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

3. The Case of Daylight Overdrafts on Federal Reserve Accounts

We now turn to the specific case of the Federal Reserve's policy regarding daylight overdrafts on accounts that banks have at the Fed.3 Most, but not all, of the value of overdrafts arises from banks' Fedwire activity.4 Fedwire is a large-value payments system and a securities settlement system that banks use to send each other funds and government securities on behalf of their customers and their own accounts. Transactions are sent over Fedwire one at a time with finality, which means that the Federal Reserve guarantees that the funds or securities a bank receives will not be revoked.5 Because transactions are processed one at a time, banks must have access to enough funds to complete each transaction. This need for available funds generates various frictions that banks face in the settlement of transactions, such as search frictions, timing frictions, and incentive frictions (see box).

The Federal Reserve alleviates the impact of these frictions by providing intraday liquidity,6 which allows qualifying banks to overdraw on their Fed accounts in order to make payments via Fedwire. Banks can acquire overdrafts throughout the day to make payments, but must ensure that their accounts are not in a negative position at the end of the day. The Federal Reserve's provision of liquidity through daylight overdrafts can be interpreted as very-short-term credit.

This exposure is something the Federal Reserve must manage to protect itself from moral hazard or adverse selection problems that may arise from the type of information frictions described earlier. For example, because the Fed does not observe all the actions of banks, it may be concerned that some banks could use daylight overdrafts to finance excessively risky bets. Similarly, the Reserve Banks may not have full information regarding a bank's risk of default on daylight overdrafts. The Fed currently manages its exposure to this form of credit risk with a combination of overdraft fees, reputation, monitoring, and collateral. We now turn to some specifics of the policy to make this connection clearer.

The Federal Reserve charges an explicit price for daylight overdrafts, currently a twenty-four-hour rate of 36 basis points less a deductible. This price, though small, is meant to provide an incentive for banks to minimize their use of daylight overdrafts. But even though this fee may help constrain the size of daylight overdrafts, and accordingly the Federal Reserve's credit exposure, it does not address the information frictions of adverse selection and moral hazard. Thus, other aspects of the policy address those issues.

The daylight overdraft fee provides some incentive for banks to constrain the size of their daylight overdrafts. In addition, the Fed uses a net debit cap, which is the maximum dollar amount of daylight overdrafts that an institution may incur in its Federal Reserve account. Each bank that has an account and that is also eligible for intraday overdrafts has a net debit cap. The policy on net debit caps is based on a set of specific guidelines and some degree of banking supervision. The policy allows for one of six ratings for a bank. For most banks, net debit caps range from zero to 2.25 times the bank's risk-based capital.7