A Model of Interbank Settlement
A settlement system is a set of rules and procedures that govern when and how funds are transferred between banks. Perhaps the most crucial feature of a settlement system is the frequency with which settlement occurs. On the one hand, a higher frequency of settlement limits the risk of default should a bank be rendered insolvent. On the other hand, a lower frequency of settlement is less costly for banks to operate. We construct a model of the banking sector in which this trade-off between cost and risk arises endogenously. We then complete the economy with a trading sector that has a micro-founded role for credit as a media of exchange. The result is a general equilibrium model that allows for welfare and policy analysis. We parameterize the economy and study the optimal intra-day borrowing policy that the operator of a settlement system should impose on member banks. We also determine conditions under which one settlement system is more appropriate than another
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