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May 15, 1995

eCONOMIC
COMM6NTORY
Federal Reserve Bank of Cleveland

How Much Is Daylight Credit Worth?
by E.J. Stevens

C

credit extended for a few hours during the business day, but not overnight,
is called daylight credit. Once largely
unnoticed, it has acquired significant
importance since the Federal Reserve
Banks stopped providing free and unlimited daylight overdrafts to financial institutions on demand. The Banks imposed
formal restrictions in 1986 and a daylight overdraft fee in 1993, both of
which were intended to reduce the subsidy of free credit. Now, as of April 13,
the fee has been raised from 10 cents to
15 cents per $100 average per-minute
daily overdraft in excess of 10 percent of
a bank's total risk-based capital.1 This
Economic Commentary examines how
much daylight credit might be worth to
the banks that use it and looks at the
implications of raising the overdraft fee.

•

More Bang for the Buck

The volume and value of payments made
in the United States have been increasing
more rapidly than the money balances
used to make payments for many years.
This rising "productivity" of money used
for transactions — or the increased
velocity of cash and checkable deposits
— reflects technological changes made
possible by the computer and telecommunications revolution. Greater speed
and precision in tracking bank balances,
and better opportunities to adjust balances "same day," have reduced the size
of the cushion needed to absorb unexpected delays in receipts and acceleration
of payments. The same revolution has
made it possible to consolidate multiple
transactions into single payments. In
retail payments, credit cards allow people

to cover a whole month's transactions
with a single payment. In wholesale
financial payments, an entire day's transactions between two traders may be netted to a single payment.
Indeed, "just in time" seems an even
more apt description of cash management technology than of business inventory control. Over the past 20 years, the
inventory of money relative to payments
in the United States has declined even
more rapidly than the inventory of goods
relative to sales. More striking is the
decline in banks' own inventories of
deposit balances at the Federal Reserve
Banks relative to interbank payments
(see figure 1).
Of course, technology is not the only reason that banks have been able to keep
relatively smaller balances at the Reserve
Banks. Reduced reserve requirements
have lowered an artificial floor that may
have prevented banks from economizing
on balances. Perhaps as important was
the ready availability of Reserve Bank
daylight credit, at least until 1986. Payments could be made against empty
accounts as long as balances were restored by the end of the day. Commercial
banks typically have been less lenient
with their depositors.
A retail customer must make a sufficient
deposit to an empty account before
funds can be drawn from a teller or automated teller machine. Corporate depositors are more likely to have access to
daylight credit for making payments,
although screening relative to an explicit
credit limit is usually necessary.

The Federal Reserve Banks raised
their daylight overdraft fee from 10
cents to 15 cents on April 13. In two
years, the Board of Governors will
consider whether to raise it further.
How high to set the fee depends
largely on attitudes toward risk management. A low fee involves questions
of moral hazard in central banking;
a high fee raises questions about risk
myopia in private credit markets.

• The Time Value of Money
Daylight credit bears no explicit interest.
An interest rate is the cost of credit, typically expressed as an annual percent.
Market and regulatory conventions have
developed for translating between
annual rates and rates for maturities of
months, weeks, and days, but not for
maturities of less than a day.2
Many credit instruments have a maturity
of only a single day, including interbank
loans (federal funds) and repurchase
agreements (RPs). Large banks (defined
here as those with more than $4 billion
in assets) have recently been borrowing
close to $150 billion daily at a one-day
rate that amounts to about 6 percent
annually. Although the rate is for one
day, frequently these are described as
overnight loans. Many lenders deliver
the funds just before the close of the
banking day, and many borrowers return
the funds the next morning.

Overnight is the same as one day in a
crucial sense. Federal Reserve Banks
close their books only once per day.
Funds borrowed in overnight markets
are deposit balances at the Federal
Reserve Banks. Adding funds to an
account at the end of a day is just as
good for most purposes as adding the
same amount at the beginning of a day.
It is the size of a bank's end-of-day balance that counts in meeting reserve and
clearing balance requirements and in
avoiding the penalty for an overnight
overdraft. In this sense, there is no time
value of money within a day. True, the
market rate for overnight federal funds
does vary over the course of a day, but
this variation bears no consistent relation
to the time of day. The only exception is
that the market closes when delivery
becomes impossible — that is, when the
Reserve Banks close for the day.
No market conventions have developed
for converting annual interest rates into
maturities of hours, minutes, and seconds because daylight credit has no
comparable time value. It does not provide end-of-day, overnight balances.
Where there have been market fees for
intraday credit, they have been risk premiums. Lacking time value, the banking
system has had no reason to reward extra
intraday money balances. However, as
long as lending involves credit risk,
lenders cannot give away money even
for short intervals without some compensation for bearing risk.
For the most part, Reserve Banks have
extended daylight credit in the process
of providing Fedwire funds and securities transfer services to depository institutions. Two examples illustrate this.
1. A bank wishes to pay $500 million
to another bank, perhaps to repay an
overnight federal funds loan. A staff
member of the sending bank enters the
relevant bank ID numbers, dollar
amount, and descriptive details into a
computer terminal and then executes
the on-line transaction. Almost simultaneously (for a sending bank in sound
condition), the computer of its Federal
Reserve Bank transfers $500 million
from the sending bank's account to that
of the receiving bank. Unlike a check or

FIGURE 1 RATIOS OF INVENTORIES TO TRANSACTIONS
Index, 1974 = 100
120
Nonfarm inventories/sales

Transaction deposits/debits to transaction accounts
Reserve + clearing balances/
debits to Federal Reserve accounts

1974

1976

1978

1980

1982

1984

1988

1990

1992

SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Board of
Governors of the Federal Reserve System.

automated clearinghouse payment, this
Fedwire payment is legally final when
received, meaning that the receiving
bank has immediate, irrevocable possession of the funds whether or not the
sending bank had a sufficient balance to
cover the payment. If the sending bank
had a zero balance at the moment the
payment was executed, then the Federal
Reserve Bank extended $500 million in
daylight credit, which the sending bank
is obligated to repay before the close of
the day.
2. A bank is, or is the banker for, a
government securities dealer. Dealers
finance the bulk of their securities
inventories in the RP market. Effectively, they borrow overnight to finance
their positions, using the securities in
their position as collateral. Agents with
large cash positions who seek an
overnight rate of return purchase the
securities with an agreement to sell
them back the next day at a profit. At
the opening of the next day's business,
they return the securities to the borrower via the Fed's securities wire. This
simultaneously takes payment from the
borrower's account, which thereby may
generate a daylight overdraft.

•

How High a Fee?

The original decision to impose a fee for
using Federal Reserve Bank daylight
credit did not specify how high the fee
might ultimately be set. The Board of
Governors initially announced a plan to
charge 10 cents until April 1995, then 20
cents until April 1996, and 25 cents
thereafter. However, the Board reserved
the right to move faster or slower. Clearly, the unanswered question was how to
know when the fee was high enough.
One criterion might be to use the volume
of daylight overdrafts as an indicator of
Reserve Banks' risk exposure. However,
this only begs the question of how much
risk the Reserve Banks should accept.
An alternative approach is to ask what
fee private institutions would set in a
competitive market. If free daylight
credit subsidized banks in a position to
use it, then it would make sense to raise
the fee at least until daylight overdraft
volume began to decline. At that point,
the marginal cost of alternatives could be
assumed to equal the price of the Reserve
Banks' daylight credit service. The presumption then would be that the Banks
were supplying an efficient volume of
daylight credit — assuming no deviation
of marginal private and social costs (discussed below).

To a bank, the value of the daylight overdraft subsidy must be worth, at most,
what it would cost to eliminate. The initial 10 cent fee resulted rather quickly in
a 40 percent decline in daylight overdraft volume. A prime reason was that,
to avoid fees passed through by their
banks, government securities dealers
shifted a significant volume of both
transactions (whether RP or outright
purchase and sale) and transaction settlements to earlier hours of the day. This
reduced overdrafts by bringing funds to
their banks earlier. However, no significant change has been noted in patterns of
daylight overdrafts associated with other
banking practices, notably federal funds
market transactions, which are thought
to be the proximate source of a substantial portion of the remaining overdrawn
positions each day.
With the incentive of a higher fee, what
kinds of changes might banks initiate to
reduce daylight overdrafts? Individual
banks, regularly in overdraft, could either
replace persistent overnight borrowing
with longer-term financing or shift to
continuing contracts with regular suppliers. This would eliminate large payments
for return of funds on many days, at the
potential cost of an interest-rate spread of
term funds or of other rates that exceed
the overnight funds rate.
Perhaps more difficult to organize would
be changes in market conventions, since
they would require the explicit or implicit agreement of many participants. Also,
they necessarily would involve earlier
delivery or delayed return of funds for
some banks. This would inevitably invite
contention about who "should" give up
the benefit of daylight credit. For example, a higher fee might induce borrowing
banks to hold overnight funds longer,
extending possession toward a full 24
hours. The incidence of fees would be on
lending banks to the extent they were
unable to pass the cost along to others.
Ultimately, a high fee could induce banks
to shift payments to alternative payment
networks. The existing CHIPS (Clearing
House Interbank Payments System) network and the once-proposed CASHwire
are examples of networks that could provide substitutes for Fedwire in transfer-

ring same-day funds between banks.
They differ from Fedwire in that they are
net settlement systems: Only the cumulative amount of a bank's network payments and receipts over the course of a
day would be posted to its Reserve Bank
account at a prearranged settlement time.
As long as a bank's network counterparties were willing to accept its payments
before it accumulated offsetting receipts,
private network credit could replace
Reserve Banks' daylight credit, with little need to change the time pattern of
funds market activity.

•

Where to Stop?

One point at which to stop raising
Reserve Banks' fee for daylight credit
would be the level at which Fedwire's
share of interbank payments began to
slip, as existing and new same-day net
settlement systems threatened to allow
private banks to replace the central bank
in supplying daylight credit. But why
stop at the margin, if a higher fee would
allow private markets to take over the
creation and allocation of daylight credit
almost entirely?3
The choice lies somewhere between a
low fee that removes pure subsidy but
preempts much of the daylight credit
that could be provided by private networks, and a high fee that removes all
traces of subsidy but eliminates much of
the daylight credit that could be provided by the central bank. Which direction to go depends largely on attitudes
toward risk management, involving
questions of moral hazard in central
banking and externalities in private
credit markets.

be that government supervisory institutions lack the motivation and multiple
independent perspectives that can be
brought to the risk-monitoring effort by
many competing banks and customers
operating through private networks and
markets. The implication is that, while
payments are uniformly safe to receive
when backed by the infinite resources of
the central bank, more payment-related
risk exists than under a private regime.
Another position, consistent with choosing a low Reserve Bank fee for daylight
credit, emphasizes a potential disparity
between the private and social costs of
credit. Private banks and their customers
will underestimate the true risk their
credit produces for society if they cannot
perceive "systemic" consequences of
bilateral credit extensions — that financial interdependencies can produce
falling dominoes.
It is true, by definition, that the risk protections built into private net settlement
systems cannot be as absolute as a finality guarantee by a central bank with
authority to create money. The question
is whether we rely too heavily on that
guarantee, forgoing the benefits of counterparty risk assessments. What is debatable in making a choice between more
and less private daylight credit is the
relation between systemic risk and moral
hazard. That is, counterparties to payments may turn a blind eye to systemic
risk because of a genuine risk myopia, or
because heretofore, the Reserve Banks
have largely accepted the moral hazard
of a liberal supply of daylight credit.

•
Moral hazard arises when the central
bank relieves banks and their customers
of the need to prudently monitor risks in
accepting payments from other banks.
Fedwire creates this hazard by making
payments final upon receipt, without
regard to whether the paying bank has
sufficient funds to cover the payment —
that is, by providing daylight credit on
demand. Recognizing this hazard,
Reserve Banks rely on bank supervision
for the prudential monitoring that Fedwire finality makes unnecessary among
their customer banks. An argument
against creating this moral hazard may

Conclusion

Daylight credit is worth what it would
cost to do without it. For banks to forgo
the daylight credit provided by the Federal Reserve might involve nothing more
than switching transactions to private
interbank networks. The necessity of
controlling risk in private net settlement
networks has commanded increasing
attention over the past decade. In the
United States, the Reserve Banks now
enter into settlement arrangements only
with large-value private payment networks that can demonstrate robust riskcontrol measures. More broadly, the
Bank for International Settlements has

produced a series of risk assessment

•

studies and recommendations for its

1. Originally, in 1993, this increase was tentatively set at 10 cents. Fees of less than $25
per day are waived. See "Policy Statement
on Payments System Risk: Daylight Overdraft Pricing," Board of Governors of the
Federal Reserve System, Docket No. 0806,
March 2, 1995.

member central banks. These emphasize
the need for explicit central bank control
of payment system risks, focusing on the
potential vulnerabilities of national
clearing and settlement systems, particu-

Footnotes
the Federal Reserve Bank of Cleveland.
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

larly for transactions in global markets.4
Neither risk myopia nor moral hazard
should go uncorrected. Therefore, it
seems prudent for the Reserve Banks to
continue raising the fee for daylight
credit. The higher the fee, the more feasible it is to rely on private counterparties to share with bank supervisors the
responsibility for risk management in
the payments system.

E.J. Stevens is a consultant and economist at

2. A difficult case in point has been the
Board of Governors' attempt to define a convention for expressing the interest rate on
savings accounts as an average periodic rate.
See Board of Governors of the Federal
Reserve System's Regulation DD, Truth in
Savings, 12 C.F.R. Part 230 (1995).

System.

3. For information about the public/private
mix in other developed countries, see Bank
for International Settlements, Payment Systems in the Group of Ten Countries, Basle,
December 1993.
4. See Bank for International Settlements,
Report on Netting Schemes, February 1989;
Report of the Committee on Interbank Netting Schemes of the Central Banks of the
Group of Ten Countries, November 1990;
Central Bank Payment and Settlement Services with Respect to Cross-Border and MultiCurrency Transactions, September 1993.

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