1/31 Congestion and Cascades in Coupled Payment Systems Prepared for the Joint Bank of England/ECB Conference on “Payments and monetary and financial stability”, November, 12-13 2007 By Fabien Renault * , Walter E. Beyeler ♦ , Robert J. Glass ♦ , Kimmo Soramäki ♣ and Morten L. Bech •, ♠ October 31, 2007 Abstract: This paper analyses liquidity and credit risks in the context of interdependent interbank payment systems. A simple model is developed to investigate the operation of two real time gross settlement systems interlinked through FX transactions conducted by a set of global banks that participate in both systems. In addition, further interdependence is created by imposing a Payment versus Payment (PvP) constraint. The model illustrates under which conditions settlement of payments in the two systems becomes correlated and how large credit exposures can be generated as the result of liquidity pressures in one of the two systems. PvP can eliminate this credit risk but will make each system dependent on the level of liquidity available in the other system. * Banque de France, fabien.renault@banque-france.fr . ♦ Sandia National Laboratories, webeyel@sandia.gov and rjglass@sandia.gov. Messrs. Beyeler and Glass acknowledge the financial support of the National Infrastructure Simulation and Analysis Center (NISAC), a program under the Department of Homeland Security’s (DHS) Preparedness Directorate. Sandia National Laboratories (SNL) and Los Alamos National Laboratory (LANL) are the prime contractors for NISAC under the programmatic direction of DHS’s Infrastructure Protection/Risk Management Division. Sandia is a multiprogram laboratory operated by Sandia Corporation, a Lockheed Martin Company, for the United States Department of Energy’s National Nuclear Security Administration under contract DE-AC04-94AL85000. ♣ European Central Bank and Helsinki University of Technology, kimmo@soramaki.net . • Federal Reserve Bank of NewYork, morten.bech@ny.frb.org (corresponding author). ♠ The views expressed in this paper do not necessarily reflect those of the Banque de France, European Central Bank, Sandia National Laboratories, Federal Reserve Bank of New York or the Federal Reserve System. The authors would like to thank Jordan Parks for excellent research assistance.