Academic journal article Journal of Money, Credit & Banking

Are Banks Risk Averse? Intraday Timing of Operations in the Interbank Market

Academic journal article Journal of Money, Credit & Banking

Are Banks Risk Averse? Intraday Timing of Operations in the Interbank Market

Article excerpt

UNTIL RECENTLY, it was seldom considered in academic work that most financial operations, such as those in foreign exchange, bonds, equities, and derivatives, trigger a flow of interbank payments whereby funds are transferred from the accounts of the buyers to those of the sellers. The interbank payment issue came to the attention of policymakers and academic economists around the end of the last decade with the spectacular growth of fund transfers triggered by financial innovation and advances in electronic technology. According to BIS data, in Japan the flow of funds channeled through large value interbank systems grew from about 20 times GDP in 1980 to 105 in 1995; over the same period, this ratio went from about 35 to 74 in the United States, from 20 to 38 in the United Kingdom, and from about 6 to 28 in Italy. The ratio of payment volumes to settlement media grew at a much faster pace, as excess reserves held at the central bank have been declining in nominal terms in most countries.

These developments have given rise to a large body of literature analyzing the features, benefits, and disadvantages of alternative interbank payment system configurations and their impact on banks' operations and on monetary policy.(1) So far, however, there have been few if any attempts to relate this subject with the main strands of literature on financial markets; in particular, there has been no explicit recognition of the fact that interbank payment systems and interbank markets are closely intertwined. In addition, while a relatively large body of analysis deals with interbank markets [Eagle (1995), Hamilton (1996, 1997), and Coleman, Gilles, and Labadie (1996) are among the latest contributions], little is known on banks' behavior in this market at the intraday level.(2) This gap is striking, considering that the technological changes mentioned above are unequivocally pointing toward the growing relevance of high frequency phenomena, and that the effects of these changes on the behavior of operators have not yet been fully understood. Monetary policy may also be affected: gross settlement systems, which are currently being implemented in several countries, generate an intraday demand for monetary base, and the ongoing move toward extended business hours is likely to gradually blur the distinction between the new concept of intraday liquidity and the end-of-day liquidity traditionally targeted by monetary authorities to control short-term interest rates (Dale and Rossi 1996).

The purpose of the present paper is to present a theory of banks' intraday behavior in the interbank market, and to corroborate it with empirical evidence from Italy. Using a simple model of demand for liquidity under uncertainty, the timing of the operations in the interbank market during the day is explained as the outcome of banks' optimizing behavior. Within this context, the existence of an informational link between the functioning of financial markets, the interbank clearing system, and the interbank market is highlighted and the hypothesis of risk-averse behavior by banks is assessed. The main underlying ideas can be summarized as follows.

In the framework proposed, banks target an end-of-day liquidity position, which depends on two factors: the clearing balance resulting from payments on behalf of clients, and the amount of funds borrowed or lent in the interbank market, chosen to offset the flow of funds generated by the clearing balance. To this end, banks optimize on the basis of available information, which essentially involves two stochastic variables: a short-term interbank interest rate, and the end-of-day clearing balance itself. In making their borrowing or lending decisions, banks face the following tradeoff: if they choose to operate early during the business day, they face relatively little interest rate uncertainty, as the interbank rate prevailing at the moment is directly observable, but considerable uncertainty concerning the clearing balance. …

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