metadata: authors: 0: author: Merrouche, Ouarda
1: author: Nier, Erlend
count: World
docna: 0: docna: Payment systems, inside money and financial intermediation
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Financial Regulation & Supervision,Inflation,Privatization,Energy Privatization,Macroeconomic Management,Financial Structures,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: This paper assesses the impact of
            introducing an efficient payment system on the amount of
            credit provided by the banking system. Two channels are
            investigated. First, innovations in wholesale payments
            technology enhance the security and speed of deposits as a
            payment medium for customers and therefore affect the split
            between holdings of cash and the holdings of deposits that
            can be intermediated by the banking system. Second,
            innovations in wholesale payments technology help establish
            well-functioning interbank markets for end-of-day funds,
            which reduces the need for banks to hold excess reserves.
            The authors examine these links empirically using payment
            system reforms in Eastern European countries as a
            laboratory. The analysis finds evidence that reforms led to
            a shift away from cash in favor of demand deposits and that
            this in turn enabled a prolonged credit expansion in the
            sample countries. By contrast, while payment system
            innovations also led to a reduction in excess reserves in
            some countries, this effect was not causal for the credit
            boom observed in these countries.
repnme: repnme: Payment systems, inside money and financial intermediation
display_title: Payment systems, inside money and
            financial intermediation
listing_relative_url: /research/2010/10/12860301/payment-systems-inside-money-financial-intermediation
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Privatization m1327236 1283,Central Banks m1327453 1235,Monetary Policy m1327609 444,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
no_of_pages: 33
model_extractions: WPS5445 Policy Research Working Paper 5445 Payment Systems, Inside Money and Financial Intermediation _Ouarda Merrouche Erlend Nier_ The World Bank Development Research Group Finance and Private Sector Development Team October 2010
Policy Research Working Paper 5445

# **Abstract**

This paper assesses the impact of introducing an efficient payment system on the amount of credit provided by the banking system. Two channels are investigated. First, innovations in wholesale payments technology enhance the security and speed of deposits as a payment medium for customers and therefore affect the split between holdings of cash and the holdings of deposits that can be intermediated by the banking system. Second, innovations in wholesale payments technology help establish well-functioning interbank markets for end-of-day funds, which reduces the need for banks to hold excess reserves. The authors examine these links empirically using payment system reforms in Eastern European countries as a laboratory. The analysis finds evidence that reforms led to a shift away from cash in favor of demand deposits and that this in turn enabled a prolonged credit expansion in the sample countries. By contrast, while payment system innovations also led to a reduction in excess reserves in some countries, this effect was not causal for the credit boom observed in these countries.

This paper—a product of the Finance and Private Sector Development Team, Development Research Group—is part of a larger effort in the department to banks and payment system. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at omerrouche@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Payment Systems, Inside Money and Financial Intermediation**<sup>**1**</sup>

Ouarda Merrouche and Erlend Nier World Bank IMF EL codes: G21, G28, E42, E44, E51. Keywords: Payment systems, money demand, credit supply.

1 Contact author at enier@imf.org. The views expressed in this paper are those of the authors, and not necessarily those of the World Bank or the International Monetary Fund. The authors wish to thank Ian Bond, Massimo Cesarino, Mario Guadamillas, Charles Kahn, Mark Manning, Loretta Mester, Nada Mora, Sean O Connor, Gabriel Sterne and seminar participants at the Bank of England, the IMF, the FIRS 2008 conference in Anchorage, the MMF conference in Birbeck College, and the IFS in London for comments and suggestions. A first version of the paper was published in the Bank of England working paper series and can be found at http://www.bankofengland.co.uk/publications/workingpapers/wpabst09.htm
“We’d always thought that if you wanted to cripple the US economy, you’d take out the payment systems. Banks would be forced to fall back on ine¢cient physical transfers of money. Businesses would resort to barter and IOUs; the level of economic activity across the country could drop like a rock.” Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, 1987-2006

# 1 Introduction

Payment systems<sup>1</sup> are the means by which inside money is transferred between banks.<sup>2</sup> Reforms to improve the e¢ciency of these systems have the potential to improve welfare by increasing the demand for inside money and reducing the need for outside money. The reason is that banks use inside money (deposits) to ...nance lending to the corporate sector and households. An economy which increases its reliance on inside money relative to outside money may therefore be able to support a higher level of capital and increased growth as that capital is accumulated. Indeed, the extant literature has found a robust relationship between ...nancial depth, as measured by the amount of credit extended by the banking system and the subsequent rate of growth of the economy as a whole.<sup>3</sup> Historically, banks have played a central role both in facilitating payments and in the creation of credit. But most theories of banking ignore the interplay between the two. These theories emphasize frictions such as asymmetric information on borrowers and incomplete markets more generally as important in understanding intermediation. In an in‡uential study, Diamond (1984) argued that intermediaries overcome asymmetric information problems by acting as "delegated monitors". Another strand of the literature, starting with Diamond and Dybvig (1983) emphasizes the role of banks in insuring liquidity needs of customers while at the same time investing in longer-term assets. However in this model and much of the subsequent literature, both a bank’s assets and liabilities are real and there is no separate role for outside money. Only very recently have economists started to provide theories of intermediation where monetary disturbances (shifts in the demand for outside versus inside money) can a¤ect the amount of credit provided by the banking system, e.g. Diamond and Rajan (2006).

> 1The term payment system refers to the instruments, organizations, operating procedures, and information and communication systems used to initiate and transmit payment information from payer to payee and to settle payments (BIS (2001), Core Principles for Systematically Important Payment Systems, Committee on Payment and Settlement Systems, January).

> 2In this process the transfer of inside money (deposits) is settled through exchanges of outside money i.e. the ultimate settlement asset, usually central bank balances.

> 3See King and Levine (1993) for an early contribution to this literature. In this paper we examine in more detail the determinants of ...nancial depth, taking its potential to contribute to economic growth as given.

2
On the other hand, a large body of empirical literature provides evidence linking monetary disturbances to business cycles. It is usually found that this link is stronger for the inside component of the money supply than it is for outside money. In their analysis of the Great Depression, Christiano et al (2004) argue that the contraction phase was primarily the consequence of a shock that induced a shift away from privately intermediated liabilities, such as bank deposits, and towards currency. This shock drove households to accumulate currency at the expense of demand deposits that could be used to fund entrepreneurs who own and operate the economy’s stock of capital. In the same vein, Rocko¤ (1993) provides evidence that the Great Depression was the consequence of a drastic deterioration in the acceptance of bank money as payment medium. At the time, it was a chain of bank failures that caused the payment system to collapse. It is thought that con...dence in bank money was restored only by structural reforms to address ...nancial risk in the banking system, such as the introduction of federal deposit insurance.

Finally, our paper is related to a small literature that has documented links between deposit taking and lending. There is evidence to suggest that information obtained through monitoring the cash ‡ow in and out of demand deposits can be used by banks to help make credit decisions (Mester, Nakamura and Renault (2007)). Moreover, Berlin and Mester (1999) show that banks that are ...nanced by core (transaction) deposits are able to insulate borrowers from changes in aggregate borrowing costs, because what banks pay on core deposits is relatively insensitive to economy-wide ‡uctuations in the cost of credit. Finally, the literature documents synergies between deposit taking and loan commitments, and hence lending more generally (Kashyap, Rajan and Stein (2002)). When withdrawals of deposits are imperfectly correlated with drawdowns on commitments, both can be o¤ered more cheaply, drawing on a common pool of liquid assets held by the bank.

These papers stop short of drawing out the role an e¢cient interbank payment system might play with regard to these mechanisms. But arguably, the e¢ciency of interbank payment systems may a¤ect both a) banks’ ability to o¤er transactions services to customers; and b) their ability to pool liquidity across banks. A greater e¢ciency of interbank payment systems is thus likely to a¤ect credit creation. In this paper we investigate whether or not payment system reform and credit creation are linked. We also study the transmission channels that might e¤ect such a link.

As summarized in Figure 1 two channels are investigated. Innovations in wholesale payments technology enhance the reliability of inside money as a payment medium for customers and therefore a¤ect the split between holdings of cash (outside money) and holdings of deposits (inside money). While cash is held by households and does not (perhaps for lack of monitoring skills) get lent out to private sector borrowers, deposits are intermediated by the banking system. An increase in the supply of deposits to the banking system can therefore in turn lead to a shift in the supply of credit to the economy 3
<!-- Start of picture text --> Payment Systems<br>Reform<br>Currency Holding Excess Reserves Holding<br>Financial Intermediation Financial Intermediation<br><!-- End of picture text --> Figure 1: Transmission Mechanisms (deposit channel). Second, innovations in wholesale payment systems help establish wellfunctioning interbank markets for end-of-day funds. This may reduce the need for banks to hold excess reserves (outside money) to self-ensure against end-of-day out‡ows and thus helps credit creation (reserves channel).

It is important to emphasize, however, that neither the deposit nor the reserves channel needs to hold by virtue of a balance sheet identity (see equation 1).

For example, even if the payments reform leads to an increase in deposits () at the expense of cash, this may result in an increase in reserves (), or other liquid assets (), leaving unchanged the level of loans () to the non-...nancial sector. The extent to which an increase in deposits results in an increase in loans is therefore an empirical question which needs to be examined carefully.

Likewise, even if reform leads to a reduction in reserves (), this can be matched by a reduction in the total amount of interbank deposits (), or an increase in other liquid assets (), rather than an increase in loans to the non-...nancial sector ()<sup>4</sup> . Whether or not a reduction in reserves has an e¤ect on loans supplied by the banking system is therefore again a question that needs to be addressed empirically.

To examine whether payment system developments help credit creation and which, if any mechanism underpins this e¤ect, we use as our laboratory a sample of transition

> 4Moreover, as emphasized by Disyatat (2008), central banks will in practice tend to accommodate ‡uctuations in desired reserves, e.g. by reducing the amount of securities taken on repo in open market operations (reducing reserve repos ), in order to prevent such ‡uctuations to have an e¤ect on interest rates.

4
economies over the period 1995-2005. All of our sample countries were part of the Eastern European bloc and all have recently joined the European Union. These countries are at a similar level of economic and ...nancial development: all sample economies have bank-based ...nancial systems and ...nancial markets play only a minor role. Our sample represents a relatively homogenous group of countries also in other respects, e.g. geographic location and size.

The empirical analysis exploits the fact that these countries have been implementing large one-time reforms of their payment systems, in order to expedite the processing of payments and reduce the risk and uncertainty associated with non-cash payments. That is, we can observe relatively big changes in payments technology. At the same time the e¤ects of these changes are unlikely to be obscured by di¤erences in habit or culture as regards the use of payment systems<sup>5</sup> . Our sample countries are all moving from a world where cash is by far the dominant means of payment to one where non-cash payments are taking hold gradually.

First, we ...nd that upon the introduction of e¢cient payment systems there is a marked increase in the trend growth of credit. This ...nding is robust to the inclusion of control variables that take account of macroeconomic determinants of credit growth, as well as other dimensions of structural change in our sample, such as variation in foreign ownership of banking assets. It is robust also to a number of re...nements in our identi...cation strategy that account for omitted variables and other forms of endogeneity.

Further investigation suggests that the trend increase in credit supplied to the private sector is associated with a trend decrease in the use of currency (outside money), relative to demand deposits (inside money), while the evidence in favor of a reduction in banks’ holding of excess reserves (outside money) is much less strong. In structural reform regressions we ...nd evidence of a more general and signi...cantly positive relationship between credit supply shocks and liquidity preference shocks away from cash and towards bank deposits, while again the relationship between reserves and credit is more tenuous.

Overall, our results suggest that for the countries in our sample, the adoption of automated interbank payment systems was an important precondition for the credit boom documented by Cottarelli et al (2003), among others, and that the e¤ect of payments reform on credit creation has worked through a "deposit channel", rather than a "reserves channel".

These ...ndings serve to illustrate a simple but fundamental point: the banking system’s function as provider of credit to the economy builds on its capacity to o¤er a reliable payment medium. This means that reforms to improve the e¢ciency of interbank payment systems can have a ...rst-order e¤ect on the amount of credit provided by the banking

> 5For example, while in most advanced countries, there has over the past two decades been a gradual demise of checks, this has taken longer in some countries (eg the United States, France) than in others (eg Germany), partly as a result of di¤erent preferences for particular payment modes, that are entrenched in habit or culture.

5
system.

The remainder of the paper is organized as follows. Section 2 reviews the process of payment systems modernization in accession countries in the context of the broader structural changes to their banking systems. Section 3 elaborates the main empirical strategy and discusses reduced-form and di¤erence-in-di¤erence estimates used to identify the effect of payment reform on credit. Section 4 assesses the relevance of the two transmission channels. Section 5 provides structural estimates of the relationship between liquidity preference shocks and credit supply shocks. Section 6 concludes the paper.

# 2 Payment Systems and Banking Reforms 3 in Transition Economies

The payment systems of the former Eastern European bloc countries were paper-based settlement systems subject to long transport and processing delays (Sundararajan and Sensenbrenner (1994) and Balino, Dhawan, and Sundararadjan (1994)).

From the mid-1990s, in many economies in the region, signi...cant reforms of payment and settlement systems were introduced as part of the process of ...nancial sector reform, in an e¤ort to improve the speed, reliability and security of payments.

Typically, early reforms relied on readily available technologies to speed up transportation of documents, modify accounting practices, standardize operating procedures, introduce and improve dedicated courier services and expedite large-value payments by use of cable and telegraphic networks. In addition, measures were adopted to address ...nancial risk in payment systems, namely (1) exposure limits; (2) collateralization, (3) loss-sharing arrangements, and (4) shortening of time lags in settlements.

The advanced reforms we focus on in our empirical analysis comprised the introduction of automated arrangements for interbank transactions that o¤er ...nality, a high degree of security, and immediate, same-day, or value-dated settlement.<sup>6</sup> Appendix 1 provides further details on payment system reforms, country-by-country. Major reforms were dated using information contained in the ECB Blue Book on payment systems in accession countries (2002) (available online) as well as national central banks’ annual reports. In almost all cases, across the sample period there is a single clearly identi...able date of introduction of a modern automated interbank payment system. In a small number of countries, multiple systems supporting di¤erent types of interbank transactions were introduced consecutively over the sample period. In these cases, we focus on the date the ...rst of these systems is introduced.<sup>7</sup>

> 6With real time gross settlement (RTGS), payments are settled one by one and in real time – that is, with virtually no delay. Since payments are not netted out, however, gross settlement systems need larger amounts of intraday liquidity to facilitate prompt settlement of payments.

> 7Our results are not a¤ected materially by changes in the dating convention.

6
While this paper highlights the e¤ects of payment system reform for our sample countries, structural changes to the banking system also occurred along other dimensions. Figure 2 provides evidence that privatization resulted in a reduction of government ownership of banking assets in many of the sample countries. Moreover, it shows that the speed of privatization varies across countries. While the government no longer owned a sizable fraction of banking system assets at or soon after the start of the sample period in Estonia, Latvia and Hungary, a gradual process of privatization was still ongoing in some other countries during our sample period. Figure 2 also documents a rising proportion of banking system assets that are foreign-owned. Finally, countries have undertaken major reforms to the regulatory and supervisory framework that banks are subject to. Figure 3 charts the path of a banking system reform index constructed by the European Bank for Reconstruction and Development (EBRD). A higher banking reform index indicates that banking laws, regulations and prudential supervision are closer to the Bank of International Settlements (BIS) standards.<sup>8</sup> In addition to the paths for the share of government ownership, the share of foreign ownership and banking system reform, Figures 2 and 3 contain a line corresponding to the date of introduction of a modern interbank payment system. While in principle, other aspects of structural reforms may represent confounding in‡uences for our analysis, Figures 2 and 3 suggest that payment system reforms are not contemporaneous with other structural changes, but that instead there is independent variation in the timing of payment system reforms – potentially re‡ecting di¤erences in central bank preferences and resources dedicated to payment system reforms – which can be exploited in the regression analysis.

> 8The index takes the following values:

1 Little progress beyond establishment of a two-tier system.

2 Signi...cant liberalisation of interest rates and credit allocation; limited use of directed credit or interest rate ceilings.

3 Substantial progress in establishment of bank solvency and of a framework for prudential supervision and regulation; full interest rate liberalisation with little preferential access to cheap re...nancing; signi...cant lending to private enterprises and signi...cant presence of private banks.

4 Signi...cant movement of banking laws and regulations towards BIS standards; well-functioning banking competition and e¤ective prudential supervision; and signi...cant term lending to private enterprises; substantial ...nancial deepening.

4+ Standards and performance norms of advanced industrial economies: full convergence of banking laws and regulations with BIS standards; provision of a full set of competitive banking services.

7
# 4 The E¤ect of Payment Systems E¢ciency on Credit Creation

In this section we develop and apply three di¤erent ways of identifying the e¤ect of payment systems reforms on credit that exploit both the time series and cross-sectional variations in payment systems development in our dataset.

## 4.1 Reduced-Form Evidence: Trend-Break Model

We ...rst propose the following reduced-form speci...cation to identify trend changes in the supply of credit around the transition to modern payment systems: where  (...nancial intermediation) stands for the credit over GDP ratio in country  in quarter  The independent variable of interest is the post-reform trend  starting at one for the ...rst post-reform quarter which measures the augmentation in credit growth from the country-speci...c trend . As  trends upwards over the sample period (for some countries) we model the e¤ect of payment systems reforms as an acceleration in credit growth above country-speci...c sample trends.

The regression includes country dummies 1 to control for all time-invariant omitted variables. Also included are seasonal dummies and year-...xed e¤ects to control for shocks common to all countries, such as credit accelerations – whatever their cause – that a¤ect the whole region. Standard errors are corrected for clustering of the error terms at the country level, to allow for serial correlation and heteroskedasticity in the error term over time.

¡2 is a vector of observable control variables. The set of controls follows closely the extant literature on the determinants of ...nancial deepening (measured by private credit over GDP). Speci...cally, it includes those factors that Cottarelli et al (2003) (among others) emphasize as the main causes of the credit boom in Eastern Europe; namely ...scal consolidations and structural reforms in the banking sector.

The ratio of total government expenditures over GDP is used to capture the potential for reductions in public spending to crowd-in credit to the private sector. We therefore expect a negative sign on this variable. We also include the level of activity, namely the log real per capita GDP and expect, based on prior evidence, e.g. Detragiache, Tressel and Gupta (2006), this variable to have a positive e¤ect on ...nancial depth (private credit over GDP).

In addition, we control for the e¤ect of in‡ation on credit. Following Boyd, Levine and Smith (2001) and Cottarelli et al (2003) we allow for this e¤ect to be non-linear, through inclusion of a high-in‡ation dummy, which takes the value of 1 when in‡ation is above a threshold (equal to the 75th percentile), and an interaction term of in‡ation with the 8
high-in‡ation dummy. Based on existing evidence, we expect in‡ation to have a negative e¤ect on credit for in‡ation rates above the threshold, while for rates of in‡ation below the threshold, increases in in‡ation are expected to have no or a small positive e¤ect on credit.

We also include a number of variables that capture structural changes to the banking sector. First we include the share of banking assets owned by the government and the share of banking system assets that are foreign-owned. While it has been suggested that privatization and a high share of foreign assets might have contributed to a relatively rapid expansion in credit extended by the banking sector in some transition economies, Cottarelli et al (2003), neither theory nor more recent existing evidence on the e¤ect of these variables on ...nancial depth is clear-cut. Cross-sectional studies do not typically ...nd a robust correlation between government ownership and credit extended by the banking system, e.g. Detragiache et al (2006). On the other hand, a recent study on the French banking reforms in 1985, that involved a retreat by the French Treasury from close control of the banking system as well as privatization of state-owned banks, ...nds that bank credit contracted in the wake of these reforms, Bertrand, Schoar and Thesmar (2007). Further tests provided in this study are consistent with the idea that state ownership implies a soft budget constraint that can give incentives for banks to lend even to unpro...table businesses.

A large empirical literature on the e¤ects of foreign ownership on credit extended by the banking sector is surveyed in Detragiache et al (2006). Again this literature has not reached ...rm conclusions. On the one hand foreign ownership leads to an import of human capital and expertise in screening borrowers. On the other hand, foreign banks may tend not to take full account of soft (and local) information, resulting in greater rationing of credit. Detragiache et al (2006) model this trade-o¤. Their model implies that foreign ownership should be associated with a reduction in credit in poor countries, while on balance no e¤ect is predicted for high-income countries. In cross-sectional regressions of bank credit on the share of foreign ownership they ...nd evidence that con...rms both of these predictions. In other words, foreign ownership leads to a reduction in credit for poor countries, but has no discernible e¤ect for high-income countries.

In addition to the share of government and foreign ownership we include the EBRD banking reform index. To the best of our knowledge, this comprehensive index of the regulatory and supervisory framework has not been used in empirical research before, but related evidence in Barth, Caprio and Levine (2006) suggests that o¢cial supervisory power correlates negatively with credit to GDP. Since structural characteristics of the banking system, captured by the EBRD index, are separately accounted for through use of government ownership variables, we expect a negative coe¢cient on the EBRD banking reform index.

According to Cottarelli et al (2003) capital in‡ows had not been a major determinant of the credit boom in Eastern European countries up to 2002. Since then however, some of 9
these countries may have experienced an increase in capital in‡ows which could have come to fuel the credit boom in some of our sample countries. To account for capital in‡ows received by the domestic banking system we include the foreign exchange reserves held at the central bank, scaled by GDP.<sup>9</sup> Last, banking crises are accounted for, by including a dummy that takes value one in crisis inception years and the following two years,<sup>10</sup> with a negative e¤ect expected on credit to GDP.

The analysis uses quarterly data covering the ten countries listed in Appendix 1 over the period 1995-2005; as set out above, the sample is chosen such that it comprises all countries that were part of the former Eastern European bloc and that now are members of the European Union.<sup>11</sup> During the sample period, seven of these countries reformed their payment systems, with two countries (Poland and Czech Republic) having completed payment system reforms before the start of the sample period and one country (Romania) embarking on major reforms only at the very end of the sample.<sup>12</sup> These countries are included to achieve greater e¢ciency in the measurement of the e¤ect of control variables. Appendix 2 contains the list of variables used and the corresponding sources.

Summary statistics for all variables used in our tests are reported in Table 1. The descriptive statistics reported in the ...rst panel con...rm an increase in ...nancial intermediation over the sample period accompanied by a decline in the currency over demand deposits ratio and a small increase in the excess reserves over total deposits ratio.<sup>13</sup> The second panel reports a correlation matrix for a number of control variables. The correlation is high among some of these variables. Our approach is therefore to check the robustness of our results to the inclusion of alternative sets of control variables.

We go on to investigate the determinants of the trend in ...nancial intermediation by estimating equation (2). The main results are reported in Table 2. The speci...cations shown include control variables lagged by two periods<sup>14</sup> (i.e. half a year), in addition to the full set of country ...xed e¤ects, country-speci...c trends, year e¤ects and seasonal e¤ects.

9We also experimented with a broader measure of in‡ows including foreign direct investment, portfolio ‡ows and debt liabilities. This variable tended not to be signi...cant.

> 10Banking crises are identi...ed using the Caprio-Klingebiel World Bank dataset (2003) at www1.worldbank.org/...nance/html/database_sfd.html. According to this source, banking crises ocourred in the following countries (with crisis inception years in brackets): Bulgaria (1996), Latvia (1995), Poland (1993), Lithuania (1994).

> 11Bulgaria and Romania joined the European Union in 2007. All other sample countries joined in 2004. Slovenia has – in 2007 – also joined the euro.

12The series used are not available for a su¢ciently long period prior to reform in Poland and the Czech Republic (notably quarterly GDP).

> 13Credit to the private sector includes credit in both domestic and foreign currency. Payments technology may a¤ect the use of domestic currency transactions accounts by residents. The monitoring of these accounts can in‡uence the decision to grant credit, independent of the denomination of the debt. Moreover, while changes in domestic currency payments technology may at the margin favour domestic credit over foreign currency credit, for lack of data we are unable to explore whether payment system reforms might have brought about changes in the currency composition of the credit extended.

> 14We will later test the robustness of our results to alternative numbers of lags.

10
The model has a very good ...t with a within R-squared at 0.89. The coe¢cient on the trend break variable is statistically signi...cant at the 5 percent level. It is also economically sizable; the size of the coe¢cient suggests that the growth in ...nancial intermediation accelerates by around 4 percentage points per annum post transition to modern payment systems, which is an economically sizable e¤ect. Moreover, all control variables have expected signs.

In line with prior evidence we ...nd the e¤ect of in‡ation to be non-linear, while overall economic activity has a robust positive e¤ect. We also ...nd evidence that ...scal consolidation leads private credit to expand.

Interestingly, the EBRD banking reform index is assigned a negative coe¢cient, suggesting that better compliance with supervisory standards puts a break on credit creation, as might have been expected.

In line with the result reported in Detragiache et al (2006) for high-income countries, we ...nd there to be no signi...cant e¤ect of foreign ownership on credit.<sup>15</sup> However, we ...nd a robustly positive relationship between public ownership and credit, in line with the evidence reported in Bertrand, Schoar and Thesmar (2007) and consistent with the idea that public ownership results in soft budget constraints on banking ...rms.

Finally, as one would expect there is a positive and signi...cant relationship between capital ‡ows into the banking system (measured by changes in foreign exchange reserves over GDP) and the credit over GDP ratio.

Overall, while macro factors (including in‡ation, capital in‡ows, and GDP) are shown to play an important role, this evidence suggests that privatization and increases in foreign ownership are unlikely to have been an important contributor to increases in credit observed in a number of countries over the sample period. Likewise, the overhaul of the regulatory and supervisory framework appears to have had the e¤ect of slowing rather than accelerating credit growth. Instead, our results single out reform of payment systems as the key ingredient within the overall reform process that led to increases in credit in some of the sample countries.

In Table 3 we present variations of the benchmark speci...cation that were conducted to examine the robustness of our ...ndings across sub samples and lag lengths. Column (1) shows a regression where the sample is restricted to those countries that experienced a payment system reform during the sample period (i.e. excluding Czech Republic, Poland and Romania), with the results virtually unchanged.

While in our preferred speci...cation, control variables are lagged by two quarters (half a year), in columns (2) and (3) we report models that employ a di¤erent lag length (four and zero quarters, respectively) for the controls. In both these speci...cations, while the R-squared remains high and the measured e¤ect on the post reform trend remains

> 15The share of foreign ownership remains insigni...cant when the share of public ownership is omitted from the equation. This implies that the insigni...cant e¤ect is not accounted for by a multicollinearity problem (high correlation) between these two variables.

11
signi...cant, some of the coe¢cients on the control variables lose signi...cance. This suggests that the e¤ects of the control variables are not immediate but take some time to work themselves through, and that at the same time there is relatively limited autocorrelation in the control variables.

Column (4) reports a control experiment. We assigned the average date of reform to the three countries (Poland, Romania and the Czech Republic) that did not undertake a reform over the sample period and checked whether evidence of a credit acceleration around the average reform time emerges for non-reform countries. The result con...rms that the accelerations in ...nancial intermediation in the reform countries do not re‡ect a global trend in the region.

# 4.2 Cross-Sectional Approach

The analysis thus far has relied on identi...cation through di¤erences in the timing of reform, with the reform being treated as a zero-one event. As an alternative strategy we use two continuous measures of payment system development: (1) the number of credit transfers per inhabitant; (2) the number of all non-cash payments per inhabitant (including direct debits and cheques). The idea is that the number of credit transfers (and to some extent all non-cash payments) directly re‡ect the system’s use.<sup>16</sup> Yearly data are reported in the ECB Blue book for the period 1996-2001 for all countries in our sample except Bulgaria. Descriptive statistics reported in Table 1 show a huge variability in the use of non-cash payment instruments across countries which, in our sample, is unlikely to be attributable fully to variations in levels of economic development or culture. For instance, the number of credit transfers per inhabitant in 1996 is 30 in the Czech Republic and 4 in Hungary.

To capture the variation in the measures of payment systems development is mostly in the cross-section, we use an ordinary least squares estimator including year ...xed e¤ects but excluding country ...xed e¤ects to identify the e¤ect of payment systems development on credit.

Our speci...cation controls for real income per capita and the full set of determinants of ...nancial development used before (all lagged one year) and as listed in Table 2. The estimation results reported in Table 4 con...rm our previous conclusions. An increase in the number of credit transfers (non-cash payments) is associated with a statistically signi...cant increase in credit. This e¤ect is again economically signi...cant. A one standard deviation increase in the number of credit transfers per inhabitant is associated with 6.4 percentage points rise in the annual credit to GDP ratio.

16Credit transfers are e¤ected directly through the main interbank payment systems, while direct debits and cheques are ...rst netted in ancillary systems before ...nal settlement occurs in the main system.

12
## 4.3 Di¤erence-in-Di¤erence Approach

To complement the evidence presented thus far we return to the payments reform model and extend speci...cation (5) to a di¤erence-in-di¤erence speci...cation that allows the size of the credit acceleration to be higher for countries that have less-developed payment systems prior to the time of reform. As set out in Section 2 and described in Appendix 1 in Estonia and the Slovak Republic (henceforth "upgraders") reforms represented upgrades of already existing automated systems to higher operation standards for settlement risk, security and e¢ciency. In contrast other countries like Latvia, Lithuania, Hungary and Slovenia (henceforth "reformers") experienced a one-time switch from paper-based to automated RTGS systems. We exploit the resulting disparities in our identi...cation of the causal e¤ect of payment systems reform on credit by interacting the reform trend break with indicators of payment systems use in the period preceding the reform in each country. The e¤ect of payment systems reforms on credit should be bigger where the reform represents a bigger technological advance.

Formally, we augment speci...cation (7) as follows: where  is the pre-reform number of credit transfers per inhabitants. The mean of  is 12 pre inhabitant for the group of reformers and 27 per inhabitant for the group of upgraders.

In Table 5 column (1) we report the results from this augmented speci...cation that conditions the size of the trend break on . We ...nd that the credit acceleration is larger in countries that had less-developed payment systems immediately prior to the payment systems reform. The di¤erence-in-di¤erence estimate in column 1 implies that post-reform upgraders experience a credit acceleration on average 3 percentage points per year higher than reformers.

We ...nally subject this ...nding to a set of robustness exercises, as follows. In column (2) we restrict the sample to countries who introduced modern payment systems during our sample period, excluding countries that reformed earlier than 1995 or later than 2005. In columns (3) and (4) we run similar regressions but control for potential mean reversion by including the trend break interacted with the pre-reform credit over GDP ratio. The point estimates remain of comparable magnitude and statistically signi...cant across these exercises.

# 5 Transmission Channels

We highlighted two channels through which a payment systems reform might a¤ect credit creation. These are: a shift in the desired holdings of cash relative to demand deposits (on the part of customers) and a reduction in the desired holdings of excess reserves relative 13
to total deposits (on the part of banks). In an attempt to determine which, if any of these channels might be related to our ...nding of an increased growth of credit post reform, we explore whether payment system reforms also induce trend breaks in these series. To this end, speci...cations analogous to equation (2) are estimated, as before including country...xed e¤ects, year e¤ects and country-speci...c time trends. Control variables are based on standard forms of the demand for currency and demand for excess reserves, respectively.<sup>17</sup> Currency is the money in circulation (domestic currency notes and coins). Total deposits include both demand deposits and term deposits.<sup>18</sup> As regards the demand for currency, <sup></sup> includes variables that capture the oppor– – tunity cost the nominal interest rate of holding currency and the "bad behavior" motives for holding currency. The latter are proxied by the ratio of government taxes over GDP,<sup>19</sup> capturing incentives for the development of black-market activities and tax avoidance. The log real GDP per capita is also included as measuring the transaction motives for holding currency.

As regards the demand for excess reserves, <sup></sup> includes variables that control for the opportunity cost of holding excess reserves (namely the nominal interest rate), the reserve requirement ratio and output growth.<sup>20</sup> We also include the foreign reserves over GDP ratio in the excess reserves equation. If the central bank sterilizes fully the increase in domestic currency brought about by in‡ows of foreign currency, commercial banks reserves should be unrelated to variations in the in‡ow of foreign currency. Otherwise, one might expect to observe an increase in reserves.

We report both ...xed e¤ects and seemingly unrelated least squares (SURE) estimates of the two equations (4) and (5) in Table 6. SURE extends ordinary least squares analysis to estimate a system of linear equations with correlated error terms, which gives more e¢cient point estimates. For both equations we obtain a reasonable overall ...t, with the more e¢cient SURE estimator giving more signi...cant point estimates.

For equation (4) we ...nd a statistically signi...cant negative post-transition trend break

> 17 We use speci...cations similar to Drehmann, Goodhart and Krueger (2002) and Rogo¤ (1998) for the money demand equation, and Agenor, Aizenman and Ho¤maister (2004) for the demand for excess reserves equation.

> 18Both "demand deposits" and "term deposits" may include foreign currency deposits.

> 19This is in practice proxied by government consumption expenditures over GDP because for most countries the tax to GDP ratio is not available at a quarterly frequency for the sample period.

> 20We also used the ratio of demand to saving deposits ratio but did not obtain robust results for the e¤ect of this variable. We therefore dropped it from our analysis.

14
in the currency ratio.<sup>21</sup> The reduction is 1.5 percentage points per quarter i.e. 6 percentage points per annum, and thus similar in magnitude to the estimated reduced-form e¤ect of payment systems reform on credit. Moreover all control variables have the expected sign and most of them are statistically signi...cant. Plausibly, lower economic development, higher taxes, and lower nominal interest rates increase the use of cash relative to deposits.

For equation (5), we ...nd that excess reserves are negatively related to output growth and, plausibly, negatively related also with the ratio of required reserves. In addition, the coe¢cient on foreign exchange reserves over GDP is not signi...cant at conventional levels, indicating that central banks sterilize foreign in‡ows fully.<sup>22</sup> However no signi...cant trend break is detected upon introduction of an e¢cient payment system.<sup>23</sup> One explanation for this ...nding is that banks’ desire to ensure against end-of-day payment shocks is only one determinant of their desired level of reserves. A determinant which may be more important is a bank’s management of liquidity over a longer horizon. This prudential motivation to hold liquid assets may dominate in our sample.<sup>24</sup> We ...nally turn to a di¤erence-in-di¤erence exercise, the idea being once again that the e¤ect of reform should be stronger where payment system reform represents a bigger technological advance.

The di¤erence-in-di¤erence estimates are reported in columns (5) and (6). We ...nd that the decline in the currency ratio is larger in countries that have less developed payment systems immediately prior to reform. The post-reform decline in the currency ratio is about 1.14 percentage points per quarter higher in the reforming countries than in the upgrading countries. For the reserves ratio by contrast, the estimates are still not statistically signi...cant. Finally, in columns (7) and (8) we obtain similar results if we control for the initial levels of the dependent variables. Here interestingly, we ...nd that where the initial level of excess reserves was particularly high payment systems reform has some e¤ect in reducing these levels.

Overall, this evidence suggests that payment systems reforms are associated with a statistically signi...cant and sizable reduction in currency relative to demand deposits (deposit channel). By contrast there is little if any evidence of a reduction in excess

> 21This estimate may be taken as a lower bound as the introduction of an e¢cient payment system is expected to trigger a decline in dollarization.

> 22A number of countries in our sample operate a currency board.

> 23We ...nd the explanatory power of the reserve equation to be lower than that of the cash equation suggesting that the high time-series variation in reserves holding is relatively hard to account for with the available explanatory variables.

> 24Another reason might have been that central banks did not take steps to drain excess reserves. If demand for excess reserves had fallen as a result of payment system reform, but central banks did not take action to drain the excess then there is no way for the excess to be reduced, since reserves will need to stay within the banking system. And while a reduction in demand would tend to drive down overnight interest rates to close to the deposit rate o¤ered by the central bank some central banks might have preferred this outcome to the draining of reserves, e.g. through issuing central bank bills, since this is costly for central banks.

15
reserve holdings (reserves channel).

# 6 Structural Model

To investigate further the relative importance of the deposits and reserves channels, we assess the structural relationship between all three variables – credit, currency and excess reserves. The idea is as follows: for a trend reduction in the currency ratio to have caused the trend increase in ...nancial intermediation, it needs to be true more generally that liquidity shocks away from currency result in an increase in credit. Likewise, for a reduction in excess reserves (if any) to have caused the increase in ...nancial intermediation, it must be true more generally that shifts in the demand for excess reserves are associated with shifts in credit supply. We therefore examine the relationship between shocks to the supply of credit and (innovation-driven) shocks to the demand for outside money (both currency and excess reserves), as follows: In this equation, j=fg denote reserves and currency respectively, 5 is an error term and b<sup></sup>  b<sup></sup>  b<sup>o</sup> are the predicted residuals from regressions (11) and (12) estimated n by seemingly unrelated least squares (SURE):  is either the excess reserves over total deposits ratio or the currency over demand deposits ratio. Speci...cation (6) allows us to explore a relationship between (innovationdriven) shocks to the demand for outside money, re‡ected in b<sup></sup> and b<sup></sup>  and unexplained variations in the level of ...nancial intermediation. The ...xed-e¤ect estimate of the structural parameter 52 is consistent after removing the e¤ects of control variables common to equations (7) and (8).

Table 7, columns (1) and (2), reports the results of estimating equation (6) using a ...xed e¤ects estimator. The point estimates con...rm that liquidity preference shocks away from cash and towards bank deposits cause positive credit supply variations that are both statistically and economically signi...cant. By contrast, we do not ...nd a relationship between shocks to the demand for excess reserves and credit. One reason could be that excess reserves are noisy relative to both deposits and credit extended by banks which makes it harder to pick up a relationship empirically. Another reason is that the demand for excess reserves plays a minor role in determining banks’ lending behavior.

16
To account for potential reverse causality between shocks to credit and shocks to currency and reserves, we employ an alternative, instrumental variables (IV) estimator, using lagged innovations as instruments for contemporaneous innovations. Our identi...cation assumption is that while there is a reasonable autocorrelation in b<sup></sup> <sup>thee¤ectofb</sup> <sup>on</sup> b<sup></sup> <sup>isimmediatetoshort-lagged25.</sup> In this case, b<sup></sup> ¡2<sup>andb</sup> ¡3<sup>arevalid(excluded)</sup> instruments for b<sup></sup> <sup>.Table7,columns(3)and(4),reportstheIVestimatesalongwith</sup> weak instrumentation and overidenti...cation tests which con...rm the validity of our instruments. We ...nd the e¤ect of shocks to the currency ratio strengthened<sup>26</sup> , while shocks to the reserves ratio have no e¤ect on credit, as before.

Overall, the structural estimates con...rm that payment system reforms could plausibly have had a causal e¤ect on credit creation, through increasing the demand for deposits, relative to cash. The structural analysis also con...rms that a reserves channel will not have been an important causal driver of the e¤ect of payment systems reforms on credit.

The latter ...nding may shed light on the ongoing debate on the mechanisms that underlie the ’bank lending channel’ of monetary policy. The traditional view is that monetary policy can a¤ect the amount of reserves held by the banking system and that this in turn can, through a money multiplier, a¤ect the supply of credit to the economy (Bernanke and Blinder (1988)). A more recent paper by Diamond and Rajan (2006) argued that this cannot be the mechanism at work when banks in modern monetary economies in fact hold only very small, if any reserves with the central bank. We ...nd that even in economies where excess reserves holdings are still relatively sizable (7% in our sample), variations in excess reserves have no discernible e¤ect on the amount of credit intermediated in the economy.

# 7 Conclusion

Previous studies pointed out ...scal consolidations and structural reforms as drivers of the credit boom observed in Eastern Europe (see e.g. Cottarelli et al (2003)). This paper emphasizes that the adoption of well-functioning payment systems was an important precondition for the observed acceleration of credit.

Our results serve to illustrate a simple but fundamental point: the banking system’s function as provider of credit to the economy builds on its capacity to o¤er a reliable payment medium. This means that reforms to improve the e¢ciency of interbank payment systems can have a ...rst-order e¤ect on the amount of credit provided by the banking system. We investigate two channels. First, payment system reform increases the attractiveness of making payments via bank deposits relative to the use of cash (deposit

> 25In other words, we assume that the supply of credit by banks adjusts to variations in retail deposits within two quarters.

> 26Presumably, measurement error biases ordinary least squares estimates downwards.

17
channel). Second, reforms to interbank payment systems enable banks to economize on their holdings of excess reserves (reserves channel).

Overall, we ...nd strong evidence that the ...rst of these channels is at work. We ...nd payment systems reforms to be associated with a trend increase in credit. We also ...nd that payment systems reforms decrease the amount of cash used in the economy, relative to bank deposits. Moreover, further evidence suggests that these two ...ndings are unlikely to be coincidental: negative shocks to the currency ratio result more generally in an increase in credit. As regards the reserves channel, we ...nd less compelling evidence. We do not ...nd payment systems reforms to be associated with a reduction in excess reserves. Moreover, we do not ...nd that changes in the excess reserves ratio results more generally in changes in credit.

Taken together, these ...ndings may have broader implications for our understanding of ...nancial intermediation, highlighting the nexus between the role of banks in the provision of payment services and their role in the creation of credit. By contrast, our ...ndings shed doubt on the relevance of central bank reserves in determining the amount of credit extended by banks, questioning traditional accounts of the "bank lending channel" of monetary policy.

# References

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- [2] Balino, T., Dhawan, J., Sundararadjan ,V., 1994. Payments systems reforms and monetary policy in emerging market economies in Central and Eastern Europe. IMF Sta¤ Papers 41, 383-410.

- [3] Barth, J.R., Caprio, G., Levine, R., 2006. Rethinking bank regulation - till angels govern. Cambridge: Cambridge University Press.

- [4] Berlin, M., Mester, L., 1999. Deposits and relationship lending. Review of Financial Studies 12, 579-607.

- [5] Bernanke, B., Blinder, A., 1988. Credit, money, and aggregate demand. American Economic Review papers and proceedings 78, 435-439.

- [6] Bertrand, M., Schoar, A.,Thesmar, D., 2007. Banking deregulation and industry structure: evidence from the french banking reforms of 1985. MIT, mimeo.

- [7] Boyd, J., Levine, R., Smith, D. B., 2001. The impact of in‡ation on ...nancial sector performance. Journal of Monetary Economics 47, 221-48.

18
- [8] Caprio, G., Klingebiel, D., Laeven, L.,Noguera, G., 2003. An update of the Caprio-Klingebiel database (1996, 1999). World Bank website www1.worldbank.org/...nance/html/database_sfd.html.

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- [10] Cottarelli, C., Dell’Ariccia, G., Vladkova-Hollar, I., 2003. Early birds, late risers, and sleeping beauties: bank credit growth to the private sector in Central and Eastern Europe and in the Balkans. IMF Working Paper WP/03/213.

- [11] Detragiache, E., Tressel, T., Gupta, P. 2006. Foreign banks in poor countries: theory and evidence. IMF Working Paper WP/06/18.

- [12] Diamond, D.W., 1984. Financial intermediation and delegated monitoring. Review of Economic Studies 51, 393-414.

- [13] Diamond, D.W., Dybvig, P. H., 1983. Bank runs, deposit insurance, and liquidity. Journal of Political Economy 91, 401-19.

- [14] Diamond, D.W., Rajan, R. G., 2006. Money in a theory of banking. American Economic Review 86, 30-53.

- [15] Disyatat, P., 2008. Monetary Policy Implementation: Misconceptions and their Consequences. BIS working paper No. 269.

- [16] Drehmann, M., Goodhart, C., Krueger, M., 2002. Challenges to currency: will cash resist the e-money challenge?. Economic Policy, April.

- [17] Kashyap, A.K., Rajan, R., Stein, J.C., 2002. Banks as liquidity providers: an explanation for the coexistence of lending and deposit-taking. Journal of Finance 57, 33-73.

- [18] King, R., Levine, R., 1993. Finance and growth: Schumpeter might be right. Quarterly Journal of Economics 108, 717-37.

- [19] Mester, L., Nakamura, L.I. and Renault, M., 2007. Transactions accounts and loan monitoring. Review of Financial Studies 20, 1-12.

- [20] Rocko¤, H., 1993. The meaning of money in the Great Depression. NBER Historical Paper no. 52.

- [21] Rogo¤, K. 1998. Blessing or curse? Foreign and underground demand for euro notes. Economic Policy, April, 263-303.

19
- [22] Sundararajan, V., Sensenbrenner, G., 1994. Linkages between payments system reforms and monetary policy: the recent experience in Russia and other former Soviet Union Countries. In: Balino, T and Cottarelli, C (Eds). Frameworks for monetary stability: policy issues and country experience, 611-54.

20
<!-- Start of picture text --> Bulgaria Czech Republic Estonia Hungary<br>1995 2000 2005<br>year<br>Public Foreign 1995 2000year 2005 1995 2000year 2005 1995 2000year 2005<br>Latvia Lithuania Poland Romania<br>1995 2000 2005 1995 2000 2005 1995 2000 2005 1996 1998 2000 2002 2004 2006<br>year year year year<br>Slovakia Slovenia<br>1995 2000 2005 1995 2000 2005<br>year year<br>80 100 100 80<br>60 80 80<br>60<br>40 60 60<br>20 40 40 40<br>0 20 20 20<br>0 0 0<br>80 100 80 80<br>60 80 60 60<br>60<br>40 40 40<br>40<br>20 20 20 20<br>0 0 0 0<br>100 50<br>80 40<br>60 30<br>40 20<br>20 10<br>0 0<br><!-- End of picture text --> Figure 2. Public and Foreign Ownership (share) of Banking Sector Assets <!-- Start of picture text --> Bulgaria Czech Republic Estonia Hungary<br>1995 2000 2005 1995 2000 2005 1995 2000 2005 1995 2000 2005<br>year year year year<br>Latvia Lithuania Poland Romania<br>1995 2000 2005 1995 2000 2005 1995 2000 2005 1996 1998 2000 2002 2004 2006<br>year year year year<br>Slovakia Slovenia<br>1995 2000 2005 1995 2000 2005<br>year year<br>1.4 1.4 1.4 1.4<br>index 1.2 index index index<br>1.3 1.3 1.3<br>1<br>.8 1.2 1.2 1.2<br>Banking refrom Banking refrom Banking refrom Banking refrom<br>.6 1.1 1.1 1.1<br>1.3 1.3 1.3 1.1<br>1.2 1.251.2 1.251.2 1.051<br>1.1 .95<br>1.15 1.15 .9<br>Banking refrom index 1 Banking refrom index 1.1 Banking refrom index .11 Banking refrom index .85<br>1.3 1.2<br>1.2 1.18<br>1.16<br>1.1 1.14<br>Banking refrom index 1 Banking refrom index 1.121.1<br><!-- End of picture text --> Figure 3. EBRD Banking Reform Index 21
# **<u>Table 1: Descriptive Statistics</u>**

# **Means and Standard Deviations**

||Mean|Standard<br>Deviation|Difference|1995-2005|Frequency|Number of<br>Observations|
|---|---|---|---|---|---|---|
|Dependent variables|||Mean|Std.|||
|Quarterly Credit over Quarterly GDP|1.099|0.587|0.565|0.894|quarterly|432|
|Annual Credit over Annual GDP†|0.264|0.165|||yearly|53|
|Currency over demand deposits|0.744|0.366|-0.376|0.322|quarterly|432|
|Excess reserves over total deposits|0.07|0.09|0.029|0.058|quarterly|432|
|Independent variables|||||||
|Inflation rate|3.462|19.94|-3.116|3.455|quarterly|424|
|Government consumption|||||||
|expenditure/GDP|0.184|0.041|-0.025|0.042|quarterly|432|
|Banking reform index|1.165|0.142|0.277|0.14|yearly|117|
|Log real GDP per capita|9.441|2.346|0.513|0.235|quarterly|428|
|Nominal interest rate|13.45|21.96|-20.14|15|quarterly|400|
|Output growth|2.064|11.185|-0.831|2.751|quarterly|424|
|Public Banks' Assets Share|25.06|22.72|-41.45|22.91|yearly|117|
|Foreign Banks' Assets Share|53.52|29.97|56.475|31|yearly|109|
|Foreign Exchange Reserves/GDP|1.161|9.178|0.036*|0.085*|quarterly|432|
|Reserve requirement ratio|8.58|5.45|-3.456|3.702|yearly|432|
||||**Min**|**Max**|||
|Credit Transfers per Inhabitants††<br>|15.96|13.97|1|67|yearly|48|
|All Non-Cash Payments per Inhabitants††|21.5|17.76|1|90|yearly|52|

† excludes Bulgaria †† data not available for Bulgaria

# **Correlation Matrix**

||Inflation<br>B|anking reform<br>index|Public Banks'<br>Assets Share|Foreign Banks'<br>Assets Share|Foreign Exchange<br>Reserves/GDP|
|---|---|---|---|---|---|
|Inflation|1|||||
|Banking reform index|-0.17|1||||
|Public Banks' Assets Share|0.13|-0.68|1|||
|Foreign Banks' Assets Share|-0.12|0.57|-0.73|1||
|Foreign Exchange Reserves/GDP|0.03|-0.37|0.21|-0.16|1|
# **<u>Table 2. The Effect of Payment Systems Reform on Credit - Post-Reform Trend Breaks</u>**

# **The dependent variable in all three panels is the Credit/GDP ratio**

||(1)|(2)|(3)|
|---|---|---|---|
|**Post-Reform Trend Break**|**0.055****|**0.040****|**0.042****|
||**(0.019)**|**(0.015)**|**(0.016)**|
|Inflation|0.006*|0.005*|0.005*|
||(0.003)|(0.002)|(0.002)|
|Inflation*(High Inflation dummy)|-0.005**|-0.004*|-0.004*|
||(0.002)|(0.002)|(0.002)|
|High Inflation dummy|0.038**|0.026|0.026|
||(0.016)|(0.015)|(0.015)|
|Expenditure over GDP ratio|-1.137*|-1.294**|-1.294**|
||(0.612)|(0.544)|(0.496)|
|Log real GDP per capita|0.867*|0.768*|0.779*|
||(0.409)|(0.379)|(0.359)|
|Banking reform index|-0.687||-0.712*|
||(0.391)||(0.387)|
|Banking crises|-0.132||0.035|
||(0.138)||(0.069)|
|Public Banks' Assets Share|0.006*|0.006*|0.005*|
||(0.003)|(0.003)|(0.003)|
|Foreign Banks' Assets Share|0.0004|-0.001|-0.001|
||(0.003)|(0.002)|(0.002)|
|Foreign Exchange reserves/GDP||0.01***|0.01***|
|||(0.001)|(0.002)|
|Country specific trends|x|x|x|
|Year fixed effects|x|x|x|
|Country fixed effects|x|x|x|
|Seasonal Dummies|x|x|x|
|Within R-squared|0.86|0.88|0.89|
|Nbr. obser.|404|400|400|

Note: Robust clustered (at the country level) standard errors in parentheses. Significant at (*) 10 per cent level; (**) 5 per cent level; (***) 1 per cent level.
**- -** **<u>Table 3. The Effect of Payment Systems Reform of Credit; Robustness to Lag Length, Sub Sample Variations and Control Experiment</u>**

**The dependent variable in all three panels is the Credit/GDP ratio**

||(1)|(2)|(3)|(4)|
|---|---|---|---|---|
|||||_Control Experiment:_<br>|
||_two lags_<br>_excluding non-_<br>_reform countries_|_four lags on_<br>_control_<br>_variables_|_No Lag_|_Trend break for non-_<br>_Adopters at the average_<br>_reform date_|
|**Post-Reform Trend Break**|**0.038****|**0.049****|**0.040***|**-0.010**|
||**(0.016)**|**(0.016)**|**(0.019)**|**(0.011)**|
|Inflation|0.006**|0.0002|0.002|0.005|
||(0.002)|(0.002)|(0.003)|(0.008)|
|Inflation*(High Inflation dummy)|-0.005*|-0.0005|-0.00005|0.0003|
||(0.002)|(0.002)|(0.003)|(0.009)|
|High Inflation dummy|0.030|-0.002|-0.015|-0.086|
||(0.019)|(0.02)|(0.032)|(0.055)|
|Expenditure over GDP ratio|-0.998|0.140|-1.364**|-1.632|
||(0.740)|(0.520)|(0.578)|(1.111)|
|Log real GDP per capita|1.258***|-0.048|0.085|0.488*|
||(0.203)|(0.164)|(0.183)|(0.169)|
|Banking reform index|-0.791*|-0.566**|-0.821|-0.137|
||(0.354)|(0.248)|(0.663)|(0.357)|
|Banking crises|0.087|0.067|0.159|-0.101|
||(0.076)|(0.073)|(0.107)|(0.112)|
|Public Banks' Assets Share|0.006|0.003|0.007*|0.007|
||(0.004)|(0.003)|(0.003)|(0.006)|
|Foreign Banks' Assets Share|-0.0007|-0.002|-0.0001|-0.002|
||(0.003)|(0.002)|(0.003)|(0.004)|
|Foreign Exchange reserves/GDP|0.009***|0.015***|0.011***|0.595|
||(0.002)|(0.002)|(0.002)|(0.495)|
|Country specific trends|x|x|x|x|
|Year effects|x|x|x|x|
|Country effects|x|x|x|x|
|Seasonal Dummies|x|x|x|x|
|Within R-squared|0.89|0.88|0.85|0.97|
|Nbr. obser.|288|380|420|112|

Note: Robust clustered standard errors in parentheses. Significant at (*) 10 per cent level; (**) 5 per cent level; (***) 1 per cent level.
**<u>Table 4. Relationship Between Alternative Measures of Payment Systems Development and Credit</u>**

**Dependent variable: Annual Credit over Annual GDP ratio**

||(1)|(2)|
|---|---|---|
|Credit Transfers per Inhabitant|0.0046***<br>(0.0013)||
|All Non-Cash Payments per Inhabitant (a)||0.0022*<br>(0.0009)|
|Year Fixed effects|x|x|
|One year Lagged Control Variables (b)|x|x|
|R-squared|0.89|0.79|
|Nbr. obser.|35|38|

Note: Robust clustered standard errors in parentheses. The sample includes all countries covered previously except Bulgaria. (a) Including direct debits and cheques. (**), (***) Stands for significance at 5 per cent and 1 per cent level, respectively. (b) All control variables as listed in Table 2

**<u>Table 5. Difference-in-Difference Estimates</u>**

# **Dependent variable: Annual Credit over Annual GDP ratio**

||(1)|(2)|(3)|(4)|
|---|---|---|---|---|
|||**_two lags excluding_**<br>**_non-reform_**<br>**_countries_**||**_two lags excluding_**<br>**_non-reform_**<br>**_countries_**|
|**Post-Reform Trend Break**|**0.073**<br>**(0.010)**|**0.069**<br>**(0.006)**|**0.109*****<br>**(0.016)**|**0.108*****<br>**(0.012)**|
|**(Trend Break)*(Pre-reform number of**|||||
|**credit transfers per inhabitant)**|**-0.190****|**-0.184****|**-0.125*****|**-0.122*****|
||**(0.070)**|**(0.069)**|**(0.029)**|**(0.028)**|
|**(Trend Break)*(Pre-reform average**<br>**credit/gdp ratio)**|||**-0.048*****<br>**(0.008)**|**-0.049*****<br>**(0.009)**|
|Inflation|0.005|0.006**|0.004*|0.005**|
||(0.002)|(0.002)|(0.002)|(0.001)|
|Inflation*(High Inflation dummy)|-0.004*|-0.005**|-0.003*|-0.004**|
||(0.002)|(0.002)|(0.002)|(0.001)|
|High Inflation dummy|0.024*|0.025|0.022*|0.024|
||(0.013)|(0.020)|(0.010)|(0.016)|
|Expenditure over GDP ratio|-0.922*|-0.632|-0.952|-0.708|
||(0.469)|(0.685)|(0.539)|(0.809)|
|Log real GDP per capita|0.802**|1.294***|0.768**|1.222***|
||(0.348)|(0.165)|(0.331)|(0.164)|
|Banking reform index|-0.582*|-0.625**|-0.701*|-0.741**|
||(0.304)|(0.251)|(0.321)|(0.286)|
|Banking crises|-0.017|0.018|-0.068|-0.051|
||(0.069)|(0.081)|(0.069)|(0.092)|
|Public Banks' Assets Share|0.004|0.004|0.004|0.004|
||(0.003)|(0.002)|(0.003)|(0.003)|
|Foreign Banks' Assets Share|-0.002|-0.001|-0.0002|0.0003|
||(0.002)|(0.002)|(0.002)|(0.002)|
|Foreign Exchange reserves/GDP|0.007***|0.006***|0.006***|0.006***|
||(0.002)|(0.001)|(0.002)|(0.002)|
|Country specific trends|x|x|x|x|
|Year effects|x|x|x|x|
|Country effects|x|x|x|x|
|Seasonal Dummies|x|x|x|x|
|Within R-squared|0.90|0.90|0.90|0.91|
|Nbr. obser.|400|288|400|288|

Note: Robust standard errors in parentheses. Significant at (*) 10 per cent level; (**) 5 per cent level; (***) 1 per cent level.
# **<u>Table 6. Transmission Channels</u>**

||**Currency ratio(a)**|**Excess Reserve**<br>**ratio(a)**|**Currency ratio**|**Excess Reserve**<br>**ratio**|**Currency ratio**|**Excess**<br>**Reserve**<br>**ratio**|**Currency rati**|**o**<br>**Excess Reserve**<br>**ratio**|
|---|---|---|---|---|---|---|---|---|
||Fixed|Effects|SU|RE(b)|SURE|(b)|SU|RE(b)|
||(1)|(2)|(3)|(4)|(5)|(6)|(7)|(8)|
|**Post-Reform Trend Break**|-0.015*|0.0003|-0.015***|0.0004|-0.026***|0.003|-0.001|0.007***|
||(0.007)|(0.0015)|(0.0003)|(0.001)|(0.004)|(0.002)|(0.007)|(0.002)|
|**(Trend Break)*(Pre-reform number of**|||||||||
|**credit transfers per inhabitant)**|||||0.076***|-0.015|0.097***|-0.0001|
||||||(0.025)|(0.010)|(0.025)|(0.011)|
|**(Trend Break)*(Pre-reform average**|||||||||
|**currency ratio)**|||||||-0.029***||
||||||||(0.007)||
|**(Trend Break)*(Pre-reform average**|||||||||
|**excess reserves ratio)**||||||||-0.085***|
|||||||||(0.022)|
|log real GDP per capita|-0.228*||-0.290***||-0.277***||-0.260***||
||(0.112)||(0.069)||(0.068)||(0.067)||
|Government expenditure over GDP ratio|0.923||0.889***||0.778**||0.603*||
||(0.587)||(0.318)||(0.315)||(0.311)||
|Nominal interest rate|-0.003***|-0.0002|-0.003***|-0.0002|-0.002***|-0.0002*|-0.002***|-0.0003**|
||(0.0004)|(0.0001)|(0.0004)|(0.0001)|(0.0004)|(0.0001)|(0.0004)|(0.0001)|
|Output growth||-0.0003*||-0.0003*||-0.0004*||-0.0004**|
|||(0.0001)||(0.0002)||(0.0002)||(0.0002)|
|Reserves requirement ratio||-0.009**||-0.009***||-0.010***||-0.011***|
|||(0.003)||(0.001)||(0.001)||(0.001)|
|Foreign Exchange reserves/GDP||0.0001||-0.0001||-0.0003||-0.0004|
|||(0.0001)||(0.0003)||(0.0003)||(0.0003)|
|Country specific trends|x|x|x|x|x|x|x|x|
|Year effects|x|x|x|x|x|x|x|x|
|Country effects|x|x|x|x|x|x|x|x|
|Seasonal Dummies|x|x|x|x|x|x|x|x|
|Within R-squared|0.57|0.48|0.93|0.80|0.93|0.80|0.93|0.80|
|Nbr. obser.|396|392|392|392|392|392|392|392|

Note: Robust clustered standard errors in parentheses. Significant at (*) 10 per cent level; (**) 5 per cent level; (***) 1 per cent level.

(a) The currency ratio is the ratio of currency in circulation (oustide the banking system) over demand deposits and the reserves ratio is the ratio of excess reserves held by private banks over total deposists.

(b) SURE stands for seemingly unrelated least squares
**<u>Table 7. Structural Model Estimates</u>**

# **Dependent variable: Shock to Credit**

||(1)|(2)|(3)|(4)|
|---|---|---|---|---|
||**Fixed E**|**ffects**|**Instrumental**|**Variables(b )**|
|Currency ratio shock (a)|-0.414**||-1.529***||
||0.168)||(0.453)||
|Excess reserves ratio shock (a)||0.636<br>(0.469)||0.439<br>(0.300)|
|Anderson LR statistic Weak Instrument Test|||43.37|161.05|
|Chi-sq(4) p-value|||0.00|0.00|
|Hansen J statistic Overidentification Test|||0.38|1.48|
|Chi-sq(3) p-value|||0.54|0.22|
|Country Fixed effects|x|x|x|x|
|Year effects|x|x|x|x|
|Seasonal Dummies|x|x|x|x|
|Nbr. obser.|374|374|364|360|

Note: Robust clustered standard errors in parentheses Significant at (*) 10 per cent level; (**) 5 per cent level; (***) 1 per cent level.

Shocks are residuals obtained after estimation of the system of equations (9) and (10) using seemingly unrelated least squares (a) The currency ratio is the ratio of currency in circulation (oustide the banking system) over demand deposits and the reserves ratio is the ratio of excess reserves held by private banks over total deposists.

(b ) We use the second and third lags of the liquidity preference shocks as instruments for contemporaneous shocks
# **Appendix 1. The Timing and Components of Payment Systems Reforms in the Ten Sample Countries, Drawing on Publications Issued by National Central Banks**

|**Countries**|**Date**|**Brief history**|
|---|---|---|
|**Bulgaria**|**2002**|The Bank Integrated System for Electronic tRAnsfers, BISERA (the national settlement system of Bulgaria) was<br>introduced in 1992. Until the introduction of RTGS in 2002, the settlement procedure was built on a queuing facility<br>and an interbank payment transaction was only carried out if the sending bank had sufficient funds on its current<br>account with the Bulgarian National Bank (BNB). If sufficient funds were not available to settle the first payment in<br>the queue, the queued payment remained unprocessed until such funds are received. When a payment, owing to the<br>lack of liquidity of a bank, could not be executed within a period of ten working days after having been entered in<br>the settlement system, the payment was rejected by the settlement system and deleted from the waiting queue. There<br>was an option for some payments to be settled during the same working day directly by the BNB, on the basis of<br>payment orders submitted on paper, or via SWIFT at BNB desks. This express service was organised for all<br>payments addressed to or initiated by the BNB, direct bank-to-bank payments related to interbank money market<br>operations, payments on the primary and secondary government securities market, and some budget payments. The<br>efficient functionality of the new RTGS system, RINGS, helps assure a more efficient liquidity management of<br>commercial banks, improving the efficiency and the security of the payment system, and reducing the systemic and<br>credit risks in the national payment system. The efficiency of the payment system reduced the banks liquidity needs.<br>As under the currency board arrangement the BNB cannot provide funding to commercial banks, a Reserve<br>Guarantee Fund was set up to ensure the settlement of the netting systems with and to mitigate systemic risk.|
|**Czech Republic**|**1992**|In 1992 the central bank introduced a new interbank payment system and set up a Clearing and Settlement Centre<br>to handle all domestic currency payments between banks. This made it necessary to introduce a modern, secure,<br>reliable and effective interbank clearing and settlement system. In a very short time (only eleven months after the<br>contract was signed) the necessary technology was installed and the software completed. On 8 March 1992, after<br>fourteen months of development, implementation and testing, the live operation of the Clearing and Settlement<br>System at the central bank Clearing Centre started. After the division of Czechoslovakia at the beginning of 1993,<br>a new clearing centre was founded in Slovakia, while the former federal Clearing and Settlement Centre remained<br>within the Czech National Bank.|
|**Estonia**|**2002**|The first interbank payment system in Estonia, EPNAS, which was owned and managed by Eesti Pank, was<br>operational from 1992 until 2002. At that time EPNAS was the only interbank payment system in Estonia and was<br>used for settlement of both high-value and retail payments. In 2002 Eesti Pank reformed the interbank payment<br>and settlement system and it was split into two systems: RTGS and the Designated Time Net Settlement System<br>(DNS). According to Eesti Pank, the final objectives of the reform were to accelerate settlements, build|
# g

# j

confidence in the banking sector and reduce the use of cash for high-value transactions. RTGS was needed in order to ensure efficient, fast and secure settlement of payments in Estonian kroons and central bank money, providing a controlled systemic risk environment. In addition, RTGS was needed in order conform with the payment systems of euro area countries and for the connection with TARGET.The implementation of the new system has allowed commercial banks to widen the choice of services provided to clients and it enables more flexible liquidity management. For bank clients, the new system primarily meant faster movement of payments between banks.

|**Hungary**|**1999**|The launch of the new real-time gross settlement system VIBER in September 1999 is an important milestone in<br>the comprehensive development of the payment systems. Implementation of VIBER is not without antecedents: it<br>carries on paper-based account management services of the National Bank of Hungary. The extended opening<br>hours of the large-value payment system (VIBER) have improved daily liquidity management by the banks. The<br>legal framework has also been strengthened by removing the legal uncertainties that had existed regarding<br>pledges, thereby mitigating the risk involved in repo contracts. This was an important step towards further<br>deepening the domestic money market.|
|---|---|---|
|**Latvia**|**1998**|The new multilateral net settlement system, the EKS, was implemented in November 1998 as a replacement for<br>the paper-based clearing system. The EKS is an automated clearing house system, which handles bulk<br>payments in electronic form. The changeover from paper-based processing of payment orders to electronic<br>exchange was gradual. A transition period of five months was established, during which, in parallel with the<br>EKS, a limited portion of payments were processed in paper form through the manual clearing system. Since<br>the end of this transitional period the Bank of Latvia has accepted only electronic payments in the clearing<br>circuit. The SAMS project was a major undertaking by the Bank of Latvia to modernise the national payment<br>system. The objective of the project was to build an RTGS system that will provide higher operating standards<br>for settlement risk, security, efficiency and capacity in the future. SAMS became fully operational in 2000.|

**Lithuania 2004** The payment system LITAS went live on 19 January 2004 and replaced the paper-based payment system TARPBANK that was operating from 1993. The payment system LITAS is fully automated and was designed to process payment transactions in real time and at a designated time. As from the date of its creation the TARPBANK system has proved to be reliable. However, the requirements for operation, capacity, speed of interbank funds transfer systems and the development of the Lithuanian banking system resulted in the Bank of
|**Poland**|**1994**|During the period in which Poland had a centrally planned economy, the system for interbank settlements was<br>based on the exchange of paper documents. There was no clearing house to intermediate in the exchange of<br>payment orders between banks. Settlement documents were sent between banks by post. Debiting of the current<br>accounts of sending banks and crediting of the current accounts of receiving banks was not performed on the same<br>day. The move towards a market economy triggered a major reform of the payment system. New, uniform<br>principles for interbank settlements in zloty became effective on 5 April 1993. At first these were only binding on<br>shareholders of the National Clearing House (KIR), ie on 17 banks, but, since 1 July 1994, they have applied to all<br>banks operating in Poland. Since then zloty payments in Poland have been processed by two different systems:<br>large-value payments by the RTGS system of Narodowy Bank Polski and retail payments in KIR. The system<br>fulfils the requirements for a modern RTGS system, ie payments are processed electronically in real time on a<br>gross basis and, once settled, are final and irrevocable.|
|---|---|---|
|**Romania**|**2005**|During the second half of 2004 and in 2005 a significant number of goals were achieved in the payment systems<br>field. A large part of the legal framework was harmonised with EU legislation and most of the former<br>infrastructure was gradually replaced by a new fully automated system. Thus, in April 2005, the large-value<br>payment system ReGIS was launched, replacing the previous system in which payment instruments were<br>manually processed and settlement was not final until the end of the operating day. ReGIS is a real-time gross<br>settlement system.|
|**Slovak Republi**|**2003**|From January 2003 significant change occurred in the Slovak Interbank Payment System (SIPS) operating since<br>1993. The National Bank of Slovakia became an operator and at the same time a settlement agent of SIPS, the<br>only interbank payment system in the Slovak Republic. The reason for this change was an effort by the National<br>Bank of Slovakia to boost the effectiveness and safety of the payment system using the state-of-the-art<br>information technology as a base for building up RTGS system under the conditions of the Slovak Republic.|
|**Slovenia**|**1998**|The payment system in former Yugolsavia was prone to systemic risks, and disconnected from the accounts held<br>by the entities at the central bank. Paper-based credit transfers dominated the system and accounted for over 90<br>% of the payments value. In 1998 the central bank implemented a new (RTGS) system SIBPS (the Slovenian<br>Interbank Payment System) and a designated time multilateral net settlement system called Giro Clearing.|
# **Appendix 2** **<u>Data Sources</u>**

|Variables|Sources|
|---|---|
|EBRD bankingreform index|EBRD website|
|Credit over GDP ratio|World Bank Fin-structure dataset online|
||IMF IFS Statistics|
|Gross domestic product|line 99b|
|GDP deflator|line 99bip|
|Government spending|line 82|
|Overnight rate or treasury bill rate|line 60b|
|Population|line 99z|
|Reserve money (currency in circulation)|line 14a|
|Reserves at central bank|line 20|
|Demand deposits|line 24|
|Time, saving and foreign currency||
|deposits|line 25|
|Public Banks' Assets Share|EBRD database website|
|Foreign Banks' Assets Share|EBRD database website|
|Foreign exchange reserves|line 1.d.d|
|Credit Transfers per Inhabitants|ECB_Blue Book_2001|
|All Non-Cash Payments per Inhabitants|ECB_Blue Book_2001<br>Central Banks annual reports and various other|
|Reserve requirements ratios|sources|