The Cross-guarantee Concept: Eliminating Risk in Interbank Markets

One of the great public policy concerns in the financial services arena is ensuring the stability of the U.S. financial system. One of the great threats to financial stability is disruption in the interbank market; that is, transactions between banks. These transactions consist of the exchange of payments by check or electronic means, usually through payment clearing mechanisms; the settlement of financial trades; and credit extensions from one bank to another. On a moment-to-moment basis, the greatest threat to financial stability is a freeze-up in the systems through which payments and financial trades are settled. A freeze-up can occur when a bank cannot or will not make full payment when it is due or requested or settle a trade at the scheduled time. The threat of systemic freeze-up exists because government banking regulation and federal deposit insurance create doubts as to whether or not a bank will make all payment requests when due or requested or settle trades when scheduled. These concerns will disappear by unequivocally ensuring that all payments will occur, no matter what, and all financial trades will settle when scheduled, no matter what. Although it sows the seeds of doubt, the existing structure of federal deposit insurance and government regulation has two important elements on which to construct a fail-safe interbank transactions system. First, post-1988 reforms have largely eliminated taxpayer risk from federal deposit insurance by turning it into a cross-guarantee mechanism fully funded by the banking industry even in times of great economic distress.