Resisting electronic payment systems: burning down the house?

This commentary explains the phenomena of path dependence, hysteresis, and network economies using lively historical and contemporary examples. The author shows how the path dependence and network economies can interact to produce a variety of undesirable ends-inefficient payment systems, the adoption of inferior technology, or disasters like the 1834 fire that destroyed the British House of Lords.Payment systems

State-dependent pricing, inflation, and welfare in search economies

This paper investigates the welfare effects of inflation in economies with search frictions and menu costs. We first analyze an economy where there is no transaction demand for money balances: Money is a mere unit of account. We determine a condition under which price stability is optimal and a condition under which positive inflation is desirable. We relate these conditions to a standard efficiency condition for search economies. Second, we consider a related economy in which there is a transaction role for money. In the absence of menu costs, the Friedman rule is optimal. In the presence of menu costs, the optimal inflation rate is negative for all our numerical examples. A deviation from the Friedman rule can be optimal depending on the extent of the search externalities.Inflation (Finance) ; Money ; Monetary policy

Reforming the over-the-counter derivatives market: what’s to be gained?

While derivative financial instruments have made the hedging and exchange of risk more efficient, the recent crisis showed that they also pose a substantial threat to financial stability in times of systemic turmoil. Underlying much of this threat is the lack of transparent reporting in the over-the-counter market for these instruments. This Commentary discusses the advantages of one solution to the transparency proble: moving the settlement or trading of derivatives to exchanges or clearinghouses.Derivative securities ; Financial market regulatory reform ; Over-the-counter markets

Substitution between net and gross settlement systems: A concern for financial stability?

While net settlement systems make more efficient use of liquidity than gross settlement systems, they are known to generate systemic risk. What does that tendency imply for the stability of the payments (or financial) system when the two settlement systems coexist? Do liquidity shortages induce banks to settle more transactions in the net settlement system, thereby increasing systemic risk? Or do banks require their counterparties to send payments through the gross settlement system when default risks are high, increasing the need for liquidity and the money market rate but reducing overall systemic risk? This paper studies the factors that drive the relative importance of net and gross settlement systems over the short run, using daily data on transaction volumes from the large- volume payment systems of all euro area countries that have had both a net and a gross settlement system at the same time. Applying a large portfolio of different econometric techniques, we find that it is actually the transaction volumes in gross settlement systems that affect the daily price of liquidity and the credit risk spread in money markets.Payment systems ; Systemic risk

Bank mergers and the dynamics of deposit interest rates

Despite extensive research interest in the last decade, the banking literature has not reached a consensus on the impact of bank mergers on deposit rates. In particular, results on the dynamics of deposit rates surrounding bank mergers vary substantially across studies. In this paper, we aim for a comprehensive empirical analysis of a bank merger’s impact on deposit rate dynamics. We base the analysis on a unique dataset comprising deposit rates of 624 U.S. banks with a monthly frequency for the time period 1997–2006. These data are matched with individual bank and local market characteristics and the complete list of bank mergers in the United States. The data allow us to track the dynamics of bank mergers while controlling for the rigidity of the deposit rates and for a range of merger, bank, and local market features. An innovation of our work is the introduction of an econometric approach for estimating the change of the deposit rates given their rigidity.Bank mergers ; Bank deposits

Bank mergers and the dynamics of deposit interest rates

Despite extensive research interest in the last decade, the banking literature has not reached a consensus on the impact of bank mergers on deposit rates. In particular, results on the dynamics of deposit rates surrounding bank mergers vary substantially across studies. In this paper, we aim for a comprehensive empirical analysis of a bank merger's impact on deposit rate dynamics. We base the analysis on a unique dataset comprising deposit rates of 624 US banks with a monthly frequency for the time period 1997-2006. These data are matched with individual bank and local market characteristics and the complete list of bank mergers in the US. The data allow us to track the dynamics of bank mergers while controlling for the rigidity of the deposit rates and for a range of merger, bank and local market features. An innovation of our work is the introduction of an econometric approach of estimating the change of the deposit rates given their rigidity. --Deposit rate dynamics,bank mergers,deposit rate rigidity

Credit default swaps and their market function

Credit derivative instruments allow default risk to be segregated from debt of all kinds. They have granted investors the ability to hedge their portfolios and provided numerous institutions with a new source of income. However, the market for credit default swaps is neither transparent nor regulated, perhaps undermining the stability of the financial system it has helped innovate.Credit derivatives ; Swaps (Finance)

Currency Portfolios and Currency Exchange in a Search Economy

We develop a dual currency search model to study equilibrium currency exchange and the determination of nominal exchange rates. Agents hold portfolios consisting of two distinct currencies. We study equilibria in which the two currencies are identical and equilibria in which the two currencies differ according to their relative purchasing power risk. We use numerical methods to solve for the steady-state distributions of currency portfolios, nominal exchange rates and value functions. When one of the currencies is 'risky', equilibria exist in which the safe currency trades for multiple units of the risky currency with the observed ratio being the nominal exchange rate. However, due to the decentralized trading environment, we obtain a steady state distribution of nominal exchange rates. The mean and variance of the nominal exchange rate distribution are based on the fundamentals of the model and change in predictable ways when the fundamentals change. -- Wir entwickeln ein Modell mit zwei Währungen, um das Gleichgewicht beim Austausch der Währungen und die nominalen Wechselkurse zu bestimmen. Die Wirtschaftssubjekte halten Portfolios, die aus den zwei verschiedenen Währungen bestehen. Wir untersuchen Gleichgewichte, in denen die zwei Währungen identische Eigenschaften haben und Gleichgewichte, in denen sich die zwei Währungen hinsichtlich ihres Kaufkraftrisikos unterscheiden. Es werden numerische Methoden verwendet, um die Verteilungen der Währungsportfolios, der nominalen Wechselkurse und der Wertfunktionen im langfristigen Gleichgewicht zu bestimmen. Wenn eine der Währungen risikobehaftet ist, dann existieren Gleichgewichte, in denen die sichere Währung gegen mehrere Einheiten der risikobehafteten Währung gehandelt wird. Das Austauschverhältnis ist der nominale Wechselkurs. Da der Handel dezentral erfolgt, ergibt sich eine Gleichgewichtsverteilung der Wechselkurse. Der Mittelwert und die Varianz dieser Verteilung hängt von den Fundamentalfaktoren des Modells ab. Wenn sich die Fundamentalfaktoren ändern, dann ändert sich diese Verteilung in vorhersehbarer Weise.

Federal Home Loan Bank lending to community banks: are targeted subsidies necessary?

The Gramm-Leach-Bliley Act of 1999 extended the lending authority of Federal Home Loan Banks to include advances secured by small-enterprise loans of community financial institutions. The authors examine three possible reasons for the extension of this selective credit subsidy to community banks and thrifts, including the need to subsidize community depository institutions, stabilize the Federal Home Loan Banks, and address a market failure for small enterprise loans in rural banking markets. They use two empirical models to investigate whether funding constraints affect small-business lending decisions by rural community banks. The results reject the hypothesis that access to increased funds will increase the amount of small-business loans made by community banks.Small business ; Federal home loan banks

The forecast ability of risk-neutral densities of foreign exchange

We estimate the process underlying the pricing of American options by using higher-order lattices combined with a multigrid method. This paper also tests whether the risk-neutral densities given from American options provide a good forecasting tool. We use a nonparametric test of the densities that is based on the inverse probability functions and is modified to account for correlation across time between our random variables, which are uniform under the null hypothesis. We find that the densities based on the American option markets for foreign exchange do quite well for the forecasting period over which the options are thickly traded. Further, simple models that fit the densities do about as well as more sophisticated models.Foreign exchange futures ; Options (Finance) ; Economic forecasting