JEVONS ON CLEARING HOUSES
(Rodrigo Peñaloza, 2002)
The role of clearing houses in the settlement of interbank payments is one of the oldest ideas in economic theory. However little was published in the 20th century about its microeconomics. This was what motivated my Ph.D. thesis in 2001 on payment systems. This short text on Jevons was extracted from its introductory chapter.
Jevons in 1875 mentions that the London Clearing House is entirely the birthplace of the system and that it seemed to have been first created about the year 1775.
To be fair, Jevons talks about the modern kind of net settlement, but medieval European banks settled on a net basis too. And before that, a system of credit transfers between banks already existed in Egypt (under the rule of the Greek Ptolemaic dynasty, 323–30 BC). Government granaries were transformed into a network of grain banks with a kind of central bank in Alexandria, where the accounts from all the state granary banks were recorded. This banking network functioned as a giro system in which payments were effected by transfer from one account to another without money passing. As double entry booking had not been invented, credit transfers were recorded by varying the case endings of the names involved: credit entries were characterized by the genitive or possessive case and debit entries by the dative case. Credit transfer was also a feature of the services provided in Delos which rose to prominence in banking during the late second and third centuries BC. After the fall of the Roman Empire banking was forgotten and had to be re-invented much later.
In Money and the Mechanisms of Exchange (1875), Jevons dedicates two of the largest chapters to the banking system and the advantages of the clearing house system. His description of the structure of what he called a complex bank system is exactly the basic structure of a modern clearing house, in which a number of banks “(…) agree to appoint, as it were, a bankers’ bank, to hold a portion of the cash of each bank, and then the mutual indebtedness may be balanced off just as when a bank acts for individuals” (p. 251).
What Jevons described is a system that resembles the deferred net settlement system (DNS), in which banks net out their transfers of funds at specified times during the day and finally transfer their netted debts in the books of the clearing house. The role of the clearing house would be to be the bankers’ bank and to keep record of all the transfers made by its members. The main advantage pointed out by Jevons is the economizing of transaction costs: “Considerable economy of the precious metals arises (…) from passing about pieces of paper representing gold coin, instead of the coin itself. But a far more potent source of economy is what we may call the Cheque and Clearing System, whereby debts are, not so much paid, as balanced off against each other” (p. 246).
It is also interesting to note that the risks involved in net settlement systems are mentioned en passant, as if they were not of much concern: “(…) but as this balance will probably tend in one direction in one day, and in the opposite direction in the next day, the balance need only be paid when it assumes inconvenient proportions” (p. 250). And he continues: “So long as the balance of accounts between any two banks does not assume large proportions, it need not be paid in cash at all (…). If it can be said to be paid in cash at all, it is in the form of a final transfer in the books of the Bank of England (…)” (pp. 256–7).
Jevons was amazed by the economy of transaction costs created by netting out debts. It seems that, to him, the risks that could jeopardize the actual settlement of debts was of less importance than the netting arrangement itself. The main risks in payment systems are: credit risk and liquidity risk. Credit risk is the risk that a counterparty will not settle an obligation for full value, either when due or any time thereafter. Liquidity risk is the risk that a counterparty will not settle an obligation when due. In addition, a systemic risk is the risk that the failure of one participant to meet its obligations will cause other participants to be unable to meet their obligations.
Even though the risks involved in the payment systems in particular were not an issue, the safety of the banking system as a whole had long been addressed. First by Thornton (1802), who spelled out the elements of sound central bank practices with respect to distress lending, and later by Bagehot (1873), who is credited for establishing the modern theory of the role of the central bank as a lender of last resort.
Thornton (1802) was well aware of the liquidity risks inherent to the banking activity and the possibility of contagion via bank panic, and he realized that depositors’ loss of confidence in the banking system as a whole may be a likely reason for the spread of bank runs. To both Thornton and Bagehot, the central bank had a fundamental role in providing the necessary liquidity to banks in distress and hence in guaranteeing a safety net for the banking system.
According to Bagehot, the central bank should lend to banks with liquidity needs, provided they had good collateral. By good collateral he meant any paper normally accepted by the central bank and the central bank charged interest rates higher than the market interest rates before the crisis. Obviously this policy had a disciplining effect, since it would discourage banks to use the lending facility unnecessarily. However, the particular issue of risks in the settlement of funds transfers is not addressed.
Historically, payments among banks have been settled on a net basis. Things changed along the increasing value of interbank transfers. It was only in 1980 that the governors of the central banks of the G-10 countries set up a group of experts on payment systems to study the risks faced by the participants in payment systems. In 1990 they created the Committee on Payment and Settlement Systems (CPSS), one of the permanent committees of the Bank for International Settlements (BIS). In the 1990’s the CPSS published a series of reports on the functioning of national payment systems and recommendations for the safety of payments settlements, securities settlements, and cross-border transactions.
Therefore, the issue of systemic risks in payment systems is recent.
Finally, it is important to notice that as recently as the early 1990s, most large-value transfer systems settled on a net basis.