Systemic Risk and Liquidity in Payment Systems (FESHI)

FESHI is a study contract with the Banque de France (11th call for projects), led by Hyun Song Shin (Princeton University) and Research Assistant Gara Afonso (Princeton University).

The risk that a financial institution fails to make an expected payment may cause its counterparties to fail to make theirs. Such a failure could trigger broader financial difficulties that might threaten the stability of the payment system and the entire economy.

We examine the implications of the fact that payment systems bond financial entities together creating a feedback channel with the potential to induce an endogenous response that far outweighs initial shocks.

A systemic crisis is distinguished by the endogenous amplification of financial distress through interlocking balance sheets (Plantin et al., 2005), collateral constraints (Kiyotaki and Moore, 1998), limited liquidity (Brunnermeier and Pedersen, 2006) and the declines in market values of assets (Morris and Shin, 2004). The precise channels of propagation define the crisis and determine the appropriate policy response.

The empirical literature on payment systems has examined case studies to analyse episodes of disruption to the financial system. Simulation techniques have also been used in the literature to better understand different features of the settlement and payment systems, such as the trade-off between the speed at which payments are settled and the liquidity required to settle them (Enge and Øverli, 2006), or the effects of the technical failure of a financial institution (Mazars and Woelfel, 2005). Another branch of the literature explains a payment system as a network of cooperative participants and focuses on characterising the topology of the interbank payment systems and their response to destabilising events (Soramäki et al., 2006).

We plan to consider the role of endogenous relationships and amplifying reactions to shocks in the context of a payment system without explicitly imposing the structure of interlinkages between financial institutions.