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

Net debit caps involve a great deal of monitoring. The Federal Reserve reviews supervisory information, evaluates banks' self-assessments (if applicable), and then uses this information to assess the appropriateness of an institution's cap category.8 This monitoring alleviates some problems associated with adverse selection.

The Federal Reserve also monitors a bank's use of its daylight overdrafts against the cap, providing an opportunity for banks to establish reputations with their regional Federal Reserve Bank. In most instances, banks that exceed their cap limit are required to explain the reason to the Fed and then be counseled to prevent it from happening again. The Fed reserves the right to reduce net debit caps unilaterally, impose collateralization or clearing-balance requirements, reject or delay certain payments, or, in extreme circumstances, prohibit the bank from using Fedwire. Thus, maintaining a reputation of staying under the cap can help banks avoid such actions and can alleviate certain moral hazard concerns.

Although most daylight overdrafts are uncollateralized, the Federal Reserve uses collateral in two situations. First, it requires collateral from problem institutions to cover any incidental overdrafts. Second, banks wishing to increase their net debit caps can pledge collateral to do so subject to the Federal Reserve's approval. The amount and type of collateral pledged are determined through an agreement between the bank and the Federal Reserve.9 Collateral plays an insurance role for the Fed in the event of a loss due to an overdraft. It also plays an incentive role for the bank to control its overdrafts and avoid risky behavior that could lead to its closure and forfeiture of the assets it pledged as collateral. Thus, the collateral here also overcomes certain moral hazard concerns.

The Federal Reserve's policy regarding daylight overdrafts uses a combination of fees, monitoring, reputation, and collateral. Changes in payments and securities settlement systems, and their effect on the need for intraday liquidity, have led to periodic reviews of this policy to determine whether changes to it can improve the safety and efficiency of the payments system. Recently, in order to ease intraday liquidity constraints and reduce operational risk, the Board proposed changes to its Payments System Risk policy to supply intraday balances to healthy banks predominantly through explicitly collateralized daylight overdrafts.10 Under the proposal, the Board would allow banks to voluntarily pledge collateral to support intraday overdrafts. Collateralized intraday overdrafts would be charged a zero fee, while the fee for uncollateralized overdrafts would increase from 36 to 50 basis points.11 We now describe how increasing the use of collateral could bring benefits as well as costs to the Federal Reserve, to banks, and to the financial system as a whole.

3.1 The Benefits of Increasing Collateral Use

Greater use of collateral has the potential to benefit the Federal Reserve, banks, and the financial system in several ways.