How do different models of foreign exchange settlement influence the risks and benefits of global liquidity management?
Large, international banking groups have sought to centralise their cross-currency liquidity management: liquidity shortages in one currency are financed using liquidity surpluses in another currency. The nature of risks to financial stability emerging from global liquidity management depends on how these foreign exchange transactions settle. I analyse these risks in a game of asymmetric information. The main result is that the transition from local to global liquidity management, and better co-ordination in settlement of foreign exchange transactions, have two effects. On the one hand, the likelihood rises that payments are delayed beyond their due date. On the other hand, solvency shocks are less likely to be passed on to other banks. The main assumption is that lending between subsidiaries of the same banking group takes place under symmetric information, while external interbank market loans are extended under asymmetric information. More co-ordinated settlement increases the exposure of the intragroup lender relative to the interbank lender and leads to more informed lending.
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