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  FinancialInstitutionsCenter Payment System Settlement and  Bank Incentives byCharles M. KahnWilliam Roberds97-32  THE WHARTON FINANCIAL INSTITUTIONS CENTER The Wharton Financial Institutions Center provides a multi-disciplinary research approach tothe problems and opportunities facing the financial services industry in its search forcompetitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance.The Center fosters the development of a community of faculty, visiting scholars and Ph.D.candidates whose research interests complement and support the mission of the Center. TheCenter works closely with industry executives and practitioners to ensure that its research isinformed by the operating realities and competitive demands facing industry participants asthey pursue competitive excellence.Copies of the working papers summarized here are available from the Center. If you wouldlike to learn more about the Center or become a member of our research community, pleaselet us know of your interest.Anthony M. SantomeroDirector The Working Paper Series is made possible by a generousgrant from the Alfred P. Sloan Foundation  Charles M. Kahn is at the University of Illinois, Champaign, IL 61820, c-kahn@uiuc.edu 1 William Roberds is at the Federal Reserve Bank of Atlanta, Atlanta, GA 30303, wroberds@frbatlanta.orgThe views expressed in this paper are those of the authors and not those of the Federal Reserve Bank of Atlanta orthe Federal Reserve System. We would like to thank Paolo Angelini, Bob Eisenbeis, Bill Emmons, Craig Furfine,Jim Moser, Bruce Smith, and Larry Wall for comments on earlier drafts, with the usual disclaimer.Address correspondence to:William RoberdsResearch Officer and Senior EconomistFederal Reserve Bank of Atlanta104 Marietta Street, N.W.Atlanta, GA 30303-2713Phone: 404-521-8970Fax: 404-521-8956E-mail: wroberds@frbatlanta.org Payment System Settlement and Bank Incentives 1 September 1996This version: January 2, 1997Abstract: In this paper we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holdingnon-interest-bearing reserves, but increases moral hazard problems. The put option valueof default under net settlement can also distort banks' investment incentives. Absent thesedistortions, net settlement dominates gross, although the optimal net settlement schememay involve a positive probability of default. Net settlement becomes more attractiverelative to gross settlement if bank assets have to be liquidated at less than book value.This paper was presented at the Wharton Financial Institutions Center’s conference on ThePerformance of Financial Institutions , May 8-10, 1997. JEL Classification Numbers: G21, G28.  Payment System Settlement and Bank Incentives Various large-value interbank payment networks employ different rules for settling of interbank payments. 1 Some networks such as the Swiss Interbank Clearing (SIC) network operate under real-time gross settlement  (RTGS). That is, payment messages entered into the payments network are continuously cleared and settled bytransfer of reserve funds from the paying bank to the receiving bank. Other networks,such as the Clearing House Interbank Payment Network (CHIPS), 2 operate under net  settlement  rules. That is, at the close of each business day, the value of all payments dueto and due from each bank in the network is calculated on a net basis. Banks ending the day in a net debit position (banks whose due-tos exceed their due-froms) transfer reserves to the network. The network, in turn, transfers these reserve funds to net creditor banks. 3 The allocation of intraday credit in large-value net settlement networks is of  policy concern, given the very large flows associated with these networks. The averagegross daily volume of payments over CHIPS, for example, is easily over $1 trillion, and Schoenmaker (1995, p. 21) puts average peak daily net debit positions on CHIPS atroughly $50 billion. To give some perspective on these numbers, consider that annualGDP for the United States is roughly $7.5 trillion, and that overnight reserve balances held by commercial banks at the Fed (i.e., the total of all non-currency reserves) averages roughly $15 billion. In policy circles, it has often been argued that net settlement of interbank  payments can reduce the riskiness of interbank payment systems. 4 Formal analyses of this question have concluded that the real result is not a reduction but a reallocation of  1 For a survey of large-value payment systems in the G-10 counties, see Bank for International Settlements(1993) or Folkerts-Landau, Garber, and Schoenmaker (1996). 2 CHIPS is operated by the New York Clearing House Association. Payments on CHIPS are most com- monly associated with the dollar legs of foreign exchange transactions. See Federal Reserve Bank of NewYork (1991) or New York Clearing House Association (1995) on the operation of CHIPS. 3 Other sets of rules for clearing and settlement are possible. For example, the Federal Reserve’s Fedwiresystem is nominally a real-time gross settlement system, since all payment messages immediately becomeliabilities of the Federal Reserve System and therefore equivalent to reserve money. However, the Fedwiresystem resembles a net settlement system in the sense that participating banks are allowed to overdraft their accounts and have access to (subject to certain limits) free daylight credit. See Federal Reserve Bank of  New York (1995) for details on the operation of Fedwire. 4 See for example, the discussion on pp. 2-3 “Lamfalussy Report” of the Bank for International Settlements (1990). 3
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