Marius Jurgilas, Ben Norman and Tomohiro Ota.
The final, practical determinant of whether a bank is a going concern is: does it have the liquidity to make its payments as they become due? Thus, the ultimate crucible in which financial crises play out is the payment system. At the height of recent crises, some banks delayed making payments for fear of paying to a bank that would fail (Norman (2015)). This post sets out a design feature in a payment system that creates incentives, especially during financial crises, for banks to keep making payments. This feature could address situations where banks in the system would otherwise be tempted to postpone their payments to a bank that is (rumoured to be) in trouble.
In June of 1974, a small German bank, Herstatt Bank, failed. While the bank itself was not large, its failure became synonymous with fx settlement risk, and its lessons served as the impetus for work over the subsequent three decades to implement real-time settlement systems now used the world over. Documents from the Bank of England’s Archive shed light on a lesser known aspect of Herstatt’s failure – the chain reaction it caused across financial centres as banks in different countries delayed settling their payments to each other. The lesson for policymakers today to grapple with is: when a bank fails, could we still expect surviving banks to delay making payments, with a potential chain reaction in the payment system?