1/17 Models of foreign exchange settlement and informational efficiency in liquidity risk management Joint Bank of England/ECB Conference on ‘Payments and monetary and financial stability’ Jochen Schanz, Bank of England

2/17 Overview 1.Background and policy questions 2.Model: Setup and Timing 3.Results

3/17 Overview 1.Background and policy questions 2.Model: Setup and Timing 3.Results

4/17 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?

5/17 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.

6/17 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.

7/17 Overview 1.Background and policy questions 2.Model: Setup and Timing 3.Results

8/17 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.

9/17 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.

10/17 Distribution of information: Implications Domestic refinancing (overnight interbank loan): Local bank does not know liquidity-short subsidiary’s solvency risk. 24 hours of exposure from uninformed lending

11/17 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).

12/17 Distribution of information: Implications Global refinancing (cont’d): A sequence of Better coordination → less uninformed lending, more informed lending. Uninformed lendingInformed lending PvP settlement: only informed lending. Limit case for very low coordination: overnight loan.

13/17 Overview 1.Background and policy questions 2.Model: Setup and Timing 3.Results

14/17 Equilibrium refinancing decisions → Global liquidity management is here to stay. Proposition 1: Liquidity shortfalls will not be refinanced domestically when intra-group liquidity can be accessed. 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

15/17 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. → Global liquidity management has benefits: Better informed lending means lower likelihood of transmission of solvency shocks. Domestic transmission of losses less likely; Cross-border transmission of losses may be more likely.

16/17 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.

17/17 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.