Analysis of systemic risk in multilateral net settlement systems

Systemic risk in multilateral net settlement systems is investigated using a four-period model. The model focuses on the tradeoff between systemic risk and the cost of interbank transfers. Banks optimize their reserve holdings at the central bank, the settlement medium, based on a future random liquidity shock and payment system parameters such as total asset and collateral requirements, and net debit caps. The model’s results are as follows. The model determines the maximum number of bank defaults that can be sustained without a stoppage in the clearance and settlement process. An interbank funds market increases the efficiency of the payment system. The payment system operator can reduce systemic risk by imposing asset and collateral requirements, and debit caps. The central bank can provide sufficient liquidity to prevent a systemic collapse but may face high costs.