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FRBSF

WEEKLY LETTER

August 14, 1987

Controlling Payments System Risk
On an average day, more than $1 trillion inpayments are exchanged by depository institutions
(here!J.fter, "banks") over large-dollar, or wholesale, wire transfer networks. In doing so, banks
create and extinguish a huge volume of intraday
credit, and thus may expose the financial system, even though for a short time, to the risk that
a participant on one of these networks could fail
before it had repaid its intraday obligations. The
ramifications of this exposure for the stability of
financial markets are discussed in this Letter
along with the Federal Reserve System's program
to reduce and control risks on large-dollar
networks.
Large-dollar networks
Large-dollar networks are electronic telecommunications networks that enable banks to
transfer funds much more quickly and with
greater security than checks and other paperbased payments systems. However, because the
per-transaction cost of using these electronic
networks is high compared to paper-based systems, their greater speed and security are attractive primarily for time-critical, large-dollar
payments among banks and large corporations.
In fact, the average size of transfers on largedollar networks is well in excess of $2 million.

A transaction can involve two steps: clearing
and settlement. For example, a corporate payor
("sender") directs its bank to make a payment to
another corporation by "wiring" funds from its
account to the bank at which the other corporation (referred to as the "receiver") has its
account. The sender's bank ("sending bank")
sends the network clearinghouse the payment
information, including the amount of the payment, the names of the payor, receiver, and the
receiver's bank. The network clearinghouse then
debits the account of the sending bank and
credits the account of the receiving bank and
notifies it of the payment ~ a process known as
"c1earing". The payment is not "final,"
however, unti I "good" funds are transferred at
"settlement", which takes place either at the

time the payment message is received or at the
end of the day in the case of a network that
delays settlement.
Currently, two facilities are involved in the bulk
of large-dollar payments transactions in this
country. Fedwire, operated by the Federal
Reserve System, provides settlement services
and enables participating banks to effect payments of good funds through reserve accounts at
the twelve regional Reserve Banks. Transactions
on Fedwire are final (and good funds are transferred) at the time notification of payment is
received by the receiving bank. Nevertheless,
because the Fed does not require banks to balance their accounts continuously throughout the
day, it is possible for a bank to overdraw its
reserve account prior to Fedwire's closing at the
end of the day by making payments in excess of
its reserve account balance.
The second major facility, CHIPS (Clearinghouse
Interbank Payments System) also handles a substantial volume of large-dollar payments, particularly those involving international dollar
payments. CHIPS is a network clearinghouse
operated by a group of private banks through the
New York Clearinghouse Association. In contrast to Fedwire, payments on CHIPS are not
final until the end of the day, when each bank's
position with the clearinghouse is determined by
netting its debits to its CHIPS account against the
credits to its account. A "net net settlement
sheet" is then presented to the New York Fed
and reserve account balances are transferred to
those in a net credit position as soon as the
Reserve Bank receives fed funds from those in a
net debit position.
Thus, at any time during the day, one or more
CHIPS participants may have net debit obligations substantially in excess of their reserve
account balances. They must make up this shortfall by the end of the day, or risk being unable to
settle with the clearinghouse.

FRBSF
Credit risk
Despite differences in settlement procedures,
transactions on both CHIPS and Fedwire
ultimately are settled through the transfer of
reserve account balances from one bank to
another. Today, the stock of these balances is
minuscule in relation to the daily volume of
transactions. Receipts and disbursements are not
synchronized and reserve account turnover is
rapid (on the order of 25 times a day). Moreover
parti~ipants on both CHIPS and Fedwire rely ,
heavily on the extension of intraday credit to
bridge timing gaps.

On Fedwire, the Fed extends credit by providing
finality of payment to receiving banks and by
permitting sending banks to overdraw their
reserve accounts during the day. On CHIPS, in
contrast, receiving banks in effect extend credit
by accepting payments from a sending bank that
is in a net debit position to the clearinghouse.
On both networks, these extensions of credit are
very short-lived, "maturing" at the close of the
business day.
Like any other extension of credit, there is a risk
to the lender that the borrower will be unable to
repay the loan at maturity. Moreover/the risk of
default may rise as the amount borrowed and
the leverage of the borrower increases. As a
result, those who bear the risk on these networks
have at least some incentive to monitor and control the size of their net debit exposures to any
given participant.
Too much risk
Although the Fed on Fedwire and receiving
banks on CHIPS attempt to monitor and control
their exposures to risk, many observers believe
that the overall level of risk on large-dollar networks is too high from society's perspective. As
an article in the Spring issue of this Bank's Economic Review details, there are several reasons
fbr this view.

First, the intraday credit extended by the Fed on
Fedwire is underpriced. The Fed does not charge
for the time value of the credit it advances when
banks incur "daylight" overdrafts. Similarly, the
Fed does not charge for the default risk it
ass.umes while banks are overdrawn. This underpricing leads participants on Fedwire to incur
daylight overdrafts more often and to a much
greater extent than otherwise, perhaps exposing
the system to greater risk than may be optimal.

Second, Mengle, Humphrey, and Summers have
argued that the incentives to limit the use of
intraday credit on private networks such as
CHIPS also may not be sufficiently strong from
society's perspective. Unlike Fedwire, there is a
risk on a private network that one participant's
inability to settle its debit obligation at closing
would affect others' abilities to settle, and possibly cause a chain of payment failures and disrupt financial markets.
They argue that because any given participant
does not bear the full cost of the risk that it
imposes on the system as a whole, it will not
limit its use of intraday credit sufficiently. (In this
sense, intraday credit on private networks, like
that on Fedwire, can be thought to be underpriced.) Moreover, if the network's participants
bel ieve that the Fed, as lender of last resort
would be willing to avert systemic settlem~nt
failure through open market operations or discount window advances, they would have even
fewer incentives to limit their own reliance on
intraday credit.
For the banks involved in large-dollar payments,
the value of the subsidy provided by underpriced intraday credit has increased over time.
The high interest rates of the late 1970s and
early 1980s made it costly both for banks to
hold reserves (which did not earn explicit interest) at the Fed and for corporations and households to hold zero-interest demand deposits.
Consequently, both groups had incentives to
develop cash management techniques that
reduced holdings of reservable transactions balances and permitted investment in higher yielding instruments. In general, these techniques
reduced required reserve balances by increasing
turnover through an increase in the number and
size of transactions on the wire networks.
Because intraday credit has been underpriced,
few resources were expended to ensure that the
timing of receipts and disbursements matched.
Instead, these systems were designed to rely
heavily on credit to bridge gaps in timing.
Controlling risk
Because of its concern for the risks involved in
~arge-dollar networks, the Fed adopted a policy
In 1986 to reduce risk on private networks and
to tighten control of risk on Fedwire. Under this
policy, banks are encouraged voluntarily to
establish limits on the net amount they can owe
at anyone time across all large-dollar networks
("cross-system sender net debit cap"). Also, they
are encouraged to set limits on the net amount
they can owe to the participants on anyone network. In other words, banks using only Fedwire
or only CHIPS agree to place limits on the

amount they send in excess of what they
receive. Banks using both networks also agree to
limit their overall use of intraday credit such that
an increase in borrowing on one network automatically reduces their borrowing capacity on
the other.
These limits, or "caps," are established as specified multiples of each bank's capital, depending
on that institution's assessment of: 1) its own
creditworthiness, 2) its credit policies towards
customers and other management policies and
controls, and 3) its ability to monitor and control
the intraday credit risk it poses to the network or
the Federal Reserve. Although this program is
voluntary, only those institutions that perform a
self-evaluation and file a cap are permitted to
incur daylight overdrafts on Fedwire. Moreover,
those institutions that are also participants on
CHIPS are required by CHIPS rules to establish
limits on the net amount of credit they are willing to grant to any given sender on the CHIPS
system.
When this policy was first introduced, the Fed
set high multiples for the cross-system caps. The
goal at the time was to give banks an opportunity to adjust to a new regime while reducing
intraday credit usage primarily at the institutions
that incurred the largest overdrafts. Overall
usage was expected to decline by a modest five
to seven percent. In the year or so that the policy
has been in effect, the volume of intraday credit
has declined relative to what it would have been
given the growth in transactions volumes. Moreover, the largest overdrafters have indeed taken
steps to reduce their reliance on intraday credit.
These successes notwithstanding, the Board of
Governors stated even at the time the new policy was announced that it intended to bring
about further reductions in intraday credit usage.
Consequently, the Board recently decided,
among other things, to reduce the cap multiples
by 25 percent. Moreover, the New York Clearinghouse has indicated its intention to move
CHIPS to settlement finality as soon as practicable to reduce the risks associated with delayed
settlement mentioned above.

Implications
The Fed's policy has had the impact of limiting
the availability of intraday credit on wire net-

works. However, even with the most recent
reductions, which will take effect in the first half
of 1988, the extent of this impact will likely
remain modest. If the policy were made more
restrictive, a market for intraday funds likely
would develop, enabling banks that are constrained by one or more caps to purchase funds
for a few hours from banks that are not so
constra ined.
The development of a market price for intraday
funds would have distinct advantages. In general, it would provide price incentives for banks
to reduce their reliance on intraday credit. Currently, only a very few large overdrafters'
behavior is constrained by the caps. A positive
price for intraday credit, by contrast, would
affect banks' intraday credit usage even at levels
below the caps. Consequently, every bank
would have incentives to alter payments practices to match better the timing of receipts and
disbursements. Moreover, for those institutions
that generally do not incur overdrafts, pricing
may provide a modest incentive to hold additional reserves to lend in the intra-day funds
market.
The development of an intra-day funds market
would be especially rapid if the Fed were to
develop a system that charged an explicit price
for daylight overdrafts. Such an approach would
be difficult to implement, given current accounting systems and problems with the queuing of
wire transactions. Potentially, there are more
fundamental difficulties with pricing. Some
observers are concerned about the systemic risks
that might be associated with the incentive overdraft pricing would create to shift risk exposure
now borne by the Reserve Banks to private participants or to other countries where the limits
on overdrafts are not as restrictive.
For these and other reasons, the Board of Governors in late July asked its Large-Dollar Payments
System Advisory Group and a System staff task
force to explore more fully the pricing of overdrafts, further cap reductions, clearing balance
requirements, collateralization, and other techniques for reducing the risks associated with
large-dollar transfers.

Barbara Bennett

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments l 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( -)

Amount
Outstanding

7/22/87
202,710
179,579
51,548
69,445
36,973
5,429
16,171
6,961
203,828
49,599
35,097
19,560
134,669

7/15/87
-

-

844
1,064
380
82
107
2
206
16
5,179
4,559
1,701
177
443

44,426

-

31,653
22,221

-

Period ended

7/13/87

Change from 7/23/86
Dollar
Percent?

Change
from

-

-

-

-

-

2.1
0.6
0.3
3.8
9.9
1.6
53.5
6.1
0.1
0.3
0.6
19.9
2.4

2,473

-

5.2

4,432
2,493

-

12.2
10.0

-

4,269
1,139
164
2,529
4,090
93
5,637
460
285
162
217
3,247
3,370

344

-

149
1,199

-

-

-

-

-

Period ended

6/29/87

24
18
42

217
18
199

1 Includes loss reserves, unearned income, excludes interbank loans
2

Excludes trading account securities

3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers

S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change

-

-

-

-