View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Federal Reserve Bank of St. Louis

5. Keehn
2nd Floor




Pricing Fedwire Daylight Overdrafts


David Humphrey and David Mengle
(Federal Reserve Bank of Richmond)
Oliver Ireland and Alisa Morgenthaler
(Board of Governors of the Federal Reserve System)

January 13, 1986
Federal Reserve Bank of St. Louis

_ Table of Contents


Summ.ary . .......................................

I I.

Bae kground . ................................................. 3

! .••••••...•.


Market Pricing Of Daylight Overdrafts ....................... 3
Industry Position On Pricing Daylight Overdrafts ............ 5
Earlier Board Positions on Pricing Daylight Overdrafts ...... 6
III. Pricing Daylight Overdrafts ................................. 7
Arguments For Pricing Fedwire Daylight Overdrafts ........... 9
Problems With Pricing ...................................... 10
Effects Of Pricing ......................................... 14


Determining The Price To Charge ............................ 18
Approximating The Long-Run Standard Price .................. 18
Possible Effects Of Pricing On Depository Institutions ..... 22


Administrative Issues ...................................... 23

The Legal Basis For Pricing Fedwire Daylight Overdrafts .... 23
Operational Considerations ................................. 24
Appendix A: Broker/Dealer Day Loans ............................. 27
Federal Reserve Bank of St. Louis
Federal Reserve Bank of St. Louis

- l -

This document is a Federal Reserve staff discussion paper.
covered have not been reviewed by the Board of Governors.

The issues

While the paper

presents a discussion of a particular framework for pricing overdrafts, this is
only illustrative and other pricing methodologies are possible.

The document is

being circulated to assist interested parties in formulating their comments on a
Board request for public comment on the concept of pricing Fedwire daylight

I. Summary.
Pricing·Fedwire daylight overdrafts could provide depository institutions
(Dis) with additional incentives to develop and implement changes that may
reduce further the level of overdrafts and Reserve Bank credit exposure.


addition, it might help redistribute risks toward those Dis with sufficient
eapital to more safely assume them,

Such a pricing policy could take place

within the existing policy framework of cross-system and network-specific caps.
Pricing may also be viewed as-a complement to the proposal, currently out for
public comment, that cross-system sender net debit caps be reduced by 25

Caps seek to limit maximum daylight overdrafts while pricing would

discourage overdrafts which occur within the lowered caps.
Experience indicates that current operational differences between Fedwire
and CHIPS (such as standard CHIPS message formats which allow for greater
automation) are more important than price differences when choosing between

Thus pricing Fedwire overdrafts need not significantly shift payment

risks from one network to the other.

In addition, the existing system of

bilateral net credit limits and network-specific caps may limit any increases in
CHIPS systemic risk as a result of Fedwire pricing.
Federal Reserve Bank of St. Louis

- 2 If pricing were implemented in the future, a low initial price might be

This could give Dis an opportunity to adopt institutional changes

which reduce overdrafts in an environment which provides these incentives but
minimizes potential disruption.

For example, an initial price of 10 basis

points (annual rate) could be applied to each day's maximum Fedwire daylight

If the- duration of Fedwire overdrafts by a DI during a <l_ay exceeded

3 hours (the current average duration of Fedwire overdrafts), the charge applied
to the maximum overdraft could be raised to some higher amount, say to 20 basis
The illustrative 10 basis point price is much less than the 100 to 125 basis
point (annual rate) price that might develop if a private market in intraday
funds were to be established.

Over time as experience is gained, Reserve Banks

could raise the overdraft price up to or above what might otherwise exist in a
private market.

The private sector could then take over the function of

providing intraday credit to fund remaining overdrafts.

In any case, pricing

Fedwire overdrafts would not be considered to be a priced service giving Dis the
"right" to incur overdrafts because they pay for them.

Rather, such pricing may

be viewed as a penalty fee on a practice which is being discouraged and Dis
would still be expected to operate within their existing net debit cap.
If the initial Fedwire price for current funds only daylight overdrafts were
10 basis points, the cost incurred by all Dis at existing levels of overdrafts
would to,day total $34.7 million annually or $708 per million of overdrafts per

On a daily basis, overdrafting Dis could be paying an aggregate total

amount of $136,000 per business day.

For those 25 institutions with the largest

average Fedwire overdrafts, a price or penalty fee of 10 basis points could
initially cost between $1,150 to $16,900 per working day.

Such a charge could

provide an incentive for institutions to adopt less costly changes in intraday
Federal Reserve Bank of St. Louis

- 3 funding operations which would reduce overdrafts and hence the cost of incurring
them on Fedwire.
In charging for overdrafts, it may be difficult for Reserve Banks always
accurately to determine the effects that their computer outages and other
operational problems may have on the daylight overdraft values computed.


some improvements in monitoring accuracy are possible and are to be implemented
soon, it may not be cost effective to obtain 100 percent accuracy.


As an

alternative, guidelines could be developed to assure uniformity in DI overdraft
treatment when Reserve Bank outages occur so that Dis are not unfairly charged.
Yet another possibility would be not to charge for Fedwire overdrafts that are
less than 25 percent of a DI's capital if it-can be reasonably shown that such
an exclusion approximates the average effect of Reserve Bank operational
problems on Dis over time.

An exclusion of this type would, on average,

compensate Dls for overdraft charges associated with inaccurate Federal Reserve
overdraft measurements and/or overdrafts caused by computer outages.

It would

also reduce the number of Dls charged by 95 percent because only 136
institutions, who account for 87 percent of all Fedwire overdrafts, regularly
incur overdrafts larger than one fourth of their capital.

II. Background.
Market Pricing Of Daylight Overdrafts.

Cross-system sender net debit caps

have been adopted_by depository institutions (Dls) on a voluntary basis.


addition, network-specific ne~_debit caps as well as bilateral net credit limits
are required on privately operated large dollar networks that settle on a
Reserve Bank's books.

To date, no intraday funds market that would ..permit Dls

to avoid daylight overdrafts has developed, and overdrafts have not been
explicitly priced.
Federal Reserve Bank of St. Louis

This is not surprising because the current system of caps

- 4 was designed initially to constrain only those Dis with the largest overdrafts
and to reduce the aggregate dollar value of daylight overdrafts by only 5 to 7

For the vast majority of institutions, therefore, caps have not been

binding, nor will they be under the Board's revised caps now out for public

A second factor is that less costly alternatives to purchasing

intraday funds have been available, especially rearranging the timing of
nonessential customer payments during the day to reduce overdrafts.

This has

lowered overdrafts from what they might otherwise have been, based solely on the
growth of the value of payments sent over large dollar networks.


Two areas in the banking industry do, however, exhibit some characteristics
of an intraday market.

These are:

(1) Day loans to security broker/dealers; and,
(2) 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.


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 a

perfected security interest is obtained through the loan agreement, day loans
are typically regarded as unsecured due to the difficulty of obtaining control
over the securities.

Day loans developed because of: (a) statutes prohibiting

the certification of checks drawn on accounts containing insufficient funds; {b)
the lag between the time broker/dealers pay for securities, subsequently deliver

1Earlier analysis suggested that the ratio of daylight overdraft value to
total value of payments sent was constant, so both could be expected to grow at
about the same annual rate.
Federal Reserve Bank of St. Louis

- 5 them to customers, and receive payment from them; and (c) the large securities
purchases involved exceed broker/dealer working capital.

An appendix provides

more information on this market, which is largely restricted to New York .


The overnight market for federal funds ~xperiences rate fluctuations
throughout the day,

Even if a DI 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.
Institutions 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 to our
knowledge it is not yet being used specifically to fund interbank daylight


Industry Position On Pricing Daylight Overdrafts.

The banking industry has

not as yet given pricing of daylight overdrafts with their customers or Reserve
Banks a great deal of thought and analysis.

The pricing of daylight overdrafts

was a collateral issue raised in an Association of Reserve City Bankers (ARCB)
report on payments risk reduction issues.

In this report,


the ARCB stated the

following about the possibility of pricing funds transfer daylight overdrafts
above a cap:

The average opening federal funds rate over 1984-85 was 9.137 percent while
the average (early) closing rate was slightly lower at 9.117 percent. On
average, borrowing in the morning and reselling the funds in the afternoon could
cost 2.0 basis points, neglecting transactions costs. If borrowing in the
morning is paired with reselling of funds at the end of the day, when the market
is thin, the average difference in rates turns negative, to -14.62 basis points.
The spread between opening and closing rates would likely be positive, however,
if such an approach to intraday funding of daylight overdrafts were attempted by
more than just a few Dis.
Association of Reserve City Bankers, Risks in the Electronic Payments
System, October 1983.
Federal Reserve Bank of St. Louis

- 6 Intra-day Funding ... If the participant requires amounts in excess of its
normal intraday overdraft limit at the Fed ... it could obtain funds by
borrowing:--,from the Federal Reserve and collateralizing that borrowing [p.
25 J.

A second ARCB report


concerning U.S. government book-entry security

transfer daylight overdrafts concluded that collateralization was the preferred
alternative but if the choice were between caps and pricing all securities
overdrafts then:
Fed pricing of overdrafts is preferable to a caps system. It provides a
more reliable and more easily managed source of funding, and avoids the
artificial and meaningless exercise of setting a high capital multiplier so
that book-entry transactions could continue at desired levels. Pricing
would provide a general incentive to minimize all overdrafts rather than
those over a cap. Pricing is a more flexible and equitable tool than caps,
and it does not preclude the development of an intraday market in funds at a
rate below the Fed price [p. 6, emphasis added).
Fed pricing should start with a low price, say 10 basis points, which could
be adJusted gradually over time. [As an offset to this price,] the Treasury
should consider improving the terms for clearing banks on Tax and Loan
accounts [p. 7].
Earlier Board Positions On Pricing Fedwire Daylight Overdrafts.


pricing represents a potentially effective way to induce reductions in daylight
o~erdrafts, it was previously reJected by the Board in favor of a system of caps
that would constrain overdrafts across all payment networks.

The reasons for

rejection were: (a) there was no clear method to use in setting the price for
intraday credit on Fedwire; and (b), the exact effects of particular prices
charged for overdrafts are uncertain since the slope of the "demand curve" for
overdrafts is unknown.


In particular, it was felt that payments risk would

merely shift between networks and not be reduced.

In a later analysis, these

concerns were summarized as:

Association of Reserve City Bankers, Report of the Working Group of the
Association of Reserve City Bankers on Book-Entry Daylight Overdraft, June 1986.
Board of Governors of the Federal Reserve System, "Risk on Large Dollar
Transfer Systems", February 1984, pp. 64-6.
Federal Reserve Bank of St. Louis

- 7 charging _for intraday credit was tentatively reJected because of the
difficulties of determining a price and, if one could be determined, fhe
difficulties of requiring that it be imposed by private wire systems.
At the time, it was important to impose the same type of controls over the use
of Fedwire and alternative wire transfer networks.

Pricing Fedwire overdrafts

but not those on CHIPS could shift Federal Reserve credit risk to CHIPS,
increase CHIPS overdrafts, and thus increase overall systemic risk.


existence of binding sender net debit caps on CHIPS today reduces the likelihood
that payments risks will be shifted from one network to another.

III. Pricing Daylight Overdrafts.
Currently, daylight overdrafts are not priced on Fedwire.

And, as far as is

known, participants using CHIPS do not charge one another to receive payments
which may exceed a receiver's established bilateral net credit limit.

Under the

cross-system caps now 1.n place, however, an indirect or "shadow" price does
exist for overdrafts over a certain level.
The shadow price is the cost
incurred when caps are actually or would otherwise be exceeded.

This cost can

involve not only being counseled for incurring overdrafts that exceed the cap,
but also the expectation of more stringent action if excessive overdrafts are
incurred regularly.

Alternatively, the cost may equal the out-of-pocket

expenses associated with adopting institutional changes that reduce overdrafts.
For example, in order to avoid excess overdrafts Dis may use rollovers of
overnight funding or else shift from overnight funding to term or continuing

1Board of Governors of the Federal Reserve System, "Reducing Risk on Large
Dollar Transfer Systems", May 1985, p. 22.
Dis may directly or indirectly charge customers for extensions of daylight
credit provided to them but are not themselves directly charged for interbank
daylight extensions of credit.
Federal Reserve Bank of St. Louis

- 8 -


The shadow price increases as overdrafts approach the caps,

necessitating>closer monitoring.

In addition, if caps are reduced, more

overdrafts would become subject to the shadow price.
Today,- the extent to which Dis have adopted institutional change to reduce
overdrafts is largely determined by the costs associated with being counseled,
along with moral suasion from regulatory authorities and the desire by an
institution's management to reduce risk.

If in the Board's opinion

institutional changes that reduce overdrafts should be further encouraged, one
of three basic approaches could be followed.
be reduced to markedly lower levels.

First, the cross-system cap could

Second, caps could be abolished and

replaced by pricing all daylight overdrafts.

Finally, caps can remain at

~urrent or lower levels and augmented with direct pricing of all daylight
overdrafts covered by caps.
Unless caps are dropped sharply, the first possibility would likely reduce
overdrafts by only modest amounts since caps are only fully used by a few
institutions and the amount of overdrafts above even a sharply reduced cap are
relatively small.

Thus, even large reductions in caps would provide little

incentive to further limit those overdrafts within the boundaries of the caps.
The second possibility, where pricing replaces caps, could make all overdrafts
costly but would seemingly permit any level of overdrafts so long as the price
were paid.

Such a policy could give users the incorrect impression that the

current level of daylight overdrafts is acceptable while the Board's policy is
that overdrafts should be reduced significantly.


The final possibility, which combines pricing with caps, provides for strict
limits on overdrafts within the caps while making all overdrafts within the caps


Reduction of Payments System Risk:
November 1985, p. C-3.
Federal Reserve Bank of St. Louis

A Manual for Depository Institutions,"

- 9 costly to those who incur them.

The combination of caps and pricing suggests

that direct pricing of overdrafts can serve as either a substitute for or
complement to future cap reductions in the sense that both pricing and caps
provide inducements to reduce·overdraft levels.
Pricing Fedwire overdrafts cannot be considered in isolation from its effect

Pricing on Fedwire alone, without bilateral credit limits or caps on

CHIPS, could have resulted in a significant shift of Federal Reserve credit risk
to CHIPS, increasing systemic risk.

Because bilateral credit limits and caps

are now in place, however, it should now be possible to price Fedwire overdrafts
,without materially increasing systemic risk on CHIPS.

In addition, experience

indicates that current operational differences between Fedwire and CHIPS, such
as standard CHIPS message formats which allow for greater automation, appear to
dominate price differences when choosing networks.
Arguments For Pricing Fedwire Daylight Overdrafts.

The major benefits from

pricing Fedwire daylight overdrafts can be summarized as:
(1) Pricing creates additional incentives for users to reduce overdrafts
through continued operational improvements (such as real time monitoring
systems and reduced computer downtime) and institutional change (such as
funds rollovers, shifts to continuing contracts, and netting of
underlying obligations by novation);
(2) Pricing provides participants more flexibility in making payments than
does an equivalent incentive brought about by a reduction in caps;
(3) Pricing generates revenues to compensate for the credit risk and related
expenses faced by Reserve Banks. These costs, which can include some
bank examination expenses which also serve to reduce Reserve Bank risk
exposure, are not now included in the current Fedwire price; and,
(4) Pricing enhances equity by placing costs on those who generate the risks
and enjoy the benefits of the payments system.
The first benefit is the most important since it could provide additional
incentives for Fedwire users to continue to implement changes that reduce their
overdrafts, a clear long-run solution to the payment risk problem.
Federal Reserve Bank of St. Louis

The second

- 10 benefit accrues mainly to Fedwire users.

While similar incentives to reduce

overdrafts can in principle be achieved by reducing caps to some lower level,
the pricing alternative provides more flexibility for participants.


If the

overdraft price is not prohibitively high, the least costly alternative for Dis
under such a policy may initially be to pay the cost of incurring an overdraft
within the current cap while working to reduce them in the future.

In contrast,

the costs of implementing procedures to reduce overdrafts immediately to meet a
lower cap level may be much larger compared to a policy of pricing that allows
an institution to choose the least costly option~
The last two arguments for pricing are consistent with comments made earlier
by the Justice Department


which suggested that the Federal Reserve attempt to

price its provision of payments finality on Fedwire.

Provision of payments

finality provides value to users since Reserve Banks absorb the credit risk of
Fedwire overdrafts.

The Justice Department noted that:

... the Federal Reserve in effect guarantees FedWire funds transfers without
charging for this valuable insurance feature. Were the private wire networks to provide a similar insurance service, perhaps in the form of settlement insurance or fees for intra-day extensions of credit, the cost of that
service would presumably be included in the f~es charged the networks.
Thus, while we are aware that the service may be a difficult one to price,
the Department urges the Board to give serious consideration to pricing the
competitively important insurance service it provides on all FedWire
transfers [p. 35}.
Problems With Pricing.

It is difficult to determine the "right" price to

charge for Fedwi~e daylight overdrafts.

If the price is set too low, little

This is true as long as the perceived cost of exceeding the caps, such as
the likelihood that the system of voluntary caps would be replaced with
regulatorily set mandatory caps if current voluntary cap levels were
consistently exceeded, is significant.

U.S. Department of Justice, "Comments on Proposals to Reduce Risk on
Large-Dollar Transfer Systems", Docket No. R-0515, November 15, 1984, pp. 34-5.
Federal Reserve Bank of St. Louis

- 11 -

incentive is generated for Dis to limit overdrafts, although it is hard to
understand how a price could have no effect at all.

If the price is set too

high, then institutions may be "overconstrained", and payments and financial
markets disrupted Just as th~y would be if caps were set too low.

The solution

may be to phase in a pricing program starting with a low price (say 10 basis
points) and then raise it over time until the desired effect is obtained.
In order to ensure that the burden of a daylight overdraft fee is borne by
those who generate risks, the fee should be a percentage of the overdraft
incurred rather than a simple markup blended into the price of a Fedwire

Otherwise, there would be little if any incentive to reduce
In addition, a choice should be made between a flat fee based on

the maximum overdraft incurred that day,

1 regardless of the duration of the

overdraft, and a fee that varies with the duration of the intraday credit
exposure, like a per hour price.

A flat fee may be less complex to implement

-but would do little to encourage Dis to reduce the duration of their overdrafts.
Alternatively, if an hourly charge were used, institutions would have incentives
to cover overdrafts as soon as possible.

Given current operational capabilities

discussed below, however, a one hour time period might be too short to start
A compromise solution which incorporates the above concepts but remains
stmple to administer and understand could be:


There are two reasons why it may be better to price overdrafts on their
maximum value rather than their average size during the day. First, two Dis
with the same average overdraft can present quite different risks to the payments system. A DI which incurs an average overdraft of 1.0 times capital based
on a relatively constant overdraft over the day is less risky than a DI having
the same average overdraft but with a fluctuation during the day between 2.0 and
0.5 times capital. Use of the average overdraft approach rather than using the
maximum value neglects these differences in risk. Second, the focus of the
current counseling effort is on the daily maximum overdraft, not the average
during the day. Even the two-week average cap calculation involves the average
of daily maximum values.
Federal Reserve Bank of St. Louis

- 12 (a) Standard Price: the-overdraft price is based on the maximum Fedwire
daylight overdraft incurred during the day; and,
(b) Duration Adjustment: if the total time an institution is in any overdraft during the day exceeds three hours, which is the average duration
of a Fedwire overdraft, the price is raised to double the initial fee.
With this pricing approach, only two elements need to be known--the maximum
overdraft incurred each day and the total time the institution was in any

If the total time of a DI's overdrafts during the day was less than

three hours, there would be no duration adJustment and the standard price could

And, since the total value of the maximum daily overdraft would be

subject to a charge, prices need not distinguish between overdrafts which are
below or above the daily cap.
by the cap.

This distinction should continue to be enforced


A second potential problem with pricing Fedwire overdrafts is that it
involves adverse selection problems common to insurance.

According to this

argument, pricing overdrafts could lead less risky Dis to seek out lower cost
alternate suppliers of intraday funds while more risky Dis continue to pay the
price at Reserve Banks.

This can result in a group of overdrafting Dis on

Fedwire that are more risky on average than before.
this problem would be serious, however.

It does not appear that

First, if some Dis refrain from

overdrafting, the overall level of risk to the system should fall from what it
is today, even if the more risky Dis continue to overdraft and pay the Fedwire

If overdrafts are not priced, risky Dis will still overdraft at least

as much or more within the caps as they would in a priced system.

Thus the

adverse selection problem associated with pricing should not be very

There is no reason to apply additional charges to overdrafts measured over
two weeks since a DI would already be charged for daily overdrafts over the samer
time period.
Federal Reserve Bank of St. Louis

- 13 significant.

Second, Dis that present more risk should have lower caps if they

have in fact =t°ollowed the guidelines set out in the self-assessment program
which determines cap selection.

If the more risky Dis remain on Fedwire after


pricing, they should also have lower caps and overdrafts, on average, than
existed previously.

This may be a good reason to combine caps with pricing,

rather than use either one alone.
A third objection to pricing is that caps are more likely to constrain
overdrafts than is pricing.

Since caps contemplate overdrafts up to a limit but

no further, they should only be preferred to pricing if the sole objective of
the risk control program is to limit the level of overdrafts.

If in addition

the total costs to all parties in the payments system should be minimized as
overdrafts are being reduced, then pricing along with caps may be preferred
because of the choice given to the overdrafting DI--to incur costly overdrafts
or to incur costs to reduce them.
A corollary to the argument that caps are more likely than pricing to
constrain overdrafts is that pricing might create an atmosphere of entitlement
to daylight overdrafts and therefore act to condqne them.

This argument is

valid if pricing is compared to a policy that totally forbids overdrafts.


choice implicit in this paper, however, is between a policy that places a
penalty or disincentive fee on overdrafts within a cap and a policy that permits
unpriced overdratts within a cap.

Since the former policy places higher costs

on overdrafters than does the latter, and contains the same restrictions as the
latter, pricing would appear to create less of an entitlement than does the

Further, under pricing the option of additional moral suasion or

cap reductions would still be available.

Thus the pricing of daylight

overdrafts on Fedwire need not connote a "right" to such overdrafts even if the
price were paid.

Instead, such pricing could be viewed as a penalty fee

intended to discourage an undesirable practice.
Federal Reserve Bank of St. Louis

- 14 Finally, pricing as well as binding caps may lead to some-redistribution of
payments volume among institutions.

Binding caps could cause a redistribution


from some institutions with no excess cap capacity to others with sufficient
capital or unused cap capaci~y to accommodate the volume.

Similarly, pricing

could redistribute payments volume from Dis on whom overdraft charges are a
significant burden toward those who may have excess cap capacity or have reduced
overdrafts through earlier adoption of institutional changes.
payments volume may have both negative and positive aspects.

Redistribution of

On the negative

side, the payments system may seemingly become more "fragmented" in that
payments may be spread among a larger number of originating institutions.


the positive side, by redistributing payments volume toward Dis that have
sufficient capital or excess cap capacity or are able to avoid overdrafts by
implementing institutional changes, and away from those who have in the past
relied heavily on overdrafts, overall payments system risk should decrease.
Effects Of Pricing.

Pricing of Fedwire overdrafts could apply to any

overdraft subJect to what can be regarded as the Fedwire cap.

Currently the

Fedwire cap is an institution-ls cross-system cap less any net debit position on
private wire systems, and covers all funds transfer daylight overdrafts in its
reserve or clearing account.

Overdrafts can arise from wire transfers of funds,

ACH, and checks presented by Reserve Banks, plus net settlement entries for
payments processed outside the Federal Reserve but settled using reserve or
clearing accounts.

Pricing could also apply to uncollateralized U.S. government

book-entry securities daylight overdrafts (plus any discount or "haircut"
applied to securities used for securities overdraft collateral) if they were to
be made subJect to the cap in the future, as suggested in a proposal now out for
public comment.

Alternatively, pricing could apply to all overdrafts, both

funds transfer and all security-related overdrafts, perhaps using differential
fees for security overdrafts that are collateralized.
Federal Reserve Bank of St. Louis

- 15 Pricing all Fedwire overdrafts would provide incentives for Dis to develop
and take furtnar actions that reduce overdrafts.

These actions are relatively

well-known and involve both a reduction in the value of daily payments sent over
wire transfer networks and an elimination of the current gap in processing time
between totally or partially offsetting payments:
(1) Rollovers where the same amount of overnight (or longer) funds borrowing
is renegotiated with the same seller. No funds move over tne 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;
(2) Continuing contracts where differing amounts of daily funds borrowings
are renegotiated with the same sellers but 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 full repayment early in the
day of the gross funds borrowed or the full reborrowing later in the day
of an altered gross amount for the next period. The value of payments
made is thus reduced and the time gap between the two gross flows
eliminated, so overdrafts fall;
(3) Term funds where 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
re borrowing;
(4) Intraday funding where excess funds or even 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; and,
(5) Netting by novation where gross bilateral payment obligations between
Dis are netted prior to the value or settlement date. Exposure is
reduced from gross to net positions so that payments satisfying these
obligations over the wire are reduced. Even though a time gap may
remain, both measured overdrafts and risk decrease.
The first three procedures have existed prior to the Federal Reserve's risk
reduction program and anecdotal information indicates that they are being
pursued more intensively than before.

In addition, the American Bankers

Association has formally supported the first two actions--rollovers and
continuing contracts--which could be used to reduce overdrafts.
Federal Reserve Bank of St. Louis

- 16 The fourth method, intraday funding, has not been used to reduce overdrafts
as far as is known.

Furthermore, it is not likely to be used under current

conditions due to the extra costs that could be incurred relative to other
overdraft reduction alternatives and because of the extra operational efforts
associated with using intraday funds.

For example, an intraday funds market

would probably require more certainty of timely Fedwire delivery than now
However, if Fedwire pricing were adopted (and/or caps reduced) and the price
were high enough (or the cap low enough), an active market in intraday funds
could well develop.

Offering a priority Fedwire message service that could

consistently assure timely delivery and circumvent computer downtime problems
would further assist the development of such a market.

The existence of an

interbank market for intraday funds might induce Dis to price daylight
overdrafts extended to their customers.

Similarly, pricing by the Federal

Reserve could lead to pricing by Dis, so that customers could eventually end up
paying some or all of the Fedwire overdraft fees.

The extent to which Fedwire

fees imposed on Dls are passed on to customers depends on the elasticities of
customer demand and the elasticity of DI supply for payment services.


The fifth method--netting by novation--is currently in the experimental

Agreements providing for this type of netting will soon become

operational in the London forward foreign exchange market and there are plans

l Pricing Fedwire overdrafts could, of course, also provide inducements to
reduce securities transfer overdrafts if some portion of these overdrafts were
covered by the current system of caps. The institutional changes pricing could
bring about in the securities area are discussed in the book-entry daylight
overdrafts proposal now out for public comment. These changes involve increased
use of securities netting prior to securities being moved over Fedwire,
reduction in position building by dealers (essentially reducing the overdraft
creating time gap between purchase of securities and redelivery), and netting bv
novation for certain types of securities trades.
Federal Reserve Bank of St. Louis

- 17 for their possible application to certain types of transactions over CHIPS.
There has been no known netting by novation application on Fedwire but it is
possible that cer~ain transactions could be handled in this manner.
It is important to note that earlier staff analyses in 1980 and 1982
indicat~d that upwards of 80 percent of all Fedwire funds transfer plus
securities transfer daylight overdrafts at large banks could be eliminated if
certain percentages of interbank overnight borrowing were shifted to term
borrowing or multi-day continuing contracts.

1 The percentages are of course

higher for those banks that had incurred large total overdrafts.
banks studied were those with deposits of $1 billion or more.

The larg~

At that time,

thege banks accounted for over 90 percent of all funds and security transfer

At one-half of these banks, 25 percent of overnight funding would

have to shift to term funding to eliminate all of their overdrafts.


one-eighth of the banks, the necessary percentage shift was over 100 percent.
-All remaining banks were between these two extremes.
The required percentage shifts are on average reduced to 8 and 33 percent (a
two-thirds reduction), however, if all securities transfer overdrafts are
excluded from the analysis.

But if some portion of securities overdrafts are

included under a revised system of caps, the above percentage shifts from
overnight to term funding are more likely to be 13 percent and 50 percent (a
one-half reduction).

Although approximate, this result demonstrates that

adoption of some or all of the five actions listed earlier may be sufficient to
virtually eliminate overdrafts which would be subJect to the (revised) Fedwire

1These studies are summarized in The U.S. Payments System: Costs, Pricing,
Competition and Risk, Monograph Series in Finance and Economics, no. 1984-1/2.
Graduate School of Business Administration, New York University, 1984, pp.
Federal Reserve Bank of St. Louis

- 18 -



cap if strong inducements were available to have these actions adopted on a more
wides~read basis.

IV. Determining The Price To Charge.
Banks commonly charge broker/dealers for the total value of intraday credit.
The charge does not vary according to the number of hours the loan is

The "Standard Price" discussed above for a Fedwire overdraft is

based on this precedent.

Further, in order to reduce overdraft durations, the

Standard Price could be doubled if the total time a DI is in overdraft during a
day exceeds three hours (Duration Adjustment).

This two-step pricing

arrangement effectively prices overdrafts in three hour increments.
Approximating The Long-Run Standard Price.

At least five methods could be

used to determine an appropriate Standard Price for three-hour increments of
Fedw1re overdrafts.

Unfortunately, many of them have serious defects and

reasonable men may differ as to the validity of any one approach.

These methods

(1) Existing Intraday Market Rate: A small (perhaps around $10 billion)
market for intraday funds exists today for broker/dealers, who need to
finance security purchases prior to delivery and payment by customers.
While there is some variation in this intraday rate, reflecting the risk
of the securities being issued and being used as collateral for the
loan, the rate has little variation over time and is typically 100 basis
points (on an annual basis);
(2) Costs Of Shifting From Overnight To Term Funding: The differential cost
of overnight funding (which typically creates daylight overdrafts) and
term funding (where overdrafts can be reduced) can represent the costs
/involved in using one simple method to reduce daylight overdrafts. This
cost, which has averaged -2.2 basis points on an annual basis over 120
weeks during 1984-86, indicates that 7-day term federal funds are, on
average, cheaper than overnight funding. The spread averages 4.5 basis
points w~en 30-day term federal funds are compared to overnight
While the current cost of shifting from overnight to term

The term funding data only exist for one DI, so generalization here may-be
Federal Reserve Bank of St. Louis

- 19 funds is -2.2 to 4.5 basis points, such a low rate is unlikely to
persist if large numbers of Dis use this approach to r~ducing their
daylight exposures;
(3) Divide The 24 Hour Overnight Rate By Eight To Obtain A Three-Hour Rate:
This ad hoc procedure 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 10 years (1976-85). This
approach effectively assumes that funds can be lent out in eight
three-hour increments or that daylight lending does not inhibit overnight use of the same funds by a different borrower;
(4) Extrapolate The Yield Curve Backwards To A 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 is only 17 basis points lower than the
average overnight rate over the last 10 years. The estimated yield curve is very flat and spreads between instruments often shift frompositive to negative over time. This approach gives results equivalent
to situations where daylight lending would prevent use of the same funds
overnight; and,
(5) Risk Premium Between Bank CDs And Treasury Bills: Over the last 10
years, the risk premium has averaged 107 basis points for 30-day
instruments, which is the shortest original maturity available for bank
CDs. Since £his premium actually falls for longer maturity
instruments, it is at least possible that a three-hour risk premium
(which does not exist) could be greater than or equal to that for the
30-day instrument.
Problems exist with all of these approaches.

For example, in the first method

the broker/dealer intraday funds rate of 100 basis points represents a market
rate on a secured intraday loan of about six hours, while Fedwire overdrafts
subject to the cap are unsecured and typically average around three hours a day
(for all overdrafting institutions). 2

Although intraday loans may be secured,

the arrangements used are loose enough that these loans are usually treated as

1For 90-day instruments, the 10 year average (1976-85) risk premium is 77
basis points, while for six month instruments the premium is only 57 basis
points. Data are from T. Rowe, T. Lawler, and T. Cook, "Treasury Bill Versus
Private Money Market Yield Curves", Working Paper, Federal Reserve Bank of
Richmond, July 1986, Table I.
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, while that for all Dis is three hours. The
average duration of overdrafts within 90 percent of each day's peak overdraft is
about 1.5 hours for all institutions and .75-hour for large institutions.
Federal Reserve Bank of St. Louis

- 20 ~

unsecured credits by the banks that make them,

The time difference, however, is

more significant, since Fedwire overdrafts are shorter on average than
broker/dealer loans,


The problems with the second method are more serious,

While the cost of

shifting from overnight to term funding can be observed in the market (unlike a
hypothetical completely unsecured three-hour intraday loan rate), this -2,2 to
4.5 basis point average spread is likely to change significantly if many Dis
seek this method to reduce overdrafts,

At present these spreads fluctuate from

positive to negative at different points in the interest rate cycle and thus
appear to be more a function of interest rate expectations than they are of the

lower liquidity and higher default risk on the term instrument.

If more Dis

turn to term funds as a substitute for overnight funds to reduce daylight
overdrafts, the observed spread should rise and the relative effect of interest
rate expectations on the demand for term or overnight funds should fall.


the current small basis point spread between term and overnight federal funds
unaerstates the spread that would likely be observed if this method of reducing
overdrafts became popular.
The last three methods involve ad hoc or statistical extrapolation to an
unobserved maturity region (three hours).

This necessarily generates a certain

amount of error even if the assumptions about the extrapolation process are

The third and fourth methods generate overdraft price estimates which

differ markedly, from 124 to 974 basis points.

Method 3 implicitly assumes that

funds lent to cover intraday overdrafts can be reused overnight (as in a private

1Since broker/dealers purchase other services from lending banks in addition
to intraday loans, these 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 which would exist if fewer related services were
purchased, as could exist in a market for interbank intraday funding for daylight overdrafts.
Federal Reserve Bank of St. Louis

- 21 market).

In this case, the daylight overdraft rate has a lower bound of 124

basis points.

Method 4, in contrast, assumes that intraday funds cannot be used

ag,ain overnight.

Here, the daylight overdraft rate would have an upper bound

very close to the overnight rate, or 974 basis points.

Since it is expected

that interbank funds borrowed to cover daylight overdraf~s could be relent
overnight to the same or a different borrower, the 124 basis point estimate is
the more accurate of the two so the higher rate of 974 basis points can be

Finally, the last method uses the current observed risk premium

between 30-day bank CDs and U.S. Treasury bills to approximate an overdraft
price which reflects the potential average risk involved in making an intraday
loan to a DI.

This risk premium of 107 basis points, however, is also affected

by the different tax treatment of income from the two instruments as well as by
their differing liquidity in secondary markets.
Of the five alternative methods of estimating the intraday price for funds
presented above, the second (shifting from overnight to term funding) and fourth
(based on an estimated yield curve) should be neglected.

Shifting from over-

night to term funding is excluded because the currently measured costs are too
low (or negative) to be representative of what the costs would likely be if many
Dis used this action to reduce overdrafts.

The yield curve results are excluded

because they imply that funds lent intraday would not be relent overnight, which
raises the rate charged on an intraday loan to a level very close to the
overnight rate.

Since intraday funds could be relent overnight if a private

intraday funds market were to develop, the rate obtained from the estimated
yield curve is unrealistically high.

The remaining three methods (1, 3, and 5)

give rates which cluster around one another at 100, 124, and 107 basis points

As a result, a best guess of an equilibrium rate which would

apply to daylight overdrafts if a private market were to develop would lie in
Federal Reserve Bank of St. Louis

- 22 the range of 100 to 125 basis points.


While it would be possible to use this best guess as an initial price for
Fedwire overdrafts, a more cautious approach would be to start pricing at some
very low intraday rate, say 10 basis points (annual rate), and slowly but
regularly raise it to higher levels over time as more experience is gained with

Following a detailed assessment of the market reaction to pricing and

the effect it has on overdraft levels, the price could be adjusted upward.
Possible Effect Of Pricing On Depository Institutions.

Fedwire funds

transfer daylight overdrafts averaged $49 billion a day over December 20, 198t.,
to July 30, 1986 (while CHIPS overdrafts averaged $45 billion a day and
securities transfer overdrafts were $47 billion).


At a Fedwire overdraft price

of 100 basis points, the initial annual cost to all Fedwire overdrafting
institutions would total $347 million(= $49 billion times .01 times (255
working days/360)), or $7,080 per one million in overdrafts per year.

On a

daily basis, this is $1.36 million per working day for all overdrafting Dis.
Wjth 10 basis points as the initial overdraft price, the overdraft cost is $34.7
million for all institutions, or $708 per million_in overdrafts per year.


overdrafting institutions would pay an aggregate of $136,000 thousand each
working day.
For those 25 institutions with the largest average Fedwire overdrafts, the
cost could be substantial if current overdraft levels were to continue despite

1This is just a guess because (1) there is no literature on determining an
intraday rate, (2) empirical observations or statistical estimates of what an
intraday rate is or could be have the defect that intraday money is currently
free to the lender and hence does not affect the rate charged to borrowers, and
(3) markets will change when intraday money has a time value.
Adding the Fedwire maximum overdraft to that for CHIPS will yield a figure
that is larger than the value associated with the cross-system cap ($78 billion
over the same time period) because the peak overdraft values occur at different
times on the two networks.
Federal Reserve Bank of St. Louis

- 23 the fee.

When a price of 10 ~asis points is charged, the cost of overdrafts per

workin~ day ranges from $1,150 to $16,900.
$~~3,000 to $4.3 million.

The cost per year ranges from

If a duration adjustment were added to double the


charge for institutions in overdraft more than three hours, cost for the same
institutions would range from $1,260 to $33,760 per work~ng day, or from
$321,000 to $8.6 million per year.
These illustrative daylight overdraft costs for Fedwire users are based on
current levels of funds transfer overdrafts and could be higher if, as proposed,
uncollateralized security transfer overdrafts were made subJect to the cap as

But more importantly, there is every reason to believe that some or all

of the above mentioned institutional changes would be used more intensively than
they are today to reduce overdrafts if pricing were adopted.

It is also

expected that all of these interbank overdraft costs would be eventually passed
on to those customers and internal bank profit centers which create, by their
current payment practices, the problem to begin with, thus providing the
incentives needed for overdraft reducing institutional change or cost recovery
from customers.

V. Administrative Issues.
The Legal Basis For Pricing Fedwire Daylight Overdrafts.

The Federal

Reserve System has authority to charge for Fedwire daylight overdrafts under
section 4, paragraph 4 (seventh) of the Federal Reserve Act which states that
the Reserve Banks may exercise "such incidental powers as shall be necessary to
carry on the business of banking within the limitations prescribed by [the
Federal Reserve Act]" (" the incidental powers clause").

Under the incidental

powers clause, the legal basis for pricing daylight overdrafts is similar to and
hinges on the legal basis for allowing daylight overdrafts.
Federal Reserve Bank of St. Louis

Essentially day-

- 24 light overdrafts are by-prod~cts of the Reserve Banks' payment functions which the Reserve Banks process payments and must be covered by the end of


Generally, the Federal Reserve Banks have incidental powers when such powers

are required to meet the legitimate demands of their authorized business and to
enable the Reserve Banks to conduct their affairs within the general scope their
charter safely and prudently.

( ~ , Lucas v. Federal Reserve Bank of Richmond,

59 F.2d 617 (4th Cir. 1932)).

Currently, permitting daylight overdrafts is

necessary for the Reserve Banks to conduct their payment functions effectively.
Controlled overdrafts are consistent with the safe and prudent discharge of
~hese functions.
The authority to charge for daylight overdrafts flows from the authority to
allow such overdrafts.

As noted previously, charging for daylight overdrafts

would discourage overdrafts within cap limits and thereby reduce Federal Feserve

Accordingly, charging for daylight overdrafts, and overnight overdrafts

as now is done, enhances the Reserve Banks' ability to perform their payment
functions safely and prudently and therefore meets the requirement for basing
authority on the incidental powers clause.
Operational Considerations.

Assessing a fee for daylight overdrafts

requires a highly accurate system to account for all payments flowing through
Reserve Bank reserve and clearing accounts.

In addition, the system should

accurately reflect the time at which funds are available for use by Dis and the
time at which payments are made by them.
Currently, the ex post monitoring system used to calculate the level and
duration of Fedwire daylight overdrafts does not always accurately reflect the
timing of certain transactions, such as check-related and ACH-related debits and
Federal Reserve Bank of St. Louis

As a result, daylight overdrafts observed in the ex post monitor may,

- 25 in fact, not have been experienced under a real time system or vice versa.
Further, bala£ces for funds and securities transfer activity are calculated at
15-minute intervals rather than po~ting transactions continuously.

Over the

long run, this approach provides an accurate representation of the average level
and duration of daylight overdrafts.

But on any particular day, the computed

individual balances may over- or understate actual daylight overdrafts compared
with continuous posting.
More importantly, there are occasional outages of Fedwire operating systems
and processing and accounting errors can affect DI intraday reserve or clearing
account balances.

When outages occur, transfers cannot be sent from or received

by the Reserve Bank.

As a result, Dis may incur overdrafts they would not have

incurred had the system been fully operational.

Reserve Banks currently

consider operating outages when their staffs review overdraft data and when
these institutions are counselled.

If prices were assessed for Fedwire

overdrafts, one way to deal with this problem could be to permit Reserve Banks,
under standardized guidelines, to waive fees when appropriate.

As an

alternative approach,_!!£ charge could be levied on Fedwire overdrafts that are
less than 25 percent of a Dis capital, if research shows that such an exclusion
approximates the average effect of Reserve Bank operational problems on DI
overdraft values over time.
Even after all practical modifications have been made to the overdraft
monitor! consideration might be given to a permanent "deductible" from Fedwire
overdrafts subject to charge--say 15 to 25 percent of a DI's capital.


deductible amount could reflect, on average, the effect on measured overdrafts
of operational difficulties experienced by Reserve Banks and/or Dis.

Such an

approach would require an understanding that Dis might from time to time be
charged because of events beyond their control but that on average these charges
would be offset by their deductible exemption each day.
Federal Reserve Bank of St. Louis

- 26 A deduction for overdrafts up to the first 25 percent of a DI's capital
would exempt from an overdraft fee 95 percent of the 3,500 institutions which
had Fedwire overdrafts.

This, given the current state of the System's

capability always monitor the true value of Fedwire overdrafts
incurred, could serve as an initial and temporary exemption until the monitoring
accuracy were suitably improved.

For the 25 institutions with the highest

average Fedwire funds transfer overdrafts, the cost of overdrafts per working
day ranges from $1,150 to $16,900 without such an adjustment but is reduced to
zero to $13,410 per working day if the exemption is allowed.

The 25 percent of

capital exemption could also be used in combination with the duration adjustment
-~hich raises the price of overdrafts if they exceed three hours.

The duration

adjusted cost per working day without the 25 percent exemption ranges from
$1,260 to $33,760 but falls to zero to $26,810 per working day with the
Federal Reserve Bank of St. Louis

- 27 Appendix

Broker/Dealer Day Loans

A day loan is advanced to a broker or securities dealer by a clearing bank
in order to enable the broker/dealer to obtain a certified check with which to
pay for securities so they may be redelivered against payment to customers.
Such a loan is granted for a period of less than a day and is expected to be
repaid by the close of business.

Although collateralized in the technical legal

sense by the underlying securities, day loans are typically considered unsecured
credits due to the difficulty in taking possession of the securities or otherwise obtaining a more secure perfected security interest in the collateral.


the loan is not repaid by close of business, the day loan must be repaid by an
overnight loan, which is charged at the broker call loan rate.
Day loans arose due to a combination of factors.

First, settlement of a

s~curities transaction is customarily made by payment with a certified check.
Second, such a transaction involves a lag between payment to the original seller
of securities and redelivery against payment from the ultimate buyer.


a check can only be certified if sufficient funds are in the broker/dealer's
account at the time he pays for the securities.

Day loans make it possible for

a check to be certified without requiring the broker or dealer to continuously
maintain sufficient working balances, into the ten and hundreds of millions of
dollars, to ensure that all securities purchases can be covered out of his own

While it seemingly appears that day loans are the result of the conven-

tion (and the Depositorv Trust Company requirement) of using certified rather
than cashiers checks for payment, according to bankers contacted for this study
even a cashiers check would not be issued for securities purchases unless
covered by sufficient funds or a day loan.
Federal Reserve Bank of St. Louis

- 28 Almost all day loans take place in New York because the vast maJority of
securities transactions occur there.

A day loan presupposes the ability of a

bank to closely monitor the intraday status of broker/dealer accounts.

If such

an ability-did not exist, it is unclear how a bank would know whether a day loan
is necessary to certify a check.
A day loan transaction may work as follows.

In the morning, a broker or

dealer finds he will need a certain sum to cover a purchase and redelivery of
securities to one of his customers.

He delivers a note to the lending bank.

Granting the loan means that the broker/dealer's account is credited for the -amount of the loan and debited for the amount of the certified check.


later that day means that the account is credited for the amount of the
~ustomer's payment for the redelivered securities (usually by certified check or
wire transfer) and debited for the principle and interest of the day loan.
The price of a day loan is a negotiated rate which consistently hovers
around 100 basis points.

Since the rate is open to negotiation, it may be as

low as 50 or as high as 200 basis points.

To the extent that the day loan rate

does vary from 100 basis points, however, it is across institutions making the
loan rather than over time for any given institution.

Further, although some of

the bankers contacted for this study felt that the riskiness of an institution
issuing the securities could play a small part in determining the day loan rate
charged, far more importance was assigned to ability of the price to cover
operational and transaction costs, the size of the broker/dealer obtaining the
loan, and other factors specific to the relationship between the bank and the
The relevance of day loans to pricing daylight overdrafts is mixed.
positive side, it is a rare example of explicitly priced intraday credit.
Further, like a daylight overdraft it represents an unfunded extension of
Federal Reserve Bank of St. Louis

On the

- 29 credit.

In other words, the-lending bank does not have to borrow or generate

funds <in order to make the loan.

Only if the day loan becomes an overnight loan

does funding become necessary.
On the negative side, since day loans are negotiated between the bank and
its broker as part of an ongoing relationship, there is·no separate market for
day loans alone.

However, there is probably no strong economic reason why day

loans could not be unbundled from other bank services.

It appears that this

simply is not done, perhaps because the payments involved are a tiny part of the
total package of broker/dealer services provided by banks.

Another negative

aspect is that the rate apparently does not change significantly over time for a
particular borrower, and so does not by itself seem to reflect changing
relationships over time between supply of and demand for intraday credit.
Rather, the rate appears to cover the bank transaction costs involved.


_the day loan rate is not affected by the number of hours it is outstanding.
Whether a day loan lasts one hour or six hours, the same rate is charged the
Federal Reserve Bank of St. Louis