ROLE OF THE CENTRAL BANK IN INTERBANK SETTLEMENT

In a complex banking system with many participants, it is inefficient for banks to establish large numbers of bilateral relationships and to hold many nostro accounts. Maintaining nostro accounts can be expensive, as the vostro banks will assess fees for the account and payment services they provide. More important, however, nostro accounts can absorb large amounts of liquidity when nostro banks try to maintain the precautionary balances needed to settle obligations and to meet minimum balance requirements established by vostro banks. Accordingly, there is a finite limit to the number of nostro accounts that banks will want to hold, which stimulates competition among the vostro banks.

However, every bank must be prepared to satisfy its customers’ needs to send money to or receive money from any other economic actor holding an account at any other bank in the system. This calls for a specialized, central institution that provides account services to virtually the entire banking system. This, of course, is an important role of the central bank.

In the banking vernacular introduced earlier, commercial banks hold nostro accounts with the central bank. The central bank, however, does not hold nostro accounts with commercial banks, at least not with respect to its domestic currency.

The central bank is a very important vostro bank because it holds accounts for almost the whole banking industry.

The nostro accounts that commercial banks hold with the central bank can be used to make interbank payments using «central bank money.» Payment using central bank money is a unique form of payment, because such payments result in a claim on an institution that cannot fail and that, because of its money creation powers, will never suffer a shortage of liquidity. Consequently, recipients of payments in the form of central bank money assume no counterparty credit or liquidity risk. Moreover, payments made with instruments issued by the central bank are completely convertible, because all banks hold accounts directly with the central bank that they use to settle interbank payments or with vostro banks that themselves use central bank payment services.

The central bank establishes terms and conditions for the vostro accounts it provides. Balances held in central bank vostro accounts are almost always noninterest bearing. Further, many central banks establish minimum reserve requirements that commercial banks must meet, at least in part, by maintaining balances in their nostro accounts with the central bank. Central banks may also charge explicit fees for their payment services. Further, central banks can provide liquidity to individual commercial banks by granting central bank credit, which contributes significantly to the efficiency of a nation’s payment system and is an important element in determining conditions in the domestic money market. By using central bank credit when liquidity is tight, commercial banks can ensure completion of payments on schedule. In a modern payment system, central bank daylight credit is especially important as a source of intraday working capital to banks. Short-term «daylight loans» to banks by the central bank, if not repaid by the end of the day, become overnight loans. Thus, there is a direct connection between a central bank’s providing intraday credit and the management of its 1 ,ombard facility.

In a generalized model of the banking system, commercial banks that hold nostro accounts with the central bank should be divided into I wo groups—those that are eligible to use central bank credit and those that are not. In some countries, for example, certain classes of hanking institutions, such as savings banks or bank-like institutions that are not required to hold reserves, may not be granted direct access to central bank credit. In any event, central bank credit to banks with access to this source of liquidity will be rationed, either by price or administratively.