The Federal Reserve Bank of New York today released Intraday Liquidity Management: A Tale of Games Banks Play—a new forthcoming article in the Bank’s Economic Policy Review series.
Author Morten L. Bech uses game theory to examine how different intraday credit policy regimes behind central-bank-sponsored settlement systems affect the behavior of commercial banks seeking to maintain an optimal level of liquidity as payments flow in and out daily. Managing intraday liquidity positions is increasingly becoming an important competitive component of commercial bank operations.
In the 1980s, central banks around the world joined the Federal Reserve and started implementing real-time gross settlement (RTGS) systems to reduce the risks surrounding the increasing volume of daily payments among commercial banks. As RTGS emerged globally, two types of intraday credit policies came to dominate: collateralized credit and priced credit.
Bech explains that in studies of the effect of credit policies on commercial bank behavior, two classic game-theory paradigms—the “prisoner’s dilemma” and the “stag hunt”—emerged as useful tools for understanding the fundamental trade-offs faced by RTGS participants, while making clear the complexity of managing liquidity.
The prisoner’s dilemma arises in a collateralized credit regime, where banks have an incentive to delay payments if intraday credit is expensive. The stag hunt occurs in a priced credit regime, where banks seek to coordinate the timing of their payments to avoid overdraft fees.
The author also notes the relevance of the discussion of intraday liquidity management to the Federal Reserve’s proposed changes to its Payments System Risk policy.
Morten L. Bech is a senior economist at the Federal Reserve Bank of New York.