United StatesChange Country

FX International Payments

The Great Recession: Why International Payments are Unlikely to Freeze Again

By Frances Coppola

When banks started to collapse during the Great Recession begun in 2007-2008, international payments practically froze – not once but three times. The worst came after the failure of Lehman Brothers in September 2008, the event seen as the official kick-off of the global financial crisis: international banks and businesses were suddenly unable to obtain dollar financing and couldn't make dollar payments, therefore.1 This caused "sudden stops" in developing countries, deep recessions in developed countries, and a lasting contraction in global trade.

This article discusses why the international payments system came so close to failing, and what has been done to prevent such a freeze from happening again.

 

How Systemic Bank Runs Can Disrupt International Payments

 

In developed countries, regulated banks are the gateway to the international payments system. Wire transfers of U.S. dollars are typically initiated through a regulated bank, which submits the request to Fedwire – the U.S. Federal Reserve's real-time gross settlement system (RTGS) – for final settlement. Fedwire settlement transfers dollar reserves from the sending bank to the receiving bank. Other types of electronic payment, such as card payments, are also settled by Fedwire, and similarly involve the transfer of reserves from one bank to another. All dollar payments except those in physical cash are thus finally settled by Fedwire.

 

Historically, banks have not generally kept more cash reserves than they need to meet anticipated payments. Thus, a sudden unexpected increase in demand for payments out of a bank can quickly drain its reserves. This, of course, is known as a "bank run." When there is no central bank, widespread bank runs can cause domino-like bank failures. They can also trigger asset price collapses, if banks are forced to sell assets at fire sale prices in order to obtain reserves to settle payments.2

 

The traditional image of a bank run is queues of people waiting outside a bank, all wanting to withdraw their money. In 2007, the British bank Northern Rock experienced such a run.3 But in these days of integrated electronic banking, bank runs are just as likely to take the form of wire transfers, and they may be initiated not by retail depositors but by financial market participants such as money market funds, or even other banks. This is what happened in 2008.

 

Central Banks Headed Off Payments Freeze During Global Financial Crisis of 2008

 

In the wake of Lehman's failure, banks refused to lend reserves to other banks for fear that they would not be repaid.4 Other market participants such as money market funds also refused to lend, because the securities that banks typically pledged to obtain funding from non-banks were falling in value dramatically.5 Thus, banks that would normally have been able to borrow reserves from the market suddenly found themselves without the means to make payments. At the same time, demand for payments massively increased, as investors sold risky assets for dollars, businesses repaid dollar loans and drew down dollar deposits, and holders of foreign currencies exchanged them for dollars. As suspicion grew that banks would be unable to meet payment demands, the entire international dollar payments system started to freeze.6

 

Central banks stepped in with emergency measures to provide banks with the money they needed to maintain domestic and international payments. The Federal Reserve bought large quantities of residential mortgage-backed securities (RMBS) from financial market participants, and lent directly to both regulated and "shadow" banks.7 It also set up swap lines with other major central banks, enabling them to exchange their own currencies for dollars and thus provide dollar funding to banks outside the U.S. For example, the British bank RBS received $25 billion from the Bank of England, enabling it to continue to make international payments on behalf of its customers even though it was on the verge of collapse.8

 

How Central Banks Protect the International Payments System Today

 

In 2008, coordinated action by central banks prevented the international payments system from seizing up. But the measures taken were exceptional, and to some degree experimental.9

 

Since then, on both sides of the Atlantic, lawmakers have reduced the likelihood of damaging systemic bank runs by introducing legislation to ensure that regulated deposit-taking banks are protected from riskier financial market activities. For example, in the U.S., the Dodd-Frank legislation aims to prevent regulated banks from putting customers' money at risk,10 while in the U.K., banks are being forced to ring-fence their retail operations from their riskier investment banking activities.11

 

Bank regulation, too, has been tightened to prevent banks from operating with dangerously low levels of capital and reserves. Regulators now undertake stress tests to prove that banks can withstand serious financial shocks. All of this helps to ensure that in a future crisis there will be as little disruption as possible to international payments.

 

Changes at central banks themselves also aim to prevent the international payments system from seizing up again in a future crisis. Firstly, the enormous expansion of bank reserves caused by quantitative easing (QE) has reduced banks' reliance on borrowing to fund international payments. This reduces the risk that a sudden increase in payment demands could cause bank failures. It also seems to speed up settlement through Fedwire, because banks no longer have an incentive to delay payment pending arrival of funds: this reduces settlement risk for businesses.12 Although the Fed is now shrinking its balance sheet, it has indicated that it intends to maintain a larger quantity of reserves in circulation than was the case prior to the financial crisis.13

 

Internationally, perhaps the most important change occurred in 2013, when the Fed made dollar swap lines with other major banks permanent so that they could be called upon when needed. In a future crisis, therefore, dollar funding could be supplied as quickly and easily to non-U.S. banks as U.S. ones. Since the dollar is the mainstay of international trade, most international payments and FX transactions involve the dollar. By ensuring that dollar funding is always available anywhere in the developed world, permanent swap lines considerably reduce the likelihood of an international payments freeze.14

 

Other central banks have also made changes that help to protect the international payments system. For example, in the financial crisis, the Bank of England was slow to respond to funding strains at British banks, partly because, unlike the Fed, it did not at that time have a permanent "discount window" funding facility. Today, it does. 15

 

The

Takeaway:

The international payments system has not changed significantly since the financial crisis. Access to it remains principally via regulated banks, and final settlement is through central bank RTGS systems, of which the most important for international businesses is Fedwire, which settles all dollar payments. Payment service providers and other non-bank financial institutions still route payments via regulated banks. But tighter regulation of banks, and improved support from central banks, means that the international payments system is less likely to freeze in a future financial crisis. Businesses may be able to transact internationally with confidence, however wobbly the banking system appears.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Reducing the systemic risk in shadow maturity transformation,” Federal Reserve Bank of New York; https://www.newyorkfed.org/newsevents/speeches/2011/kri110308.html
2. “Anatomy of a bank run,” Coppola Comment; www.coppolacomment.com/2013/07/anatomy-of-bank-run.html
3. “Rush on Northern Rock continues,” BBC; http://news.bbc.co.uk/1/hi/business/6996136.stm
4. “What happened to U.S. interbank lending in the financial crisis?” VoxEU; https://voxeu.org/article/what-happened-us-interbank-lending-financial-crisis
5. “Awaiting the return of repo,” FT Alphaville; https://www.ft.com/content/38f6ce8a-cbb3-11dd-ba02-000077b07658
6. “How the collapse of Lehman Brothers pushed capitalism to the brink,” The Guardian; https://www.theguardian.com/business/2009/sep/04/lehman-brothers-aftershocks-28-days
7. “Reducing the systemic risk in shadow maturity transformation,” ibid.
8. “Review of the Bank of England’s provision of Emergency Liquidity Assistance in 2008-9,” Bank of England https://www.bankofengland.co.uk/-/media/boe/files/news/2012/november/the-provision-of-emergency-liquidity-assistance-in-2008-9
9. “Reducing the systemic risk in shadow maturity transformation,” Federal Reserve Bank of New York; https://www.newyorkfed.org/newsevents/speeches/2011/kri110308.html
10. “Dodd-Frank Wall Street Reform and Consumer Protection Act,” Investopedia; https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp
11. “Ring fencing information,” HM Treasury; https://www.gov.uk/government/publications/ring-fencing-information/ring-fencing-information
12. “The Payment System Benefits of High Reserve Balances,” Federal Reserve Bank of New York; https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr779.pdf?la=en
13. “Fed’s Powell Suggests Outsized Balance Sheet Is Here To Stay,” Bloomberg; https://www.bloomberg.com/news/articles/2017-06-01/fed-s-powell-suggests-outsized-balance-sheet-is-here-to-stay
14. “Central bank liquidity swaps,” U.S. Federal Reserve; https://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm
15. “Review of the Bank of England’s provision of Emergency Liquidity Assistance in 2008-9,” Bank of England https://www.bankofengland.co.uk/-/media/boe/files/news/2012/november/the-provision-of-emergency-liquidity-assistance-in-2008-9

Related Articles

Emerging Trends In International Payment Solutions
Technology and Innovation in Global Payment Solutions
Advanced Payments Solutions are Revolutionizing the Retail Experience

Make International Payments

Existing FX International Payments customers log in here