capital posi­ annual rate; overnight Eurodollar deposit tions of the U.S. banking system, two specific holdings were growing at a 50 percent annual developments suggest this conclusion. One rate starting in 1977. The burgeoning daily has to do with the range of institutions eligi­ flow of payments through CHIPS involving ble for direct access to Fedwire and the second New York-based subsidiaries of foreign banks with the burgeoning role of foreign partici­ was a likely source of increased risk exposure. pants in the daily flow of inter-bank large- Foreign-owned institutions handling the trans­ dollar payments. actions of foreign-based banking establish­ Prior to 1980, access to Fedwire was re­ ments subject to unfamiliar legal and regula­ stricted to member banks, a (declining) sub­ tory systems necessarily injected uncertainty set of depository institutions that included and new risks into banking relationships. all national banks plus those state banks that chose to become members. With passage of the Depository Institutions Deregulation and Systemic Risk Monetary Control Act of 1980, access was The conclusion to be drawn must be that, both broadened to include all commercial banks, on account of growing daylight credit exten­ thrift institutions, and credit unions eligible sions and on account of the widening set of for federal deposit insurance. Without argu­ banking institutions whose creditworthiness ing that any particular newly eligible institu­ tions were less creditworthy than any mem­ ber banks, it is still possible to argue that Fed­ eral Reserve risk exposure increased. More

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is relevant, individual risk exposures of par­ be expected to isolate settlement failure ticipants in large-dollar transfer systems has and control systemic risk. been growing. Systemic risk exposure is not That systemic risk has increased seems necessarily driven by these individual expo­ clear. Whether the exposure is that of private sures, however. Mechanisms to isolate the financial institutions and their customers impact of a settlement failure might have been or that of the Federal Reserve Banks is not so strengthened or weakened, offsetting or aug­ clear. The distribution could only be deter­ menting the effects of growing daylight credit mined by experience with failures, which does extensions and the changing creditworthi­ not exist and no one wants, or by a binding ness of individual banks. Nonetheless, it would commitment by the Federal Reserve about how appear that systemic risk has also been grow­ it would act in the event of a failure, which ing in recent years. is fraught with difficulty. Systemic risk is absent from Fedwire because A lender of last resort could state its commit­ of the finality of Fedwire payments. Since ment not to lend in the event of a settlement 1970, the percentage of the dollar volume of failure, thereby attempting to concentrate large-dollar-value payments made on Fedwire systemic risk exposure squarely on private has declined from 88 percent to 54 percent, institutions. That such a commitment could suggesting substantial growth of systemic risk be credible is itself incredible, given the panic- exposure. Moreover, the shift from next-day avoiding objective of a central bank lender of to same-day CHIPS settlement completed last resort. Ambiguity might be the most that in 1981 might be interpreted as a further in­ could be gained from such an approach, cre­ crease in systemic exposure in one important ating a minimal sense of systemic risk expo­ sense. Participants did reduce the duration sure in private institution managements and of their bilateral exposures to settlement risk, some minimal risk-controlling behavior. On and the shift to same-day settlement was de­ the other hand, a stated commitment to isolate signed for that purpose. However, systemic all institutions from the impacts of a settle­ risk exposure may have been increased because ment failure, while more credible than a pledge of the shortened time available during which of inaction, carries with it the banks, in the event of a settlement failure, that private institutions will have weak incen­ could develop alternative financing arrange­ tives to consider systemic risk in their con­ ments. This would be the case if a participant’s trol practices. ultimate inability to settle were known or strongly suspected before normal settlement hour, so that the period between the end of Recent Proposals a day’s activity and settlement could be used Silence about settlement-risk exposure was by otherwise sound banks to find alterna­ a reasonable Federal Reserve policy when cash tive funds in the cash markets. balances equaled or exceeded all of a day’s Whether individual bank participants would payments on Fedwire, when Fedwire was the have recognized the potentially offsetting in­ dominant large-dollar transfer system, and crease in systemic risk exposure when their when supervisory oversight of member banks individual exposures were reduced cannot be provided a monitor of the creditworthiness determined. Their own systemic risk expo­ sure would depend as well on the extent to which Federal Reserve Banks’ lending could

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of all participants in Fedwire. Recently, how­ current interest of bankers and the Federal ever, risk exposure has grown rapidly, both Reserve in assuring prudent management individual and systemic. Uniform procedures of settlement-risk exposure by private finan­ for examination have been adopted by the Fed­ cial institutions and their customers and eral Financial Institution Examination Coun­ by the Federal Reserve. cil that seek to assure, among other things, Two matters seem central to prudent man­ that financial institution managers are aware agement of settlement-risk exposures. One is of settlement-risk exposure. Beyond that, the ability of participants to maintain limits the Federal Reserve has sought comment on on their own bilateral net credit and aggre­ three principal risk-management devices (re­ gate debit positions. This involves both infor­ ceiver guarantees, bilateral net credit limits, mation systems that track those positions and sender net debit caps) that might be used and control over their size. Improved position- singly or in combination by network partici­ monitoring capabilities are being developed pants, by network managements, and/or by the respective large-dollar payment systems by regulators seeking to assure prudent set­ that may provide the necessary information; tlement-risk management. proposals are being considered that would The Federal Reserve clearly has a large result in debit and credit limits, either self- stake in this. Its own bilateral credit risk has imposed or derived from uniform rules. been growing rapidly, unshared with its de­ The other matter is the recognition of set- positor banks because of Fedwire finality of tlement-risk exposure. Supervisory examina­ payment. Its systemic risk exposure has also tion may assure that banks have settlement- grown rapidly because its lender-of-last-resort risk-management procedures in place, but risk function implies an obligation to isolate the unperceived will go unmanaged. Ambiguity impacts of a settlement failure. A prudent about who is at risk in making large-dollar central bank, no less than a prudent private payments clouds this perception. The Federal bank, must manage its risk exposure. Reserve is at risk in extending daylight credit on Fedwire and must manage its exposure. In the absence of receiver guarantees, banks IV. Conclusion and their customers are both at risk in mak­ Settlement risk is real, although actual set­ ing payments on net settlement systems. tlement failures have been nonexistent. Rec­ Whether either party, but especially custom­ ords of bilateral daylight credit positions ers, clearly perceives the full extent of its are beginning to be kept, but evaluating risk exposure is hard to determine. Systemic risk exposures will always be judgmental. This exposure cannot be unambiguously located, is because the creditworthiness of “borrow­ but must be managed by the Federal Reserve ers” is a subjective judgment and because jointly to protect the resilience of the bank­ the incidence of systemic risk depends on ing system to an unexpected settlement fail­ the reaction of the lender of last resort to an ure and the discipline of a grudging lender actual settlement failure. It seems clear, none­ of last resort. theless, that both individual and systemic settlement risk exposure have increased rap­ idly in recent years. This has prompted the

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