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Outline of talk on "Payment System Risk" before the St. Louis Cash
Management Association, at Centerre Bank,
February 18, 1988
I.
Introduction
I welcome the opportunity to talk about the Fed's payment^a^stem
risk policy, which is currently being reviewed. As ^yr^taiow, I am a
member of the System's Payments System Policy Covmi^tee and have
been since its inception about a year and a ha>f*ago. In addition,
Alton Gilbert, Assistant Vice President in^dr Economic Research
division, is a member of the task forc^x€valuating policy options as
part of the review. Most of my repatflcs this evening will be devoted
to a discussion of two possible^ftiture approaches to policy and
their implications: first .^xontinuat ion of the present policy
based on sender net debij&^caps (or implicit pricing), and second,
explicit pricing of daylight overdrafts. Before getting into the
details of theseajSproaches, let me first distinguish between
payments systgafrisk, daylight overdrafts, and Federal Reserve
risk. Alsj^fl
should review what our policy has been and why it is
being reevaluated now.
II.^Payment system risk and the role of the Federal Reserve,..in the
^^.«~.™ - - - «-• — — ™ ~~~
^^^jiayment^
A.
Definition of payment system risk
It is the risk that the operation of the payment system will be
disrupted as a result of some participant in the payment system
failing to meet its obligations.
B.
Daylight overdrafts
1. What are they?
a. Fedwire — negative reserve balances of individual banks
during the business day.
b. CHIPS — net debit positions on payments messages during
the business day.
2.
Role of daylight overdrafts in the operation of the payment
system
A payment system that permits daylight overdrafts
facilitates rapid payments without forcing depository
institutions to coordinate incoming and outgoing payments
throughout each business day.
3.
Relation of daylight overdrafts to payment system risk
Failure of a depository institution during a business day
when in an overdraft position may impose losses on other
- 2 participants in the payment system. The larger the
potential daylight overdrafts, the larger the potential
losses to other payment system participants.
4.
How large are daylight overdrafts?
The daylight overdraft of a bank on a given business day is
measured by combining its reserve balance with its net
position on CHIPS throughout the day. The relevant measure
is the greatest negative balance at any time during the
business day. Measured in this way, aggregate daylight
overdrafts for the banking system averaged about $80 billion
in 1987. Some daylight overdrafts are tied directly to
transfers of securities. A bank has its reserve account
debited when it receives book entry Treasury securities.
Daylight overdrafts generated through transactions in book
entry securities are netted out of the $80 billion figure.
Including overdrafts related to securities transfers raises
average daylight overdrafts to about $t2©*i>illion.
C. Federal Reserve risk
1.
How does the involvement of the Federal Reserve in the
payment system expose the Federal Reserve to risk?
The Federal Reserve provides final payment for funds
transferred over Fedwire. The Federal Reserve absorbs any
losses resulting from the failure of a bank with an
overdrawn reserve balance.
2.
Why does the Federal Reserve assume this risk?
Since the Federal Reserve was founded, it has had a mandate
to promote a safe and efficient payment system. This risk
is incidental to the pursuit of those goals.
^&>^Nature of Policy
B.
1.
Eis4t the amount of daylight overdrafts that can be incurred
by a <5te©|>sitory institution based on a self-assessment.
2.
Self-assessmentxj^o be based on an analysis of the
institution's creditworthiness, credit policies, and
operational controls / V
Purpose of Phase I of Policy (MayN^85)
1.
Control of the level of daylight ovelNkqaf ts.
2.
Improve operational and credit controls.
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Pros and Cons of Caps. The arguments for and against caps and
continued cap reductions summarize the discussion presented above.
The pros
of this policy include:
* Caps represent an existing and accepted program whose parameters
are reasonably understood by most if not all payments participants.
A policy which continued to reduce the level of cross-system caps
would thus be the easiest to implement and, like pricing, would
continue to provide incentives to reduce overdrafts and risk.
* A single cap applies to all large dollar wire transfer networks
together—CHIPS and Fedwire. Thus cross-system cap reductions
would not lead to shifts in risk from one network to another,
although incentives may exist to shift payments and risk to
offshore clearing arrangements (unless these too were deemed
similar by regulatory authorities and net debits incurred by banks
there included with those measured on CHIPS and Fedwire).
* Caps are set to reflect differences in the underlying operational
capabilities, credit procedures, and creditworthiness of banks.
This translates into an assessment of a given bankfs riskiness to
the payments system and thereby equitably distributes incentives to
reduce/control overdrafts among payments participants. These
distinctions are likely greater than those which may exist in a
free market environment (e.g., the small tiering which arises in
the overnight market for funds or in markets for bank CDs).
A listing of the cons would include:
* Caps impose an implicit price on daylight overdrafts above a
certain level. This price is around 750 basis points when the cap
multiple is 2 (where overdrafts can be twice capital) and somewhat
lower for higher cap multiples. Since overdrafts below the cap
carry no explicit or implicit price, the system of caps is
essentially a way of pricing overdrafts on the margin, rather than
treating each dollar of overdrafts more equally.
* Caps are relatively inflexible and do not allow choice by
participants to incur overdrafts even if they may be willing to
incur a fee to do so. This lack of choice often makes quantitative
limits inferior to policy options where some choice is permitted
(e.g., pricing below a cap versus continued cap reductions).
"*' Rgdtr&feAans in caps, at least on the order of the 25 percent
decrease plarmeB""^
continued in the future can be very
disruptive to the smooth ope^^TTi^^
markets.
Consequently, a status quo policy on capHT*^^
1988
reductions) can be less disruptive but, over t ime 7stT3^h*^^QyJ.d e
incentives to reduce overdrafts as payments value continues to^8**,,**,•
grow.
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- 15 -
flow and speed of payments as each bank attempts to minimize costs by delaying
its payments until its reserve balance is positive, and the payment can be
made without charge.
To limit potential disruption, pricing would have to
start at a very low level, way below any target long run price.
The price
could then be slowly raised over time so that institutional adjustments which
reduce overdrafts can be implemented and, importantly, the market adopts
customer pricing arrangements which compensates banks for their overdraft
costs.
Once these two aspects of institutional structure are altered, further
increases in the price to significant levels should not lead banks to delay
sends and degrade the speed of the payments system.
Pros and Cons of Pricing Fedwire Overdrafts.
The pros and cons
listed here summarize the discussion presented above for this policy alternative.
**)
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The pros would include:
*
Reduces Reserve Bank credit risk.
*
Less disruptive to financial markets and payments speed than
quantitative limits as can allow for "emergency credit" when
needed.
*
Decision failure in payments markets is corrected as costs of
overdrafts are borne more fully (and equitably) by beneficiaries
of daylight credit.
*
Treats each dollar of overdrafts equally whether below or at the
cap since the cost per overdraft dollar is constant,
*
Easy to set price, if private market is to supply all credit.
A listing of the cons would include:
*
If pricing is not also implemented on CHIPS, Fedwire pricing can
increase systemic risk by shifting overdraft risks to CHIPS, to
new offshore clearings, or to sellers of rollovers or continuing
contracts. But offsetting market responses should be expected and
would concern increased monitoring and control of this risk to
maintain the previous risk/return ratio in the payments area.
This can also include new institutional arrangements such as
netting by novation and the likelihood that the net increase in
systemic risk will be spread thinly enough to reduce the average
institution's probability of failure.
- 16 -
*
Difficult to ?et price if Federal Reserve is to supply the
overdraft credit, and especially if such a price is to reflect
differing risks posed by overdrafting banks. The range of
reasonable market or Federal Reserve prices is from 20 to 100
basis points (annual rate) per dollar of overdraft.
*
Operationally difficult to do.
Reserve Bank computer outages.
*
As proposed, treats overdrafters and holders of "excess" daylight
reserves differently, unless the private market supplies most or
all of the daylight credit and holders of excess daylight balances
can sell them in an intraday funds market.
*
Expensive to users, unless price is set very low or phased-in over
time. If a high price were not carefully phased-in, starting very
low and slowly- rising over time, payments speed could be degraded
as users delay sends to minimize overdraft costs. This response,
however, should be temporary and be reduced once it became
industry practice to recover overdraft costs from customers who
order the payments to be made.
Will somehow need to correct for
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