Working Paper No. 370
By Ouarda Merrouche and Jochen Schanz
We investigate how settlement banks in CHAPS, the United Kingdom’s large-value payment system, deal with operational risk. In particular, we are interested in payments behaviour towards a bank that is, for operational reasons, unable to make but able to receive payments. If other banks did not sufficiently monitor their outgoing payments, operational shocks could impact the entire payment system because the affected bank may absorb liquidity from the system. We first build a game-theoretic model in which a bank’s decision to make payments depends both on whether another bank experiences operational problems, and on the time of day at which the outage occurs. We then investigate these reactions empirically using a non-parametric method. Our theory predicts that banks stop paying to a bank which has been unable to make payments early in the day, when they are uncertain about the payment instructions they might have to execute. When this uncertainty has been resolved (later in the day), healthy banks make payments even to a bank experiencing the operational problem. Both predictions are supported by the data. We show that this behaviour effectively contains the disruption caused by the operational outage: payment flows between healthy banks are largely unaffected.