Intraday Credit: Risk, Value, and Pricing - Federal Reserve Bank

INTRADAY CREDIT: RISK, VALUE, AND PRICING David L. Mengle, David B. Humphrey, and Bruce J. Summers* I. Introduction Electronic payment networks are of value because they provide certainty of payment, security, timeliness, and low cost relative to the dollar value transferred.1 Timeliness is particularly important to money market participants who want to be able to act immediately on changes in market conditions, but it does not come without cost. While banks have invested heavily in speeding up wire transfers, the same level of emphasis has not been placed on control- ling wire transfer risk. Because the banking system does not exactly synchronize the increasing volume of intraday payments activity, outgoing transfers are not always ade- quately funded by the originating

party. Consequently, wire transfer networks are characterized by exposure of participants to intraday credit risk, that is, risk that lenders may not be repaid at the end of the business day. Traditionally, bank regulation has focused on risks reflected on bank balance sheets. For example, bank supervision attempts to reduce credit risk from loan losses by examining asset quality, while capital requirements seek to build a protective buffer into balance sheets. More recently, regulators have also become concerned with risks connected with growing off balance sheet activities such as letters of credit and loan commitments.2 Now, intra- day credit risk associated with wire transfer networks is attracting attention. This risk cannot be measured by tradi- tional methods that focus on balance sheets showing banks’ financial positions only at the end of the day. Even looking at contingent liabilities off the balance sheet does not help here. Rather, one must look at payment activity during the day to see how intraday financial intermedi- ation affects the banking system. The purpose of this article is to develop a framework to illustrate why intraday credit risk exists and what deter- mines its level. The analysis will show how pricing intra- day credit could lead to behavioral changes that would reduce intraday risk exposures. In addition, the empirical section of the paper will explore ways in which pricing might be put into practice. The views in this article are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Richmond or the Board of Governors of the Federal Reserve System. The authors wish to acknowledge the expert research assistance of William Whelpley. Sec- tion IV and the box on pp. 8-9 are based on Humphrey et al. (1987). 1 The most important wire transfer networks are described in more detail on p. 4. 2 Bennett (1986) and Summers (1975). Most discussions of risk on wire transfer networks assume either explicitly or implicitly that intraday credit risk arises from the inherent nature of electronic funds transfer systems.3 By this assumption, the level of risks faced by payments system participants is attributable to such institutional factors as the large volume of wire transfers, a high degree of interdependence among banks, the speed with which funds change hands, and the ex- treme difficulty of exactly matching inflows with outflows. In contrast, it will be argued here that risk levels and...

Website: www.richmondfed.org | Filesize: 105kb
No of Page(s): 12
Download Intraday Credit: Risk, Value, and Pricing - Federal Reserve Bank of ....pdf