By Dwight Cass
Interbank payments slow down and require greater liquidity immediately after a crisis.
Improving cash-flow forecasting and cash management are two of treasury’s top priorities. According to PricewaterhouseCoopers’ PwC Treasury Survey 2012, only managing credit risk and ensuring access to long-term funding is more important to treasurers. But the best forecasting and cash management efforts could be insufficient if interbank payment systems clog up during a crisis—a not far-fetched scenario, given the ongoing eurozone bank drama.
The fallout from such payments impairment has been a topic of interest for central bank and academic researchers since the September 11, 2001 terrorist attacks, and more recently, the Lehman Brothers meltdown. In August, researchers published an analysis of the aftermath of the Lehman event: “Bank behavior and risks in an interbank payment system after a major credit event,” by Evangelos Benos and Peter Zimmerman of the Bank of England, and Rod Garratt of UC Santa Barbara. The authors found that interbank payments in the Clearing House Interbank Payment System, or CHIPS, the UK’s large-transaction payment systems, were notably slower in the two months after Lehman than they were immediately before its collapse.
Clogged plumbing
This is important to treasury because earlier studies of the effects of 9/11 on the interbank system demonstrated how another crisis could affect corporate access to bank cash facilities and services. To recap, the market’s two main clearing banks—JP Morgan Chase and Bank of New York—had their clearing operations near the World Trade Center, and had to evacuate them after the attacks. JP Morgan switched to an offsite and continued to function, but BONY was not fully back online for a week.
According to a 2003 analysis by Jeffrey Lacker of the Federal Reserve Bank of Richmond (“Payment System Disruptions and the Federal Reserve Following September 11, 2001”), the attacks slowed payments markedly. The US counterpart to CHIPS is the Fedwire Funds Transfer System. On it, large-transaction-size customers (mainly banks, government securities broker/dealers and interdealer brokers) could net trades within BONY or JP Morgan, if both parties used the same bank. Otherwise, payments were transferred between the two clearing banks.
The problem arose because, on Fedwire, the sender of funds initiates payment transactions. If the bank is unable to send those funds, they build up in its account. That means funds in the rest of the system are correspondingly lower. Lacker writes, “At one point during the week after September 11, BONY publicly reported to be overdue on $100 billion in payments. A handful of New York banks found themselves in a similar situation—unable to make payments or loan funds. Balances accumulated in these banks’ accounts and resulted in a corresponding reserve drain and large negative aggregate position for the remainder of the banking system.”
Lacker’s analysis shows that the fund buildup went beyond BONY—some 800 other banks saw “a noticeable increase in their account balance.” Not all cleared through BONY; some experienced their own connectivity problems. Banks’ difficulty securing information about loan payments, short-term credit facilities and cash management systems, along with the money drained out of the financial system by the accumulating balances at the clearing banks, became a growing problem for their corporate clients. This was only ameliorated when the Fed injected some $100 billion of liquidity into the system, and as BONY got its backlog of transactions processed in the following weeks.
The Lehman Effect
Fast-forward seven years, and while many of the system’s operational vulnerabilities had been addressed via offsite back-up facilities, a similar slowing of interbank payments took place after Lehman’s collapse. Lehman shattered the widespread belief that the government would bail out any failing bank, after it arranged Bear Stearns’ shotgun wedding to JP Morgan. As Benos, Zimmerman and Garratt wrote, when this belief was punctured, payments slowed due to burgeoning uncertainty about interbank counterparty risk. They explain:
“We show that this delay was partly explained by concerns about bank-specific as well as system-wide risks. The rationale is as follows: suppose that bank A expects a payment from bank B in the afternoon, but itself has a payment to bank B scheduled that morning. Then, if bank A thinks that bank B might default during the day, it may choose to delay its payment to B until after it has received the payment from bank B in the afternoon. That way, bank A may be able in effect to net its exposure to Bank B and in case of a default of bank B may be able to reduce any amounts to be recovered through bankruptcy proceedings.”
Why is this a problem? If banks delay their payments (and therefore provision of liquidity to the system) due to the credit concerns outlined above, and some operational event prevents them from doing so—say, a problem at a clearing bank or in communications architecture—that liquidity is “irrevocably lost” to the system.
Happily, when Benos, Zimmerman and Garratt ran the numbers, they found that the average potential economic cost of the post-Lehman situation was only GBP6,700 per bank per day. This is in part because UK clearing banks have minimum percentage amounts of their portfolios they must clear at certain times every day, which reduced the cash accumulation. Had they not been able to do so, however, the economic cost—and the consequent ramifications for their corporate customers—could have been much higher.