Liquidity-Driven Risks to Large Valued Payments

Abstract

During particularly stressed financial or macroeconomic circumstances, banks’ access to liquidity can become severely restricted. The recent financial crisis demonstrated this phenomenon all too plainly, when, in a climate of fear and uncertainty, both the interbank and international money markets ceased to function in a meaningful manner. Liquidity shortages can potentially create problems for a bank’s ability to meet its outward intraday payments obligations on the TARGET2 real-time gross settlement system. Such a situation not only has negative implications for the respective bank but could also produce contagion effects for the TARGET2 system as a whole. In order to provide increased clarity regarding liquidity driven risks to large value payment systems, the Central Bank of Ireland has developed a ‘liquidity buffer’ indicator for the domestic credit institutions. The initial focus of this project centred primarily upon the development of an ‘early warning’ system, capable of identifying TARGET2 liquidity issues as they occurred in real time. However, during the development of such a platform, the analysis has also presented a means from which it is possible to derive a proxy for the level of risk banks detect in their environment. The analysis undertaken reveals that the Reserve Requirement (RR) plays an important role in how banks formulate their liquidity management strategies throughout the maintenance period. In times of increased uncertainty banks appear willing to hold excess liquidity, at a greater expense, in order to be guaranteed access to liquidity towards the latter half of the maintenance period. In a similar fashion, during a period of stability or relative certainty, banks do not choose to maintain excess liquidity on the TARGET2 platform, implying a degree of increased confidence in accessing liquidity when they require it later in the maintenance period. In this sense we can, to some degree, infer the degree of risk a bank perceives to be present in its immediate environment, by examining the respective institutions’ liquidity management strategy over the maintenance period. In a broader fashion, the indicator also serves as a tool from which the Central Bank of Ireland can monitor banks’ liquidity position with increased precision.