Dimitar Bogov: Modern payment systems' impact on monetary policy
and financial stability
Welcome speech by Mr Dimitar Bogov, Governor of the National Bank of the Republic of
Macedonia, at the 16th International Conference of Clearing Institutions in Central and
Eastern Europe (ICCI), Skopje, 12 October 2011.
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Mr. Chairman, Dear Participants and Guests,
It is an honour and pleasure to give a welcome speech to such a distinguished audience. I
thank Klirinski Interbankarski Sistemi Skopje (KIBS) for this opportunity. My topic will be the
link of payment systems with the two main central-bank tasks of monetary policy and
financial stability.
While money needs to circulate freely through the economy, without imposing excessive
burdens, other economic agents also need to be confident that commercial banks will honour
their sight liabilities by converting them into banknotes, i.e. central-bank money, at their
demand. The central bank allows commercial banks to transfer among them funds held in
accounts with the central bank. The development of a payment system is thus part of the
development of a central bank and out of this operational capacity grew the cooperation with
the commercial banking system when setting-up the facilities it operates and overseeing the
facilities other participants operate.
This pivotal role of the central bank, unmatched by any other participant, does make us
humbly aware of the strong link between payment systems and monetary policy on one
hand, and payment systems and financial stability on the other. Let me devote the central
part of this welcome speech to these different, yet interrelated links.
Monetary policy impulses are transmitted from those financial institutions that have a direct
relationship with the central bank to other institutions and households. The central bank
typically conducts its monetary policy only with designated financial institutions, mostly
commercial banks rather than with other economic agents. As a result other economic
agents rely on the designated financial institutions that have a direct relationship with the
central bank. The functioning of the transmission relies on the smooth functioning of payment
infrastructures enabling transactions of these institutions with the central bank, as well as
amongst themselves at the interbank market.
If the operation of payment systems is underdeveloped, these designated financial
institutions choose to keep a relatively large buffer of central-bank money to help them
manage their liquidity, which in turn leads to weaker than intended monetary-policy impulses
from the central bank. But in general, after the payment systems in the economy have
reached a certain threshold, the influence of the payment systems on monetary policy needs
to be assessed not by efficiency alone, but by reference to the velocity of money, defined as
the average frequency with which a unit of money is spent in a specific time, under the
assumption of a given money supply.
Velocity of money circulation is endogenously determined by the economic agents' decisions
regarding liquidity holding, lending, borrowing, investing, consumption and labour. Yet an
increase in the efficiency of payment systems increases the velocity of money circulation
exogenously. From a monetary policy point of view it becomes important to estimate the
quantitative and qualitative impact of this exogenous change.
An increase in the efficiency of payment systems results in an increase in the use of
accounts relative to the use of banknotes and coins. Less time is required for each peace of
money or securities to lie unused in an account between two successive payments, leading
to a shorter time period between inflow and outflow, i.e. to a higher velocity of money in
circulation. The new situation is reflected in a higher turnover in markets, provided that
economic agents are able to use the electronic forms of payment, are able to monitor their
cash flow and are confident that the increased efficiency does not compromise security in
terms of fraud.
The task of the central bank is to facilitate a more efficient management of liquid funds. An
efficient management of liquid resources enables economic agents to use cashless payment
systems not only as a signal for their willingness to pay, but also to pay for the exact amount
they owe. Cash payments, in contrast, make economic agents incur costs in the form of
interest foregone and increased security risks
However, the increase in the velocity of money circulation is not linear. As technological
advances in payment systems are seldom used at their maximum capacity, the increase in
their efficiency is a gradual, rather than spasmodic process. In order to better estimate the
impact of technology-driven change on the velocity of money in circulation and thereby on
monetary policy, central banks thus need to use data from a variety of sources
In sum, payment systems are an essential precondition for the implementation of operational
monetary policy and their degree of sophistication has a direct impact on the velocity of
money circulation, thereby influencing monetary policy itself
Turning to financial stability, there is a strong link between efficient payment systems and
financial stability. Financial stability implies that the financial system is robust to systemic
risk, i.e. the risk that problems in one financial institution lead to problems in other previously
sound institutions. Financial stability allows the financial system to withstand shocks without
giving way to cumulative processes which impair, first, the processing of payments in the
economy, and second, the allocation of savings to investment opportunities. A robust and
resilient market infrastructure is essential for financial stability
The provision of credit to commercial banks led the central bank to establish a function to
control the creditworthiness of the borrowers. This function eventually developed into
"banking supervision". A commercial bank can be the source of financial instability if it faces
technical difficulties or if it fails to repay funding. This funding can come either from the
regular operations of the central bank or from other depositors. Such an occurrence can
affect other economic agents. They may face illiquidity and even insolvency, affecting market
interest rates, in turn leading to changes in trading activities and a disruption in market
confidence
Payment systems are an essential component in preventing such occurrences and a
technical mechanism for the central bank to step in order to challenge contagion or potential
contagion. The interest of central banks in financial stability was largely triggered by the
Herstatt incident of June 26, 1974. German banks processed Deutsche Mark payments to
Herstatt bank in exchange for US Dollars, to be delivered through Herstatt correspondent
account in New York. Regulators, deciding to close the bank for lack of solvency
immediately, failed to appreciate the time-zone difference between Frankfurt and New York,
leaving transactions half-completed. German banks did not receive their US Dollar
payments. Although the Herstatt incident did not lead to a financial-stability crisis, it made
central banks aware of the risk and they started developing a continuous linked settlement
platform, whereby commercial banks manage settlement of foreign exchange amongst
themselves on a payment versus payment basis.
Cooperation in this area led central banks to share experiences covering other areas of
payment systems and financial stability. Well-functioning markets depend on the willingness
to develop adequate solutions to ensure smooth functioning of payment systems. Ironically,
part of the problem stems from the very fact that technological advances speed up the
payment systems and make them more reliable. This in turn enables banks to economise on
liquid balances.
A financial-stability crisis can start when a financial institution is unable to repay funding to
the lender at the repayment date, whilst the lender needs the liquidity at that repayment date.
Fear of such occurrences happening simultaneously was an important element in the
proliferation of the US subprime lending crisis to a global one. Central banks, recognisant of
the impediments to markets' functioning and the threat to the existence of solvent economic
actors, utilise payment systems to grant liquidity not only to the market as a whole, but to
individual institutions as well. Because of the re-emerging crisis, central banks can still use
unconventional or non-standard monetary policy operations or target individual banks for
assistance. The latter is however under-utilised by banks, because they avoid incurring a
penalty over the market rate, fearing it may stigmatise them in the interbank markets. Talk of
"emergency liquidity assistance" or "acting as a lender of last resort" is at present fading into
the background because the commercial banks' liquidity scare is largely, though not
exclusively, a symptom of the sovereign debt crisis
Nevertheless, risk stems from commercial banks typically holding positions across many
participants (the central bank, other banks, brokerages, non-bank businesses and
households) and across different payment systems. These positions lead to
interdependencies among the real-time gross settlement systems, mainly operated by central
banks, and designated-time net settlement systems, mainly operated by commercial banks
jointly. The successful operations of both Macedonian Interbank Payment System (MIPS),
the RTGS system of which the central bank is both the owner and operator and Klirinski
Interbankarski Sistemi Skopje (KIBS), of which the central bank is the settlement agent, have
contributed to a high level of confidence throughout the years and have a positive effect on
the stability of the banking and financial system and the economy as a whole.
To conclude, commercial banks transferring among them funds held in accounts with central
banks have facilitated the proper functioning of the banking and financial systems and
mitigated disruptions and instability globally. This historical development has been
accompanied with a slow, but steady movement towards a higher velocity of money
circulation.
Settling payments in accounts at the central bank still provides the link with the two main
tasks of monetary policy and financial stability. While steering monetary conditions the
central bank cooperates with commercial banks and thereby reduces transaction costs. This
reality is a layered architecture in which central bank money is the ultimate settlement asset
in the economy. The positive network externality is best described by referring to the risk
reduction, service assurance and competitive neutrality the central bank provides. Using
money held in accounts at the central bank to effect payment is generally regarded as risk
free, service is assured even in extraordinary times of global and domestic crises, while
using the central bank as a hub ensures that payment systems' participants are not forced to
rely on actual or potential competitors for payment. These arguments that were compelling at
the dawn of central banking are most likely to ensure that modern payment systems continue
to have a determined impact upon monetary policy and a positive influence upon the stability
of the financial system as whole.
Thank you for your attention.