Academic journal article Atlantic Economic Journal

Central Bank Policy Making in Competing Payment Systems

Academic journal article Atlantic Economic Journal

Central Bank Policy Making in Competing Payment Systems

Article excerpt

DAVID D. VANHOOSE [*]

This paper analyzes the interaction between two payment systems. Administrators of both systems establish intraday credit interest fees, caps, and collateral requirements. Analysis of the model indicates that if a central bank does not take into account the effects that its policies have on its share of payment system transactions, then its efforts to contain risks associated with daylight overdrafts on its wire system will require a loss in its share of total transactions volume. If it does recognize the potential loss in its share of payments, then socially optimal policy instrument settings are unlikely to emerge. (JEL E5)

Introduction

During the 1980s, officials at the Federal Reserve System became increasingly concerned about the growth in banks' daylight overdrafts on large-dollar wire transfer systems. In 1988, staff economists at the Federal Reserve System widely agreed that significantly reducing daylight overdrafts of Fedwire accounts would require an interest fee of about 25 basis points. Nevertheless, in April 1994, the Federal Reserve initially set its administered price for intraday credit on Fedwire at only 10 basis points. The following year, the Federal Reserve raised the fee to 15 basis points instead of the 25 basis points that it originally had announced publicly. [1]

Why did the Federal Reserve backtrack from its original pricing policy? One answer might be that it has determined that 15 basis points is the socially optimal interest fee, given a multipart objective involving trade-offs among competing policy goals of maximizing bank profitability while simultaneously minimizing payment system gridlock, systemic risk, and the Federal Reserve's own risk exposure. Nevertheless, as Hancock and Wilcox [1996] have documented, the real average and peak daily volumes of Fedwire overdrafts have fallen only to the levels that existed in the mid-1980s when the Federal Reserve first determined that the overdraft problem was serious enough to warrant close scrutiny.

One purpose of this paper is to offer a possible explanation for the Federal Reserve's pricing of daylight overdrafts on Fedwire. This proposed explanation is that noncooperative rivalry with the Clearing House Interbank Payment System (CHIPS) can induce the Federal Reserve to price its intraday credit at a level that is inefficiently low. Competition with CHIPS for sufficient payments volume to cover the costs of providing Fedwire services can, in principle, lead to suboptimal fees on intraday credit extensions by the Federal Reserve. At the same time, CHIPS's interest in maximizing members' profits while maintaining sufficient payment volumes to cover system costs can induce administrators of this private system to enact socially inefficient policies regarding pricing and collateral, particularly in a noncooperative equilibrium with the Federal Reserve. This argument is not based on any presumption that either Federal Reserve or CHIPS officials intentionally seek to enact socially suboptimal policies. The fundamental point stems from the standard game-theoretic result. That is, in the absence of other complicating factors such as time inconsistency problems (which add further layers of complexity in policy games), noncooperative policy interactions in settings characterized by policy interdependence typically produce Pareto-inefficient outcomes. [2]

A broader objective of the paper is to provide a starting point for consideration of the interaction of payment systems in the U.S. and elsewhere. There has, of course, been considerable work recently on central bank policy making in payment systems. Federal Reserve studies on likely market responses to pricing, collateral requirements, and caps include Lindsey et al. [1988], Meulendyke et al. [1988], Belton et al. [1987], Humphrey [1989], Evanoff [1988], Gilbert [1989], and Stevens [1989]. More recent work on payment and clearing system risks and policies by other central bank economists and academics includes Angelini [1996, 1998], Angelini et al. …

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