James J. McAndrews

Opening the Black Box of Network Externalities in Network Adoption

Recent theoretical work suggests that network externalities are a determinant of network adoption. However, few empirical studies have reported the impact of network externalities on the adoption of networks. As a result, little is known about the extent to which network externalities may influence network adoption and diffusion. Using electronic banking as a context and an econometric technique calledhazard modeling, this research examines empirically the impact of network externalities and other influences that combine to determine network membership. The results support thenetwork externalities hypothesis. We find that banks in markets that can generate a larger effective network size and a higher level of externalities tend to adopt early, while the size of a banks own branch network (a proxy for the opportunity cost of adoption)decreases the probability of early adoption.

Precautionary Reserves and the Interbank Market

Liquidity hoarding by banks and extreme volatility of the fed funds rate have been widely seen as severely disrupting the interbank market and the broader financial system during the 2007-08 financial crisis. Using data on intraday account balances held by banks at the Federal Reserve and Fedwire interbank transactions to estimate all overnight fed funds trades, we present empirical evidence on banks’ precautionary hoarding of reserves, their reluctance to lend, and extreme fed funds rate volatility. We develop a model with credit and liquidity frictions in the interbank market consistent with the empirical results. Our theoretical results show that banks rationally hold excess reserves intraday and overnight as a precautionary measure against liquidity shocks. Moreover, the intraday fed funds rate can spike above the discount rate and crash to near zero. Apparent anomalies during the financial crisis may be seen as stark but natural outcomes of our model of the interbank market. The model also provides a unified explanation for several stylized facts and makes new predictions for the interbank market.

E-Finance: An Introduction

E-finance is defined as “The provision of financial services and markets using electronic communication and computation”. In this paper we outline research issues related to e-finance that we believe set the stage for further work in this field. Three areas are focused on. These are the use of electronic payments systems, the operations of financial services firms and the operation of financial markets. A number of research issues are raised. For example, is the widespread use of paper-based checks efficient? Will the financial services industry be fundamentally changed by the advent of the Internet? Why have there been such large differences in changes to market microstructure across different financial markets?

Settlement Risk under Gross and Net Settlement

Previous comparative analyses of gross and net settlement have focused on the credit risk of the central counterparty in net settlement arrangements, and on the incentives for participants to alter the risk of the portfolio under net settlement. By modeling the trading economy that generates the demand for payment services, we are able to show some largely unexplored advantages of net settlement. We find that net settlement systems avoid certain gridlock situations, which may arise in gross settlement in the absence of delivery versus payment requirements. In addition, net settlement can economize on collateral requirements and avoid trading delays.

Changes in the Timing Distribution of Fedwire Funds Transfers

The Federal Reserves Fedwire funds transfer service - the biggest large-value payments system in the United States - has long displayed a peak of activity in the late afternoon. Theory suggests that the concentration of late-afternoon Fedwire activity reflects coordination among participating banks to reduce liquidity costs, delay costs, and credit risk; as these costs and risk change over time, payment timing most likely will be affected. This article seeks to quantify how the changing environment in which Fedwire operates has affected the timing of payment value transferred within the system between 1998 and 2006. It finds that the peak of the timing distribution has become more concentrated, has shifted to later in the day, and has actually divided into two peaks. The authors suggest that these trends can be explained by a rise in the value of payments transferred over Fedwire, the settlement patterns of the private settlement institutions that use the system, and an increase in industry concentration. Although the studys results provide no specific evidence of heightened operational risk attributable to activity occurring later in the day, they point to a high level of interaction between Fedwire and private settlement institutions.

Stability of Funding Models: An Analytical Framework

Using information on bonds issued over the 1985-2009 period, this study finds that the largest banks have a funding advantage over their smaller peers. This advantage may not be entirely attributable to investors’ belief that the largest banks are “too big to fail,” because the study also finds that the largest nonbanks, as well as the largest nonfinancial corporations, have a cost advantage relative to their smaller peers. However, a comparison across the three groups reveals that the funding advantage enjoyed by the largest banks is significantly larger than that available to the largest nonbanks and nonfinancial corporations. This difference is consistent with the hypothesis that investors believe the largest banks to be too big to fail.

Money is Privacy

An extensive literature in monetary theory has emphasized the role of money as a record-keeping device. Money assumes this role in situations where using credit would be too costly, and some might argue that this role will diminish as the cost of information and thus the cost of credit-based transactions continues to fall. In this article we investigate another use for money, the provision of privacy. That is, a money purchase does not identify the purchaser, whereas a credit purchase does. In a simple trading economy with moral hazard, we compare the efficiency of money and credit, and find that money may be useful even when information is free.

Settlement delays in the money market

We track 38,000 money market trades from execution to delivery and return, and provide a first empirical analysis of settlement delays in financial markets. In accord with the predictions of recent models of strategic settlement of financial claims, we document a tendency by lenders to delay delivery of loaned funds until the afternoon hours. We find banks to follow a simple strategy to manage the risk of account overdrafts, by delaying settlement of large payments relative to that of small payments. More sophisticated strategies such as increasing delays when own liquid balances are low and when dealing with small trading partners play a marginal role. We find evidence of strategic delay also when returning borrowed funds, although we can explain a smaller fraction of the dispersion in delays in the return than in delivery leg of money market lending.

The Economics of Two-Sided Payment Card Markets: Pricing, Adoption and Usage

This paper provides a new theory for two-sided payment card markets. Adopting payment cards requires consumers and merchants to pay a fixed cost, but yields a lower marginal cost of making payments. Analyzing adoption and usage externalities among heterogeneous consumers and merchants, our theory derives the equilibrium card adoption and usage pattern consistent with empirical evidence. Our analysis also helps explain the card pricing puzzles, particularly the high and rising merchant (interchange) fees. Based on the theoretical framework, we discuss socially desirable payment card fees as well as the interchange fee cap regulation.

Entry-Deterring Debt

RECENT STUDIES, including Kaplan (1988) and Jarrell, Brickley, and Netter (1988), have provided striking evidence that leveraged buyouts and corporate takeovers result in increased profitability. In this paper we demonstrate that leverage itself can improve the competitive position of firms at the expense of consumers and business rivals, and that leveraged aggressiveness, rather than increased efficiency, may be responsible for the increased profitability of buyouts. It is now well accepted that an incumbent can deter a rivals entry only through credible threats, that is, actions which maximize the incumbents profits once entry has occurred. Only by changing its payoffs in a way which effectively commits it to being an aggressive rival can an incumbent deter otherwise profitable entry. Brander and Lewis (1986) showed that in an oligopoly increased debt is procompetitive, in the sense that debt makes firms more aggressive, when the firms enjoy limited liability. 1 In this paper it is shown that increased debt can serve the anticompetitive purpose of deterring entry. This is an example of the general principle that a device that commits the firm to act procompetitively (that is, more aggressively) toward its rivals can be used anti-