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A Methodological Toolkit to Reform Payment Systems Cost-Benefit Analysis (CBA) World Bank, Washington DC, November 5th, 2003 The Core CONTENTS ¶ The need for CBA in payment systems reforms. ¶ A primer in CBA. ¶ An application to payment systems reforms. ¶ Concluding remarks. The Core 2 RATIONALE FOR CBA IN PAYMENT SYSTEMS REFORMS • CBA concerns the maximization of efficiency given a certain quality of output (and of quality of output given a certain budget constraint) • CBA allows to prioritize across several options of payment systems reforms • Explicit references: CPSS, IOSCO and the World Bank/IMF call for a thorough cost-benefit analysis (CBA) for all the key decisions that must be taken regarding payment systems reforms The Core 3 MAIN REFERENCES IN THE PAYMENT SYSTEMS LITERATURE • Core Principles for Systematically Important Payment Systems (2001), Core Principle VIII • Recommendations for Securities Settlement Systems (2001), Recommendation 15 • Policy Issues for Central Banks in Retail Payments (2003), Public Policy Goal C • Bossone and Cirasino (2001) • Listfield and Montes-Negret (1994) The Core 4 CONTENTS ¶ The need for CBA in payment systems reforms. ¶ A primer in CBA. ¶ An application to payment systems reforms. ¶ Concluding remarks. The Core 5 BIBLIOGRAPHY (MAIN) • Brent, R., “Applied Cost-Benefit Analysis”, Edward Elgar, 1996 • Zerbe, R. O., Dively, D., “Benefit-Cost Analysis”, Harper Collins, 1994 • Squire, L. and van der Talk, G., “Economic Analysis of Projects”, John Hopkins, 1975 The Core 6 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 7 PROBLEM STRUCTURING Issue identification Problem structuring Deterministic Decision structuring Stochastic The Core 8 ISSUE IDENTIFICATION National Payment Council Issue Sub-Issue • What do we want? • Which objectives / Principles / Targets? • What do we have? • Which Infrastructures / Procedures / Legal situation? • What organization / Role of the Central Bank/ Stakeholders involved? • What could we • Which are the available options? have? • What timing / Costs / Difficulty of implementation? The Core 9 ISSUE IDENTIFICATION (cont.) National Payment Council Issue Sub-Issue • What should we • How do we rank options? How do we have? prioritize? What’s the social welfare utility function? • How should we • What organization / Role of the Central get to that? Bank / Stakeholders to be involved? • What funding? • How do we manage the transition? The Core 10 DECISION STRUCTURING National Payment Council Diagnostic Systematically Important PS Assessing options •Core Principles CPSS (2001) Short–term / transition? Securities •Recommendations Settlement Systems CPSS (2001) Retail Payments Decision to be made •Public Policy Goals CPSS (2003) What’s best for the system .. ? Foreign Exchange •Check CPSS Settlement Systems The Core Long term / Vision? Option A Option B Option 1 Option 2 11 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 12 PLAYERS, ROLES, AND UTILITY FUNCTIONS IN A NATIONAL PAYMENT SYSTEM (NPS) Main Role Arguments of utility function Player • Central Bank Overseer* • National Payment Council • Safety • Securities and Exchange Commission • Efficiency • Banking supervision Authority • Antitrust Authorities Regulator • Ministry of Finance • Other specific public issues (competition, customer protection,…) • Legislative Authorities * Oversight, bank supervision, market surveillance The Core 13 PLAYERS AND ROLES IN A NPS (cont.) Main Role System provider Arguments of utility function Player • Clearinghouses • Safety • Stock Exchange • Efficiency (private system providers focus mostly on own) • Central Security Depository •… Lobbyist / Mediator • Banking Association The Core • Safety • Efficiency 14 PLAYERS AND ROLES IN A NPS (cont.) Main Role System participant Heavy user End-user Arguments of utility function Player • Financial Institutions • Brokers / Dealers • Efficiency (own) • Public Sector (Treasury) • Efficiency • Safety (own and overall) • Employment • Firms • Profits (own) • Consumers • Consumption (own) • Leisure (own) The Core 15 UTILITY FUNCTIONS Hints Functional form • Use a concave function (linear, Cobb-Douglas, logarithmic) • Keep it simple! • To find weights, several techniques are available: Weighting arguments - Survey - Revealed preferences - Estimation The Core 16 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs Assessing costs and benefits per player • Identifying players and utility • Assessing the functions decisions to be evaluated Aggregating values over time The Core 17 KEY ELEMENTS Assessing levers • Prices • Quantities • Probabilities • Externalities Mapping costs and benefits onto arguments of utility functions The Core 18 PRICES competitive markets Technique Market Prices Prices non competitive markets non-traded goods • Benchmarking Prices from • Survey Ad hoc techniques • Output of utility maximization problem of the agent Shadow Prices traded goods World Prices The Core 19 OTHER ISSUES Issue Quantities Technique • Output of maximization problem of the agent • Benchmarking Probabilities Externalities • Estimation (data needed) • Benchmarking • Careful assessment of all levers involved • Estimation (data needed) • Benchmarking The Core 20 KEY LEVERS IN PAYMENT SYSTEMS Levers Issue • Quantity of transactions • There is a critical mass that makes a payment system an effective network • Pricing of transactions to participants • Given the quantity of transactions, it defines the business value of the system provider • Pricing of transactions to end-users • Given the levers above, it defines the number of profitable sustainable system participants, for a certain amount of fixed costs The Core 21 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs Assessing costs and benefits per player • Identifying players and utility • Assessing the functions decisions to be evaluated Aggregating values over time The Core 22 DISCOUNT RATE • It is the rate through which future outcomes are compared with current ones • It is the relative price of tomorrow vs. today • It can be thought as an opportunity cost by both the saving and the investment side of the production The Core 23 PERSPECTIVES ON DISCOUNT RATES Focus Production perspective Social Perspective Investment Savings (Private) Private Investment agent rate (Private) Saving rate Social planner Social discount rate The Core • Investment and saving rate might be different due to market imperfections • The private discount rates do not consider the effect of what today has been saved on the members of the future generations 24 SOCIAL DISCOUNT RATE (SDR) Discount rate to be used Alternative investments • CAPM (Capital Asset Pricing Model) The social planner, when investing in a project, forgoes: Consumption instead of savings today • STPR (Social Time Preference Rate) The Core • SDR is a weighted average of CAPM and STPR • The weights are given according to the type of project (if closer to a private investment, give a higher weight to CAPM, otherwise to STPR) 25 COMPUTING SDR Discount rate CAPM Description • Formula: d1 = RF+ b (RM-RF) • Where: -RF: risk free rate -RM: return to the market - b : systematic risk of the equity STPR • Formula: d2 = r + m g • Where: -r: pure rate of time preference -g: expected growth rate in per capita consumption - m: negative elasticity of marginal utility with respect to consumption The Core 26 COMPUTING SDR (cont.) Discount rate CAPM Caveat • RF: if not available, use government debt on foreign markets • RM and b: if nothing else available in the country, use S&P 500 as a benchmark STPR • r: use low values (0 to 5%) to acknowledge that the government cares about future generations • g: historically it might turn out to be negative; use perspective growth • m: estimation requires micro data; if data are not available, use benchmarks The Core •There exist high discretionary margins in computing both CAPM and STPR, especially in LDC •A reasonable rule of thumb sets the minimum SDR at the risk free rate, keeping it as low as possible 27 AGGREGATING OVER TIME Aggregator Project ranking criterion • The higher the NPV (if positive), the better NPV NPV • Adding all future streams of costs and benefits, discounted at a proper discount rate d • Internal Rate of Return (IRR) It is the discount rate d* that makes the above NPV equal to zero IRR • The lower d* (if below d), the better The Core 28 AGGREGATING OVER TIME (cont.) • Among several ranking techniques, NPV is the one preferred • For IRR, there may exist multiple values of d* for the same stream of costs and benefits • NPV outcome is very sensitive to changes in the value of the discount rate (the lower d, the higher the NPV) The Core 29 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 30 PRIORITIZING Activity Comments Problem formalization Optimal choice • Each agent has now all the elements to structure formally her own utility maximization problem • Each agent then chooses her utility maximizing strategy -Available strategies -Constraints • The difficulty of the prioritization can range from trivial (choose project A or B) to cumbersome • If more than one agent decides taking into account other agents’ decisions, a game has to be played (see Game Theory analysis) The Core 31 EXAMPLE • For the social planner on the right, given the production possibility frontier PPF and the social indifference curves U1 and U2, the optimum social outcome is at point B U1 U2 B PPF The Core 32 CONTENTS ¶ The need for CBA in payment systems reforms. ¶ A primer in CBA. ¶ An application to payment systems reforms. ¶ Concluding remarks. The Core 33 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 34 CONTEXT Attention! The example does not refer to any country in particular • A technological shock occurs in the economy, implying a choice also in the payment system on whether to upgrade it or not • Each player in the economy must assess the convenience of such an upgrade • The upgrade concerns both the system provider’s and the participants’ procedures The Core 35 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 36 PLAYERS • The Central Bank is the social planner, being: - Overseer / Regulator / Investor - System provider (through an ad hoc unit) • Financial Institutions are the sole participants to the payment systems (there are 50 in the economy) • Consumers are the sole end-users of the payment systems (there are 10 Millions in the economy) The Core 37 UTILITY FUNCTIONS Player Shape of the utility function Consumer • UCON = U (Consumption, Leisure) Participants • UP = DCF* Central Bank • UCB = U( UCON + UP ) and given a nonnegative DCF* for the System provider * Discounted Cash Flow The Core 38 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 39 SIMPLIFYING ASSUMPTIONS • Central Bank’s own costs pertain only to the system operator activity • (worst case scenario hp.) There are no effects (or negligible) on: -The velocity of circulation of money -The overall level of consumption The Core 40 STRUCTURE OF COSTS AND REVENUES System provider Participants • Levers: Revenues • Levers: - Fees applied to the participants - Fees applied to the end-users - Quantity of transactions (Q) -Q • Variable costs levers: - Unit costs per transaction Costs • Variable cost levers: - Fees paid to the system provider -Q • Fixed costs (G&A, personnel, other) -Q • Fixed costs (G&A, personnel, other) • Initial investment • Initial investment The Core 41 EFFECTS OF THE UPGRADE ASSUMPTIONS Player • Big Bang happens three years after the initial investments are made by both the system provider and the participants Consumers Assumption • Each transaction requires 1 minute instead of 5 minutes • Fixed costs: reduction by 50% Participants System provider • Initial investment per participant: 1.5 Millions • Fixed costs: reduction by 25% • Variable costs: reduction by 50% • Initial investment: 20 Millions The Core 42 CBA AS A STEP-WISE PROCEDURE • Prioritizing • Assessing payoffs • Identifying players and utility • Assessing the functions decisions to be evaluated The Core 43 UTILITY POSSIBILITY FRONTIER • For each agent costs and benefits are found • A utility possibility frontier (UPF) for the social planner can be drawn in terms of the extra utilities (with respect to the current status) of both the consumers (DUC) and the participants (DUP) in the economy if the upgrade is made DUP Quadrant of Pareto optimal solutions UPF • Each point in UPF is supported by a fee system (fees to participants, fees to end-users) DUC The Core 44 PRIORITIZATION Central Bank’s perspective • The Central Bank must pick a point in UPF by choosing a fee system DUP UCB1 • Given the indifference curves on the right side, it would choose solution A, where the participants’ extra DCF is close to 0 UCB2 UPF A DUC The Core 45 OUTPUT Selected information Player Issue Participants • Fees to the participants (per transaction) • -43% • Fees to the end-user (per transaction) • -18% • Transactions per consumer • +12% • Total costs per consumer • - 7% • Total time employed per consumer • -77% Consumers % Change The Core 46 CONTENTS ¶ The need for CBA in payments systems reforms. ¶ A primer in CBA. ¶ An application to payments systems reforms. ¶ Concluding remarks. The Core 47 FINAL REMARKS • CBA can be beneficial for payment system reforms, mostly to Central Bank and National Payment Council • Two main hurdles must be tackled: -Tractability: keep it simple -Data availability: make (at worst) judgmental assumptions The Core 48