Illiquidity in the Interbank Payment System Following Wide-Scale Disruptions

Abstract

We show how the interbank payment system can become illiquid following wide-scale disruptions. Two forces are at play in such disruptions-operational problems and changes in participants' behavior. If the disruption is large enough, hits a key geographic area, or hits a "too-big-to-fail" participant, then the smooth processing of payments can break down, and central bank intervention might be required to reestablish the socially efficient equilibrium. The paper provides a theoretical framework to analyze the effects of events such as the September 11 attack. In addition, the model can be reinterpreted to analyze shocks to fundamentals that affect the parameters of the intraday liquidity management game. We demonstrate this by showing how processing behavior changed in response to heightened credit risk at the time of the Lehman Brothers failure. © 2012 Federal Reserve Bank of New York.