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August 31, 1990

Moral Hazard in Payments Systems
Payments systems enable financial institutions
and their customers to exchange funds and effect
transactions quickly and efficiently. For highvalue transactions, there are two main payments
systems in the
Fedwire, managed by the
Federal Reserve System, and CHIPS (Clearinghouse Interbank Payments System), managed by
the New York Clearinghouse Association, a group
of private banks. "Large dollar" payments systems can entail considerable systemic risk (that
is, the risk that the failure of one transaction
could trigger the failure of many other, related
transactions). The success of efforts to control
systemic risk depends on how effectively such
measures control the "moral hazard" that is at
the heart of systemic risk. The story of how systemic risk arises, and how effectively moral
hazard is controlled on Fedwire and CHIPS,
are the topics of this Letter.


Risks in payments systems
Transactions initiated through a payments system
typically involve two steps: clearing and settlement. Once the payor (which may be a bank or a
bank's customer) initiates a transaction, the clearinghouse or other system manager debits the system account of the payor's bank and credits the
system account of the recipient's bank; this is the
clearing phase of the transaction. In the settlement phase, the payment is made "final" through
the transfer of "good" funds, which, in the U.s.,
are reserve account balances at the Federal
On Fedwire, settlement occurs prior to clearing,
in the sense that the Federal Reserve credits good
funds to the receiving bank's reserve account at
the time that the bank receives notification of
payment, but it does not debit the sending bank's
reserve account until the end of the day. On
CHIPS, in contrast, clearing occurs prior to settlement; all payments are "provisional" until good
funds are transferred at the end of the day.
Both Fedwire and CHIPS permit participating
banks to send payments during the day that exceed the balance in their reserve account. On

Fedwire, where transfers are final at the time of
notification, this practice puts the Federal Reserve in the position of granting intra-day credit
("daylight overdrafts"), which, in turn, exposes
the Fed to the risk that the sending bank could
fail before the end of the day and not cover its
overdraft. On CHIPS, in theory, no analogous
credit is extended, since all payments are provisional until settlement at the end of the day.
At the same time, however, it is common practice on all large-dollar systems for participants
to make transferred funds available to recipients
soon after notification of payment. To the extent
that CHIPS participants are doing this, they are
making funds available before settlement, and
are thus exposing themselves to credit risk. For
example, by allowing recipients to withdraw
funds from their account before settlement,
CHIPS participants face the risk that in the
event good funds to cover the withdrawals are
not forthcoming, they will not be able to recover
the funds from their customers.
On systems such as CHIPS, where there is some
risk that initiated transactions will not be settled,
there also exists a "systemic risk" that one participant's settlement default will trigger a chain
reaction, resulting in many interdependent transactors being unable to settle. Systemic risk, as
distinct from the credit risk faced by individual
participants, exists because of a "moral hazard"
problem; namely, individual participants do not
bear all the risk that their transactions generate.
The costs of systemic risk include both the costs
of the increase in credit risk faced by interdependent participants and the transactions costs of
"unwinding" defaulted payments, which, for a
major default, might entail substantial disruption
in financial markets.

Controlling systemic risk
To control systemic risk on CHIPS, beginning this
fall; participants will be required collectively to
guarantee transactions on this system by posting
a total of about $4 billion in collateral to cover
defaults by system participants. The collateral

fund technically should eliminate most of the
systemic risk on CHIPS, since all but the largest
defaults would be covered, thereby short-circuiting a chain of defaults among many participants.
On Fedwire, the Federal Reserve's offer of
immediate payment finality precludes systemic
risk. By granting immediate credits to receiving
banks' accounts and delaying debits from sending banks' accounts, there is no risk to participants that a transaction will not settle; the
Federal Reserve System takes all of this risk upon
itself. When defaults occur, the Federal Reserve
usually provides the liquidity to cover them. The
most well known example of this involved the
liquidity crisis of Continental Illinois Bank in

Moral hazard
However, when credit risk borne by the bank
receiving payment is systematically reduced,
banks may lose any incentive to control their
credit risk exposure to other payments system
participants. Because each individual bank's risk
is perceived to be lower, its use of the payments
system and exposure to other participants will
increase. Thus, the very measures that are
designed to reduce systemic risk in payments
systems also may exacerbate the moral hazard
that under! ies system ic risk.
Consequently, on CHIPS, it is possible that the
new collateral fund would not be effective in
reducing risk, were it not for additional measures
that will be put in place, as discussed below.
Likewise, Fedwire officials have taken a number
of steps to control risk, recognizing that the
Federal Reserve's provision of daylight overdrafts
and guarantee of payments finality otherwise
would tend to aggravate moral hazard.

Reducing moral hazard
Both Fedwire and CHIPS are attempting to
reduce moral hazard, and thereby both systemic
risk and the risk exposure of the respective guarantors, the Federal Reserve in the case of Fedwire
and the contributors to the collateral fund in the
case of CHIPS.
At present, Fedwire policy requires that participants set sender "net debit caps" limiting the net
amount that they can send in excess of what they
receive. These caps limit daylight overdrafts and
therefore the Federal Reserve's exposure to credit

risk. Moreover, the Federal Reserve is proposing
that beginning in mid-1991, banks will be required to pay 0.25 percent interest (annual rate)
on the amount of their average daily intra-day
Fedwire overdrafts that exceeds 10 percent of
their risk-based capital. Such a fee presumably
1 I
woula give reawlre paruclpams an even greater
incentive to reduce their daylight overdrafts and
thereby the risk exposure of the Federal Reserve.
However, the fee most likely is too far below the
true time value of money to be effective. In comparison, the interest rate on reserves banks lend
one another overhight in the federal funds market
currently is around eight percent. Moreover, the
overdraft fee is tied neither to an institution's
credit-worthiness nor to the riskiness of the particular transaction. This further diminishes the
fee's effectiveness in inducing desired changes
in banks' behavior.
Thus, a higher, risk-adjusted fee may be appropriate, even though some observers worry that a
high overdraft fee would induce Fedwire participants to try to synchronize payment inflows and
outflows, thereby obstructing the smooth and
efficient operation of Fedwire. If the overdraft
fee were in fact so high that banks would prefer
to delay transactions, we would expect the emergence of a private intra-day market to compete
with the F~deral Reserve Banks in providing intraday good funds credit. Such a market could be
expected to set risk-based prices for credit,
which, in itself, would be beneficial in reducing
systemic risk.

CHIPS' loss-sharing rule
On CHIPS, the proposal to reduce systemic risk
also attempts to limit moral hazard. As discussed
earlier, CHIPS is proposing to require each participant to post collateral to fund a $4 billion
pool that would guarantee settlement by covering virtually all defaults. The amount of collateral
required of each participant will be determined
by a loss-sharing formula, up to a predetermined
maximum. This loss-sharing formula stipulates
that a given participant's obligation to cover another's shortfall will be higher the higher is its
allowable credit exposure to that participant.
Each CHIPS participant is required to establish
a net credit limit on its transactions with every
other participant. These "bilateral credit limits"
determine the maximum amount of payments

outstanding that a participant is willing to accept
from another, net of the payments it has outstanding to that other participant.
The CHIPS loss-sharing formula thus draws a
direct link between each bank's self-determined
maximum exposure to a given counterparty and
its liability for losses due to the default of that
counterparty. In this way, the rule should give
banks an incentive to limit their potential bilateral credit risk exposure and thereby their potential contribution to systemic risk. !n addition, it
should give receiving banks an incentive to set
lower credit limits on their transactions with less
credit-worthy sending banks. This approach
could prove highly effective in controlling systemic risk and moral hazard, provided participants have timely access to accurate information
regarding other participants' behavior.
A private market?
Some have argued that the best way to control
the risks involved in large-dollar payments systems is to allow a private market for intra-day
funds to develop. Such an interbank market, the
federal funds market, already operates for overnight funds. The primary reason it does not provide an intra-day credit facility is that the Federal
Reserve has been providing unpriced intra-day
credit on Fedwire.
In a private market, credit would be priced
according to the credit-worthiness of the borrower, thereby providing incentives to control
risk. Critics of such a proposal contend that the
risk-based pricing that would arise in a private
intra-day credit market would not adequately
take into account systemic risk. The experience

of existing private clearing and settlement systems, which face systemic risk problems, suggests that this concern may be unfounded,
however. The proposed collateral fund for CHIPS,
for example, is one way to control systemicrisk.
In addition, the private clearinghouses for the
futures, options, and stock markets, such as the
Options Clearing Corporation, effectively control
systemic risk by legally assuming the obligation
of guaranteeing the execution of each trade.
Guaranteeing the execution of every trade, it is
true, aggravates moral hazard, but these clearinghouses have taken a number of steps to reduce
the probability that a member will default. For
example, they set capital requirements, position
limits, and other financial standards for members, they collect margin payments (a kind of
collateral), and they continuously monitor the
financial strength of and portfolio positions
taken by member firms.
For the future•••
The steps proposed by Fedwire and CHIPS to
limit systemic risk and control moral hazard will
strengthen the U.S. financial system. The proposed overdraft fee for Fedwire is a first step in
reducing the potential liability of the Federal
Reserve for losses due to Fedwire participant
defaults. However, more extensive efforts to
control moral hazard on Fedwire may be called
for. In particular, risk-based overdraft fees and the
type of loss-sharing rule proposed for CHIPS are
indicative of the kinds of practices that could be
considered for Fedwire in the future.
Elizabeth Laderman

Opinions expressed in this newsletter do not necessarily refiect the views of the management of the Federai Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) 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.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
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