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 could benefit because collateral provides it with some insurance in the event a bank cannot repay its overdraft. It may also benefit if greater use of collateral increases the incentives for banks to repay their overdrafts over and above the incentives already in place because of monitoring, reputation, and the existing use of collateral.

Banks could benefit if greater use of collateral relaxed some credit constraints. As we observed in the construction loan example, providing collateral can often allow a borrower to obtain better terms on a loan. For similar reasons, the Board's policy proposal includes a zero fee on collateralized daylight overdrafts. In such a case, banks' overdraft costs could decrease when they pledge collateral.

The financial system may benefit if the increased use of collateralized intraday overdrafts at the zero fee speeds up the flow of payments across financial markets. The lower cost of collateralized intraday overdrafts may lead to more payments being made earlier in the day, as banks would have less need to delay payments until they have sufficient incoming funds. By encouraging more banks to have collateral pledged at the Fed, increased use of collateral could make it easier for the Federal Reserve to inject liquidity both intraday and overnight in times of financial stress. This is true in particular because collateral is required for overnight loans. In addition, increased use of collateral may prepare banks for financial stress by increasing their ability to borrow at the discount window. All of these spillover benefits may accrue to the financial system through greater use of collateral.

3.2 The Potential Costs of Greater Collateral Use

There are also possible costs to increasing the use of collateral.

The Federal Reserve could face higher costs associated with monitoring collateral, such as making sure it is available and valuing it properly. The Federal Reserve already pays such costs because it accepts collateral for overnight loans, but these costs could rise if the amount of collateral increases. Moreover, if there is a greater reliance on collateral for intraday overdrafts, banks may ask to manage their collateral more actively at the Federal Reserve, requiring the Fed to invest in enhancements to its collateral management systems.

Banks would have to pay costs associated with acquiring, managing, and tracking their collateral. Additionally, they may face an opportunity cost associated with using collateral to secure overdrafts because that collateral may no longer be used for other purposes. Banks may also reallocate their portfolio of assets to acquire enough collateral for daylight overdraft purposes. Whether this would constrain banks much depends on the type of collateral that the Federal Reserve and other banks are willing to accept.12

The financial system as well may be negatively affected by the greater use of collateral. Collateralized overdrafts make the Federal Reserve a higher claimant on assets of a failed bank, which reduces the attachable assets to residual claimants in the event of a bank liquidation, adversely affecting the unsecured creditors of that bank. This is an issue mainly if the policy is not explained well in advance so that some long-term contracts cannot be renegotiated. Another potential cost would occur if too much of the banking system's assets are tied to collateralized daylight overdrafts. In extreme situations, this could lead to credit rationing in the economy should a shortage of collateral occur. Thus, the increased use of collateral could have negative spillover effects on the economy. Again, whether such a cost is likely to be large is an empirical question and depends on the range of collateral that would be acceptable to the Federal Reserve and other banks.