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INTRADAY CREDIT: RISK, VALUE, AND PRICING
David L. Mengle, David B. Humphrey, and Bruce J. Summers*

I.

Introduction
Electronic payment networks are of value because they
provide certainty of payment, security, timeliness, and low
cost relative to the dollar value transferred.1 Timeliness
is particularly important to money market participants who
want to be able to act immediately on changes in market
conditions, but it does not come without cost. While banks
have invested heavily in speeding up wire transfers, the
same level of emphasis has not been placed on controlling wire transfer risk. Because the banking system does
not exactly synchronize the increasing volume of intraday
payments activity, outgoing transfers are not always adequately funded by the originating party. Consequently,
wire transfer networks are characterized by exposure of
participants to intraday credit risk, that is, risk that
lenders may not be repaid at the end of the business day.
Traditionally, bank regulation has focused on risks
reflected on bank balance sheets. For example, bank
supervision attempts to reduce credit risk from loan losses
by examining asset quality, while capital requirements seek
to build a protective buffer into balance sheets. More
recently, regulators have also become concerned with risks
connected with growing off balance sheet activities such
as letters of credit and loan commitments.2 Now, intraday credit risk associated with wire transfer networks is
attracting attention. This risk cannot be measured by traditional methods that focus on balance sheets showing
banks’ financial positions only at the end of the day. Even
looking at contingent liabilities off the balance sheet does
not help here. Rather, one must look at payment activity
during the day to see how intraday financial intermediation affects the banking system.
The purpose of this article is to develop a framework
to illustrate why intraday credit risk exists and what determines its level. The analysis will show how pricing intraday credit could lead to behavioral changes that would
reduce intraday risk exposures. In addition, the empirical
section of the paper will explore ways in which pricing
might be put into practice.
The views in this article are those of the authors and do not necessarily
reflect the views of the Federal Reserve Bank of Richmond or the Board
of Governors of the Federal Reserve System. The authors wish to
acknowledge the expert research assistance of William Whelpley. Section IV and the box on pp. 8-9 are based on Humphrey et al. (1987).
1

The most important wire transfer networks are described in more detail
on p. 4.
2

Bennett (1986) and Summers (1975).

Most discussions of risk on wire transfer networks
assume either explicitly or implicitly that intraday credit
risk arises from the inherent nature of electronic funds
transfer systems.3 By this assumption, the level of risks
faced by payments system participants is attributable to
such institutional factors as the large volume of wire
transfers, a high degree of interdependence among banks,
the speed with which funds change hands, and the extreme difficulty of exactly matching inflows with outflows.
In contrast, it will be argued here that risk levels and the
institutional factors that determine them are primarily a
product of the existing legal and regulatory environment
rather than simply intrinsic to the technology of wire
transfer systems. If laws, regulations, and expectations
regarding Federal Reserve policy were different from what
they have been thus far, institutional practices and levels
of intraday credit risk would also be different.

II.

Risk and Wire Transfer Networks
At present, the two major wire transfer networks are
Fedwire and the Clearing House Interbank Payment
System (CHIPS). The form intraday credit risks take differs for each network.4 On Fedwire, transfers take place
by debiting the reserve account of the sending bank and
crediting the reserve account of the receiving bank.
However, the sending bank is not required to have funds
in its reserve account sufficient to cover the transfer at
the time it is made. Rather, the transfer must be covered
by the end of the day. Allowing reserve balances to
become negative during the day leads to “daylight overdrafts,” and it is these overdrafts that are the major source
of risk to Federal Reserve Banks from Fedwire. Since a
Fedwire transfer becomes final when the receiving institution is notified of the transfer, the Federal Reserve could
not revoke the transfer if the sending institution failed
to cover its overdraft by the end of the day. Thus, the
receiving institution would have its funds while the Fed
would be left with the task of collecting the payment from
the defaulting sending bank. Credit risk in this case is
borne by the Reserve Banks and possibly by the public.
3

See, for example, Association of Reserve City Bankers (1983) and
Smoot (1985).

4

For a more detailed discussion of risks on electronic funds transfer
networks, see Mengle (1985).

FEDERAL RESERVE BANK OF RICHMOND

3

WIRE TRANSFER NETWORKS
Fedwire is the wire transfer network operated
by the Federal Reserve Banks. Currently, approximately 200,000 Fedwire funds transfer transactions totaling over $500 billion occur on an
average day. Mean transfer size is about $2.5
million. Transfers involving book-entry U.S. government securities total well over 30,000 per day
for a total daily value of over $260 billion. Average
securities transfer size is $8.7 million. Both funds
and securities transfers have grown dramatically over
the past decade. An important distinction between
Fedwire and other networks is that settlement of
transactions made over Fedwire is immediate, inasmuch as it occurs by means of credits and debits
to depository institution reserve accounts on the
books of the Federal Reserve Banks. Because the
immediate settlement feature means that Fedwire
transactions constitute “good” or final funds as soon
as notification of payment is made, banks participating in Fedwire as receivers of payments are
relieved of risk. The risk that the sending bank may
not be able to fund its position is borne by the
Federal Reserve when it accepts and settles a Fedwire transfer.

Because CHIPS, a private wire transfer network, is a
net settlement system, it presents a more complex set of
risks. With net settlement, actual transfer of funds does
not occur until settlement of net positions takes place at
the end of the day. But bank customers may be given
access to these transfers prior to settlement, creating credit
risk that a sending bank might fail to settle. This leads
to systemic risk, in which the failure of one system participant to settle its debit obligation to other participants
in the network might, if the debit were large enough, lead
to a domino-like pattern of settlement failures among other
participants. Such risks are found on CHIPS not only
because net debit positions and dollar values are large, but
also because there is uncertainty regarding the precise
rights and liabilities of all parties to a payment transaction in the event of a settlement failure. Statutory law is
unclear in this area and, since a settlement failure has never
actually occurred, case law has not developed to fill the
void.
4

CHIPS The Clearing House Interbank Payments
System (CHIPS) is a privately operated funds
transfer wire network associated with the New York
Clearing House. About one-half of its transfers concern international dollar transactions involving U.S.
depository institutions. As of the end of 1986, approximately 114,000 funds transfers amounting to
almost $425 billion were transacted on CHIPS
daily. The average transaction was approximately
$3.7 million. CHIPS was started in 1970 to efficiently transfer interbank balances involving international transfer of dollars on the books of the twelve
New York Clearing House Association banks. This
essentially eliminated the use of the paper draft to
effect the transfers. While payment messages are
sent over CHIPS throughout the business day,
actual settlement of net debit and credit positions
takes place at the end of the day through a special
account at the Federal Reserve Bank of New York.
Membership in CHIPS for other depository institutions is provided through an associate membership
arrangement. Associate members must settle their
CHIPS transfers on the books of one of the twelve
New York banks (also known as settling banks).

At the end of 1986, the size of the average funds transfer
on Fedwire was $2.5 million. On CHIPS, the average
funds transfer was $3.7 million. Securities transfers over
Fedwire averaged $8.7 million. Given the growing number
of such large transfers each day, there is increasing concern with the credit risks assumed by banks as they clear
payments many times the size of their reserve positions.
An idea of the size of payments relative to reserve balances
may be seen in Chart 1, which shows the ratio of average daily payments through the major payment networks
to average daily reserve balances maintained with the
Federal Reserve Banks. This ratio is a rough measure of
the leverage exerted using reserve balances to support payment activity. The ratio has increased steadily from only
about .9 in 1960 to over 30 by 1985. The largest increase
in payments has taken place on Fedwire and CHIPS, both
of which are used primarily for money market activity and
third party payments. The growth of wire transfers has
far exceeded that of checks.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

Chart 1

RATIO OF
PAYMENTS TO RESERVES
1960 - 1985

1960 1965 1970 1975

1980 1985

Note: Payments are average daily dollar volume of checks, and
Fedwire, CHIPS, and ACH credit payments. “On us” checks are
excluded. Reserves are average daily reserve balances.

III.
The Nature of lntraday Credit Risk
Demand for Intraday Credit5
Payments system participants value intraday credit on
electronic funds transfer networks because wire transfer
payments and receipts are not perfectly synchronized.
Intraday credit is an alternative to delaying payments
until they are funded by receipts. In addition, it eliminates
the necessity of holding clearing balances large enough to
cover all expected outflows of funds. By using intraday
credit, payments system participants escape the costs of
scheduling payments to match receipts, along with overnight interest and opportunity costs of maintaining higher
reserve balances. In short, there would be little if any demand for intraday credit if it were not costly to schedule
all receipts to arrive at a bank in time to fund payments
to be sent out.
5

In the remainder of this article, intraday credit will refer to both
Fedwire daylight overdrafts and CHIPS net debits. Neither necessarily
involves overdraft credit extended by banks to corporate customers.

The cost of synchronizing payments and receipts is
likely to grow as funds transfer volume expands. Thus,
anything that increases volume is likely to increase
demand for intraday credit as well, other things staying
the same. Contributing to higher payment volumes and
demand for intraday credit are two legal requirements that
cause banks and their corporate customers to use more
funds transfers than would otherwise be the case.
First, prohibitions on paying interest on demand deposits held by medium- and large-sized businesses create
incentives to reduce these deposits to the minimum each
evening in order to put funds to work earning interest.
The resulting investments in overnight money market
instruments lead to a higher volume of Fedwire and
CHIPS transfers than would otherwise occur. This means
a higher probability that the banks through which these
transactions are sent will go into overdraft. Second,
Federal Reserve Banks cannot pay interest on reserve
balances held by depository institutions. Since demand
deposits are subject to higher reserve requirements than
are other deposits, paying interest on reserves would
reduce the cost to banks of paying interest on demand
deposits.
Besides bridging payments and receipts, intraday credit
on wire transfer networks also enhances the ability of
banks and their customers to make an immediate payment
considered final by all parties involved whether or not
sufficient clearing balances are held at the time of the
transfer. Without intraday credit, final payment could only
be made if sufficient clearing balances were on hand.
Alternatively, immediate use of funds would be possible
using a check or cash, but the opportunity costs of using
these other means of payment are relatively high.
For example, in order for a check recipient to gain immediate access to funds, he or his bank would have to
present the check for collection at the paying institution.
If the check were written on a bank in another city or
country, immediate (or same day) access to funds could
be quite costly, if not downright impossible in certain
situations. Thus, even if the explicit costs (in the form
of charges and fees) of payment by check are lower than
those of wire transfer, the implicit costs of getting the
check to the payor bank, along with foregone interest
when same day presentment is not feasible, are likely to
be higher. As an alternative to payment by check, payment in cash would give the recipient immediate use of
funds. Still, there is a relatively high risk of loss or theft.
In addition, transporting large amounts of cash can be
cumbersome and time-consuming. As with checks, the
implicit costs of using cash to gain immediate use of funds
are likely to be much higher than those for wire transfers.
This more than offsets the relatively high observed
explicit wire transfer costs.

FEDERAL RESERVE BANK OF RlCHMOND

5

The demand for intraday credit is portrayed as the
demand curve in Figure 1. The horizontal axis measures
the dollar volume of intraday credit within a given time
period, and the vertical axis shows the value placed on
each additional dollar of credit. As is generally the case
for other goods and services, the demand curve is expected
to be downward sloping, although very little is known
empirically about the curve. It is reasonable to say,
however, that as the price of intraday credit is raised,
payments system participants can be expected to use less
of it. That is, banks will use more intraday credit so long
as the extra revenue generated by the credit exceeds what
must be given up to use it.
Changes in the overall value placed on intraday credit
would shift the entire demand curve. For example,
demand could shift due to structural changes in the
banking system that make intraday credit less useful to
banks. Specifically, if all unit banking states converted to
unlimited branching, large banks in unit states that
previously gathered funds through the federal funds market
would now be able to provide some part of them internally through branches rather than continue to purchase
them from other banks. Since fewer electronic funds
transfers would be necessary, demand for intraday credit
would decrease and the curve would shift to the left. The
shift would likely be greater if, along with unrestricted
intrastate branching, interstate banking were permitted on
a wider scale than today.

Figure 1

MARKET SUPPLY
AND DEMAND FOR
INTRADAY CREDIT

Volume of
lntraday
Credit

6

The elasticity of demand, that is, the sensitivity or
responsiveness of volume of intraday credit demanded
to changes in its price, is determined by existing
technological factors and institutional payment practices.
Since technology and institutional practices are costly to
change quickly, demand may be expected to be more inelastic (that is, less responsive to price) in the short run
than over a longer period. Given more time to adjust,
banks would be better able to develop substitutes for intraday credit for processing payments. Examples of institutional changes that could serve as substitutes making the
curve more elastic are discussed separately in “Institutional
Changes That Reduce Intraday Credit Risk,” page 8.
Supply of Intraday Credit
If intraday credit were supplied in a private market in
which all parties bear directly the costs they incur, the
supply curve for intraday credit would slope upward to
reflect the increasing opportunity cost of additional units
of credit. This cost would in turn consist of transactions
costs plus two elements. The first is the value of intraday
credit to suppliers, that is, the value suppliers place on
using additional units of credit themselves.6 The second
is a premium to compensate suppliers for credit risks
assumed. At present, however, there is no active private
market for intraday credit. In order to both simplify the
exposition and concentrate on the risk issues involved,
the supply curve presented in this analysis will be
assumed to reflect only transactions costs plus costs related
to risks, and will abstract from the value of intraday credit
to suppliers.
The current supply curve (S0), showing how the
marginal or incremental cost of additional units of intraday credit changes with volume supplied, is horizontal in
Figure 1 because the only cost to banks of each additional
dollar of intraday credit used is the transactions cost of
the transfer. This transactions cost, represented by the
vertical distance OH, is assumed to remain constant as
volume increases. Higher volumes of credit extended
during a period, however, mean higher potential losses,
so the true opportunity cost of intraday credit is better
portrayed as rising as more intraday credit is extended.
The shape of supply curve S1, then, illustrates the full
social costs of wire transfer intraday credit due to risks
to the payments system. But under the current institutional and regulatory framework, S0 is the supply curve
faced by depository institutions on both Fedwire and
CHIPS, so private costs associated with intraday credit
volume Q0 diverge from actual costs to society by an
amount equal to the area of triangle HFG in Figure 1. The
reasons banks do not face the full costs they incur differ
between the two networks.
6

In loanable funds analysis, this is called the risk-free rate, and it reflects
the pure time preference component of interest.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

On Fedwire, the supply curve perceived by banks is
horizontal mainly because the current charge levied by
Federal Reserve Banks on each transfer does not vary to
reflect the amount of intraday credit extended. Fedwire
fees do not take account of the size of daylight overdrafts
associated with the payments being processed, even
though the Federal Reserve assumes the risk that a
daylight overdraft will not be covered by the end of the
day. Thus, the availability of unpriced daylight overdrafts
guaranteed by the Fed leads to a supply curve (S 0) for
banks that does not reflect the full costs they incur, and
area HFG represents an implicit subsidy from the Federal
Reserve to banks using intraday credit on Fedwire.
On private net settlement networks such as CHIPS, the
supply curve faced by payments system participants
diverges from the supply curve reflecting risks to society
the same as occurs on Fedwire. This reflects the degree
to which systemic risk may not be borne by CHIPS participants. The divergence is at least partly due to the belief
of some CHIPS participants that the Federal Reserve as
lender of last resort would intervene to prevent systemic
failure rather than allow a chain of settlement failures to
significantly disrupt financial markets. If payment network
participants believe that regulatory agencies would likely
take actions to enable a failing institution to complete
settlement, then the consequences of one institution’s
failure to settle would not appear as severe to the other
participants as would be the case if they had to bear the
risk themselves. For example, if a discount window loan
were extended to a bank failing to settle on a private sector wire transfer network, systemic failure would be
averted. However, the assumed availability of such a loan
would also reduce incentives for receiving banks to
monitor the riskiness of sending banks. As a result,
existing institutional arrangements on such networks are
likely to be more risk-prone than would be the case if the
Federal Reserve were expected definitely to take a “handsoff’ attitude toward settlement failures regardless of the
consequences for financial markets.7
Another factor contributing to the divergence between
costs perceived by CHIPS participants and costs to society
is the lack of a uniform body of law dealing with electronic
funds transfers. The Uniform Commercial Code and
CHIPS rules are silent regarding when payment obligations between customers are discharged and payments are
final. Consequently, it is not nearly as clear who would
bear the risk if a sending bank on CHIPS were to fail to
settle as it is with, say, check payments. Although
receiving banks might attempt to revoke funds they had
released to receiving customers, there is no assurance that
they would be successful. If revocation is successful,
receiving customers might then attempt to collect pay7

Stevens (1984).

ment from sending customers. This could be a problem,
however, if the sending customer had released funds to
the sending bank that failed before settlement. Because
the law does not specify whether the sending customer
had discharged his payment obligation to the receiving
customer, the assignment of risks between the parties to
the transaction is unclear. In such an environment, incentives for receiving banks to monitor risks could be weaker
for some participants than they would be if the assignment
of risks and liabilities were more explicit.
On both Fedwire and CHIPS, the height of the true
supply curve (S1) and the degree to which it slopes upward is influenced by at least two factors. First, since the
marginal cost of intraday credit is largely determined by
expected losses if an institution defaults, the supply curve
will probably be higher as the riskiness of the banking
system in general grows. Second, if banks augment their
capabilities to monitor and control risks associated with
intraday credit, the supply curve will likely shift down or
become flatter. Thus, even if banks continue to perceive
their supplycurve as the horizontal portion of S0, policies
that reduce risks connected with banking and that encourage risk control will have the effect of reducing the
intraday credit risk associated with the divergence of
private from social costs of intraday credit.
Equilibrium
Equilibrium in the market for intraday credit is found
where the extra (or marginal) cost to a depository institution of an additional million dollars’ worth of intraday credit
equals its extra benefit in terms of facilitating payments
or other benefits to the using institution. The equilibrium
will determine the level of intraday credit risk in the
payments system.
When individual payments system participants face the
horizontal supply curve S0 in Figure 1, they do not
themselves face all the costs and risks they create.
Equilibrium volume of intraday credit is Q0 and total costs
due to intraday credit risks are HFG. In contrast, if
depository institutions face the full costs of their decisions as reflected in supply curve S1, equilibrium volume
of intraday credit is Q1 and the total cost associated with
intraday credit risk is the area HEI.
The difference in costs between using S0 and S1 as the
supply curve is EFGI. Of this area, EGI represents a
transfer from society in general to payments system
participants in particular, while EFG represents a cost to
all of society. Since actual costs to society exceed the value
of the intraday credit to institutions participating directly
in the payments system, risk levels are higher than
optimal.

FEDERAL RESERVE BANK OF RICHMOND

7

INSTITUTIONAL CHANGES THAT REDUCE INTRADAY CREDIT RISK
Many banks negotiate overnight federal funds purchases in the morning, leading to an inflow of funds
to the borrowing banks later the same day. The
following morning, the borrowings are repaid. The
cycle repeats itself day after day for many net buyers
of fed funds. Although the banks often end up borrowing similar if not identical amounts from the same
lending banks each day, the borrowers repay most
of their fed funds loans each morning in order to
have the flexibility to react to changed borrowing
requirements. In addition, they are able to take advantage of favorable rates that arise during the day.
Finally, lending banks are assured control over their
funds before they are re-lent.
These funding practices are encouraged by two
aspects of the legal and regulatory environment.
First, federal and state laws do not yet allow nationwide branching. If banks could branch nationwide,
relatively more funds would be gathered internally
from branches rather than externally from the fed
funds market. Because fed funds flows move between banks over wire transfer networks, eliminating
branching restrictions would mean fewer fed funds
transactions and therefore lower daylight overdrafts.
Second, in terms of regulatory environment, so long
as daylight overdrafts are kept within a bank’s net
debit cap, there is no explicit penalty for overdrafting. Thus, branching restrictions give banks
incentives to borrow more from each other than
would otherwise have been the case, while the lack
of penalties turn daylight overdrafts into a low cost
liabilities management tool.
If branching restrictions continue, what institutional practices might be expected to change if
intraday credit in the form of daylight overdrafts
were priced? Many likely changes are relatively well
known and involve both reduction of the daily
payments volume over external wire transfer networks and elimination of the current gap in processing time between totally or partially offsetting
payments. For example:
(1) Rollovers. The same amount of overnight (or
longer) funds borrowing is renegotiated with
the same seller. No funds move over the wire
networks except the initial borrowing and the
final repayment. Importantly, there is no time
gap between daily repayment of borrowed
funds and receipt of borrowings for the next
time period. As a result, the value of
payments over wire networks is reduced, the
time gap is eliminated, and associated daylight overdrafts fall.

8

(2) Continuing contracts. Differing amounts of

daily funds borrowings are renegotiated with
the same sellers so only the net change in the
position (including interest) is sent over the:
wire. The value of the single net transfer is
less than either the (early in the day) full
repayment of the gross funds borrowed or the
(later in the day) full reborrowing of an altered
gross amount for the next period. Because the
value of payments made is reduced and the
time gap between the two gross flows eliminated, overdrafts fall.
(3) Term funds. Longer-term borrowings are
substituted for overnight funding. Overdrafts
fall due to the lower average daily value of
funds sent and returned over the wire network, as well as the now more infrequent
daily time gap between return of borrowed
funds and subsequent reborrowing.
(4) Intraday funding. Excess funds or unused
overdraft cap capacity are sold and sent to
other payments participants to fund, for a
price, what otherwise would be daylight
overdrafts at the purchasing institution.
(5) Netting by novation. Gross bilateral payment
obligations are netted using contracts among
the parties prior to the value or settlement
date. Both legal exposure to payment obligations and payment flows satisfying the
obligations are reduced from gross to net
positions. This eliminates the time gap between flows and thereby reduces both
measured overdrafts and risk.
The first three institutional changes or alterations
in interbank funding procedures existed prior to the
Federal Reserve’s risk reduction program and there
is some anecdotal information that these procedures
are being pursued more intensively than before. In
addition, the American Bankers Association has formally supported the first two methods.
The fourth method-intraday funding- has apparently not yet been used to reduce overdrafts.
This may be due to the extra costs that would be
incurred relative to other overdraft reduction alternatives and because of the extra operational efforts
associated with using intraday funds. It is possible
that adoption of policies to price intraday credit (see
p. 10) could lead to an intraday credit market in two
ways. First, if the daylight overdraft fee on Fedwire
were set at a very high level, banks might begin to

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

exchange intraday funds among themselves at rates
lower than the administered rate. On CHIPS, if new
risk bearing arrangements lead banks to perceive
significant risks in the system, they may wish to borrow intraday funds to cover their net debit positions
and reduce the risks. Second, if pricing were instituted in connection with caps that were so low
as to be binding for many banks, institutions with
unused cap capacity might lend to those constrained by the caps. In this case, there would be
two prices for intraday credit, the administered Fed
price and the intraday funds market price.
The fifth method-netting by novation-is currently in the experimental stage. New legal contracts
providing for this type of netting are now being
used by some U.S. banks in the London forward
foreign exchange market and there are plans for their
possible application to certain types of transactions
over CHIPS. There has been no known netting by
novation application over Fedwire so far, but some
transactions could probably be handled in this
manner.
Federal Reserve analyses in 1980 and 1982, summarized in greater detail in Humphrey (1984, pp.
86-89), suggested that upwards of 80 percent of all
Fedwire funds transfer plus securities transfer
daylight overdrafts at large banks (deposits of $1
billion or more) could be eliminated if certain
amounts of interbank overnight borrowing were
shifted to term borrowing or multi-day continuing
contracts. At the time of the analyses, large banks
accounted for over 90 percent of all funds and
securities transfer daylight overdrafts. About onehalf of these banks could eliminate all their funds
plus securities overdrafts by shifting 2.5 percent of
overnight funding to term funding. For some of the
remaining large banks, the shift would have to exceed 100 percent. However, many securities
transfer overdrafts are to be collateralized in order
to lower risk to Reserve Banks. With collateralization, the percentage shifts from overnight to term
funding (or rollovers or continuing contracts) required to eliminate funds transfer daylight overdrafts
(and the remaining securities transfer overdrafts that
cannot be collateralized) would be reduced. As a
rough approximation, the above required percentage
shifts of 25 and 100 percent could fall to 13 and
50 percent. Thus, widespread adoption of some or
all of the five institutional changes listed above would
virtually eliminate funds transfer daylight overdrafts
from Fedwire.

Note, however, that it is not necessarily in the interest
of the payments system to purge the system of all intraday credit risk, but rather to ensure that costs to everyone
do not exceed benefits. So long as the value placed on
an additional dollar of intraday credit by payments system
participants is greater than the cost in the form of risk to
the rest of the payments system, it is in the interest of
payments system participants and the rest of society to
incur that risk. Thus, the purpose of risk control policies
is not to eliminate risks, but rather to confine them to
levels considered acceptable.
Policies to Control Risks
Caps and Limits In recognition of concerns about
intraday credit risks, the Board of Governors of the Federal
Reserve System in 1986 implemented a voluntary program to limit intraday credit and improve control over risk
by users of all large dollar wire transfer networks.8 The
current program is voluntary and consists of three main
elements.

(1) Banks using any large-dollar wire transfer system
are requested to perform a self-evaluation based on
their operational and credit controls, policies, and
procedures, as well as their creditworthiness or
ability to fund themselves to cover unexpectedly
large funds outflows or reduced inflows.
(2) Based on the results of the self-evaluation, each
participant adopts a total ratio of Fedwire daylight
overdrafts plus CHIPS net debits to capital as its
limit on how much a participant may send out in
excess of what it receives across all networks.
The ratio is called a cross-system net debit cap
multiple.
(3) Participants also establish network-specific sender
net debit caps as well as bilateral net credit limits
(limits on how much a receiving bank may be a
creditor to a particular sending bank) on CHIPS
to obtain net settlement services from the Federal
Reserve.
Under the policy, CHIPS participants are required to
compute two net debit caps. First, cross-system caps
covering Fedwire and CHIPS together are calculated as
a multiple of capital. Second, a network-specific cap for
CHIPS is based on a formula that attempts to capture the
market’s assessment of other CHIPS participants’ soundness. If a bank only uses Fedwire, then its cross-system
cap and its network-specific cap are one and the same.
In Figure 1, the risk control policy is illustrated as the
vertical portion of the supply curve, S,. While intraday
credit within the caps is still not explicitly priced, it is
not permitted to rise beyond the level of the caps, Q 0.
8

Board of Governors (1985).

FEDERAL RESERVE BANK OF RICHMOND

9

This shows an advantage of net debit caps, namely, they
are sure to restrict overdrafts to levels specified by policymakers. In terms of Figure 1, they are designed to limit
intraday credit, and they do not necessarily shift the supply
curve faced by depository institutions from S0 to the curve
reflecting all costs to society (S1).
A disadvantage is that caps could either underconstrain
or overconstrain intraday credit. Figure 2 shows two possible effects for individual institutions rather than for the
entire market. The cap level represented by s2 brings
about some reduction of overdrafts below the unconstrained overdrafts level. While such caps are binding for
a very small number of institutions, they underconstrain
because they allow a level of intraday credit (q2) above
the equilibrium level that would prevail if banks faced the
full costs of their decisions (q0). The dotted area in Figure
2 shows how underconstraining leaves an excess of intraday credit risk costs over the value of the intraday credit
to the participant. On the other hand, the cap level
represented by s3 reduces intraday credit so low that it
overconstrains. The crosshatched area in Figure 2 shows
that some overdrafts are restricted even though their value
to the institution exceeds their cost to society.
Underconstraining overdrafts appears to be a more
serious problem than overconstraining because it leaves
the payments system with too much intraday credit risk.
More important, there are no incentives for participants

Figure 2

EFFECTS OF RESTRICTIONS
ON INTRADAY CREDIT
(INDIVIDUAL

INSTITUTION)

Volume of
lntraday
Credit

10

to reduce risk toward equilibrium levels. In contrast,
attempts to constrain overdrafts by reducing them “too
much” are less serious because even highly restrictive caps
are not likely to be binding on all institutions. Different
demands for overdrafts by different institutions would lead
to incentives for development of a private market for intraday credit. In such a market, institutions on whom caps,
are binding as shown by s3 could borrow intraday funds
(that is, excess cap capacity) at a negotiated price from
those on whom the caps are not binding. Overall risk levels
would be reduced not only by limiting overall intraday
credit in the system as a whole, but also by diversifying
intraday credit among a larger number of institutions.
Trading excess cap capacity is not the only way an
intraday market could work. If some banks maintain
excess reserve balances during the day while others incur
overdrafts, an intraday market could arise in which funds
were lent and repaid during the business day and were
still available to lend out overnight. This type of market
could arise even if daylight overdrafts were forbidden, since
those who would like to incur overdrafts but cannot will
have the option of borrowing excess reserves in order to
fund payments that would have otherwise created overdrafts.
Pricing Intraday Credit Pricing could be brought about
indirectly by policies that lead to development of an
intraday credit market as just described. Alternatively,
pricing could be adopted directly on Fedwire by levying
explicit fees on daylight overdrafts. Likely market effects
of pricing on Fedwire are shown in Figure 3. Fedwire overdrafts are priced at Pf. Banks will overdraft up to the
point at which the price they pay is equal to the value
they place on the credit.9 Thus, charging a fee for Fedwire overdrafts has an effect similar to that of binding caps,
that is, lower overdrafts.
On CHIPS, it is less clear how explicit pricing could
operate. A possible solution is to devise policies that
attempt to shift the supply curve faced by CHIPS participants from S0 in Figure 3 to that reflecting the full costs
to society (S1). In other words, risk control policies could
attempt to lead banks to internalize the risks in the
payments system.
Shifting the supply curve could take the form of policies
under which CHIPS and other net settlement networks
bear more directly the risks of a settlement failure. For
example, a sending bank could effectively post a bond
against failure to settle its obligation by collateralizing its
net debits. Alternatively, losses due to failure of one bank
to settle could be borne by receiving banks that are
creditors of the failed sending bank (receiver finality).
9

For the moment, the analysis conveniently assumes that policymakers
are able to select the “right” price. The problems involved will be dealt
with presently.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

Finally, risks could be shared by the receiving bank and
its customers (settlement finality).10 An example of how
CHIPS participants could reduce risks under such policies
is to not release funds to customers prior to settlement
if the sending bank were either of questionable soundness
or not known to the receiver.
Figure 3 shows the likely short-run and long-run effects
of levying a fee on daylight overdrafts and adopting new
risk bearing measures on CHIPS. On Fedwire, a policy
of overdraft pricing within caps would effectively shift the
supply curve from So up to level Pf. In the short run,
relatively inelastic demand (Dsr) would lead to a reduction of overdrafts to Q1. On CHIPS, since the supply
curve faced by participants is now S,, volume of intraday
credit demanded also falls to Q1.11 Over the long run,
institutional change (as described on page 8) becomes
less costly. This makes demand more elastic over time,
as shown by the long-run demand curve D lr. The result
is that long-run volume demanded falls to even lower
levels on both Fedwire and CHIPS.12
10

In order for the above policies to be effective, all three require that
banks know they will not be released from their obligations in the event
of a settlement failure.
11

If intraday credit were supplied in a private market, determination
of a price would have to take account of the time value of intraday funds
to suppliers. This would place the intraday private market supply curve
above S,.
12

It is also possible that improved risk controls over time would shift
the supply curve down or make it less steep.

Figure 3

MARKET EFFECTS OF
PRICING INTRADAY CREDIT

Volume of
lntraday
Credit

One objection to pricing is that, while it would provide
incentives for most banks to reduce intraday credit, it
would do little to discourage highly risky institutions from
running excessive daylight overdrafts. This would be
especially true of an institution in danger of imminent
failure, the managers of which may be tempted to take
desperate measures. The answer to this objection is to
maintain net debit caps along with pricing. Daylight overdrafts would be permitted to those who pay the price so
long as they did not exceed cap levels, but no overdrafts
would be allowed beyond the caps. Thus, pricing could
be used to regulate overdrafts for most institutions, while
caps would still be there to protect the system against the
highest risk institutions.
The most obvious problem with a policy of pricing
intraday credit is that it is not immediately apparent
what the price should be. While the price shown in
Figure 3 fortuitously matches the price at which benefits
of intraday credit to participants equal costs to society,
there is no guarantee that such a price would necessarily
be chosen. In practice, the price could be set too low or
too high, although the distortions induced by too high a
price could be alleviated by a private market for intraday
credit. Because Fedwire credit risks are currently
absorbed by Reserve Banks without explicit charge,
however, no private market for intraday credit has yet
arisen. In order to demonstrate some practical problems
involved in using pricing to control intraday credit
risk, the following section explores possible ways to
estimate the value of intraday credit to payments system
participants.

IV.
From Theory to Practice:
Determining the Value of lntraday Credit
There are several reasons it would be useful to know
the value of intraday credit. For one, if the Federal Reserve
were to seriously consider pricing Fedwire daylight overdrafts, it would be important to have some idea of the value
placed on intraday credit by market participants. Further,
it would give an indication of what the price of borrowed
intraday funds might be if net debit cap reductions or
pricing were to lead to a private intraday credit market.
Finally, if policymakers wanted to quantify and compare
the benefits and costs of further risk reduction efforts,
estimates of the value of intraday credit would be essential.
If an intraday funds market now existed, it would reveal
the value of intraday credit. No such market has yet
developed to fund daylight overdrafts for at least three
reasons. First, intraday credit risk on Fedwire is not borne
directly by payments system participants, but rather by
the Federal Reserve. Second, the current system of net

FEDERAL RESERVE BANK OF RICHMOND

11

debit caps was initially designed to constrain only those
institutions with the largest overdrafts and to reduce the
aggregate dollar value of daylight overdrafts by only 5 to
7 percent. For the vast majority of institutions, therefore,
caps have not yet been binding. Finally, less costly alternatives to purchasing intraday funds, especially rearranging the timing of nonessential customer payments during
the day, have been available to reduce interbank overdrafts.
The failure of an intraday market for bank reserves to
develop so far does not mean, however, that it is not
practical. In fact, there already exist two markets that
exhibit some characteristics of an intraday market. These
are day loans to securities broker/dealers and intraday
funding associated with the market for overnight funds.
Day loans are advanced by banks to securities dealers
and brokers in order to permit payment by certified check
to sellers at the time of delivery. The market for such loans
is relatively small, averaging perhaps $10 billion per day,
compared with total funds transfer daylight overdrafts of
$76 billion per day. This market is almost entirely confined to New York. The loans are granted for periods less
than a day (six hours or less), are expected to be repaid
by the close of business, and typically cost 100 basis points
(annual rate). Although collateralized by the underlying
securities so that technically a legally perfected security
interest is obtained through the loan agreement, day loans
are usually treated as unsecured due to the difficulty of
taking actual possession of the securities. Day loans
developed because there is a lag between the time
broker/dealers pay for securities, subsequently deliver
them to customers, and receive payment for them.
Brokers and dealers pay by certified check, and funds must
actually be in their account in order for the check to be
certified. Since the large securities purchases exceed
broker/dealer working capital, a loan enables the check
to be certified.
The overnight market for federal funds experiences rate
fluctuations throughout the working day. Even if a bank
starts the day with good information on its funding
requirements, it is often necessary to enter the market
several times during the day to deal with contingencies
that had not been anticipated. Banks may purchase funds
in the morning only to find, later in the day, they are not
needed overnight and must be sold in the afternoon. It
is in this restricted sense that an intraday interbank market
already exists, but it apparently is not yet being used
specifically to fund interbank daylight overdrafts.13
13

The average opening federal funds rate over 1984-85 was 9.14 percent while the average (early) closing rate was slightly lower at 9.12 percent. Thus, borrowing in the morning and reselling the funds in the afternoon could cost 2 basis points (neglecting transactions costs) on average.
By the end of the day when the market is thin, however, the average
difference in rates turns negative to - 15 basis points. This spread
between opening and closing rates would likely turn positive if banks
attempted to profit by the spread by buying in the morning and reselling late in the afternoon.

12

Approximating the Long-Run Value of
Intraday Credit
This section presents five methods which could be
used to determine an approximate value for intraday credit
on Fedwire. The methods are:
Use the existing day loan market rate.
Determine and use as a rate the costs of shifting
from overnight to term funding.
Determine and use as a rate the observed risk
premium between bank certificates of deposit
(CDs) and Treasury bills.
Divide the overnight rate by eight to obtain an
implied rate for overdrafts lasting three hours.
Extrapolate an estimated yield curve backwards to
determine an implied rate for three hours of overdrafts.
The first three alternatives develop prices that do not vary
according to the length of time an institution is in overdraft. In contrast, the fourth and fifth alternatives attempt
to determine a value for three-hour increments of Fedwire overdrafts, which is the average length of time a bank
incurs these overdrafts.
Existing Day Loan Market Rate It is possible that the
rate on day loans used by broker/dealers to finance
securities purchases prior to delivery and payment by
customers could be used to approximate a daylight overdraft price. While there is some variation in this intraday
rate, reflecting the risk of the securities issued and used
as collateral for the loan, the rate is largely administratively
determined, has little variation over time, and is typically
100 basis points (on an annual basis).
In this alternative, the broker/dealer intraday funds rate
of 100 basis points represents a market rate on a
(technically) secured intraday loan for perhaps six hours,
while Fedwire overdrafts subject to the cap are unsecured
and typically average around three hours a day (for all overdrafting institutions).14 Although day loans may be secured
in the strict legal sense, the arrangements used are loose
enough that the loans are usually treated as unsecured
credits by the banks that make them. The time difference,
however, is more significant, since Fedwire overdrafts are
of shorter average duration than broker/dealer loans.
Further, since broker/dealers purchase other services from
lending banks in addition to intraday loans, the loans, may
be priced as part of a package of jointly produced services.
Thus the observed 100 basis point intraday loan rate may
or may not equal the rate that would exist if fewer related
services were purchased, as might be the case in a market
for interbank intraday funding for daylight overdrafts.
14

The average duration of overdrafts for large institutions (those with
assets of $5 billion or more and who today account for 90 percent of
all funds transfer overdrafts) is four hours. The average duration of overdrafts within 90 percent of each day’s peak overdraft is about 90 minutes
for all institutions and 45 minutes for large institutions.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

Costs of Shifting from Overnight to Term Funding Overnight funding typically creates daylight overdrafts while
term funding is one way they can be reduced (see page
8). The difference between the costs of the two funding
methods can represent the cost of reducing daylight overdrafts. Charging an overdraft fee at least equal to this cost
would eliminate the cost advantage of overnight funding
and reduce daylight overdrafts by making term funding
relatively more attractive.
Surprisingly, the cost difference between overnight and
7-day term funding has averaged - 2.2 basis points on an
annual basis over 120 weeks during 1984-86. This suggests that 7-day term federal funds are on average cheaper
than overnight funding. However, when 30-day term fed
funds are compared with overnight funding, the spread
becomes positive, averaging 4.5 basis points.
A possible advantage of using the cost of shifting from
overnight to term funding as a price for daylight overdrafts
is that it can be observed in the market. As such, it would
reveal the market value placed on intraday credit by
payments system participants. However, the observed
-2.2 to 4.5 basis point average spread is a function of
demand for term funding under current policies. Demand
is likely to change significantly if new risk control measures
lead more banks to use term funding to reduce overdrafts.
At present these spreads fluctuate from positive to negative
at different points in the interest rate cycle. Thus, they
appear to be more a function of interest rate expectations
than of the lower liquidity and higher default risk of the
term instrument. So the observed spread between term
and overnight funding would today be a poor indicator of
the market value of daylight overdrafts.
If more banks turn to term funds as a substitute for overnight funds to reduce daylight overdrafts, one can expect
two results. Fist, the observed spread should rise because
the demand for term funds would rise while that for overnight funds would fall. Second, because of the shift in
demand, the relative effect of interest rate expectations
on the relative costs of term or overnight funds should
fall. Consequently, the current low spread between term
and overnight fed funds understates the spread that would
likely be observed if risk control policies like pricing or
cap reductions made overdrafts more costly.
Risk Premium between Bank CDs and Treasury Bills
This alternative uses the current observed risk premium
between 30-day bank CDs and U.S. Treasury bills to approximate an overdraft price that reflects the average risk
involved in making an intraday loan to a bank. Over the
last ten years, the risk premium has averaged 107 basis
points for 30-day instruments, which is the shortest
original maturity available for bank CDs. But this risk
premium of 107 basis points is also affected by the
different tax treatment of income from the two instru-

ments as well as by their differing liquidity in secondary
markets. Unless the tax and liquidity effects are believed
to be small or can be separated from the risk premium,
this measure must be considered only as a first approximation, one that probably overstates the true risk
premium by itself.15
Divide the 24-Hour Overnight Rate by Eight to Obtain an
Implied Three-Hour Rate So far, the alternatives presented
resemble a charge for an overdraft line of credit in which
a price is applied to the maximum amount of credit used
during a day. If, in contrast, one wishes to determine the
value of shorter increments of intraday credit, it is
necessary to use ad hoc or statistical extrapolations to an
unobserved maturity (here, three hours). This necessarily generates a certain amount of error even if the
assumptions about the extrapolation process are accepted.
The ad hoc procedure of dividing the 24-hour overnight
rate by eight yields 124 basis points (annual rate) for an
implied three-hour overdraft rate based on the 9.91 percent average overnight federal funds rate over the last ten
years (1976-85). This implicitly assumes that funds can
be lent out in eight three-hour increments or that daylight
lending does not inhibit overnight reuse of the same
funds by a different borrower. Such an assumption
seems reasonable.
Extrapolate the Yield Curve Backwards to an Implied
Three-Hour Rate Statistical estimation of a yield curve
over 180-day, 90-day, and 30-day bank CDs, and overnight federal funds, gives an implied average three-hour
overdraft rate of 9.74 percent. This computed rate is
only 17 basis points lower than the average overnight rate
over the last ten years. The estimated yield curve is very
flat and spreads between instruments often shift from
positive to negative over time. The approach gives results
equivalent to situations where daylight lending would prevent use of the same funds overnight. Since it is expected
that interbank funds borrowed to cover daylight overdrafts
could be re-lent overnight to the same or a different borrower, the 974 basis point rate does not appear to be
reasonable and should not be used as a guide as to what
intraday credit would likely cost if a private market were
to develop in the future.
Choosing between the Alternatives
Of the five alternative methods of estimating the intraday price for funds, at least two can be ruled out. Shifting
from overnight to term funding can be excluded because
the currently measured costs are too low (or negative) to
15

Further, the spread fluctuates widely, making it even more difficult
to distinguish the risk premium from tax and liquidity effects. See Cook
and Lawler (1983).

FEDERAL RESERVE BANK OF RICHMOND

13

be representative of what the costs would be if more
institutions used term funding to reduce overdrafts.
Extrapolating the yield curve backwards to a three-hour
rate can also be excluded since it implies that funds lent
intraday would not be re-lent overnight (and as a result
raises the rate charged on an intraday loan to a level very
close to the overnight rate). Since a private intraday funds
market would probably not involve any restriction on
using funds overnight, the rate obtained from the
estimated yield curve is unrealistically high.
The remaining three alternatives, the existing day loan
market rate for securities broker/dealers, the CD-Treasury
bill risk premium, and dividing the overnight fed funds
rate by eight, give rates which cluster around one another
at 100, 107, and 124 basis points. As a result, a “best
guess” of an equilibrium rate which might apply to daylight
overdrafts in a private market currently lies in the range
of 100 to 125 basis points.
In connection with the above illustrations of what a best
guess of an intraday market rate may be, it should be
emphasized that markets will change if daylight overdrafts
were priced. Today most of the intraday credit risk
exposure that creates the costs connected with Fedwire
intraday lending is absorbed by the Federal Reserve at
a zero explicit charge to users. If the Fed were to charge
for the risk it absorbs, or if it were to reduce its risk
exposure by tightening the net debit caps well below their
current levels, depository institutions could be expected
to explore ways of charging for the value of intraday credit
they extend to their customers and internal bank profit
centers as well. Because of such future efforts, the intraday credit cost estimates presented here should be thought
of as only a starting point for daylight overdraft pricing
or as points of departure for further research efforts. It
is only with the development of an active private sector
market for intraday funds and a better understanding of
the costs involved in reducing overdrafts that an accurate
idea of the value of intraday credit will be obtained.

V.
Concluding Comments
The foregoing analysis makes several points. First,
intraday credit has value to payments system participants,
regardless of whether or not it is explicitly priced. Second,
the volume of intraday credit and the associated level of
intraday credit risk in the payments system result largely
from a failure to require that the full risks and costs of
daylight overdrafts be borne by their users. Third, policies
seeking to control intraday credit risks may attain their
objectives in at least two different ways. One is by
limiting intraday credit by such means as sender net debit
14

caps. The other places costs on the institutions that create
overdrafts by pricing the risks involved. Finally, the
empirical portion of the article suggests some possibilities
for determining the price that may be charged for intraday credit if a private market were to develop. This price
ranges from 100 to 124 basis points (annual rate) per dollar
of credit extended.
As the payments system grows, two areas for further
research become increasingly important. The first, determining the value of intraday credit, was explored in this
paper. The second area is no less important, namely,
quantification of actual risk exposures connected with
intraday credit. While the potential losses are huge, they
have not in fact occurred and therefore it has been difficult to determine their expected value. If generally
acceptable estimates of expected losses can be developed,
they would be helpful in determining the necessity of
developing and adopting other, and potentially more
stringent, methods the Federal Reserve and private sector payment participants can use to further reduce intraday credit risk.

References
Association of Reserve City Bankers. Risk in the Electronic Payments
Systems. Washington, D.C.: Association of Reserve City Bankers.
1983.
Bennett, Barbara. “Off Balance Sheet Risk in Banking: The Case of
Standby Letters of Credit.” Federal Reserve Bank of San Francisco,
Economic Review (Winter 1986), pp. 19-29.
Board of Governors of the Federal Reserve System. “Policy Statement
Regarding Risks on Large-Dollar Wire Transfer Systems.” Federal
Register 50, May 22, 1985, pp. 21120-30.
Cook, Timothy Q., and Thomas A. Lawler. “The Behavior of the Spread
between Treasury Bill Rates and Private Money Market Rates since
1978.” Federal Reserve Bank of Richmond, Economic Review 69
(November/December 1983): 3-15.
Humphrey, David B. The U.S. Payments System: Costs, Pricing, Competition and Risk. Monograph Series in Finance and Economics, no.
1984-1/2. Salomon Brothers Center for the Study of Financial
Institutions, Graduate School of Business, New York University,
1984.
Humphrey, David, David Mengle, Oliver Ireland, and Alisa Morgenthaler. “Pricing Fedwire Daylight Overdrafts.” Federal Reserve
System staff discussion paper, January 13, 1987.
Mengle, David L. “Daylight Overdrafts and Payments System Risks.”
Federal Reserve Bank of Richmond, Economic Review 71 (May/June
1985): 14-27.
Smoot, Richard L. “Billion-Dollar Overdrafts: A Payments Risk
Challenge.” Federal Reserve Bank of Philadelphia, Business Review
(January/February 1985), pp. 3-13.
Stevens, E.J. “Risk in Large-Dollar Transfer Systems.” Federal Reserve
Bank of Cleveland, Economic Review (Fall 1984), pp. 2-16.
Summers, Bruce J. “Loan Commitments to Business in United States
Banking History.” Federal Reserve Bank of Richmond, Economic
Review 61 (September/October 1975): 15-23.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

REPURCHASE AND
REVERSE REPURCHASE AGREEMENTS
Stephen A. Lumpkin

Recent years have witnessed a considerable growth in
the market for repurchase agreements (RPs), both in terms
of daily activity and in the numbers and types of participants in the market. Many years ago RPs, or “repos”
as they are frequently called, were used primarily by large
commercial banks and government securities dealers as
an alternative means of financing their inventories of
government securities, but their use has expanded substantially in recent years. RPs are now used regularly by a
variety of institutional investors in addition to banks and
dealers, and the Federal Reserve Bank of New York
(FRBNY) uses repo transactions to implement monetary
policy directives and to make investments for foreign
official and monetary authorities. This article describes
RPs and their principal uses and discusses the factors
influencing the growth and development of the RP market
over the past few years.
What is a Repo?
A standard repurchase agreement involves the acquisition of immediately available funds through the sale of
securities with a simultaneous commitment to repurchase
the same securities on a date certain within one year at
a specified price, which includes interest or its equivalent
at an agreed upon rate.1 Repo transactions have many
characteristics of secured lending arrangements in which
the underlying securities serve as collateral. Under this
characterization, the sale of securities under an agreement
to repurchase is a type of collateralized borrowing and
represents a liability to the “seller,” reflecting the contractual obligation to transfer funds to the “buyer” on the
final maturity date of the agreement.
A reverse RP (technically a matched sale-purchase
agreement) is the mirror image of an RP. In a reverse repo,
securities are acquired with a simultaneous commitment
to resell. Because each party to the transaction has the
The author is an economist at the Board of Governors of the Federal
Reserve System. This article was prepared for Instruments of the Money
Marker, 6th ed., Federal Reserve Bank of Richmond.
1

Immediately available funds include deposits in Federal Reserve Banks
and certain collected liabilities of commercial banks that may be transferred or withdrawn on a same-day basis.

opposite perspective, the terms repo and reverse repo can
be applied to the same transaction. A given transaction
is a repo when viewed from the point of view of the supplier of the securities (the party acquiring funds) and a
reverse repo when described from the point of view of
the supplier of funds.2 In general, whether an agreement
is termed a repo or a reverse repo depends largely on
which party initiated the transaction, but an RP transaction between a dealer and a retail customer usually is
described from the dealer’s point of view. Thus, a retail
investor’s purchase of securities and commitment to resell
to a dealer is termed a repo, because the dealer has sold
the securities under an agreement to repurchase.
There is no central physical marketplace in which RPs
are negotiated. Rather, transactions are arranged overthe-counter by telephone, either by direct contact or
through a group of market specialists (dealers or repo
brokers). The securities most frequently involved in repo
transactions are U.S. Treasury and federal agency
securities, but repos are also arranged using mortgagebacked securities and various money market instruments,
including negotiable bank certificates of deposit, prime
bankers acceptances and commercial paper. If executed
properly, an RP agreement is a low-risk, flexible, shortterm investment vehicle adaptable to a wide range of
uses. For instance, dealers use repo and reverse repo
transactions not only to finance the securities held in their
investment and trading accounts, but also to establish short
positions, implement arbitrage activities, and acquire
securities for their own purposes or to meet specific
customer needs.3 Investors in the repo market, such as
nonfinancial corporations, thrift institutions, state and local
government authorities, and pension funds, in turn, are
provided with a low cost investment alternative which
2

For some participants, notably thrift institutions and the Federal
Reserve, the terminology is reversed. That is, the Federal Reserve
arranges RPs when it wants to inject reserves (supply funds)
temporarily.
3

A dealer establishes a short position by selling a security he does not
have in his inventory. To make delivery of the securities the dealer
either borrows them or acquires them by making reverse repurchase
agreements.

FEDERAL RESERVE BANK OF RICHMOND

15

offers combinations of yields, liquidity, and collateral
flexibility not available through outright purchases of the
underlying securities.
The key features of RP agreements are described in the
following section. Subsequent sections explain the
pricing of RP contracts and discuss the various procedures for transferring the different types of collateral
between the repo counterparties.

Characteristics of RP Agreements
In most RP agreements, the purchaser of the repo
securities acquires title to the securities for the term of
the agreement and thus may use them to arrange another
RP agreement, may sell them outright, or may deliver
them to another party to fulfill a delivery commitment on
a forward or futures contract, a short sale, or a maturing
reverse RP. This feature makes RPs particularly useful
for securities dealers, who use repos and reverses to
implement a wide variety of trading and arbitrage
strategies. As suggested previously, a wide range of other
institutional participants also derive benefits from the RP
market. The principal use of repos by these investors
is the short-term investment of surplus cash either for their
own accounts or on behalf of others in their fiduciary
capacities or as agent. The various yields and maturities
offered in RP transactions make them well-suited for this
purpose.
Maturities RP agreements usually are arranged with
short terms to maturity. Most RPs in Treasury securities,
for example, are overnight transactions. In addition to
overnight contracts, longer-term repos are arranged for
standard maturities of one, two, and three weeks, and one,
two, three, and six months. Other fixed-term multi-day
contracts (“term repos”) are negotiated occasionally and
repos also may be arranged on an “open” or continuing
basis. Continuing contracts in essence are a series of
overnight repos in that they are renewed each day with
the repo rate adjusted to reflect prevailing market
conditions. These agreements usually may be terminated
on demand by either party.
Yields In some RP agreements, the agreed upon repurchase price is set above the initial sale price with the
difference reflecting the interest expense incurred by the
borrower. It is more typical, however, for the repurchase
price to be set equal to the initial sale price plus a
negotiated rate of interest to be paid on the settlement
date by the borrower. Repo interest rates are straight
add-on rates calculated using a 360-day “basis” year.
The dollar amount of interest earned on funds invested
in RPs is determined as follows:
16

For example, a $25 million overnight RP investment at
a 6 3/4 percent rate would yield an interest return of
$4,687.50:
Suppose instead, that the funds were invested in a 10-day
term agreement at the same rate of 6 3/4 percent. In
this case, the investor’s earnings would be $46,875.00:
As a final example, suppose that the investor chose to
enter into a continuing contract with the borrower at an
initial rate of 6 3/4 percent, but withdrew from the
arrangement after a period of five days. Suppose also that
the daily RP rates over the five days were 6 3/4 percent,
7 percent, 6 1/2 percent, 6 3/8 percent, and 6 1/4
percent. Then the total interest earned on the continuing contract would be:
First day:
($25,000,000 x .0675)/360 x 1 = $ 4,687.50
Second day:
x 1 = $ 4,861.11
($25,000,000 x .07)/360
Third day:
x 1 = $ 4513.89
($25,000,000 x .065)/360
Fourth day:
($25,000,000 x .06375)/360 x 1 = $ 4,427.08
Fifth day:
($25,000,000 x .0625)/360 x 1 = $ 4,340.28
$22,829.86
Total interest earned:
If the investor had entered into a term agreement for the
same period at the rate of 6 3/4 percent prevailing on the
first day, he would have earned $23,437.50 in interest.
Thus, in this hypothetical example the movement in rates
worked to the advantage of the borrower.
The purchaser of securities in a repo transaction earns
only the agreed upon rate of return. If a coupon payment
is made on the underlying securities during the term of
the agreement, the purchaser in most cases must account
to the seller for the amount of the payment. Securities
in registered definitive form generally are left registered
in the seller’s name so that any coupon payments made
during the repo term may be received directly.
Principal Amounts RP transactions are usually arranged in large dollar amounts. Overnight contracts and
term repos with maturities of a week or less are often
arranged in amounts of $25 million or more, and blocks
of $10 million are common for longer maturity term
agreements. Although a few repos are negotiated for
amounts under $100,000, the smallest customary amount
is $1 million.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

Valuation of Collateral Typically, the securities used as
collateral in repo transactions are valued at current market
price plus accrued interest (on coupon-bearing securities)
calculated to the maturity date of the agreement less a
margin or “haircut” for term RPs.4 Technically, the
haircut may protect either the lender or the borrower
depending upon how the transaction is priced. In the
usual case, the initial RP purchase price is set lower than
the current market value of the collateral (principal plus
accrued interest), which reduces the lender’s exposure to
market risk. A dealer arranging a reverse RP with a
nondealer customer frequently takes margin, which covers
his exposure on the funds transferred.
To illustrate the computation of market risk haircuts,
consider the case of a lender who in December 1984 was
holding $10 million par value of 52-week Treasury bills
as collateral for a 7-day term RP agreement. In 1984,
the average week-to-week fluctuation in the yield of
recently offered 52-week bills was 0.21 percent, measured
as the standard deviation of the change in yield from
Tuesday to Tuesday. The corresponding price volatility measure was 0.20 percent. To reflect a 95 percent
confidence level the lender would compute a market risk
haircut factor of 0.50 percent (2.5 times the standard
deviation of week-to-week price changes). On December 27, for instance, year bills were trading at a discount rate of 8.38 percent or at a price of $91.504 per
$100 par value. Thus, the current market value of the collateral was $9,150,361.11. The lender would calculate
its per week risk of loss at $45,751.81 (the market risk
haircut factor times the market value), and would value
the collateral accordingly at $9,104,609.31 (the current
market value less the haircut in dollars).
In principle, the dollar amount of the haircut should be
sufficient to guard against the potential loss from an
adverse price movement during the repo term. The sizes
of haircuts taken in practice usually vary depending on
the term of the RP contract, type of securities involved,
and the coupon rate of the underlying securities. For example, discount bonds are more price volatile than
premium bonds and thus are given larger haircuts. Similarly, haircuts taken on private money market
instruments generally exceed those of comparable-maturity
Treasury securities, due to an additional credit riskinduced component of price volatility. In general, haircuts are larger the longer the term to maturity of the repo
securities, and larger haircuts are common for less liquid
securities as well. Currently, market risk haircuts range
4

The failure of Drysdale Government Securities in May 1982 and
Lombard-Wall in August 1982 uncovered weaknesses in the pricing of
RPs. RPs are now priced with accrued interest included in full in the
purchase price, but prior to adoption of full accrual pricing in October
1982, it was common for RPs to be priced without accrued interest.

from about one to five percent, but may be as low as oneeighth of a point for very short-term securities.
Because both parties in a term repo arrangement are
exposed to the risk of adverse fluctuations in the market
value of the underlying securities due to changes in
interest rates, it is common practice to have the collateral value of the underlying securities adjusted daily
(“marked to market”) to reflect changes in market prices
and to maintain the agreed upon margin. Accordingly,
if the market value of the repo securities declines
appreciably, the borrower may be asked to provide additional collateral to cover the loan. However, if the
market value of the collateral rises substantially, the
lender may be required to return the excess collateral to
the borrower.
Special Repo Arrangements The bulk of the activity in
the RP market involves standard overnight transactions
in Treasury and agency securities, usually negotiated
between a dealer and its regular customers. Although
standard overnight and term RP arrangements are most
prevalent, dealers sometimes alter various provisions of
these contracts in order to accommodate specific needs
of their customers. Other arrangements are intended to
give the dealer flexibility in the designation of collateral,
particularly in longer-term agreements. For example,
some contracts are negotiated to permit substitution of
the securities subject to the repurchase commitment. In
a “dollar repo,” for instance, the initial seller’s commitment is to repurchase securities that are similar to, but
not necessarily the same as, the securities originally sold.
There are a number of common variants. In a “fixedcoupon repo,” the seller agrees to repurchase securities
that have the same coupon rate as those sold in the first
half of the repo transaction. A “yield maintenance agreement” is a slightly different variant in which the seller
agrees to repurchase securities that provide roughly the
same overall return as the securities originally sold. In
each case, the maturity of the repurchased securities must
be within an agreed upon range, but may be only
approximately the same as that of the original securities.
These agreements are frequently arranged so that the purchaser of the securities receives the final principal payment from the issuer of the securities.
In other repo arrangements, the repo counterparties
negotiate flexible terms to maturity. A common example of this type of contract is the repo to maturity (or
reverse to maturity for the lender of funds). In a repo
to maturity, the initial seller’s repurchase commitment in
effect is eliminated altogether, because the purchaser
agrees to hold the repo securities until they mature. The
seller’s repurchase commitment depends on the manner
in which the final principal payment on the underlying

FEDERAL RESERVE BANK OF RICHMOND

17

securities is handled. When the purchaser of the repo
securities receives the final principal payment directly
from the issuer of the securities, he usually retains it and
nets it against the seller’s repurchase obligation. However, if the seller of the repo securities receives the
principal payment, he must pay the purchaser the full
amount of the agreed upon repurchase price when the repo
is unwound.
Reverses to maturity often involve coupon securities
trading at a discount from the price at which the “seller”
initially purchased them. Typically, reverses to maturity are initiated by an investor who is reluctant to sell
the securities outright, because an outright sale would
require taking a capital loss on the securities. A reverse
to maturity enables the investor to acquire funds to
invest in higher yielding securities without having to sell
outright and realize a capital loss. The dealer participating in the transaction usually takes margin on the
securities “purchased”.

Participants in the RP Market
The favorable financing rates and variety of terms and
collateral arrangements available have led government
securities dealers to expand their use of repos in recent
years. Many years ago, dealers relied primarily on collateralized loans from their clearing banks (“box loans”)
to meet their financing needs, but RPs and reverse RPs
are now their principal sources of financing. Major dealers
and large money center banks in particular finance the bulk
of their holdings of Treasury and agency securities by RP
transactions. Most of these transactions are arranged on
a short-term basis (i.e., overnight or continuing contracts)
via direct contact with major customers, typically banks,
public entities, pension funds, money market mutual
funds, and other institutional investors. The Federal
Reserve Bank of New York also arranges repos and reverse
repos with dealers to implement monetary policy directives and to make investments for foreign central banks
and other official accounts.
Early each morning a dealer’s financing desk arranges
repo financing for expected changes in the firm’s securities
inventory (“long position”) and for replacement of maturing RPs, and also arranges reverse RPs to cover known
or planned short sales or to meet specific customer
needs. 5 The bulk of these arrangements are finalized by
10:00 a.m. Eastern Time.

Dealers use reverse RPs to establish or cover short positions and to obtain specific issues for redelivery to
customers. Major suppliers of securities to the market
include large commercial banks, thrifts, and other financial institutions. Nonfinancial corporations and
municipalities also supply collateral to this market. A
dealer “reverses in” securities, in effect, by buying them
from the holder under an agreement to resell; the term
of the agreement usually ranges from a week to a month,
but may also run for the remaining term to maturity of
the securities (reverse to maturity). The use of reverse
repos to cover short positions is similar to securities borrowing arrangements in which the dealer obtains securities
in exchange for funds, other securities, or a letter of credit.
However, reversing in securities typically is cheaper than
borrowing the securities outright and also gives the dealer
greater flexibility in his use of the securities. For instance,
reverse RPs are arranged for fixed time commitments, but
borrowing arrangements usually may be terminated on a
day’s notice at the option of the lender.
If a dealer has exhausted its regular customer sources
but is still in need of funds or specific collateral, it may
contact a repo broker. Dealers use repo brokers most
often for term RP agreements and in arranging reverse
RPs. The repo brokers market is particularly important
for obtaining popular issues in short supply (“on special”).
Although the use of bank loans as a source of financing
has declined considerably, a dealer still may obtain financing from its clearing bank in the form of an overnight
box loan if it has a negative balance in its cash
account at the end of the day. 6 The rate the clearing bank
charges is generally 1/8 to 1/4 of a point or more above
the Federal funds rate, with slightly higher rates charged
for loans arranged late in the day, so dealers acquire box
loans only as a last resort. A dealer who is unable to obtain adequate financing using his own customer base, or
has an unexpected receipt of securities late in the day,
may choose to obtain a “position” loan from another bank
rather than a box loan from his own clearing bank. Position loans are often available at more favorable rates than
available on box loans. In these circumstances, the lender
frequently wires the dealer’s clearing bank the amount of
the loan. The clearing bank, in turn, segregates the required amount of the dealer’s securities as collateral for
the loan and acts as custodian for the lender.
In addition to using repos and reverse repos to finance
their long and short positions, dealers also use RP
agreements in transactions in which they act as inter6

5

A short sale is the sale of securities not currently owned, usually under
the expectation that the market price of the securities will fall before
the termination date of the transaction. The seller later purchases the
securities at a lower price to cover his short position and earns an
arbitrage profit.

18

Securities received by a clearing bank on behalf of a dealer customer
generally are delivered first into a central clearing account known as the
“box.” Any securities that have not been allocated to other uses by
the dealer, and have not been financed through other means, may be
used to collateralize an overnight loan (box loan) from the clearing
bank.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

mediaries between suppliers and demanders of funds in
the repo market. A dealer acts as principal on each side
of the arrangement, borrowing funds from one party
(against the sale of securities) and relending the funds to
another party (against the receipt of securities). The
combination of repo and reverse repo transactions in this
fashion is termed a “repo book.” A repo book in which
an RP and a reverse RP in the same security have equal
terms to maturity is referred to as a “matched book.”
Larger, better capitalized dealers are able to borrow in the
RP market at more favorable rates than smaller dealers
and non-dealer customers, and thus can profit through
arbitrage in matched transactions. Dealers also may
profit from a differential in the margin taken on the
underlying collateral in the two transactions.
At times, a dealer may choose not to match the
maturities of the repo and reverse repo agreements in an
effort to increase profits. For example, if interest rates
are expected to rise during the term of the agreement,
the dealer may arrange an RP with a longer term than the
reverse RP in order to “lock in” the more favorable
borrowing rates. Conversely, in a declining rate environment, a longer-term reverse RP may be financed through
a number of shorter-term RPs arranged at successively
lower rates.
Many types of institutional investors derive benefits
from RP and reverse RP transactions with dealers, including nonfinancial corporations, state and local government authorities and other public bodies, banks, and thrift
institutions. Repos are adaptable to many uses and RP
maturities can be tailored precisely to meet the needs of
lenders. This enables corporations and municipalities
with temporary surplus cash balances to earn market rates
of return on a timely basis but have their funds available
when needed. Thus, in effect, RP agreements convert
cash balances into interest-bearing liquid assets. In this
fashion, RPs are more attractive investments than alternative money market instruments which do not offer the
same combination of liquidity, flexibility, and ease of
negotiation. Newly issued negotiable CDs, for example,
must have a minimum maturity of at least 14 days and
commercial paper is seldom written with maturities as
short as a day.
Repos are also attractive investments for investors subject to restrictions on the types of assets in which they
may invest. Many public bodies, for example, are required by law to invest their tax receipts and proceeds
from note and bond sales in Treasury or federal agency
issues until the funds are to be spent. As opposed to buying the securities outright, these entities often invest in
repos collateralized by government securities and record
the ownership of the securities rather than the repos on
their books.

The Federal Reserve also is a major participant in the
repo market. When the Manager of the System Open
Market Account needs to inject reserves in the banking
system overnight or for a few days, the Domestic Trading
Desk of the FRBNY arranges RPs with primary dealers
in government securities.7 These agreements are arranged for specified periods of up to 15 days and are collateralized by Treasury and agency securities. Investments on behalf of foreign official and international
accounts also involve RPs, either arranged in the market
or internally with the System’s Account. When the
Manager wants to absorb reserves for a few days, the Desk
arranges matched sale-purchase transactions with primary
dealers, in which specific securities are sold from the
System’s portfolio for immediate delivery and
simultaneously repurchased for settlement on the desired
date.

Growth and Development of the RP Market
It is difficult to ascertain when the repurchase agreement originated. Some suggest that RPs date back to
the 1920s, about the time that the Federal funds market
evolved. Other sources state that the use of RPs was
initiated by government securities dealers after World War
II as a means of financing their positions. There is general
agreement, however, that for many years RPs were used
almost exclusively by government securities dealers and
large money center banks. Since the late 1960s
however, the number and types of participants in the RP
market has grown considerably.
A number of factors have influenced the growth and
development of the RP market over this period, including
changes in the regulatory environment, inflation, growth
in federal debt outstanding, and increased interest rate
volatility. The higher levels and greater volatility of
interest rates since the 1960s have been particularly
important. They have raised the opportunity cost of
holding idle cash balances in demand deposit accounts,
on which the explicit payment of interest is prohibited,
and have led to an expanded use of active cash management techniques. Accompanying these developments
have been key innovations in telecommunications and
7

Primary dealers are a group of dealers who have met eligibility criteria
established by the Federal Reserve Bank of New York (FRBNY). To
be on the FRBNY’s primary dealer list, a firm is expected to make
markets in the full range of Treasury and agency issues under “good’
and “bad” market conditions for a diverse group of nondealer customers,
and to maintain certain minimum capital levels. The FRBNY selects
appropriate counterparties from this list when it conducts open market
operations.

FEDERAL RESERVE BANK OF RICHMOND

19

computer technology, which have contributed to the
development of sophisticated cash management systems
for managing and transferring large volumes of funds. As
a consequence, a variety of financial institutions, nonfinancial corporations, pension funds, mutual funds, public
bodies, and other institutional investors have joined
securities dealers and money center banks as active
participants in the RP market.
As a result of this growth, the RP market is now considered to be one of the largest and most liquid markets
in the world. Although total daily activity in the RP
market is not known, as most agreements are negotiated
directly between counterparties over the telephone, an
indication of the growth in the market over recent years
can be seen in the use of RPs and reverse RPs by primary
dealers. As shown in Table I, on an annual average basis,
repo financing by major dealers has nearly tripled since
1981. The same is true for the use of matched book
transactions (Table II), which account for about half of
all repo transactions. In fact, for some nonbank dealers
matched book transactions account for as much as 90
percent of overall repo activity. Bank dealers are
subject to capital requirements imposed by bank
regulators, which raise the cost of using these transactions relative to alternative investments; thus, they
have not participated as much in the use of matched RP
agreements.
The rapid growth and development of the RP market
over recent years has not occurred without incident.
In particular, the failures of a few unregistered non-primary
government securities dealers has had a significant effect
on the operation of the market. These failures generally had some common characteristics, including the use
of pricing techniques which ignored accrued interest in

Table I

ANNUAL AVERAGES OF OUTSTANDING
REPURCHASE AND REVERSE REPURCHASE
AGREEMENTS BY CATEGORY OF
PRIMARY DEALER1
(Millions of Dollars)
Year

1981

1982
1983
1984
1985

1

Bank Dealers

19,173

22,337
24,812
26,706
34,453

Nonbank Dealers

92,565

147,890
159,319
218,282
286,365

Total

111,738
170,227
184,131
244,988
320,818

Figures are obtained from reports submitted weekly to the Federal
Reserve Bank of New York by the U.S. government securities dealers
on its published list of primary dealers. Figures include matched
agreements.

20

Table II

ANNUAL AVERAGES OF OUTSTANDING MATCHED
REPURCHASE AND REVERSE REPURCHASE
AGREEMENTS OF PRIMARY DEALERS1
(Millions of Dollars)
Year

1981
1982
1983
1984
1985

Bank Dealers

6,167
7,534
6,839
7,207
9,118

Nonbank Dealers

51,177
88,315
84,523
121,938
152,914

Total

57,344
95,849
91,362
129,145
162,032

1

Figures are obtained from reports submitted weekly to the Federal
Reserve Bank of New York by the U.S. government securities dealers
on its published list of primary dealers. Figures include repurchase
agreements, duebills, and collateralized loans used to finance reverse
repurchase agreements, as well as the reverse side of these
transactions.

computing the value of repoed securities, and the.
fraudulent use of customers’ collateral. The failures
resulted in considerable uncertainty regarding the legal
status of repos and the contractual rights of the counterparties when one of them files for protection under federal
bankruptcy laws.
Repurchase agreements have never been defined in a
strict legal sense either as collateralized loans or as outright
purchases and sales of securities. Under recent court rulings involving the bankruptcy proceedings of Bevill,
Bresler, and Schulman, Inc., the court has determined that
the appropriate characterization of a repo for legal purposes depends upon the manner in which the transaction
was arranged. For instance, if the repo counterparties
arranged the transaction as a consummated sale and contract to repurchase, then the court would adopt the same
characterization in the event of a default and subsequent
bankruptcy of one party.
Market participants have long operated under the
assumption that the purchaser of repo securities is entitled to liquidate them if the seller is unable to fulfill
the terms of the agreement at settlement, but the validity
of this assumption relies importantly on the court’s interpretation. For instance, in September 1982, in the
bankruptcy proceedings involving Lombard-Wall, Inc.,
Federal Bankruptcy Judge Edward J. Ryan ruled that certain repos involved in that case were to be considered
secured loan transactions for purposes of the proceedings.8
As a consequence, under the existing law, RPs became
8

Lombard-Wall failed in August 1982 when it was unable to return funds
it had obtained in overvalued long-term RPs. The failure of LombardWall occurred shortly after the collapse of Drysdale Government
Securities, Inc. Drysdale failed in May 1982 when it was unable to make
payments on accrued interest on securities it had acquired under RP
agreements and could not return the securities it had obtained through
over-collateralized reverse RPs.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

subject to the “automatic stay” provisions of the Bankruptcy Code. The automatic stay provisions block any
efforts of a creditor to make collections or to enforce a
lien against the property of a bankrupt estate. Consequently, Lombard-Wall’s repo counterparties could neither
use the funds obtained nor sell the underlying repo
securities without the court’s permission, because to do
so would constitute the enforcement of a lien and thus
would violate the automatic stay provision.
As a result of the developments in the Lombard-Wall
case, the perceived risks of lending in the RP market were
raised, resulting in a contraction in the volume of repo
transactions entered into by non-dealer entities, including
mutual funds and state and local government authorities.
With the reduction in a major source of repo funds, the
financing costs for some non-primary dealers rose, as other
participants regarded them as higher credit risks. At the
same time RP rates paid by some well-capitalized firms
declined somewhat. Similar movements in repo financing rates have occurred in the wake of failures of other
government securities dealers, including the recent failures
of E.S.M. Government Securities, Inc. and Bevill, Bresler,
and Schulman Asset Management Corp. in 1985.
In response to the repurchase agreement issue, Congress, in June 1984, enacted the Bankruptcy Amendments
Act of 1984, which amended Title 11 of the U. S. Code
covering bankruptcy. The legislation exempts repurchase
agreements in Treasury and agency securities, certain
CDs, and bankers acceptances from the automatic stay
provision of the Bankruptcy Code. Although the legislation does not resolve the question of whether an RP
agreement is a secured lending arrangement or a purchase
and sale transaction, it enables lenders to liquidate the
underlying securities under either interpretation and
resolves a major question about the status of RP collateral
in bankruptcy proceedings.9
With the encouragement of the Federal Reserve Bank
of New York (FRBNY), primary dealers began to include
the value of accrued interest in the pricing of RPs and
related transactions in October 1982. At that time, the
FRBNY also recommended that dealers follow uniform
procedures in establishing repo contract value for purposes
of maintaining margin. These actions helped to correct
certain inadequacies in standard repo pricing practices.
However, recent dealer failures have demonstrated that
proper pricing of repo transactions alone is insufficient to
ensure the safety of a repo investment. Investors must
also concern themselves with the creditworthiness of their
repo counterparties. For instance, many of the investors
dealing with E.S.M. and Bevill, Bresler, and Schulman lost
their money because they did not protect their ownership
9

Note that the automatic stay provision is irrelevant if an RP is considered to be an outright purchase and sale of securities.

interest in the repo securities pledged to them as collateral.
Investors can best establish their ownership claim to repo
securities by taking delivery of the securities, either
directly or through a clearing bank-custodian.
Repo Collateral Arrangements
As mentioned previously, most RPs involve Treasury
and federal agency securities, the bulk of which are maintained in book-entry form. Usually, when an RP is
arranged, the underlying securities are transferred against
payment over the Federal Reserve’s securities wire (“Fedwire”) to the lender/purchaser, resulting in a simultaneous
transfer of funds to the borrower. At maturity, the RP
collateral is returned over the wire against payment and
the transfers are reversed. Direct access to the Federal
Reserve’s securities and payments transfer systems is
restricted, so transfers of the repo securities usually are
processed by means of Reserve Bank credits and debits
to the securities and clearing accounts of depository
institutions acting as clearing agents for their customers.
Transfers of physical securities also frequently involve
clearing agents.
The transaction costs associated with the payment and
delivery of repo securities include some combination of
securities clearance fees, wire transfer charges for securities
in book-entry form, custodial fees, and account
maintenance fees. The exact charges can vary considerably from case to case depending on the type of
securities involved and the actual method of delivery.
For example, Fedwire charges for securities transfers are
higher for off-line originations than for transfers initiated
on-line, and the fees for transfers of agency securities are
slightly higher than those for Treasury securities. In any
event, the total transaction costs to process transfers of
securities from the seller/borrower to the buyer/lender are
higher the greater the number of intermediate transactions.
Although these costs are often inconsequential for longermaturity transactions in large dollar amounts, they may
add significantly to the overall costs of others. As a result,
a number of repo collateral arrangements have been
developed that do not involve the actual delivery of
collateral to the lender. Not surprisingly, the rates
available to investors in such nondelivery repos are higher
than rates offered on standard two-party RPs with collateral delivery. Of course, the risks may be greater as
well.
At one end of the spectrum of nondelivery repos is the
“duebill” or letter repo. A duebill in essence is an
unsecured loan similar in form to commercial paper; the
borrower merely sends a transaction confirmation to the
lender. Although specific securities might be named as
collateral, the lender does not have control of the

FEDERAL RESERVE BANK OF RICHMOND

21

securities. Thus, the lender relies for the most part on
the integrity and creditworthiness of the borrower. Duebills are used primarily in overnight arrangements that involve small par amounts of non-wireable
securities.
A similar arrangement is the “hold-in-custody” repo in
which the borrower retains possession of the repo
securities but either transfers them internally to a customer
account or delivers them to a bulk segregation account
at its clearing bank; the securities are left in the dealer’s
name and not that of the individual customers. The
extent to which the investor’s ownership interest in the
pledged securities is protected depends on the type of
custody arrangement. If the borrower acts as both custodian and principal in the transaction, the investor relies
on the borrower’s integrity and creditworthiness.10
A lender can protect his ownership claim to repo
securities by using “safekeeping” arrangements involving
a clearing bank-custodian acting solely in its behalf or
jointly as agent for both repo counterparties. The most
popular of these arrangements is the “triparty repo” in
which a custodian, typically the borrower’s clearing bank,
becomes a direct participant in the repo transaction with
the borrower and lender. The clearer-custodian ensures
that exchanges of collateral and funds occur simultaneously
and that appropriate operational controls are in place to
safeguard the investor’s ownership interest in the underlying collateral during the term of the agreement. When
the repo is unwound at maturity, the clearer makes an
entry in its internal records transferring the securities
from the segregation account to the borrower’s clearing
account and wires the loan repayment to the lender.
The rates available to investors in tri-party repos are
lower than those available on nonsegregated RPs without
collateral delivery, but higher than the rates offered on
standard two-party RPs with delivery. Thus, safekeeping arrangements of this type are attractive both to
investors, who earn a higher risk-adjusted return than
available on standard RPs, and to borrowers, whose total
financing costs are lowered through the avoidance of
clearance costs and wire transfer fees.
Determinants of RP Rates
The interest rate paid on RP funds, the repo rate of
return, is negotiated by the repo counterparties and is set
independently of the coupon rate or rates on the underlying securities. In addition to factors related to the terms
and conditions of individual repo arrangements, repo
interest rates are influenced by overall money market
10

Under the Uniform Commercial Code, an investor can establish an
ownership interest in securities it has left with a dealer for a period of
up to 21 days if it obtains a proper written agreement and “gives value”
for the securities.

22

conditions, the competitive rates paid for comparable
funds, and the availability of eligible collateral. As mentioned previously, changes in the perceived risks
associated with RP investments also affect the level of RP
rates and the spreads between RP rates and comparable
money market rates.
Because repurchase agreements are close substitutes for
Federal funds borrowings, overnight RP rates to a large
extent are determined by conditions in the market for
reserve balances and thus are closely tied to the Federal
funds rate. For example, when the demand for reserves
is high relative to the existing supply, depository institutions bid more aggressively for Federal funds, thereby
putting upward pressure on the Federal funds rate. As
the funds rate rises, some institutions will enter into repurchase agreements, which also puts upward pressure on
the RP rate. Both rates will continue to rise until the
demand and supply for reserves in the banking system
is again in balance.11 Federal Reserve policy actions have
a major influence on overnight financing rates through their
effect on the supply of reserves via open market operations and discount window policy.
Repo rates for overnight RPs in Treasury securities,
usually lie about 25 to 30 basis points below the Federal
funds rate. Properly executed RP agreements are less
risky than sales of Federal funds because they are fully
backed by high-quality collateral. Thus, the rate spread
generally reflects a risk premium paid to compensate investors for lending unsecured in the Federal funds market
rather than investing in a collateralized RP agreement.
The spread between the Federal funds rate and RP rate
has narrowed when the perceived risks associated with
RP investments have increased, e.g., when the legal status
of the repo securities backing an RP agreement has come
under question.
The spread between the funds rate and the RP rate can
also depend on the supply of collateral held by government securities dealers. Dealers reduce their demand for
RP financing when the dollar volume of securities they
hold in their investment and trading accounts is low.12
Other things the same, this also puts downward pressure
on the RP rate relative to the Federal funds rate. Conversely, the RF rate rises, and the rate spread narrows,
when the volume of securities to be financed is high
relative to the availability of overnight financing. This
11

See Kenneth D. Garbade [1982, Chapter 5].

12

This sometimes occurs after major tax payments when incoming tax
receipts exceed the capacity of Treasury Tax and Loan (TT&L)
accounts at commercial banks and are transferred to the Treasury’s account at Federal Reserve Banks. Because the transfer of funds from
the public to the Federal Reserve (Fed) drains reserves from the
banking system, the Fed often arranges RPs to inject reserves to offset
the effect of the movement. These RPs must be collateralized, of
course, and funds held in TT&L accounts also must be collateralized.
Both actions tend to remove a large quantity of eligible collateral from
the market.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

sometimes occurs after Treasury mid-quarter refundings,
particularly when the new issues are not well distributed
to investors.
Conclusion
The use of RPs as a major financing vehicle is likely
to continue to expand during the forseeable future, with
a sizable increase in the volume of RPs outstanding and
a broadening of the types of assets used as collateral. In
coming years, the move toward a more complete globalization of securities markets and the associated growth in
trading activity will further enhance the demand for flexible financing arrangements. This is likely to be associated
with further efforts to clarify the rights of repo counterparties in written agreements and the expanded use of triparty agreements and other segregation arrangements.

References
Garbade, Kenneth D. Securities Markets. New York: McGraw-Hill,
1982.
Lucas, Charles, Marcos Jones, and Thomas Thurston. “Federal
Funds and Repurchase Agreements.” Federal Reserve Bank of
New York, Quarterly Review (Summer 1977), pp. 33-48.
Simpson, Thomas D. “The Market for Federal Funds and Repurchase Agreements.” Staff Studies 106. Washington, D.C.: Board
of Governors of the Federal Reserve System, 1979.
Smith, Wayne J. “Repurchase Agreements and Federal Funds.”
Federal Reserve Bulletin (May 1978), pp. 353-60.
Stigum, Marcia. The Money Market. Rev. ed. Homewood, Illinois:
Dow Jones-Irwin, 1983.

FEDERAL RESERVE BANK OF RICHMOND

23

THE AGRICULTURAL OUTLOOK FOR 1987
. . . Financial Turnaround Unlikely
Raymond E. Owens

After a mediocre 1986, the outlook for agriculture this
year promises only a slight improvement in income and
further declines in asset values for the nation’s farmers.
For crop producers, large harvests worldwide continue to
depress market prices and limit export opportunities; and
although lower energy and interest expenses will likely
lessen production costs, the incomes of crop farmers will
remain heavily dependent on federal crop support
payments. Livestock producers, however, should enjoy
wider margins due to low grain prices and relatively strong
demand. Lower energy and interest expenses will likely
lessen production costs, although overall financial conditions in agriculture will probably continue to weaken.
The United States Department of Agriculture (USDA)
held its annual Outlook Conference in December. Aware
of continuing problems in agriculture, analysts at the conference discussed current conditions in this sector and
outlined their expectations for this year. A consensus of
their assessments of agriculture’s performance in 1986 and
their forecasts for 1987 are summarized below, following
a brief review of the behavior of agricultural exports and
the features of current federal farm programs.

I.

FOREIGN TRADE AND
DOMESTIC AGRICULTURAL POLICY
The present condition of the agricultural sector has been
greatly affected by trade developments and domestic
agricultural policy. In many ways these two influences are
difficult to separate, so intertwined are their effects on one
another, but an effort at such a separation is made here.
Exports
As agricultural exports from the United States increased in the 1970s through early 1980s, domestic crop producers became more dependent on world developments.
A combination of factors caused domestic exports to increase, including higher earnings and greater access to
credit by foreign nations and more emphasis on improving their diets. As a result, the rest of the world came to
rely on the United States-the holder of a major portion
of the world’s available grain reserves-for its purchases.
24

Increased exports reduced domestic carryover stocks and
boosted grain prices and the incomes of American farmers.
Farmers increased their investments in land and equipment on the premise that the strong world demand would
continue. In recent years, however, world demand has
grown less rapidly than anticipated while world production has exceeded expectations. Both developments
lowered foreign demand for U.S. agricultural goods.
Underlying these general developments are three primary
factors pressuring agricultural exports.
First, increased foreign supplies have partly displaced
U.S. exports. The annual growth rate of agricultural production abroad increased from 2.2 percent in the 1970s
to 2.6 percent in the 1980s.
A second factor has been slow economic growth
worldwide. Growth slowdowns have effectively reduced
real incomes in many nations, lowering the growth rates
of food consumption in these nations. Worldwide growth
in demand dropped sharply, falling from an average
yearly increase of 34 million tons of grain in the 1970s
to 19 million tons in the 1980s. A third factor is the
decreased availability of foreign exchange to foreign
nations that purchase U.S. goods. With the higher interest
rates that prevailed in the early 1980s, many nations in
debt found more of their foreign exchange committed to
debt service, leaving less available for imports.
Domestic agricultural policy may have hampered exports as well. Federal price supports in the early 1980s
priced domestic grain well above prevailing world prices.
Also, increased availability of grain from other nations
allowed importing countries to buy on a least cost basis
in the world market. That relatively expensive domestic
grain supplies faced cheaper foreign substitutes undoubtedly contributed to decreased exports.
Agricultural Policy
The U.S. Food Security Act of 1985, usually referred
to as the Farm Bill, has two primary objectives-to support the income levels of American farmers and to reduce
the surpluses of many agricultural commodities. These objectives conflict, as the efforts to support farm incomes
tend to encourage more production and accumulation of
surplus commodities. Policymakers at USDA have at-

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

tempted to reduce the conflict by offering farmers price
subsidies only in exchange for limiting commodity production.
In the crop sector, attempts to limit production have
generally taken the form of acreage reduction programs
(ARPs). Under these programs, farmers who agree to limit
planted acreage of eligible crops and place the removed
acreage in an approved conservation use for one year
become eligible to receive nonrecourse loans and deficiency payments from the Commodity Credit Corporation (CCC).1 Participation in ARPs was strong in 1986.
Preliminary estimates by USDA indicate that 45 million
acres were removed from crop production under the
program.
In an effort to reduce dairy production, the Dairy Termination Program (DTP) was enacted in 1986. Under the
terms of this program, dairy farmers agreed to sell their
dairy cows and remove their dairy facilities from production for 5 years in exchange for a lump sum payment from
USDA. USDA accepted a substantial number of these
offers. About 14,000 dairy farmers participated in the program, receiving $1.8 billion and sending 1.5 million head
of dairy cows to market in 1986. Of the total payment,
about one-third is being paid from an assessment against
all dairy producers and two-thirds by USDA.
In addition to limiting production, USDA is trying to
expand the export of commodities by using federal loan
guarantees. Under this plan, credit extended to foreign
purchasers is guaranteed by the federal government. A
second export program is that embodied in U.S. Public
Law 480. This program, which has been in effect a
number of years, authorizes government-held food stocks
to be transferred to “deserving” nations. The transfers can
occur by direct donation, or by United States-backed
credit purchases.
Federal farm programs also provide credit to some
farmers and rural areas. Under the Farmers Home Administration, for example, qualified farmers may receive
farm ownership and operating loans, emergency disaster
loans, and loan buydowns. In addition, rural communities
are eligible for rural housing and community development
grants. Loans must be repaid, of course, but the terms
of these loans are usually favorable compared to the private
financial market alternatives.
1

Eligible producers are allowed to borrow from the Commodity Credit
Corporation using their crops as collateral. Should producers choose not
to repay these loans, ownership of the crop is passed to the CCC. Eligible producers may also receive direct government payments called deficiency payments which are based on crop production allowed under the
program.

II.
A REVIEW OF THE
AGRICULTURAL SECTOR IN 1986
Entering 1986, analysts were guardedly optimistic that
the policy changes embodied in the 1985 Farm Bill,
together with a declining dollar exchange rate, would encourage stronger exports. However, real export volume
was apparently little changed in 1986, and with prices
lower than in 1985, the nominal balance of agricultural
trade continued to deteriorate. In the absence of improved export earnings, farm income continued to be
dominated by government support payments and by continued efforts to reduce production costs. The value of
farm land fell further in 1986, though generally not quite
as rapidly as in 1985. Agricultural lenders continued to
experience stress, but as the year progressed there were
some signs that conditions were steadying.
Agricultural Trade Remains Sluggish
Despite a lower foreign exchange value of the dollar and
export incentive programs, the agricultural trade balance
deteriorated sharply in 1986. The value of exports was
sharply lower, falling to $26.3 billion, almost $5 billion
less than in 1985. Import value increased about $1 billion,
largely due to higher coffee prices. In light of these
changes, the agricultural trade balance registered a surplus
of only $5.5 billion, less than half the level of a year earlier.
Since peaking at $26.5 billion in 1981, the agricultural
trade surplus has trended downward, due primarily to
lower exports.
Farm Income Measures Mixed
Agricultural policy and sluggish exports were important
determinants of farm income in 1986. Table I shows cash
receipts from farm marketings were sharply lower in 1986,
falling 7 percent to $138 billion, Responsible for the
decline was the fall in crop cash receipts which, including
the net change in CCC loans, decreased over $10.7 billion
dollars. Lower crop cash receipts resulted in part from farm
policy initiatives which acted to lower production, and
from lower market prices.
Livestock cash receipts were higher in 1986 as strong
demand helped boost prices and the DTP encouraged
cattle marketings. Increased direct government payments
helped soften the impact of lower crop cash receipts to
farmers. Direct payments totaled $12 billion in 1986, up
sharply from the $7.7 billion of 1984. Higher crop deficiency payments accounted for most of the increase.
Reduced plantings, lower livestock inventories, and
lower input prices contributed to a 5 percent drop in expenses over 1985. Total expenses including some noncash categories fell to $129 billion, the lowest level since
1979.

FEDERAL RESERVE BANK OF RICHMOND

25

Table I

FARM INCOME STATISTICS
(Billion dollars)

F = midpoint of forecast range.
1
Income from machine hire, custom work, sales of forest products, and other misc. cash sources.
Numbers in parentheses indicate the combination of items required to calculate a given item.
3
Value of home consumption of self-produced food and imputed gross rental value of farm dwellings.
4
Excludes capital consumption, prerequisites to hired labor, and farm household expenses.
5
Excludes farm households.
Note: Totals may not add due to rounding.
Source: U.S. Department of Agriculture, Economic Research Service.
2

The net cash income received by farmers totaled $44
billion in 1986, unchanged over the previous year as lower
cash receipts were almost exactly offset by higher govern26

ment payments and decreased expenses. The 1986 cash
income level, though not the highest on record, is above
the average levels of the early 1980s.

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

The Balance Sheet Deteriorates
As shown in Table II, farm assets totaled an estimated
$702 billion in 1986, a 9 percent drop from the previous
year. As in most years, the change in asset values was
primarily due to the change in the value of farmland.
Farmland asset values fell 9.8 percent, accounting for
$55.6 billion of the total asset value decrease of $69.4
billion. Weak market conditions and uncertainties about
the long-run prospects for government support continues.
As economist Emanuel Melichar at the Federal Reserve
Board has pointed out, however, lower farm debt has partially resulted from the transfer of farmland from heavilyindebted operators to financial institutions and lessindebted farmers through foreclosure and other actions.
The value of non-real estate farm assets also fell
sharply in 1986, to $198 billion, a decrease of 6.5 percent. Machinery and motor vehicles accounted for $3.2

billion of the decrease, as sluggish replacement rates
pushed farm equipment numbers down and the average
age up. Crops in storage fell $7.1 billion in value, due
primarily to lower values of corn and wheat.
Farm liabilities also decreased in 1986, although much
less than the drop in asset values. Real estate debt
showed the largest fall, decreasing $8.3 billion to $89
billion (Table II). The declines were due to the repayment of loans and the write-off of loans by lenders. Nonreal estate loans totaled $87 billion at the end of 1986,
8.2 percent below the level of 1985. The volume of Commodity Credit Corporation (CCC) loans rose over 12
percent to $19 billion due to low grain prices.
Farm equity decreased 9.2 percent in 1986, falling to
$526 billion. That was the sixth consecutive decline, with
the 1986 level the lowest on record in nominal terms since
1976, and as low as the levels of the late 1960s when adjusted for inflation.

Table II

BALANCE SHEET OF THE U. S. FARMING SECTOR
(Billion dollars)

1

Excludes farm household.

F = midpoint of forecast range.
NA = Not available.
Source:

U. S. Department of Agriculture, Economic Research Service.
FEDERAL RESERVE BANK OF RICHMOND

27

Farm Credit Stabilizes
Farm credit conditions were steadier in 1986. Total debt
shrank, both in the real estate and non-real estate
categories. Several factors depressed debt levels including
debt write-offs at financial institutions, debt paydowns by
farmers with strong cash positions, and lower operating
debt requirements of farmers participating in federal ARP
programs.
Interest rates on farm loans fell sharply. According to
the Federal Reserve’s quarterly survey of the terms of bank
lending, the rate of interest on non-real estate loans at commercial banks averaged 10.8 percent in November 1986,
4 percentage points below that reported in August of 1984,
the most recent peak.
Farm loan delinquencies and chargeoffs at agricultural
banks showed signs of stabilization in 1986. Although
chargeoffs as a percentage of the total loans outstanding
increased slightly in 1986 compared to 1985, delinquency rates appear to have peaked early in the year and
then declined by year-end to a level below that of late
1985. In the fourth quarter, loan chargeoffs at agricultural
banks also were down from a year earlier.

loans, are projected to total $58 billion in 1987, $4 billion
below 1986. Total livestock cash receipts will likely
remain unchanged, at $71 billion, as higher production
offsets generally lower prices.
Forecasters anticipate that increased farmer participation in federal programs and the carryover of payments
owed from 1986 programs will increase government.
payments in 1987.2 Direct government payments may
add $16 billion to farm income in 1987, up from the $12
billion paid in 1986.
Total production expenses are projected to fall about
4 percent this year. Production expenses for the crop sector will fall due to lower planted acreage, as well as to lower
prices of seed, fuel, fertilizer and other inputs. Large reductions in planted acreage are anticipated as low market
prices will encourage farmers to participate in government
ARPs. 3
Net farm income is forecast to rise in 1987 in nominal
and real terms. The projected $32 billion of net income
will represent an increase of $3 billion over the 1986
figure. Measured in 1982 dollars, net farm income in 1987
will increase by $1 billion, but will still fall short of incomes received in 1984 and 1985.
Farm Balance Sheet May Deteriorate Further

III.

PROSPECTS IN 1987
Lower production expenses and large federal outlays will
influence farm income again in 1987. Low market prices
projected for crops in 1987 should increase USDA program participation, with a total of 65 to 70 million acres
expected to be removed from production. This level of
acreage reduction would be second only to that achieved
in 1983 under the payment-in-kind program.
More emphasis will be placed on the longer-term retirement of land in 1987. This will be accomplished through
the Conservation Resource Program (CRP). The CRP
is similar to the ARP, but applies to highly erodible land
and is effective for a lo-year term. Farmland enrolled
under this program is expected to total 15 million acres
but should impact little on crop supplies in 1987 as much
of this land is of low productivity. A larger impact can be
expected if enrollment grows to 40 million acres as expected by 1990.
If planted acreage is reduced by the amount currently
projected in 1987, less farm production inputs will be required, further reducing production costs. Large participation would also increase government payments.

Despite a slight improvement in income, farmers’ net
worth will likely decrease by the close of 1987. Farm asset
values will be generally weaker as the future income prospects remain uncertain. While higher farm income is expected in 1987, this income remains dependent on government payments. Uncertainty surrounding the continued
receipt of high levels of direct government payments combined with weakness in the outlook for agricultural exports
have made many potential farmland buyers wary of future
farm income prospects. Weaker farm asset values have
resulted.
The value of farm assets may fall another 5.5 percent
in 1987, totaling $663 billion. As in 1986, a large part
of the decrease is expected to be a result of lower farm
real estate values. Non-real estate asset values may also
fall slightly.
Liabilities will likely come down in 1987 with lower nonreal estate debt accounting for most of the decrease. Total
liabilities shown in Table II should decline by $11 billion,
to $165 billion.
Farm equity will likely fall by $28 billion to a level of
$498 billion in 1987, making it more difficult for farmers
2

Cash Receipts May Fall Slightly

Many USDA programs operate on a fiscal year or some other basis
that does not correspond to a calendar year. Because of this, a calendar
year could reflect overlapping payments from government programs.

Total cash receipts for 1987 are expected to fall
slightly to $130 billion, as crop prices and production
continue to decline. Crop cash receipts, including net CCC

Government programs provide price supports to farmers in exchange
for reduced plantings by farmers. When crop prices fall, participation
in government programs usually rises as more farmers opt to receive
higher government payments and agree to reduce production.

28

3

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

to borrow as their collateral shrinks. Thus, although lower
interest rates have made debt service more affordable,
shrinking equity has made credit expansion more difficult.
As shown in Table II, the debt-to-asset ratio, which had
been rising for eight years, topped 25 percent in 1986 but
is expected to fall to 24.9 percent in 1987-a level equal
to that of 1985. A projected decrease in this key ratio is
a welcome sign to the agricultural sector as it may reflect
emerging stability in the equity position of farmers.

however. For 1987, total commercial pork production is
expected to total 13.8 billion pounds, 1 percent less than
in 1986. Slaughter should be down about 5 to 7 percent
in the first two quarters of the year as breeding stocks are
held back and high returns encourage producers to
overfeed. Strong production gains should appear in the
second half of the year.

Trade Outlook Should Be Slightly Brighter

Large supplies of competing meats, a reduction in dairy
herd liquidations, and retention of breeding animals are
likely to limit cattle production in 1987. Large poultry supplies are likely to constrain consumer demand for beef in
1987. At the start of the year cattle numbers were 4 percent below year earlier levels. Although overall slaughter
rates were up 1 percent in late 1986, the slaughter of cows
was down 6 percent and heifer slaughter was down 8 percent from a year earlier as producers began retaining
breeding stock.
Total beef production will likely fall 5 to 7 percent in
1987, with the sharpest declines in cow slaughter. A
tighter supply will help boost prices, with feedlot finished
cattle rising to the $60s per hundredweight by spring.
Further price increases will be difficult because of the
abundance of competing meat supplies.

The dollar value of agricultural exports is not likely to
rise in 1987. Lower domestic prices and a weaker dollar
may push the quantity of exports up slightly from 1986
but the adverse revenue consequences of price weakness
will likely outweigh any quantity increases, possibly lowering the value of exports from 1986’s $26.3 billion to the
$26 billion range.
Imports are expected to fall to $20 billion in 1987, a
decrease of $900 million from 1986. The decline, due
chiefly to lower coffee prices, would be the first in four
years.
The agricultural trade surplus should widen slightly to
$6 billion in 1987. Though improved from 1986’s $5.5
billion, the trade surplus remains well below the peak level
of $26.5 billion achieved in 1981. The continued low level
of exports and relatively high level of imports holds little
promise for reducing United States’ grain stocks in the
near term. It is encouraging, however, that the agricultural
trade balance is now stabilizing after trending sharply
downward during the early 1980s.

IV.
COMMODITY OUTLOOK
Commodity analysts attending the Outlook Conference
discussed market conditions surrounding individual
agricultural commodities in 1986 and expectations for
1987. A summary of their comments for some of the major commodities produced in the Fifth District is presented
below.
Hogs
Low feed prices and strong retail pork demand widened margins considerably for pork producers in 1986.
Nevertheless, total pork production fell about 6 percent
from the previous year. Analysts normally expect high
margins to quickly translate into increased hog production, but many pork producers are in poor financial condition due to weak profits over the last few years and this
is limiting expansion ability. Analysts do expect moderate
production increases to occur late in 1987 or early in 1988,

Cattle

Poultry and Eggs
Higher production of poultry and eggs is projected in
1987. Low feed costs should widen margins to producers
and boost output even in light of anticipated lower prices.
Broiler production was 4.7 percent higher in 1986, with
bird slaughter up 3.9 percent and slaughter weights 1.2
percent above 1985 levels.
Broiler production should increase about 6 percent this
year, encouraged by higher prices of meat substitutes and
additional demand arising from fast food outlets. Foreign
demand for broilers was up sharply in 1986, and is expected to remain at those levels in 1987.
Turkey production rose 12 percent in 1986 with
favorable margins encouraging expansion by producers.
Large stocks of frozen turkeys on hand in addition to
anticipated increases in production will likely lead to
lower prices. Prices could be down as much as 6 cents
per pound, probably ranging from 59 to 65 cents per
pound in the first half of the year, then rising to 70 to
75 cents per pound in the second half as the holidays boost
demand.
Egg production is expected to rise 1 percent in 1987
after increasing sharply in 1986. Producers may retain
older laying hens longer as low feed costs provide wider
margins. Average price per dozen eggs is expected to fall
about 1 to 5 cents in 1987.

FEDERAL RESERVE BANK OF RICHMOND

29

Tobacco
Production was sharply lower in 1986, down about 21
percent compared to the previous year. Additionally,
carryover stocks were somewhat lower, reducing total
supply about 8 percent, to 5 billion pounds. Lower prices
prevailed despite lower supplies partly because quality was
lower and partly because exports decreased.
Production should increase in 1987 as the effective production quota for tobacco increases by 5 percent. Prices
should hold at their 1986 levels as normal weather increases quality and domestic consumption offsets declines
in export demand.
Corn
Domestic usage is stagnant and export prospects are
weak for corn in 1986/87. Usage expanded 20 million
bushels in 1986/87 compared to normal annual growth
of 80 to 100 million bushels. Exports for 1986/87 fell 9
percent, totaling 1.13 billion bushels. As a result, carryover
stocks are at record levels, 5.8 billion bushels in
1986/87-surpassing the previous record of 4 billion
bushels.
Corn prices have fallen 35 percent since the beginning
of the 1986/87 marketing year. For 1986/87, corn prices
are expected to average between $1.35 and $1.65 per
bushel.

V.
FOOD PRICES
As a final note, the paragraphs below review food prices
for 1986 and present the outlook for 1987.
Modest increase in 1986...

. . . And Again in 1987

Food prices rose only 3.1 percent in 1986, at about the
same annual rate as over the last four years. The modest
increase was the result of small increases in the components that influence food prices. Lower farm price supports limited the increases in the prices of many farm products. Lower inflation limited increases in both processing and transportation cost. Modest economic growth
fostered a slightly lower unemployment rate and somewhat
higher disposable income level causing strengthened consumer demand. Although the rise in the general level of
food prices was modest, individual food categories exhibited a broad range of price changes.
Red meats and poultry showed stronger price increases
than did food overall. Beef and veal prices fell over the
first 5 months of 1986 as large supplies kept downward
pressure on prices. Over the second half of 1986, beef
liquidations eased and prices adjusted upward. But the
yearly average price of beef rose less than 1 percent in
30

1986. Pork prices rose 7.5 percent in 1986 as production
and stocks remained low throughout the year. Because
buyers switched to cheaper substitutes, poultry benefited
from increasing prices of beef and pork. Poultry also
benefited from wider usage at fast food chains. Poultry
supplies were reduced somewhat by extreme heat in the
Southeast, which diminished weight gains and fertility
rates. Retail poultry prices rose 6.4 percent in 1986. Demand for fish and seafood was strong in 1986 as domestic
consumption reached a record high. This component of
food prices showed the strongest gain in 1986, rising 9
percent.
The prices of dairy products were unchanged in 1986
as attempts to reduce surpluses did not affect consume]
prices. The Dairy Termination Program (DTP) reduced
dairy cow herds but not enough to raise prices of milk
and other dairy products in 1986.
Cereal and vegetables showed only slight price increases
in 1986. Grain supplies were abundant because the
domestic harvest was large and export sales relatively
small. The resulting lower grain prices had only a small
impact on the cost of cereal and bakery products because
processing and marketing costs dominate the retail price:.
Cereal and bakery product prices rose about 3 percent
in 1986.
Fresh fruit and vegetable supplies were higher in 1986.
Citrus production was strong as trees damaged by cold
weather several years ago began to recover. Vegetable
price increases were dampened by a large potato harvest
in late 1985, leading to large supplies carried over into
1986. Fresh fruit prices rose 2.3 percent and vegetable
prices 3 percent in 1986. Processed fruit prices were down
2.9 percent in 1986 due to lower frozen orange juice
prices. Processed vegetable prices were unchanged.

For 1987, food prices are again expected to increase
about 3 percent. As was the case in 1986, stronger price
increases will likely occur in food consumed away from
home while price increases in food consumed at home will
be more modest.
The farm value of meats is again expected to exceed
increases in grain and vegetable prices in 1987. Beef and
pork prices are expected to rise 5 and 4 percent, respectively, as supplies are expected to be below 1986 levels.
Rapid expansion of poultry production should lead to
slightly lower prices at the retail level.
Strong consumer demand for fish and seafood will
likely continue in 1987, driving prices up another 7 to 10
percent. The prices of imported foods, especially coffee,
should rise only moderately, averaging 1 percent higher.
The prices of dairy foods are expected to be unchanged to slightly higher. Supplies are expected to be

ECONOMIC REVIEW, JANUARY/FEBRUARY 1987

little changed despite dairy herd reductions. Fruit prices
will probably remain level, while vegetable prices are
projected to rise 7 to 10 percent. A smaller supply of
potatoes and vegetables is expected in 1987 as producers
reportedly intend to reduce acreage planted. With low
inflation and low grain prices expected, cereal product
prices should rise only modestly.

Consumer demand for food should be slightly higher
in 1987 if economic growth is somewhat stronger than
in 1986. Such demand expansion would place some upward pressure on prices. On the other hand, a continued
low rate of inflation would limit upward price movements
in the labor, processing, packaging, and distribution components of retail food cost.

BUYING TREASURY SECURITIES AT
FEDERAL RESERVE BANKS

This easy-to-read booklet outlines the step-by-step procedure whereby
individuals can purchase Treasury securities from the Federal Reserve Banks.

In

addition, the booklet describes the various types of Treasury securities-bills, notes,
and bonds-available for purchase. Suitable for the public. $2.00 per copy.
Advance payment is required by check or money order in U. S. dollars, payable
to the Federal Reserve Bank of Richmond.

Send your order and payment to:

Public Services Department
Federal Reserve Bank of Richmond
P. O. Box 27622
Richmond, VA 23261

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31