Payment Instruments and Collateral in the Interbank Payment System
This paper presents a three-period model to analyze the need for bank reserves in the presence of other liquid assets like Treasury securities. If a pair of banks settle bank transfers without bank reserves, they must prepare extra liquidity for interbank payments, because depositors’ demand for timely payments causes a hold-up problem in the bilateral settlement of bank transfers. In light of this result, the interbank payment system provided by the central bank can be regarded as an implicit interbank settlement contract to save liquidity. The central bank is necessary for this contract as the custodian of collateral. Bank reserves can be characterized as the balances of liquid collateral submitted by banks to participate into this contract. This result explains the rate-of-return dominance puzzle and the need for substitution between bank reserves and other liquid assets simultaneously. The optimal contract is the floor system, not only because it pays interest on bank reserves, but also because it eliminates the overthe-counter interbank money market. The model indicates it is efficient if all banks share the same custodian of collateral, which justifies the current practice that a public institution provides the interbank payment system.
Base money consists of currency and bank reserves. Banks hold bank reserves not merely to satisfy a reserve requirement, but also to make interbank payments to settle bank transfers between their depositors. In fact, the daily transfer of bank reserves in a country tends to be as large as a sizable fraction of annual GDP. Also, several countries have abandoned a reserve requirement. Banks in these countries still use bank reserves to settle bank transfers.