AN ECONOMIC PERSPECTIVE ON THE ENFORCEMENT OF CREDIT ARRANGEMENTS: THE CASE OF DAYLIGHT OVERDRAFTS IN FEDWIRE

Economic Policy Review - Federal Reserve Bank of New York, Sep 2008 by Martin, Antoine, Mills, David C

* The Federal Reserve's extension of daylight overdrafts to banks exposes the central bank to some credit risk during the day.

* The Fed manages this exposure through a combination of tools, including monitoring, an awareness of banks' reputations, and collateral requirements.

* Under a proposed policy change, the Fed would supply intraday balances to healthy banks through collateralized and uncollateralized overdrafts; banks would be allowed to pledge collateral voluntarily to support intraday overdrafts.

* An analysis of the increased use of collateral resulting from the change points to potential benefits-as well as costs-for the Federal Reserve, banks, and the financial system.

1. Introduction

Credit arrangements between a borrower and a lender are a prevalent part of the economy. A fundamental concern for any lender is the risk that the borrower fails to fully repay the loan as expected, a type of risk called credit risk. Thus, lenders want credit arrangements that are designed to compensate them for- and help them effectively manage-credit risk.

In certain situations, central banks engage in credit arrangements as lenders to banks. For example, the Federal Reserve offers certain banks overnight loans at the discount window. Additionally, it provides liquidity to many banks during the day whenever those banks must overdraw on their Federal Reserve accounts in order to make payments and settle securities. This extension of daylight overdrafts by the Fed can be interpreted as very-short-term credit, so the central bank is exposed to credit risk that it must manage.

This article discusses how the Federal Reserve manages its credit risk exposure from daylight overdrafts. We first present a simple economic framework for thinking about the causes of credit risk and the possible tools that lenders have to help them manage it. We then apply this framework to the Federal Reserve's Payments System Risk Policy, which uses a variety of tools to manage credit risk. Finally, we discuss a possible increase in the use of collateral as a credit risk management tool, as presented in a recent policy proposal published by the Board of Governors of the Federal Reserve System (hereafter, the Board) that considers changes to its Payments System Risk Policy (Board of Governors of the Federal Reserve System 2008).

2. A Framework for Thinking about Contractual Relationships

Economists have developed a framework for thinking about contracts in general and credit arrangements in particular. We now summarize and illustrate the main elements of this framework. The emphasis is on first principles, an approach that provides a helpful basis for policy analysis.

2.1 Bad Luck versus Opportunistic Behavior

A borrower may not fully repay a lender for one of two reasons: bad luck or opportunistic behavior. By "luck," we mean all random factors that affect borrowers' and lenders' actions and that are independent of their behavior. For example, weather is a random factor that can influence a farmer's yield of corn independent of the amount of effort the farmer exerts. The effect of luck can typically be priced into a contract.

In contrast, opportunistic behavior-a privately beneficial action that increases costs to the other party in the transaction- typically cannot be priced into a contract. Opportunistic behavior occurs when borrowers may not have sufficient incentive to do all they can to repay their debts. In the example of the farmer, the lender wants the farmer to put forth great effort to yield a large amount of corn and would like to be assured that the farmer will do so. The farmer is opportunistic if he does not work very hard in the field. By not working very hard, he may not yield enough corn to fully repay his debt to the lender.

Why do borrowers have an incentive to engage in opportunistic behavior? At the time a credit arrangement is made, all borrowers promise to repay their debt. Otherwise, lenders would refuse to lend. Once the loan is made, however, borrowers have an incentive to renege on their promise and default. The economic decision of the borrower is time inconsistent. In other words, the best decision at a given time (the promise made at the beginning of the credit arrangement to repay the loan) may no longer be optimal later because of the consequences of the original decision (once the loan is obtained because of the promise to repay, the borrower no longer wants to repay it). Anticipating this outcome, the lender may choose to forgo making the loan in the first place.

2.2 Enforcement

To achieve a good outcome, borrowers would like to be able to credibly commit to not reneging on their promise. A strong enough commitment can sufficiently address the timeinconsistency problem.1 Experience shows, however, that this kind of commitment is difficult to make. Institutions, formal or informal, that help economic agents make credible commitments are said to provide enforcement. Courts are an example of such institutions, but many other examples exist.