FINANCIAL NETWoRKS
Payments Canada has released its latest discussion paper, De-Tiering Large Value Payment Systems: The Case of the Canadian LVTS. Many large value payment systems are characterized by a ‘tiered’ structure, whereby a small number of banks are direct members of the system (also called ‘first tier’) and the majority of banks are indirect members (‘second tier’). The smaller the number of direct banks over the total sector, the higher the level of tiering. Although the causes of high tiering can vary across countries and jurisdictions, the general consensus in the current principles for financial market infrastructures are to encourage direct participation, i.e. ‘de-tiering’ the system. However, it is not clear what impact de-tiering would have on the topology of payment flows. This is mainly due to the lack of complete information about the originator and final receiver of each payment that is usually mandated by FMIs. This paper estimates the payment flows between initial payers and final payee banks. Those flows would correspond to the equivalent fully de-tiered payment system that is consistent with the observed payment structure of the tiered system. It then defines metrics to assess any risks from tiering or arising from de-tiering the payment system.
Keywords: De-tiering, network reconstruction, Large Value Payment Systems, liquidity risk.
JEL classification: C610, C670, L520
This paper uses FDIC call report data to calibrate the financial network of CDS obligations. It shows how, given the maladaptation of banks to perverse incentives of the Joint Agencies Rule 66 (Federal Regulation 56914 and 59622) and Basel II Credit Risk Transfer (CRT) frameworks, regulatory policy might actually have unintentionally intensified systemic risk and instability as the use of CDS contracts increased. In particular, the paper shows that, in the years following the introduction of Basel II, the topological complexion of the CDS market was progressively altered as the entrenchment of regulations resulted in a growing degree of clustering and concentration of CDS obligations amongst a few large banks. Moreover, it shows that inadequately accounting for contingent payments under credit derivatives contracts due to the assumed transfer of risk under CRT can ultimately result in the undercapitalisation of banks where market conditions imply that contracts are not easily replaced upon the failure of trade counterparties.
Keywords: Financial contagion, Credit default swaps, Basel II, Joint Agencies Rule 66 Federal Regulation No. 56914, Credit risk transfer, Financial stability, evolution of financial networks, Policy monitoring
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