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Working Paper 8816

PRICING DAYLIGHT OVERDRAFTS
by E. J. Stevens

E.J. Stevens is an assistant vice president
and economist at the Federal Reserve Bank of
Cl eve1 and.
Working papers of the Federal Reserve Bank of
Cleveland are preliminary materials
circulated to stimulate discussion and
critical comment. The views stated herein
are those of the author and not necessarily
those o f the Federal Reserve Bank o f
Cleveland or of the Board of Governors of the
Federal Reserve System.

December 1988

Introduction

The 12 Federal Reserve Banks extend about $1 15 b i 11i o n o f c r e d i t w i t h i n a
few hours on an average business day, o n l y t o take i t back again before the
close of business.

Very l a r g e commercial banks extend an a d d i t i o n a l $45

b i l l i o n o f c r e d i t t o o t h e r domestic and f o r e i g n banks each day, again, o n l y t o
take i t back again before the close o f business.
This huge volume o f d a y l i g h t c r e d i t takes the form o f temporary o v e r d r a f t s
of deposit accounts a t Federal Reserve Banks and accumulated u n s e t t l e d n e t
payment p o s i t i o n s between banks who p a r t i c i p a t e i n C l e a r i n g House I n t e r b a n k
Payment System (CHIPS).'

I n both cases, telecommunication o f payments t o

o t h e r banks produces the day1 i g h t c r e d i t .

Subsequent telecommunication of

payments t o overdrawn banks extinguishes the temporary c r e d i t .
c r e d i t i s n o t a1 located by any market process.

Daylight

I t i s simply a by- product of

the o r d e r i n which a bank's payments and r e c e i p t s occur.
D a y l i g h t c r e d i t created on Fedwire and CHIPS i s f r e e .

Banks do pay a

small fee t o send telecommunicated payment messages, on b o t h Fedwire and
CHIPS, b u t t h e r e i s no e x p l i c i t o r , as f a r as one can t e l l , i m p l i c i t charge
f o r t h e amount o f d a y l i g h t c r e d i t extended on e i t h e r network.

I n fact, u n t i l

r e g u l a t o r y l i m i t s were imposed i n 1986, d a y l i g h t c r e d i t had been i n a p p a r e n t l y
unl i m i t e d supply from Federal Reserve Banks, a1 though n o t necessari l y between
CHIPS p a r t i c i p a n t s .
Of course, a bank would have t o pay f o r o v e r n i g h t f i n a n c i n g i f t h a t were

needed t o cover an o v e r d r a f t a t t h e Fed o r a n e t d e b i t p o s i t i o n on CHIPS a t
close o f business.
financing.

N e i t h e r network i s intended t o p r o v i d e automatic o v e r n i g h t

I t i s the nature o f the American banking system t h a t o v e r n i g h t and

longer-maturity credit is scarce (with the degree o f scarcity controlled in
the aggregate by monetary pol icy) and must be paid for, but dayl ight credit is
in virtually unlimited supply and is free.'
Using daylight credit is not a basic necessity for making payments.

A

bank could avoid any need for dayl i ght credi t at a1 1 , if it were wi 1 1 i ng t o
a1 locate a large enough portion o f its assets t o reserve deposit balances.

Of

course, that would be expensive, because reserve deposits are non-interestbearing assets.

A1 ternati vely, modifying current transactions practices could

reduce dependence o n daylight credit.

Banks o r their customers could

eliminate some payments (for example, by lengthening the maturity of
1 iabi 1 i ties) , o r adopt del i berate payment sequencing programs, o r borrow other
banks' idle balances f o r short periods during the day.

However, the incentive

t o d o any of these things has been lacking because dayl ight credit has been
free.
Daylight credit may be

free,

but it is not without cost.

Growing

recognition of its costs has prompted proposals that both Fedwire and CHIPS
reduce dayl ight credit by pricing.
induce banks to economize o n it.

Pricing dayl ight credit would then
One proposal would encourage this simply by

imposing a slight per-dollar fee o n daylight overdrafts.

Another would treat

each daylight overdraft of a reserve account as an automatic overnight
di scount-window loan, booked at a penalty rate.

A third would require banks

t o hold additional balances at a Federal Reserve Bank in proportion t o their
dayl i ght overdrafts.
Evaluating these proposals requires an understanding of the costs of
daylight credit, as well as of policy objectives being sought.

An obvious

cost of daylight credit is creditors' risk exposure, which is why this topic
has become known as the payment system risk (PSR) problem.

Ri sk-taking is a

normal feature of financial markets. To the extent that informed lenders
assume risk in extending daylight credit, the cost of their exposure to
daylight credit risk would not necessarily create a policy problem. However,
current institutional arrangements for making large-dollar-value payments in
the U.S. fully insure payor banks' access to daylight credit in making
payments on the Federal Reserve el ectroni c network.
Three problems are associated with daylight credit. First, institutional
insurance creates a moral hazard problem. Second, extensions of dayl ight
credit on the private CHIPS network create a systemic risk problem, and third,
the attempt of private networks to compete with Fedwire suggests a competitive
inequality problem. These three problems associated with dayl ight credit,
plus concern about the application of old law to new technology, create the
PSR policy problem, which is examined in Part I. Questions about possible
policy objectives are raised in Part 11, and Part I11 evaluates three recent
reform proposal s that would introduce pricing to resolve PSR problems. The
conclusion reached in Part IV is that none of these pricing proposals would,
in itself, resolve the problems. More basic decisions about technology and
regulation must come first.

I. Daylight Credit and Payment System Risk
In a monetary economy, a payee must be concerned with the validity of the
device used by the payor to transfer value. Finality characteristics of a
payment specify circumstances under which the payee has irrevocable ownership

of the amount transferred so that the payor's obligation is discharged.
Settlement characteristics of a payment determine the risk that irrevocable
ownership is not accompanied by access to good funds.

A.

F i n a l i t y and Risk.

Cash--legal tender f i a t money i n the U.S.--i s a

r i s k l e s s form o f payment because r e c e i p t o f cash gives the payee both
ownership and funds.

For checks, on the o t h e r hand, the payee has o n l y

p r o v i s i o n a l ownership u n t i l the payment i s s e t t l e d .

The check must c l e a r back

t o the paying bank, which then has an o p p o r t u n i t y t o r e j e c t i t f o r reasons
such as i n s u f f i c i e n t funds o r a stop payment order.

Settlement occurs when

t h e payor's bank f a i 1s t o take t i m e l y a c t i o n t o r e t u r n the check, thereby
accepting a d e b i t t o i t s account a t the Federal Reserve o r a correspondent
bank.

U n t i l t h i s settlement has been accomplished, however, the payment i s

not final.

The payee's bank i s extending c r e d i t t o the payee i f i t a1 lows

proceeds of the check t o be used, and i s exposed t o r i s k .
Fedwire payments provide r e c e i v e r f i n a l i t y and immediate settlement, as
s p e c i f i e d by Federal Reserve Regulation 3 .

Receipt o f the payment message i s

t h e signal both t h a t the payment i s f i n a l and t h a t good funds a r e a v a i l a b l e i n
t h e payee bank's reserve d e p o s i t account.

This means t h a t the Federal Reserve

i s extending c r e d i t t o any payor bank having i n s u f f i c i e n t balances t o cover
i t s Fedwi r e payments.

Hence, day1 i g h t o v e r d r a f t s on Fedwire expose Federal

Reserve Banks t o c r e d i t r i s k .
C H I P S i s a d i f f e r e n t matter, f o r which there i s no "coherent framework" of

law o r r e g u l a t i o n f o r f i n a l i t y .

Payment i n s t r u c t i o n s are recorded among

t h e 137 p a r t i c i p a t i n g i n s t i t u t i o n s d u r i n g the day.

A t any moment d u r i n g the

day, banks t h a t have made more payments than they have received are i n a n e t
d e b i t p o s i t i o n , r e p r e s e n t i n g c r e d i t granted by o t h e r p a r t i c i p a t i n g banks.
P o s i t i o n s are s e t t l e d o n l y a t t h e close o f the day through a settlement
account a t the Federal Reserve.

Banks i n a n e t d e b i t p o s i t i o n pay t h e n e t

amounts due from them i n t o the settlement account, enabling payments of n e t
amounts due t o banks i n n e t c r e d i t p o s i t i o n s .

Settlement i s complete o n l y if

each of the n e t d e b i t p o s i t i o n banks a c t u a l l y makes the payment r e q u i r e d t o
repay the c r e d i t i t has received.

CHIPS r u l e s r e q u i r e t h a t i f a bank cannot

make t h i s settlement payment, and one o r more lenders are u n w i l l i n g t o fund
the n e t debi t, then a1 1 o f the day's transactions i n v o l v i n g t h a t bank are t o
be backed out, and a new s e t of n e t d e b i t and c r e d i t p o s i t i o n s c a l c u l a t e d f o r
the remaining p a r t i c i p a n t s .

As c u r r e n t l y constructed, t h e r e f o r e , payments
Nhatever

made on CHIPS are based on interbank extensions o f day1 i g h t c r e d i t .

the l e g a l outcome f o r f i n a l i t y , a n e t d e b i t p o s i t i o n bank's f a i l u r e t o s e t t l e
means t h a t o t h e r banks are deprived o f good funds.
With no coherent framework f o r f i n a l i t y , i t i s n o t e n t i r e l y c l e a r who i s
exposed t o c r e d i t r i s k (payor, payor bank, payee bank, payee) i n the event of
settlement f a i l u r e s .

However, aside from t h i s u n c e r t a i n t y , an important

p o l i c y concern a r i s e s from the cost o f settlement f a i l u r e i t s e l f .

Although a

s i n g l e bank may have extended c r e d i t d i r e c t l y to the bank t h a t f a i 1s t o cover
i t s n e t d e b i t a t settlement, a l l banks are s u b j e c t t o u n c e r t a i n t y about the
amount of good funds they w i l l r e c e i v e o r need t o pay a t settlement as long as
any bank can be backed o u t o f the settlement.
A presumption has a r i s e n t h a t the f e d e r a l s a f e t y n e t removes t h i s

uncertainty.

CHIPS handles an enormous dai l y volume o f payments, p a r t i c i p a n t s

accumulate s u b s t a n t i a l n e t d e b i t p o s i t i o n s r e l a t i v e t o t h e i r c a p i t a l d u r i n g
the day, and the CHIPS network plays an i n t e g r a l r o l e i n the global money and
foreign-exchange markets.

The view i s t h a t , were a settlement f a i l u r e t o

happen, r e g u l a t o r s would be forced t o do whatever was necessary t o a1 low
settlement t o proceed by arranging a quick rescue package f o r the f a i l e d
i n s t i t u t i o n , o r perhaps by p r o v i d i n g f i n a n c i n g t o c r e d i t o r banks i n the amount
of t h e i r u n s e t t l e d b i l a t e r a l c r e d i t p o s i t i o n s w i t h respect t o the f a i l e d
institution.

The f e d e r a l safety net, n o t CHIPS p a r t i c i p a n t s , i s a t r i s k .

There i s an a1 t e r n a t i v e s t r u c t u r e f o r p r i v a t e payment networks, which
CHIPS i s soon expected t o adopt.

Settlement would be guaranteed by a

r i s k - s h a r i n g agreement among p a r t i c i p a n t s , p r o v i d i n g f o r settlement f i n a l i t y .
I n the event o f a settlement f a i l u r e , p a r t i c i p a n t s would p r o v i d e funds t o
cover the c r e d i t represented by the f a i l e d banks' p o s i t i o n , i n accordance w i t h
an ex ante s h a r i n g agreement.

The obvious d i f f e r e n c e between t h i s and Fedwire

i s the c r e d i t w o r t h i n e s s o f t h e e n t i t i e s u n d e r w r i t i n g payee banks' guarantee of
good funds a t settlement.
Evaluating t h e s i g n i f i c a n c e o f PSR i s d i f f i c u l t .

I n c i d e n t s o f payor

f a i l u r e s d u r i n g a business day have been almost unknown.

Bank f a i l u r e s

t y p i c a l l y are arranged t o take p l a c e o v e r n i g h t , w i t h the a c t i v e involvement of
regulatory authorities.

A l a r g e constituency o f foreign- based i n s t i t u t i o n s i n

CHIPS may make unexpected f a i l u r e d u r i n g the day more 1i k e l y , i f f o r e i g n

r e g u l a t o r s were t o a c t a f t e r the close o f business i n t h e i r time zone, b u t
before c l o s e o f business i n t h e U.S.

For Fedwire, a l o s s from the i n t r a d a y

f a i l u r e o f a bank t o cover i t s d a y l i g h t o v e r d r a f t s would depend on terms
worked o u t i n a r e g u l a t o r y d i s p o s i t i o n o f t h e f a i l e d bank.
Actual exposure t o loss- - the enormous amount o f d a y l i g h t c r e d i t extended
evaluated a t an h i s t o r i c a l l y minuscule probabi 1it y o f loss--seems q u i t e small
r e l a t i v e t o Treasury r e c e i p t s and expenditures.
risk.

I t i s taxpayers who are a t

Any charge t o Federal Reserve income, a l l e l s e equal, would r e s u l t i n

an e q u i v a l e n t decrease i n Treasury revenue and, i n the s h o r t run, an increase
i n Treasury debt issued t o the p u b l i c .

I n a d d i t i o n , o f course, t h i s does

represent a roundabout open-market o p e r a t i o n t o create the reserves r e c e i v e d
by payees of t h e f a i l e d bank.

However, any monetary impact could be o f f s e t by

o r d i nary System open-market securi t y sales .

8.

Payment System R i s k and Cost.

The PSR problem i n l a r g e - d o l l a r payment

networks i s n o t so much the p o t e n t i a l d o l l a r l o s s t o taxpayers o r even t o
p r i v a t e network p a r t i c i p a n t s , b u t t h r e e d e r i v a t i v e problems:
systemic r i s k , and competitive i n e q u a l i t y .

moral hazard,

I n a d d i t i o n , there i s some concern

about how u n c o l l a t e r a l i z e d d a y l i g h t c r e d i t r e s u l t i n g from modern
telecommunication o f payments f i t s i n t o the 75-year o l d framework of the
Federal Reserve Act.
1. Moral Hazard.

The Federal Reserve creates moral hazard by i n s u r i n g access
s

to d a y l i g h t c r e d i t f o r payor banks.

Payee banks have no i n c e n t i v e t o concern

themselves w i t h t h e c r e d i t w o r t h i n e s s o f banks f r o m whom they r e c e i v e Fedwire
messages, i f t h a t i s the o n l y r e l a t i o n s h i p between them.

Nor do payor banks

have any i n c e n t i v e t o concern themselves w i t h market perceptions o f t h e i r own
c r e d i t w o r t h i n e s s as a means o f assuring the w i l l i n g n e s s o f o t h e r banks t o
accept payments from them.

Uninsured c r e d i t o r s , as w e l l as supervisors and

r e g u l a t o r s , o f course, are concerned w i t h the c r e d i t q u a l i t y o f banks, but,
u n t i 1 the p r e p a r a t i o n and i n t r o d u c t i o n o f the Board's P'sR p o l i c y i n 1986,
l i t t l e o r no a t t e n t i o n was g i v e n t o PSR--at l e a s t i n p a r t because t h e r e had
been no way t o document the e x t e n t t o which d a y l i g h t o v e r d r a f t s e x i s t e d .
J u s t as 100-percent automobile l i a b i l i t y insurance may d e t e r accident
prevention, so too, 100- percent payment r i sk i nsurance s u r e l y has d e t e r r e d
payment r i s k prevention.

M a n i f e s t a t i o n s o f moral hazard i n the payments case

may seem more obscure than nonchalance a t the wheel i n the automobile case.
Nonetheless, they e x i s t , and r e g u l a t i o n has o n l y r e c e n t l y begun t o focus on
them.
I d e n t i f y i n g m a n i f e s t a t i o n s o f moral hazard may be e a s i e r i f the b e n e f i t s
o f 100- percent payment r i s k insurance a r e c l e a r l y i n view.

The o v e r r i d i n g

b e n e f i t t o consumers and businesses i n the U.S. i s t h a t t h e r e i s no r e a l

impediment t o r e c e i v i n g o r making l a r g e ( o r small) value same-day payments
through any p a i r of t h e thousands o f banks w i t h access t o Fedwire.

Those

impediments otherwi se would be the c o s t o r unavai l a b i 1i t y o f immediate,
re1 i a b l e information about the solvency and l i q u i d i t y o f any bank i n the
n a t i o n from which chance might b r i n g a payment.

Fedwire, by design of the

Federal Reserve System e a r l y i n t h i s century, has provided a mechani sm f o r
encouraging a t r u l y n a t i o n a l payment system o u t o f a f r a c t i o n a t e d p r i v a t e
banking system.
The obverse o f t h i s o r i g i n a l b e n e f i t i n the modern world o f
telecommunications can be seen i n the r e l i a n c e o f many banks on o v e r n i g h t
borrowing f o r a s i g n i f i c a n t p o r t i o n o f t h e i r f i n a n c i n g , w i t h attendent
p o s s i b i l i t i e s o f r a p i d run- off o f t h a t financing.
each day whether t o r i s k another o v e r n i g h t loan.

Lenders can decide anew
The o v e r n i g h t borrower bank

can r e t u r n funds each morning and t a i l o r borrowing t o the needs o f the new
day, w i t h the i n t e r v a l spent i n d a y l i g h t debt t o t h e c e n t r a l bank.

Similarly,

a p l e t h o r a of new markets i n s o p h i s t i c a t e d f i n a n c i a l instruments has grown up
on a foundation o f r i s k l e s s p r i v a t e payments i n which the q u a l i t y o f the
p a y o r ' s bank i s l a r g e l y i r r e l e v a n t t o t r a d i n g decisions.
The moral hazard i s t o the pub1i c t h a t provides the insurance.

Any

unexpected question about t h e c r e d i t q u a l i t y o f a bank can c r e a t e an immediate
1i q u i d i t y c r i s i s t h a t n e c e s s a r i l y must have an immediate r e s o l u t i o n .

That

r e s o l u t i o n w i l l be t o r o l l over the bank's d a y l i g h t o v e r d r a f t i n t o e i t h e r an
o v e r n i g h t o v e r d r a f t a t the c e n t r a l bank o r a discount-window loan from the
c e n t r a l bank.

A s an o p e r a t i o n a l matter, an o v e r n i g h t o v e r d r a f t i s automatic

if a bank does n o t come t o the discount window t o borrow.

Only a small subset

of banks, i n c l u d i n g those under close supervisory watch, have a1 1 t h e i r
Fedwire payments monitored i n r e a l time against agreed minimum balances d u r i n g

the day. In the more normal cases, the central bank is not in a position to
refuse overnight overdrafts because account balances are only monitored ex
post. In effect, the insurer knows about reckless driving only after the
accident.
2. Systemic Risk. Absence of payment insurance on a private payments network

like CHIPS avoids the moral hazgrd problem of Fedwire. Payee banks themselves
must recognize the possibi 1 ity that a payor bank might fail to cover its
daylight debt on the network. Evaluating the probability of loss, controlling
dayl ight exposure with respect to each payor bank, and maintaining a capital
cushion appropriate to these exposures would be the expected behavior of payee
banks in the face of such direct dayl ight credit risk. However, systemic risk
would remain for the most part unmanzged because it is not readily evaluated
and is probably underestimated by network participants.
The concept of systemic risk reflects the interdependence of a payments
network and the consequent potential for chain reactions of settlement
failures. The triggering event would be failure of a network participant to
repay net daylight credit extended by other network participants. Under the
current CHIPS rule, backing out a1 1 of that day's payments from and to the
failed bank wi 1 1 create new and unexpected net credit and debit positions for
remaining banks. It is at this point that the systemic risk phenomenon might
begin. If one or more banks were unable to fund their new and unexpected net
debit positions, then their day's transactions would have to be backed out and
yet another new settlement calculated. The chain reaction might continue if
additional banks were unable to fund these newer and unexpected positions, and
so forth.'
Granted that such a chain reaction might occur, it need not be of any
unique concern to policymakers if network participants were able to evaluate

and manage t h e i r systemic r i s k exposure.

But, as c u r r e n t l y c o n s t i t u t e d ,

payment system arrangements probably prevent that, because systemic r i s k i s
l i k e l y t o be underweighted i n bank decisions t o extend d a y l i g h t c r e d i t .

This

r e f l e c t s two informational d e f i c i e n c i e s .
The f i r s t i s a l a c k o f i n f o r m a t i o n t h a t would a l l o w banks t o evaluate
c o n d i t i o n a l p r o b a b i l i t i e s o f settlement f a i l u r e .

While a bank may evaluate

the probabi 1i t y o f f a i l u r e by each p a r t i c i p a n t from which i t d i r e c t l y accepts
payments, i t c u r r e n t l y seems d o u b t f u l t h a t there i s a f i r m basis f o r judging
the probabi 1i t y o f a second-round f a i 1ure o f each p a r t i c i pant, condi tioned on
p r i o r f a i l u r e o f another, and f u r t h e r conditioned on f a i l u r e s a t succeeding
stages o f t h e chain.

Aside from computational complexity, these probabi 1i t i e s

would depend on the b i l a t e r a l c r e d i t - p o s i t i o n o f each bank w i t h respect t o
each of t h e others, and the mu1t i l a t e r a l n e t posl t i o n o f each.

Each of these

p o s i t i o n s may show r e g u l a r i t i e s , b u t they are unknown t o a l l b u t t h e d i r e c t l y
concerned p a r t i c i p a n t s .
Another aspect o f t h i s problem i n v o l v e s a negative e x t e r n a l i t y .

Extension

of d a y l i g h t c r e d i t by any p a r t i c i p a n t a f f e c t s o t h e r p a r t i c i p a n t s because each
e x t r a d o l l a r o f c r e d i t extended increases the r i s k i n e s s o f each p r i o r
c r e d i t o r ' s exposure.

Social cost ( i n terms o f r i s k ) o f e x t r a d a y l i g h t c r e d i t

may be l a r g e r than the perceived p r i v a t e cost, leading t o overlending.
The second i n f o r m a t i o n a l d e f i c i e n c y i s simply a general l a c k o f knowledge
of how t h e chain r e a c t i o n o f systemic f a i l u r e s would p l a y i t s e l f o u t .

The

process i s n o t a known q u a n t i t y because i t has n o t happened, o r has n o t been
a1 lowed t o happen.

Three u n c e r t a i n t i e s i 1l u s t r a t e t h i s , i n v o l v i n g t h e

l i k e l i h o o d o f p r i v a t e interbank lending, supervisory treatment o f l i q u i d i t y
i n s o l v e n c i e s , and the r o l e o f the l e n d e r o f l a s t r e s o r t .
A chain r e a c t i o n would continue o n l y i f p o t e n t i a l end-of-day lenders of

o v e r n i g h t funds ( i n c l u d i n g t h e network p a r t i c i p a n t s w i t h new and unexpected
n e t c r e d i t p o s i t i o n s ) were u n w i l l i n g t o lend the funds r e q u i r e d f o r settlement
by those i n new and unexpected n e t d e b i t p o s i t i o n s .

A f t e r a1 1, if the o n l y

unsound i n s t i t u t i o n were the bank t h a t t r i g g e r e d the p o t e n t i a l chain r e a c t i o n ,
why wouldn't p o t e n t i a l p r i v a t e lenders recognize t h a t next- round banks were
merely i11i q u i d , n o t i n s o l v e n t ? Even i f t h e next- round banks had s u b s t a n t i a l
loans outstanding t o the t r i g g e r i n g i n s o l v e n t bank, the chances o f those loans
being a t o t a l l o s s i n eventual 1i q u i d a t i o n , and o f d e p l e t i n g the c a p i t a l of
the next- round banks, would seem remote.
Nonetheless, u n w i l l i n g n e s s o f p r i v a t e i n s t i t u t i o n s t o lend does seem
r a t i o n a l , and t h e r e f o r e p l a u s i b l e , under the combination o f two q u i t e 1 i k e l y
conditions.

One i s t h a t new and unexpected n e t d e b i t p o s i t i o n s of some banks

can be q u i t e l a r g e r e l a t i v e t o t h e i r c a p i t a l .

Interbank o v e r n i g h t l e n d i n g i s

unsecured, so t h a t a borrower's c a p i t a l cushion r e l a t i v e t o the s i z e of t h e
needed c r e d i t i s a s i g n i f i c a n t i n d i c a t o r o f t h e l e n d e r ' s r i s k , whether t h a t
lender a c t s alone o r i n some h a s t i l y arranged consortium o f lenders.
The o t h e r c o n d i t i o n i s t h e haste w i t h which such l e n d i n g must be
arranged.

A settlement f a i l u r e would become known, and unexpected n e t d e b i t

and c r e d i t p o s i t i o n s c a l c u l a t e d , o n l y a t , o r c l o s e t o , t h e end o f a day's
normal market a c t i v i t y .

Lending would have t o be completed before the opening

of the next business day i f market d i s r u p t i o n were t o be avoided.

Within t h i s

s h o r t time frame, r e l i a b l e i n f o r m a t i o n upon which t o base c r e d i t d e c i s i o n s
would be scarce, r e q u i r i n g hasty judgments about i n s t i t u t i o n s and t h e i r assets
and l i a b i l i t i e s i n an interdependent network o f banks.
A second u n c e r t a i n t y concerns the r e a c t i o n o f supervisory a u t h o r i t i e s if

second, t h i r d , and f u r t h e r - r o u n d banks were unable t o f i n a n c e new and
unexpected n e t d e b i t p o s i t i o n s as the chain r e a c t i o n proceeded.

These banks

would show a net debit in the amount that forced them out of the settlement
process, but with an offsetting net credit position with respect to one or
more banks that already had been backed out of that, and previous, rounds of
the settlement process. Except for the trigger bank, each bank in backed-out
status might be solvent in the usual sense, but insolvent in the sense that it
was unable to honor requests for payment--a liquidity insolvency.
Would supervi sory authori ties declare such banks insolvent and force them
to close, or would they allow them to continue operating? Given time to sort
out obligations free of a threat of imminent failure, such banks might resume
normal operations once they had demonstrated their sound credit condition to
lenders under more lei surely conditions and with full informztion disclosure.
But such a reaction by supervisory authorities to permit this resolution of a
chain reaction is uncertain.
Third, the reaction of the lender of last resort is uncertain, hinging in
part on the outcome of the solvency issue. Discount-window loans may not be
made to insolvent institutions, Loans to solvent institutions at any round of
the chain reaction would bring an immediate end to the reaction by providing
the funds needed to achieve a successful settlement. Acceptable col lateral
might be difficult to assemble, but the presence of a willing last-resort
lender to banks other than the trigger bank would eliminate systemic risk to
network participants.
Systemic risk may exist, but network participants are not in a position to
evaluate the risk fully in making daylight credit judgments. This risk is
probably underestimated by banks, because private risk costs understate social
cost in extensions of private daylight credit, and because it seems reasonable
to expect supervisory and lender-of-last-resort actions to prevent the chain
reaction of settlement failure. For these reasons, control 1 ing systemic risk

might i n v o l v e a c t i v e p o l i c y oversight o f p r i v a t e network arrangements.

3.

Competitive I n e q u a l i t y .

competi t i ve advantage.

Free d a y l i g h t c r e d i t insurance gives Fedwire a

Fedwi r e i s a money t r a n s f e r system, w i t h settlement on

the books o f the Federal Reserve.

Other domestic money t r a n s f e r systems have

attempted t o compete w i t h Fedwire (Cashwire and CHESS), b u t c o m p e t i t i o n was
d i f f i c u l t before the Monetary Control Act (MCA) r e q u i r e d Fedwire t o p r i c e
transfers e x p l i c i t l y , r a t h e r than i m p l i c i t l y as p a r t o f the c o s t of membership
i n the Federal Reserve System.

Since the MCA, p r i c e and s e r v i c e qua1i t y

features of making payments have provided a basis f o r competition, b u t
settlement has been a problem.
The Federal Reserve provides a settlement f a c i l i t y f o r p r i v a t e networks,"
i l l u s t r a t e d by the CHIPS settlement process described above, b u t t h i s i s a

net

settlement, meaning t h a t settlement r i s k e x i s t s throughout the day, u n t i 1 t h e
net settlement process i s successful l y completed.

Current PSR p o l i c y r e q u i r e s

t h a t each p a r t i c i p a n t i n a p r i v a t e network s e t a l i m i t on the amount of c r e d i t
i t w i 11 extend t o each o t h e r p a r t i c i p a n t , and t h a t the network impose a 1 i m i t
on t h e c r e d i t a s i n g l e p a r t i c i p a n t may o b t a i n from a l l o t h e r p a r t i c i p a n t s
combined, and t h a t the t o t a l c r e d i t drawn by a s i n g l e bank on p r i v a t e systems
plus i t s d a y l i g h t o v e r d r a f t a t the Federal Reserve n o t exceed a p r e s e t maximum
a t any time d u r i n g a day.

P r i v a t e system c r e d i t r i s k s t i l l e x i s t s , although

s u b j e c t t o these l i m i t s , such t h a t each p a r t i c i p a n t has some i n c e n t i v e t o
concern i t s e l f w i t h the c r e d i t q u a l i t y o f each o t h e r network p a r t i c i p a n t .
The upshot o f these i n s t i t u t i o n a l arrangements i s simply t h i s :

Fedwire

provides r e c e i v e r f i n a l i t y because t h e Federal Reserve extends d a y l i g h t c r e d i t
t o payors, and a t no charge.
finality.

Net settlement systems o f f e r settlement

Without b i n d i n g assurance t h a t the lender o f l a s t r e s o r t w i 11

underwrite settlement, p a r t i c i p a n t s are exposed t o d i r e c t and (probably
underestimated) systemic r i s k , as on CHIPS, o r a t l e a s t t o i n d i r e c t r i s k as a
r e s u l t of some ex ante r i s k - s h a r i n g agreement among network p a r t i c i p a n t s .
Managing r i s k imposes costs on p a r t i c i p a n t s i n the form o f m o n i t o r i n g the
c r e d i t w o r t h i n e s s o f o t h e r p a r t i c i p a n t s , managing b i l a t e r a l c r e d i t l i m i t s , and
m a i n t a i n i n g a c a p i t a l cushion a g a i n s t p o t e n t i a l losses.

On Fedwire, these

costs are absent.
That CHIPS f l o u r i s h e s d e s p i t e t h e competitive i n e q u a l i t y of a pub1i c
subsidy t o Fedwire i s u s u a l l y a t t r i b u t e d t o i t s market niche i n s e r v i n g
f o r e i g n p a r t i c i p a n t s , which Fedwire has n o t entered.

But competition o f o t h e r

networks w i t h Fedwire f o r domestic funds t r a n s f e r t r a f f i c under c u r r e n t
i n s t i t u t i o n a l arrangements would seem f e a s i b l e o n l y i f p r i v a t e competitors
were so much more e f f i c i e n t i n processing payment messages t h a t t h i s cost
advantage would o f f s e t t h e i r r i s k disadvantage.

I t may be t h a t t h i s

c o m p e t i t i v e disadvantage was a f a c t o r i n the demise o f CashWire and CHESS, two
networks t h a t once competed f o r domesti c payments business.

Thi s suggests

t h a t t h e r e i s no b a s i s f o r a market t e s t o f t h e w i l l i n g n e s s o f p r i v a t e agents
t o accept r i s k i n making domestic payments, nor o f the o p e r a t i n g e f f i c i e n c y of
Fedwi r e .

4.

Law and Technology.

Arguments t h a t d a y l i g h t o v e r d r a f t s should be

p r o h i b i t e d can take another form.

The Federal Reserve, as the n a t i o n ' s

c e n t r a l bank, i s a unique governmental i n s t i t u t i o n .

Since the demise of the

g o l d exchange standard, t h e System has had u n l i m i t e d abi 1i t y t o create c r e d i t
b y i s s u i n g high-powered money i n the form o f currency and bank reserve
deposits.

The Federal Open Market Committee i s charged w i t h making the

d e c i s i o n s t h a t determine t h e aggregate amount o f t h i s f i a t money i n

existence. The Federal Reserve Act constrains System credit creation to two
riskless activities. One is the purchase of U.S. government securities in the
open market (not directly from the Treasury).

The other is direct

discount-window loans to eligible institutions at the prevailing discount
rate, fully secured by eligible collateral.
Daylight overdrafts of reserve deposit accounts can be viewed as a third
means of extending central bank credit, which was not contemplated in an Act
drafted before the development of sophisti cated telecommunication networks.
Daylight overdrafts not only are free, but also are uncollateralized. That
this third means of extending credit is not mentioned specificaliy as
requiring collateral in the Federal Reserve Act probably reflects an
historical understanding that such overdrafts would not take place. For
example, the first operating letter of the Federal Reserve Bank of Cleveland
governing transfers of funds, when adopted in 1939, said, "Collected funds on

-- are available for telegraphic or mail transfer ..."; "Telegraphic
transfers ... of bank balances ..." would be processed, where "The term 'bank

deposit

balances' shall be construed to mean an accumulation of funds comprising an
establ i shed account maintained by a member bank . . . " (emphasis added).

'

When Subpart B of Regulation J was first adopted, August 1 , 1977, however,
the fact of daylight overdrafts was clearly recognized by providing that, if a
bank did not have a sufficient "...balance of actually and finally collected
funds" to cover transfers during a day, the Reserve Bank claimed a security
interest in any or all of the bank's assets in the possession of, or held for
the account of, the Reserve Bank. Notwithstanding that claim, the Reserve
Bank also could refuse to act on a transfer request "...at any time when such
Federal Reserve Bank has reason to believe that the balance maintained or used
by such transfer is not sufficient to cover such item." Purists may be

forgiven for questioning whether the treatment of daylight overdrafts, even as
protected by these regulatory provisions, is fully consonant with provisions
of the Federal Reserve Act.

11.

Objectives Underlying Payment System Risk Policy
Entering into PSR policy debate requires a clear notion of policy

objectives. To date, Federal Reserve PSR policy has been fashioned with the
explicit objective of reducing PSR, quantified as daylight overdraft exposure
plus net daylight credit drawn on CHIPS.
Historical background suggests that existing PSR policy was a reaction to
mushrooming PSR exposure associated with the telecommunications rev01 ution in
the payment mechanism (see appendix).

For example, in 1947, reserve deposit

balances represented 700 percent of (seven times) the value of daily debits
(Fedwire, checks, etc.) to member bank reserve accounts; by 1983, balances
were a minuscule 4 percent of daily debits.'

That is, in 1947, the average

bank could make all necessary payments for seven successive business days
without ever receiving a single offsetting payment before exhausting its
initial reserve deposit balance. By 1983, the average bank could meet demands
for payment for only 20 minutes of a single eight-hour business day before it
would have had to receive some offsetting payments, or go into overdraft.
Over the course of 35 years, the Federal Reserve apparently moved from a
cash-in-advance system, in which Fedwire payments involved no risk, to a
largely automatic daylight credit system, in which the Federal Reserve is
exposed to upwards of $50 billion of daily credit risk on Fedwire alone, plus
another $60 bi 1 1 ion on the book-entry system, whi 1 e CHIPS participants extend
about $45 billion.
It is understandable that policy discussion has emphasized daylight credit

reduction:

having seen a horse escape from the c o r r a l i n t o t h e f i e l d s ,

the

f i r s t r e a c t i o n i s t o close any holes i n the fence around the f i e l d s so the
horse c a n ' t go any f u r t h e r , and then begin the process o f moving the horse
back toward the c o r r a l .

Without pushing t h i s analogy t o o f a r , much of c u r r e n t

PSR debate i s about which combination o f sugar cubes and whips should be used
t o g e t the dayl i g h t o v e r d r a f t "horse" back c l o s e r t o the o l d l o w - r i sk
" c o r r a l , " on the assumption t h a t moving the horse i n t h a t d i r e c t ion--reduci ng
Federal Reserve dayl i g h t o v e r d r a f t s - - i s the appropriate o b j e c t i v e .
Before i n v e s t i g a t i n g various p o l i c y proposal s t o reduce r i sk, i t seems
o n l y prudent t o recognize t h a t reducing dayl i g h t o v e r d r a f t s might n o t be t h e
only, o r best, o b j e c t i v e f o r p u b l i c p o l i c y today.

Some o t h e r choices i n c l u d e

doing nothing, achieving c o m p e t i t i v e e q u a l i t y , o r r e s t r u c t u r i n g i n s t i t u t i o n a l
arrangements t o a1 low p r i v a t e agents more choice between r i s k y and safe
payment devices.
Doing nothing, i n the sense o f delaying f u r t h e r pol i c y a c t i o n , may seem
counterproductive even as a short- run pol i c y o b j e c t i v e .

However, c u r r e n t

pol i c y has placed some l i m i t s around s u b s t a n t i a l f u r t h e r increases i n PSR
exposure.

Delay might y i e l d b e t t e r decisions w i t h a broader consensus f o r

more e f f e c t i v e f u t u r e p o l i c y a c t i o n s .

Current PSR exposure appears t o be an

accident of h i s t o r y i n the sense t h a t i t grew t o s u b s t a n t i a l p r o p o r t i o n s
before g a i n i n g widespread r e c o g n i t i o n .

PSR r e f l e c t s , i n p a r t , the

r e v o l u t i o n a r y impact o f t e c h n o l o g i c a l change on payment p r a c t i c e s .

Perhaps

the new technology i s most u s e f u l when abetted by a s u b s t a n t i a l volume of
d a y l i g h t c r e d i t t h a t i s somehow worth the moral hazard and systemic r i s k
cost.

Reducing exposure may seem an agreeable o b j e c t i v e , b u t how f a r should

i t be reduced? How can we determine whether the optimal q u a n t i t y o f dayl i g h t
c r e d i t i s s u b s t a n t i a l l y lower than c u r r e n t 1eve1 s?

C o m p e t i t i v e e q u a l i t y m i g h t be a more b a s i c i s s u e than r i s k .

Deposit

insurance and t h e l e n d e r of l a s t r e s o r t may be capable o f d e a l i n g w i t h t h e
c o s t s o f d a y l i g h t c r e d i t r i s k exposure.

The b a s i c i s s u e may be how t o

s t r u c t u r e i n c r e a s i n g l y unnecessary p u b l i c p r o v i s i o n o f payment s e r v i c e i n such
a way t h a t p r i v a t e s e r v i c e s a r e n o t precluded from o p e r a t i n g i n t h e same
market.

Modern telecommunication capabi 1 it i e s and n a t i o n w i d e banking may make

o b s o l e t e t h e o r i g i n a l b a s i c r a t i o n a l e f o r government p r o v i s i o n o f
service- - assuring uniform n a t i o n w i d e access t o t h e payment system.

The MCA

r e q u i r e s t h a t Federal Reserve s e r v i c e s pass a market t e s t , b u t , so f a r , MCA
implementation has n o t encompassed t h e p o s s i b l e i n e q u i t y o f t y i n g Federal
Reserve s e r v i c e s t o f r e e c e n t r a l - b a n k r i s k u n d e r w r i t i n g .
Why n o t a1 low p r i v a t e agents t o choose t h e r i s k exposure t h e y want?

The

f e d e r a l government has d e f i n e d r i s k l ess cash-payment d e v i c e s s i n c e 1792, b u t
p r i v a t e agents have chosen t o accept r i s k i n making some payments, f i r s t b y
u s i n g p r i v a t e bank notes, and t h e n checks, b o t h w i t h r i s k y f i n a l i t y and
settlement features.

E l e c t r o n i c payments a r e now i n t h e ascendency, due i n

p a r t , no doubt, t o f r e e Federal Reserve s e t t l e m e n t insurance.

Perhaps t h e

o b j e c t i v e o f PSR p o l i c y s h o u l d be t h e c r e a t i o n o f an i n s t i t u t i o n a l environment
i n which agents f a c e a f a i r c h o i c e n o t o n l y among r i s k - f r e e , b u t a l s o between
r i s k - f r e e and r i s k y , e l e c t r o n i c payments.
An obvious o b j e c t i o n t o t h i s p e r s p e c t i v e i s t h a t , by a l l o w i n g r i s k y
e l e c t r o n i c payments, more r i s k may f a l l i n t o t h e f e d e r a l s a f e t y n e t .

Other

o b j e c t i o n s t o t h i s , o r t o d e l a y , o r t o seeking c o m p e t i t i v e e q u i t y as p o l i c y
objectives, are surely relevant.

The p o i n t i s , however, t h a t e v a l u a t i n g

p r o p o s a l s t o reduce PSR s h o u l d n o t obscure t h e view t h a t r i s k r e d u c t i o n w i t h i n
t h e e x i s t i n g i n s t i t u t i o n a l environment may n o t be t h e b e s t o b j e c t i v e .

111.

Three Pol i c y Proposal s
Recently, three d i f f e r e n t proposal s f o r r e f o r m i ng PSR pol i c y have drawn

attention.

A1 1 three aim a t reducing Federal Reserve PSR exposure by making

dayl i g h t c r e d i t c o s t l y , b u t they i n v o l v e seemingly q u i t e d i f f e r e n t
i n s t i t u t i o n a l features.

A b r i e f sketch o f each w i l l s e t the stage f o r an

evaluation o f t h e i r d i f f e r e n c e s , and o f t h e i r p o t e n t i a l impacts.

As an o p e r a t i o n a l matter, the three proposals are a1i k e i n presuming no
change i n the r e g u l a t o r y and o p e r a t i o n a l framework w i t h i n which Fedwire
operates.

Banks would be able t o c o n t r o l t h e i r dayl i g h t o v e r d r a f t s by

r e a l - t i m e m o n i t o r i n g o f t h e i r account balances a t the Fed.

The Reserve Banks,

however, would n o t i n c o r p o r a t e the r e a l - time monitor i n t o Fedwi r e .

R e l y i n g on

the e x i s t i n g ex-post dayl i g h t o v e r d r a f t m o n i t o r i n g system means t h a t the
Reserve Banks would n o t be i n a p o s i t i o n t o delay o r r e j e c t payment requests
t h a t would cause an o v e r d r a f t , f o r example, by r o u t i n g them i n s t e a d t o the
discount window, o r t o a supplemental balance department, o r t o a
1i m i t- enforci ng department under t h e r e s p e c t i v e proposals, before d e c i d i n g
whether t o l e t a Fedwire payment proceed.

Of course, Reserve Banks would

p o l i c e the balances o f problem banks and c e r t a i n special Fedwire users i n r e a l
time a g a i n s t predetermined o v e r d r a f t l i m i t s , j u s t as they do now.
A t the i n d i v i d u a l bank l e v e l , d a y l i g h t o v e r d r a f t s (DOD) a r i s e when
accumulated d e b i t s (Db) t o the bank's reserve balance a t some p o i n t d u r i n g t h e
day exceed t h e sum o f i t s opening balance o f r e q u i r e d (RR) and excess (XR)
reserves h e l d overnight, p l u s accumulated c r e d i t s (Cr) t o t h e account:
DOD = (Db

-

RR

-

XR

-

Cr) > 0 .

The n a t u r e o f the d a y l i g h t c r e d i t f i n a n c i n g problem i s t h a t a bank
r e q u i r e s f u n d i n g o n l y f o r a p o r t i o n o f a day--whether a few moments o r a few
hours--before incoming c r e d i t s t o i t s account o f f s e t the need.

A f u l l day

of 24 hours might i n c l u d e an 8-hour " d a y l i g h t " p e r i o d (10:OO a.m.
p.m.) and a 16-hour " overnight" p e r i o d (6:00 p.m. t o 10:OO a.m.
day).

t o 6:00

t h e next

D a y l i g h t o v e r d r a f t s and reserve balances borrowed i n a d a y l i g h t funds

market, i f one were t o develop, would be drawn down and then r e p a i d d u r i n g one
d a y l i g h t period, w i t h o u t any need f o r o v e r n i g h t f i n a n c i n g .

A f u l l 24-hour day

loan o f reserve balances would be drawn down a t t h e beginning of one dayl i g h t
p e r i o d and repaid a t t h e beginning o f t h e next d a y l i g h t period.

Overnight

loans o f reserve balances would be drawn down a t the end o f one dayl i g h t
p e r i o d and repaid a t the beginning o f the next.
The p e n a l t y r a t e proposal, o f f e r e d i n several v a r i a n t s by Wayne Angel 1,
member o f the Board o f Governors o f t h e Federal Reserve System, would
e l i m i n a t e current q u a n t i t a t i v e r e s t r i c t i o n s on each bank's use o f dayl i g h t
credit.

Instead, a bank would borrow the amount o f any dayl i g h t o v e r d r a f t as

a c o l l a t e r a l i z e d loan from i t s Federal Reserve Bank discount window, ex post,
a t an above-market p e n a l t y r a t e .

The Federal Reserve Banks would pay a (below

market) r a t e o f r e t u r n on excess reserves, p r o v i d i n g an offset t o t h e costs of
any e x t r a reserve- account balances t h a t banks might h o l d t o a v o i d t h e p e n a l t y
r a t e on o v e r d r a f t loans.

Thus, under normal circumstances, no bank would run

a d a y l i g h t o v e r d r a f t and pay the p e n a l t y r a t e i n t e n t i o n a l l y because the
maximum c o s t t o a bank of a v o i d i n g a dayl i g h t o v e r d r a f t would be o n l y the
i n t e r e s t r a t e spread between i t s c o s t o f f i n a n c i n g e x t r a excess reserves and
the r a t e earned on those holding^.^

I n t h e aggregate, t h i s e x t r a demand f o r

reserve balances would be matched by e x t r a supply produced by open market
purchases o f Treasury s e c u r i t i e s f o r the System Open Market Account.
The supplemental balance proposal, described by s t a f f o f the Federal
Reserve Bank o f New York, a l s o could e l i m i n a t e c u r r e n t q u a n t i t a t i v e 1i m i t s on
each bank's use o f dayl i g h t c r e d i t .

Instead, a bank would be r e q u i r e d t o

maintain e x t r a below-market , i nterest- beari ng reserve deposi t s i n a c u r r e n t
p e r i o d ( t h e supplemental balance) equal t o some f r a c t i o n , r < 1, of d a y l i g h t
o v e r d r a f t s o f i t s r e g u l a r reserve- deposit balance i n a p r i o r p e r i o d .

The

maximum cost t o a bank o f a do1 l a r ' s dayl i g h t o v e r d r a f t today would be the
f r a c t i o n , r, o f the expected next- period spread between t h e c o s t of f i n a n c i n g
a do1l a r ' s supplemental balance and the r a t e earned on t h e supplemental
balance.

The proposal envisions f i x i n g both the f r a c t i o n , r, and the spread;

assuming t h a t the spread i s measured from a market r a t e reasonably c l o s e t o
the bank's cost o f f i n a n c i n g , the maximum c o s t o f a d a y l i g h t o v e r d r a f t would
be a constant, a = r (spread).

Again, i n the aggregate, t h e e x t r a

supplemental balance demand f o r reserve balances would be matched by e x t r a
supply produced by the System Open Market Account.
The p r i c i n g proposal, suggested by the System's Large- Dollar Payments
System Advisory Group, would r e t a i n ( o r perhaps reduce) c u r r e n t q u a n t i t a t i v e
1i m i t s on each bank's use o f dayl i g h t c r e d i t , but, w i t h i n t h a t 1i m i t, have the
Federal Reserve charge a p r i c e f o r any bank's Fedwire o v e r d r a f t s i n excess of
a base amount.

The maximum c o s t t o a bank o f a d o l l a r ' s d a y l i g h t o v e r d r a f t ,

w i t h i n the two l i m i t s , would be the administered p r i c e , a.

A.

D a y l i q h t Overdraft Reducing Mechanisms
I n each proposal, a bank would pay a p o s i t i v e e x p l i c i t o r i m p l i c i t p r i c e

t o prevent o r cover a n e t d e b i t i n i t s reserve account.

Federal Reserve

dayl i g h t o v e r d r a f t s would be expected t o d e c l i n e because t h i s p r i c e would be
higher than the c u r r e n t p r i c e o f a dayl i g h t o v e r d r a f t , which i s zero.

Banking

operations would be expected t o respond t o the increased p r i c e through some
combination o f t h r e e adjustment mechanisms:

increased holdings of excess

reserve balances, r e d i s t r i b u t i o n o f reserve balances through a dayl i g h t funds

market, and m o d i f i e d payment p r a c t i c e s .
E x t r a o v e r n i g h t holdings o f excess reserves would increase the i n i t i a l
balance from which d e b i t s could be absorbed.

A p r i v a t e d a y l i g h t c r e d i t market

could r e d i s t r i b u t e e x i s t i n g reserve balances from banks having them and n o t
needing them d u r i n g the day, b u t o n l y overnight, t o banks n o t having them and
needing them o n l y d u r i n g the day, b u t n o t overnight.

'

The Federal Reserve

preempts such a market now by p r o v i d i n g f r e e d a y l i g h t o v e r d r a f t s , b u t if
overdrafts were c o s t l y , and t i m e l y del i v e r y o f funds were re1i a b l e , borrowing
i n an interbank d a y l i g h t funds market might be an inexpensive means of
preventing n e t d e b i t s t o a reserve account d u r i n g a day.
F i n a l l y , m o d i f y i n g payment p r a c t i c e s could change the r e l a t i v e amounts of
d e b i t s and c r e d i t s , o r t h e i r sequence d u r i n g the day.

A bank might do t h i s by

lengthening t h e m a t u r i t y o f i t s 1 i a b i 1i t i e s o r adopting a continuing c o n t r a c t
f o r f e d e r a l funds borrowing, w i t h d a i l y r e n e g o t i a t i o n o f the r a t e b u t no d a i l y
repayment and r e - r e c e i p t o f funds.

Or, a bank might induce p a i r s of

i n s t i t u t i o n a l customers o p e r a t i n g i n s e c u r i t i e s markets t o n e t t h e i r
t r a n s a c t i o n s o b l ig a t ions d u r i n g a day, producing a s i ngle small o b l i g a t i o n f o r
d a i l y payment, again reducing d e b i t s t h a t might now precede c r e d i t s .

Or,

groups o f banks might j o i n p r i v a t e payment networks, w i t h o n l y n e t settlement
a t the Federal Reserve.
Each o f t h e t h r e e proposals might induce these adjustment mechanisms.
Each has the common c h a r a c t e r i s t i c o f i n c r e a s i n g the cost t o a bank of
f i n a n c i n g payments d u r i n g a day, here c a l l e d t h e marginal cost of p r e v e n t i n g a
n e t d e b i t t o i t s reserve account,

MCDb.

A cost- minimizing bank seeking t o avoid a d a y l i g h t o v e r d r a f t might
consider the adjustment mechanism of a c q u i r i n g excess reserves i n the federal
funds market a t a c o s t

RF.

A f t e r meeting i t s temporary d a y l i g h t need t o

cover payments, the bank would then have these extra funds avai lable to hold,
or to loan out overnight, at a rate of return RON, if there were a private
overnight market. The marginal cost of preventing a net debit in its reserve
account would be the difference between the two rates: MCgE
RON).

=

(RF

-

A1 ternatively, the bank might turn to a daylight credit market,

borrowing the funds and repaying before the close of business, at the rate
Roc. This rate would represent the marginal cost of preventing a net debit
in its reserve account: MCE;
As

=

Roc.

a third alternative (and presumably adopted as a relatively permanent

change by many banks and their customers over a longer period than a single
day), it might modify some payment practices. This, too, would involve some
cost, such as paying higher rates on longer-term liabilities or receiving
lower prices or revenues for payments services when institutional customers
engage in netting obl igations, or by sharing the cost of a private payment
network." Assuming banks adopt the cheapest payment modifications first
and then contemplate more expensive changes, the marginal cost of preventing
successively larger net debits in reserve accounts by modifying payments
practices, MC:LP, would increase, suggesting a rising marginal cost
relationship with the volume of net debit avoided by this means.
In equilibrium, cost-minimizing banks would adopt the unique combination
of adjustment mechanisms with marginal costs equal to or less than the

marginal cost of a daylight overdraft, MCEz

=

MCEE

=

MC:EP~ MCDoD.

Banks would avoid one of these three mechanisms only if its marginal costs
were fixed permanently above the others. It is within this cost-minimizing
context that the effects of the three proposals on daylight overdrafts can be
compared.

B.

Effects on D a y l i g h t Overdrafts
The p e n a l t y r a t e proposal would s e t t h e marginal c o s t o f a d a y l i g h t

o v e r d r a f t a t t h e above-market r a t e , R p .

NO bank would choose t o pay t h i s

p r i c e as l o n g as a cheaper a1 t e r n a t i v e were a v a i l a b l e .

Except i n the waning

moments o f t h e business day, when markets i n reserve balances were c l o s i n g o r
closed, banks would have cheaper a l t e r n a t i v e s because o f the r a t e s t r u c t u r e
envisioned i n the proposal .

With

RF

< Rp, and w i t h

RON

> 0, a bank

could h o l d excess reserves and avoid a n e t d e b i t d u r i n g the d a y l i g h t p e r i o d a t
a cost

(RF

-

RON).

equilibrium, i n

Market a r b i t r a g e would be expected t o r e s u l t , i n

RDc =

(RF

-

RON),

SO

the a l t e r n a t i v e of borrowing i n the

d a y l i g h t funds market would be j u s t as a t t r a c t i v e . ' '

And, w i t h p o s i t i v e

marginal c o s t s f o r these reserve and funds market adjustments, banks would be
expected t o adopt modified payment p r a c t i c e s w i t h marginal costs l e s s than o r
equal t o

(RF

-

RON).

The supplemental balance proposal would create a marginal c o s t of day1 i g h t
o v e r d r a f t s o f rEt(RF

-

Rse),+,.

A d o l l a r o f d a y l i g h t o v e r d r a f t today

would i n c u r a c o s t equal t o the f r a c t i o n , r, o f the expected n e t c o s t of
financing t h e h o l d i n g o f a d o l l a r supplemental balance i n a f u t u r e p e r i o d .
design, t h i s cost would be a constant amount, o.

By

Again, a d a y l i g h t c r e d i t

market m i g h t develop, b u t w i t h an upper p r i c e l i m i t of o.

The same upper

1i m i t would apply t o the marginal c o s t o f modifying payment p r a c t i c e s .

Note

t h a t excess reserves over and above any supplemental balances would n o t earn
interest.

T h i s means t h a t " p l a i n v a n i l l a " e x t r a excess reserves would n o t be

a c o s t - e f f e c t i v e means o f a v o i d i n g d a y l i g h t o v e r d r a f t s because t h e c o s t of
financing them normally would be g r e a t e r than o, the c o s t o f a d a y l i g h t
overdraft.

T h i s a l s o means t h a t the source o f funds f o r a d a y l i g h t c r e d i t

market would be r e s t r i c t e d t o the r e q u i r e d reserves o f banks whose payments

needs for daylight balances were less than their need for required reserves.
The pricing proposal sets the marginal cost of a dayl ight overdraft at the
administered price,

w.

Excess reserves would not be a cost-effective means

of avoiding daylight overdrafts in this proposal, either. The cost of

financing excess reserves normally would be higher than

n.

A 1 imi ted

dayl ight credit market could develop, redi stri buti ng the required reserves of
those banks whose needs for daylight balances were less than their need for
required reserve balances. Modifications in payment practices with marginal
cost no greater than s would be the only other cost-effective means of
avoiding daylight overdrafts in this proposal.
The three proposals, equivalently priced, would not necessari ly produce
equivalent reductions in Federal Reserve daylight overdraft risk exposure.
This can be seen by standardizing the marginal cost of preventing a net debit
at a common rate (CR):

CR

=

(RF - RON)

= u = n.

13

At this common

rate, a1 1 three proposals would yield identical modifications in payment
practices--namely, a1 1 those dayl i ght-credi t economizing modifications that
produce a marginal cost of preventing a net debit less than or equal to CR.
In addition, they should produce equivalent redistribution of required reserve
balances through a private dayl ight credit market. Only if those two effects
were sufficient to prevent a1 1 net debits would the three proposals have the
same impact on Federal Reserve daylight overdrafts--by complete elimination.
Otherwise, the remaining need to avoid or cover net debits would differ among
the proposals.
In the penalty rate proposal, the remaining need would be met by excess
reserves, supplied by the System Open Market Account as it sought to maintain
a pol icy-desired (or determined) RF. These extra reserve balances might be
redistributed through the private daylight funds market to maintain

Roc

=

CR, the difference between RF and the rate paid on overnight excess

reserves. (A1 ternatively, if the System Open Market Account were directed to
maintain a pol icy-desired stock of reserves, CR would be determined in the
first instance by moving up the list of feasible, but increasingly costly,
daylight-credi t economizing modifications in payment practices. This bidding
up of Roc and RF would continue unti 1 the unmet need for dayl ight credit
at some level of CR were equal to the supply forthcoming through the private
daylight credit market, given the rate paid on (and for) overnight reserve
balances).
In the supplemental balance proposal , any remaining need for dayl ight
credit would be available in unlimited supply as daylight overdrafts from the
Federal Reserve at the rate CR, or from the dayl ight credit market augmented
by holdings of supplemental balances by banks whose short-run payments needs
had declined after the balance calculation period. In a long-run equilibrium,
with unchanging payments needs at every bank, daylight overdraft exposure
would decline for two reasons: the cost of supplemental balances would reduce
dayl ight overdrafts directly, and the balances would provide col lateral to
offset some of the risk exposure represented by overdrafts.
In the pricing proposal, setting a direct charge of

r =

CR per dollar of

dayl ight overdraft at the Federal Reserve would call for the same payment
practice modifications and dayl ight-credi t-market redi stri bution of required
reserves common to the other two proposals. Any remaining need for dayl ight
credit would be avai 1 able in unl imi ted supply as Federal Reserve dayl i ght
overdrafts.
Standardizing the three proposals at a common marginal cost of preventing
a net debit, CR, reveals their similarities and differences as strategies for
reducing Federal Reserve daylight overdrafts and direct exposure to risk. The

three proposals would generate identical modifications in payment practices
and in required-reserve-balance redistribution in a daylight credit market,
with identical reductions in dayl i ght overdrafts. In addition, the penal ty
rate proposal would el iminate virtually 100 percent of any remaining dayl ight
overdrafts. The supplemental balance proposal would eliminate only some of
any remaining overdrafts, but with some additional reduction in risk exposure
from the col lateral value of supplemental balances. The pricing proposal
would not eliminate any remaining overdrafts.
These differences in dayl i ght overdraft reduction in turn ref 1ect
differences in the volume of excess reserves associated with each proposal and
the related potential volume of trading in a daylight credit market. Because
all excess reserves earn interest in the penalty rate case, holding excess
reserves overnight and using them directly for payments purposes, or
indirectly by supplying them to a daylight credit market, allows complete
elimination of daylight overdrafts without resorting to penalty rate borrowing
at the discount window. Because excess reserves do not earn interest in the
other two cases, and because a dayl ight overdraft involves no penalty relative
to the cost of avoiding a daylight overdraft, excess reserves play no role,
and the volume of trading in a private daylight credit market will be
restricted to redistributing required reserve balances of banks not needing
them for payment purposes.
It may seem curious that excess reserves play no role in the supplemental
balance and pricing proposals. Why couldn't some banks hold excess reserves
with the expectation at least of lending in both daylight and overnight funds
markets, just as might happen in the penalty case? The answer is that anyone
who did this repeatedly would be a sure loser: there can be no net demand for
pure overnight funds as long as the aggregate supply of reserve balances is

more than s u f f i c i e n t t o s a t i s f y r e q u i r e d reserve needs, even though it 1s
i n s u f f i c i e n t t o supply a l l payments needs.

I n these two proposals there a r e

o n l y two funds markets: one f o r balances t h a t s a t i s f y reserve requirements and
one f o r funds t h a t do not.

The aggregate supply o f the f i r s t k i n d o f funds i s

established by monetary p o l i c y decisions ( s e t t i n g " the funds r a t e " o r the
supply o f those reserves), w h i l e t h a t o f the second i s e s t a b l i s h e d by payment
system p o l i c y ( s e t t i n g u o r n ) , and there i s no c o s t - e f f e c t i v e way t o
a r b i t r a g e between the two k i n d s o f funds markets.

The p e n a l t y r a t e case i s

d i f f e r e n t because the earnings r a t e p a i d on excess reserves provides an
e f f e c t i v e basis f o r a t h i r d market, connecting the o t h e r two.

An important

i m p l i c a t i o n i s t h a t v a r i a t i o n s i n payments needs f o r balances can influence
the monetary-pol i cy- relevant funds r a t e i n the p e n a l t y r a t e proposal , b u t n o t
i n the o t h e r two cases.

C.

E l i m i n a t i n g D a y l i g h t O v e r d r a f t Exposure
So f a r , we have seen t h a t , when e q u i v a l e n t l y priced, the three proposals

could have markedly d i f f e r e n t imp1i c a t i o n s f o r Federal Reserve dayl i g h t
overdrafts.
difference

Another way t o c o n t r a s t the three proposals i s t o ask what
i n p r i c i n g would be r e q u i r e d t o achieve a common r e d u c t i o n i n

Federal Reserve dayl i g h t o v e r d r a f t exposure.

Thi s r e q u i r e s examining the

r e s p e c t i v e p r i c e s r e q u i r e d t o reduce dayl i g h t o v e r d r a f t exposure t o zero,
because the p e n a l t y r a t e proposal i s incapable o f achieving l e s s than
v i r t u a l l y complete e l i m i n a t i o n o f dayl i g h t o v e r d r a f t s .

l4

That i s , as long

as a n e t d e b i t a t any time d u r i n g a day r e s u l t s a u t o m a t i c a l l y i n a 24-hour
d i s c o u n t window loan a t a r a t e h i g h e r than the funds r a t e , no bank would
choose t o overdraw.

Even i f a l l o t h e r adjustment mechanisms f a i l e d t o

m a t e r i a l i z e , a bank could always borrow 24-hour funds t o a v o i d a d a y l i g h t n e t

d e b i t , could h o l d i n t e r e s t - e a r n i n g excess reserves, and would be b e t t e r off
than w i t h an o v e r d r a f t .
The supplemental balance approach could achieve the same r e s u l t i n e i t h e r
of two ways.

F i r s t , i f the balance r a t i o , r, were s e t equal t o 1,

supplemental balances would equal dayl i g h t o v e r d r a f t s , e l i m i n a t i ng Federal
Reserve r i s k exposure i n e q u i l i b r i u m w i t h constant payments needs a t each
bank.

This r e s u l t i s independent o f the r a t e spread,

Et(RF

-

and depends o n l y on the balance r a t i o , r, being equal t o 1.

Rs~)t+l,

J u s t as i n t h e

p e n a l t y r a t e case, complete e l i m i n a t i o n o f Federal Reserve dayl i g h t o v e r d r a f t
exposure can be achieved a t more o r l e s s cost t o banks, depending on the s i z e
of the r a t e spread,

(RF

-

RSB).

The second way t o e l i m i n a t e d a y l i g h t o v e r d r a f t exposure would be t o s e t a
very h i g h r a t e spread,

(RF

-

RSB).

Holding

RF

a t a l e v e l desired f o r

monetary p o l i c y purposes, and w i t h r s e t a t a p o s i t i v e f r a c t i o n l e s s than 1,
the o n l y way t o do t h i s i s through the s e t t i n g o f Rse, the earnings r a t e on
supplemental balances.

Lowering the value o f Rs8 r a i s e s the cost of

d a y l i g h t o v e r d r a f t s toward the basic money market r a t e o f i n t e r e s t , R F .

AS

the c o s t r i s e s , more extensive and expensive m o d i f i c a t i o n s i n payment
p r a c t i c e s become an economical means o f reducing the need f o r dayl i g h t
credit.

I f the marginal cost o f m o d i f i c a t i o n s i n payment p r a c t i c e s were

reasonably e l a s t i c , a1 1 dayl i g h t c r e d i t needs might be e l i m i n a t e d a t some
p o s i t i v e , a l b e i t low, earnings r a t e on supplemental balances.

On t h e o t h e r

hand, i f t h a t marginal cost were q u i t e i n e l a s t i c , t h e earnings r a t e on
supplemental balances could go as low as ((r-l)/r)RF( t h a t i s , a n e g a t i v e
earnings r a t e and a marginal cost of p r e v e n t i n g a n e t d e b i t equal t o
before a1 1 dayl i g h t o v e r d r a f t s were e l i m i nated.
a t t h i s o r any marginal c o s t higher than

RF

RF)

That they would be e l i m i nated

i s assured because a t such a

high cost, banks would find 24-hour holdings of extra non-interest-earning
excess reserves a cheaper means of avoiding the cost of preventing a net
debit, and monetary policy operation would supply the extra excess reserves to
maintain a desired funds rate while satisfying the extra demand for reserves.
The markets for required reserve balances and payments balances would become
one.
The pricing case is similar. Complete elimination of Federal Reserve
dayl ight overdraft exposure could be assured if the price, n, were less than
RF, but high enough to elicit payment practice modifications eliminating all
unmet needs for daylight credit. If that did not work, then setting n above
RF would, as in the supplemental balance case, merge the reserve requirement
and payments markets for reserves, and excess reserves would become a more
economical means of avoiding a net debit than paying the price of daylight
overdrafts. The result with

i

1
1

/

IT

> RF would be much the same as an outright

prohibition on dayl ight overdrafts, sternly enforced.
In summary, all three of the proposals considered would reduce Federal
Reserve dayl i ght overdraft exposure. Moreover, a1 1 exposure could be
eliminated if the marginal cost of modifications in payments practices and
redistribution of daylight-surplus required reserve balances were sufficiently
elastic. If this were not the case, then significant differences would be
observed among the three proposals:

- the penalty rate regime would eliminate all remaining daylight
overdrafts by expanded holdings of excess reserves and their
redistribution in a daylight credit market;

- the supplemental balance regime would eliminate some of the remaining
daylight overdrafts by expanded holdings of excess reserves in the
form of supplemental balances and their redistribution in a daylight
credit market;

- the pricing regime would eliminate none of the remaining daylight
overdrafts.

0. Reducing the Cost of Payment System Risk

Implementing one or another of the day1 ight-overdraft-reducing proposal s
has been shown to trigger a variety of adjustment mechanisms. If a proposal
will reduce what we have called the costs of PSR, it must be because those
adjustment mechani sms wi 1 1 reduce moral hazard, systemic risk, or competitive
inequality. Of course, none of the three proposals deals with private net
settlement networks like CHIPS, or with overdrafts arising from payments for
book-entry government securities. Therefore, no matter how effective a
proposal might be in reducing PSR costs, it would not represent complete PSR
reform.
Two conclusions emerge from tracing the effects of adjustment mechanisms
on PSR costs. One is simply that the three proposals could differ
substantially in their effectiveness in ameliorating the costs of PSR. The
other is that no firm conclusions are likely to be drawn about these three (or
any other) reform proposals unti 1 the Federal Reserve makes 1 asti ng deci sions
about some institutional details of its own operating and regulatory structure.

1.

Moral Hazard. Moral hazard arises from an informational asymmetry that

prevents those at risk from controlling their exposure effectively. The
exi sting PSR program, whi le setting 1 imi ts on permi ssi ble overdrafts based on
each bank's assessment of its own credit quality, is thought to be ineffective
because the limits are, in many cases, not binding, and in any event not
strictly enforceable. (Reckless driving is discovered only after the
accident.) The three proposals would either replace or supplement existing

1 imi ts by making dayl ight overdrafts costly.

Modified payment practices could reduce moral hazard. It is true that
such devices as long-maturi ty bank 1 iabi 1 i ti es, customer netting of
obl igations, and new private payment networks wi 1 1 transfer exposure to
private market participants. However, even if these adjustments were merely
part of a zero-sum risk game, moral hazard could decl ine. Whereas payee banks
now have no reason, and existing Federal Reserve limits are not adequate, to
enforce credit qua1 i ty standards on users of dayl ight credit on Fedwire,
rep1acement creditors introduced by modified payment practices might have a
direct incentive to base credit extensions on credit judgments about payor
banks.

A

similar conclusion would hold to the extent that payor banks would

need market financing of excess reserve or supplemental balances. Market
financing would require passing a market test of the kind that is lacking in
today's dayl ight overdrafts.
The same argument has been made about a private daylight credit market:
payor banks borrowing dayl ight funds to avoid dayl ight overdrafts wi 1 1 not
escape careful credit judgments of lenders. Unfortunately, Dr. Seuss' "If
such a thing could be, it certainly would be" is not necessarily true. 1 5
Replacing dayl ight overdrafts with some o f these a1 ternatives could, but need
not, reduce moral hazard. The matter is in doubt because the outcome depends
on some unspecified institutional details of daylight credit, of private net
settlement systems, and of the reformed daylight overdraft facilities
introduced by the proposals.
A

private interbank daylight credit market would reduce moral hazard only

if daylight lenders knew themselves to be at risk and had information

necessary to control their exposure. Both conditions are questionahle.
Would lenders in a private dayl ight credit market face a risk of

nonpayment? The problem i s t h a t , whi l e any o f t h e proposals might l e a d banks
t o borrow d a y l i g h t c r e d i t i n the p r i v a t e market under normal circumstances,
none o f the proposals would prevent a bank from overdrawing d u r i n g t h e day and
o v e r n i g h t under abnormal circumstances, which i s what r i s k i s about.

Would a

debtor bank, unexpectedly i n t r o u b l e , suspend payments by d e f a u l t i n g on a
d a y l i g h t loan r a t h e r than overdraw i t s deposit account a t a Federal Reserve
Bank?

A bank unexpectedly i n extremis should have no d i f f i c u l t y i n repaying

i t s dayl i g h t c r e d i t o r s on Fedwire even i f i t had i n s u f f i c i e n t funds because
o v e r d r a f t monitoring a t Federal Reserve Banks i s o n l y ex post.

None of the

c u r r e n t proposals suggests moving t o r e a l - t i m e balance monitoring.

Such

payments c a r r y r e c e i v e r f i n a l i t y , and none o f the c u r r e n t proposals has so
much as h i n t e d a t a l t e r i n g the i r r e v o c a b l e nature o f Fedwire payments.
The o n l y banks subject t o r e a l - t i m e m o n i t o r i n g are those t h e a u t h o r i t i e s
a l r e a d y know t o be i n t r o u b l e .

Would the a u t h o r i t i e s a l l o w banks under t h e i r

continuous s c r u t i n y t o become f u r t h e r overextended through dayl ig h t borrowing
and then prevent the t r o u b l e d banks from repaying?
Answers t o these two questions can be o n l y conjecture, b u t t h e r e seems t o
be a f a i r chance t h a t d a y l i g h t loans would be considered r i s k l e s s by d a y l i g h t
lenders, and i n f a c t would be r i s k l e s s t o them because the exposure would
remain w i t h the Federal Reserve, e i t h e r as operator o f Fedwire o r as
supervisor o f t r o u b l e d banks.

Moral hazard would remain i n t a c t even t o the

e x t e n t t h a t Federal Reserve dayl i g h t o v e r d r a f t s were replaced by dayl i g h t
loans i n a p r i v a t e i n t e r b a n k market.
A s i m i l a r argument a p p l i e s i f t h e proposals r e s u l t i n the development of

p r i v a t e payment network's i n c o m p e t i t i o n w i t h Fedwire, comparable t o CHIPS.
long as there i s no coherent framework o f payments f i n a l i t y on such systems,
banks extending d a y l i g h t c r e d i t may n o t perceive the e x t e n t o f the

As

c r e d i t r i s k they assume, and t h e r e f o r e may f a i l f u l l y t o manage r i s k .

Unlike

the dayl i g h t c r e d i t market case, however, r i s k exposure would n o t remain w i t h
the Federal Reserve.
I n f o r m a t i o n a l d e f i c i e n c i e s a r i s i n g from e x t e r n a l it i e s i n p r i v a t e dayl i g h t
c r e d i t arrangements might d i m i n i s h the r e d u c t i o n i n moral hazard even if
p r i v a t e lenders were (and knew they were) exposed t o c r e d i t r i s k .

How could

dayl i g h t lenders judge c r e d i t qua1i t y o f banks who could borrow a d d i t i o n a l
amounts f r o m other lenders i n the d a y l i g h t c r e d i t market, o r how c o u l d a
c r e d i t o r i n a p r i v a t e payment network s e t an appropriate b i l a t e r a l n e t c r e d i t
1i m i t f o r a payor bank i n ignorance o f b i l a t e r a l c r e d i t s provided t o the same
payor bank by o t h e r network p a r t i c i p a n t s ?
This i s n o t a problem unique t o d a y l i g h t c r e d i t : recent leveraged buyouts
of i n d u s t r i a l f i r m s have h i g h l i g h t e d t h i s "event r i s k " problem i n corporate
bond markets, b u t i n t h a t case new issues have begun t o include bond covenants
p r o t e c t i n g the lender from takeover- re1 ated increases i n debt-equi t y
ratios.

''

Day1i g h t c r e d i t arrangements may n o t be amenable t o comparable

covenants, b u t p r o t e c t i o n s might s t i l l be p o s s i b l e i n standard l e g a l
agreements u n d e r l y i n g d a y l i g h t loans, o r by making the r a t e p a i d depend on
t o t a l d a y l i g h t borrowing which i t s e l f became a matter o f p u b l i c r e c o r d v i a
b r o k e r s ' screens.

S i m i l a r l y , on p r i v a t e payment networks, b i l a t e r a l l i m i t s

and amounts drawn, and network d e b i t caps and amounts drawn, a1 1 might become
i n f o r m a t i o n provided on a continuously updated basis throughout the dayl i g h t
hours f o r the use o f p o t e n t i a l d a y l i g h t lenders.
C l e a r l y , the three r e f o r m proposals would have i d e n t i c a l , i f q u i t e
u n c e r t a i n , imp1i c a t i o n s f o r reducing moral hazard i n t h a t , e q u i v a l e n t l y
p r i c e d , t h e y would induce i d e n t i c a l m o d i f i c a t i o n s i n payment p r a c t i c e s and
r e d i s t r i b u t i o n o f d a y l i g h t - s u r p l u s r e q u i r e d reserves.

Beyond t h a t , however,

their implications differ. The penalty rate proposal relies heavily on excess
reserves, and therefore on market scrutiny of a bank's creditworthiness in
traditional markets for bank liabilities, both insured and uninsured. Thus, a
moral hazard problem of Federal Reserve daylight overdrafts is transformed
into a moral hazard problem of deposit insurance. In part, the same is true

of the supplemental balance proposal, but is not true at all of the pricing
proposal. By the same token, the pricing proposal would simply retain the
existing daylight overdraft facility and, with a flat-rate price unrelated to
risk, retain moral hazard. The supplemental balance proposal does the same,
although on a smaller scale.
At

a more basic level, all three proposals might retain a substantial

moral hazard. None of the proposals envisions pricing based on the actuarial
or judgmental probability of a bank's inability to repay daylight credit, and
none removes the simple mechanism by which the Federal Reserve now insures all
but problem banks against a shortage of daylight credit. Pricing still
assures any bank that is unexpectedly in extremis of unlimited daylight
credit; the supplemental balance proposal retains the same assurance; even the
penalty rate proposal , whi le requiring col 1 ateral for discount window loans to
cover dayl ight overdrafts, nonetheless has no means of preventing overdrafts
in excess of collateral. Only a real-time balance monitor, with the
capability of rejecting or at least pending-for-approval at risk-based limits,
could remove this ultimate moral hazard: that the existence of an assured
source of dayl ight credit wi 1 1 invite practices that increase the probabi 1 i ty
of its use.

2. Systemic Risk. Issues of systemic risk are not addressed directly by any

of the three proposals; none is specifically directed at the CHIPS network, or

a t s i m i l a r networks t h a t might develop i n competition w i t h Fedwire when
Federal Reserve d a y l i g h t c r e d i t becomes more expensive.

To the e x t e n t t h a t

p r i v a t e networks provide a s u b s t i t u t e f o r Federal Reserve day1 i g h t c r e d i t ,
systemic r i s k might become a more c o s t l y problem, o f f s e t t i n g gains from
reduced moral hazard.

For t h i s reason, the proposal s cannot be considered i n

i s o l a t i o n , b u t must be incorporated i n t o an i n t e g r a t e d view o f Federal Reserve
PSR p o l i c y , whether t h a t p o l i c y be i m p l i c i t o r e x p l i c i t .

The cost o f systemic r i s k i s the p o s s i b i l i t y o f a chain o f l i q u i d i t y
insolvencies for banks l e f t empty-handed a t the end o f a day because o t h e r
banks are unable t o make settlement, and the market d i s r u p t i o n s brought on by
u n c e r t a i n t y about who p a i d whom on t h a t day and about opening balances on
succeeding days.

I f p r i v a t e networks are t o c a r r y a l a r g e r share of

large-do1l a r payments, then there i s a need t o assure a coherent framework i n
law, r e g u l a t i o n , o r network r u l e s t h a t e i t h e r removes serious t h r e a t o f
systemic r i s k , o r makes t h a t r i s k manageable by network p a r t i c i p a n t s .
Otherwise, the lender o f l a s t r e s o r t and o t h e r banking a u t h o r i t i e s face a
moral hazard- - that the existence o f a s a f e t y n e t i n v i t e s disregard of systemic
r i s k by banks.
C o n t r o l l i n g systemic r i s k i s not a s e t t l e d matter.

One issue i s whether

the framework f o r p r i v a t e network settlement r e q u i r e s a t t e n t i o n t o both
f i n a l i t y and settlement, o r simply t o settlement.

That i s , can systemic r i s k

be c o n t r o l l e d o n l y by a c r e d i b l e guarantee of f i n a l i t y , so t h a t a1 1 payments
made by the o f f e n d i n g bank are f i n a l d e s p i t e i t s i n a b i 1i t y t o s e t t l e , o r i s a
c r e d i b l e guarantee o f settlement s u f f i c i e n t , w i t h f i n a l i t y o n l y p r o v i s i o n a l so
t h a t payments can be reversed l a t e r , i f necessary?
important.

The d i s t i n c t i o n could be

A guarantor o f f i n a l i t y might have recourse f o r repayment o n l y t o

t h e (presumably) f a i l e d bank.

A guarantor o f settlement o n l y , however, might

have recourse t o u n f a i l e d p a r t i e s whose payments were n o t f i n a l , l e a v i n g a1 1
p a r t i e s w i t h a heal t h y concern f o r c r e d i t r i s k i n making payments.

A

s e t t l e m e n t guarantee would seem s u f f i c i e n t t o p r e c l u d e systemic r i s k of
l i q u i d i t y i n s o l v e n c i e s i n a p r i v a t e network, b u t whether a network w i t h o u t a
f i n a l i t y guarantee c o u l d be c o m p e t i t i v e w i t h Fedwire i s n o t c l e a r .
A second i s s u e i s t h e a p p r o p r i a t e r o l e o f t h e Federal Reserve i n

c o n t r o l 1i ng systemic r i s k on p r i v a t e networks, o t h e r than a concern t h a t t h e r e
be a coherent framework f o r f i n a l i t y and s e t t l e m e n t .

The System m i g h t have

d i f f i c u l t y guaranteeing f i n a l i t y because i t would seem t o i m p l y guaranteed
access t o t h e d i s c o u n t window f o r i n s o l v e n t banks.

Less troublesome m i g h t be

a s e t t l e m e n t guarantee implemented, f o r example, by a s s u r i n g access t o t h e
d i s c o u n t window f o r o t h e r w i s e s o l v e n t banks caught s h o r t o f good funds by
f a i l u r e of one o r a s e r i e s o f o t h e r network members t o make end-of-day
s e t t l e m e n t payments.
The p o i n t i s s i m p l y t h a t a d o p t i n g PSR p o l i c y p r o p o s a l s t o reduce day1 i g h t
o v e r d r a f t s t h a t induce banks t o develop p r i v a t e payment networks may be
premature u n t i 1 a coherent framework f o r c o n t r o l 1i ng systemic r i s k can be
developed.

3.

Competitive I n e q u a l i t y .

Making d a y l i g h t c r e d i t more expensive when u s i n g

Fedwi r e f o r payments reduces t h e apparent competi t i ve advantage of Fedwi r e i n
t h e payment system.

The e x t e n t o f t h i s r e d u c t i o n would depend on b o t h t h e

l e v e l o f t h e " p r i c e " s e t under any one o f t h e t h r e e proposal s and t h e n a t u r e

of t h e framework f o r f i n a l i t y and s e t t l e m e n t on p r i v a t e payment networks.
I t i s one t h i n g t o observe t h a t o f f e r i n g r e c e i v e r f i n a l i t y and immediate
s e t t l e m e n t a t no charge on Fedwire precludes s i g n i f i c a n t p r i v a t e c o m p e t i t i o n
w i t h Fedwire.

I t i s q u i t e another t h i n g t o d e f i n e the p r i c e f o r d a y l i g h t

c r e d i t , o r p r i v a t e network r u l e s f o r f i n a l i t y and s e t t l e m e n t , t h a t would
define competi t i v e equal i t y between Federal Reserve payment s e r v i ces and
p r i v a t e networks.

The Federal Reserve must always have a c o m p e t i t i v e edge i n

e n s u r i n g access t o c r e d i t because i t alone can manufacture u n l i m i t e d c r e d i t ,
and t h e r e i s no sound b a s i s for i n c o r p o r a t i n g t h a t advantage i n p r i c i n g .

17

Product d i f f e r e n t i a t i o n must be t h e b a s i s f o r c o m p e t i t i o n between t h e Federal
Reserve and p r i v a t e payment networks.

Regulatory o v e r s i g h t may c a l l f o r

i n t e r n a l network r u l e s about s e t t i n g and m o n i t o r i n g p a r t i c i p a n t r i s k , t o
assure t h a t moral hazard i s minimized.

Some form o f s e t t l e m e n t guarantee may

be r e q u i r e d t o minimize systemi c r i sk.

I n combination, these requirements

mean t h a t Fedwire would be d i f f e r e n t i a t e d f r o m p r i v a t e networks on t h e b a s i s
of t h e r i s k exposure o f payees who become n e t c r e d i t o r s on a p r i v a t e network.
Imposing a p r i c e f o r Federal Reserve day1 i g h t c r e d i t i n t r o d u c e s a problem
of adverse s e l e c t i o n : t h e h i g h e r t h e Federal Reserve p r i c e , t h e l o w e r t h e
1i k e l y qua1 i t y o f t h e average bank r e m a i n i n g on Fedwire, and t h e r i s k i e r t h e
pool of c r e d i t extended by t h e Federal Reserve i n making payments.

Even w i t h

t h e p e n a l t y r a t e p r o p o s a l , t h e r e may be banks who f i n d t h e a d m i n i s t e r e d
p e n a l t y r a t e on o v e r d r a f t s more a t t r a c t i v e than t h e risk- augmented market
terms t h e y m i g h t f a c e t o meet c r e d i t requirements on a competing p r i v a t e
network.

U l t i m a t e l y , i f p o l i c y i n t e n t were t o a l l o w c o m p e t i t i o n w i t h o u t

a1 l o w i n g adverse s e l e c t i o n , an o u t r i g h t p r o h i b i t i o n o f Federal Reserve
d a y l i g h t c r e d i t , e n f o r c e d w i t h a r e a l - t i m e m o n i t o r , m i g h t be t h e o n l y
effective

IV.

solution.

Conclusion
The fundamental concern- - that uncol 1a t e r a l i zed Federal Reserve c r e d i t,

even though l i m i t e d t o d a y l i g h t m a t u r i t i e s , may be i n c o n s i s t e n t w i t h t h e

Federal Reserve Act--would provide the clearest direction for PSR pol icy.
Alternatively, any of the three proposals examined here could be employed to
el iminate dayl ight overdrafts. But the world has changed since Fedwi re
payments involved no daylight credit. Returning to that cash-in-advance
system in a world of telecommunications and tri 1 1 ion-do1 1 ar transaction days
would require integrating the chosen proposal into a broader pol icy reform
focused on moral hazard, systemic risk, and terms on which private payment
networks would operate. This surely would require a real-time monitor to
enforce.
The more pragmatic concern about Federal Reserve risk exposure from
daylight overdrafts could be addressed by the three proposals in slightly
different ways. The pricing proposal to set a fee per dollar of daylight
overdraft is simple and direct. Setting the price "low" initially and raising
the price periodically thereafter has the advantage of testing a frequently
voiced judgment that most dayl ight overdrafts could be el iminated cheaply by
simple changes in payments practices. If that did not turn out to be the
case, then the supplemental balance proposal could achieve a 1 arger reduction
in overdrafts simply by the larger balances from which transactions are made.
The penalty rate proposal would go further, assuring virtually complete
elimination of daylight overdrafts.
Imp1 ementi ng any of these proposal s, however, does not deal effectively
with the underlying costs of moral hazard, systemic risk, and competitive
inequality that characterize the payment system risk problem. Indiscriminate
provision of daylight credit, even at a positive price, retains moral hazard.
Inducing the development of a private daylight credit market need not reduce
moral hazard either, if no real-time monitor is in place to enforce assignment

of credit risk to private lenders. Inducing the development of private

payment networks leaves r i s k assignment muddy i f f i n a l i t y and s e t t l e m e n t r u l e s
a r e i n e x a c t , and i n c r e a s e s t h e presumption o f rescue by t h e f e d e r a l safety n e t
i f systemic r i s k i s n o t managed.

Nor c o u l d p r i v a t e networks be r e l i e d upon

w i t h o u t a s s u r i n g terms on which t h e y m i g h t compete successful l y w i t h Fedwire
w i t h o u t c r e a t i n g an adverse s e l e c t i o n problem.
I n s h o r t , none o f t h e t h r e e proposals b r i n g s a s a t i s f a c t o r y r e s o l u t i o n t o
t h e payment system r i s k problem.
more encompassing p o l i c y r e f o r m .

Resolution r e q u i r e s t h e i r i n t e g r a t i o n i n t o a

Footnotes

CHIPS i s a p r i v a t e interbank telecommunication payment network operated
by t h e New York C l e a r i n g House. This paper deals o n l y w i t h CHIPS and
w i t h Fedwire, the Federal Reserve's e l e c t r o n i c funds t r a n s f e r system. A
t h i r d system, f o r t r a n s f e r s o f book- entry Treasury s e c u r i t i e s a g a i n s t
reserve d e p o s i t balances, c o n t r i b u t e s $60 b i 11i o n of the $1 15 b i 11i o n
average sum o f t h e maximum d a i l y d a y l i g h t c r e d i t on Fedwire. This system
i s n o t considered here because o f i t s s p e c i a l i z e d business and because
i t s relevance i s concentrated a t o n l y a handful o f banks.
Two f o r c e s a r e now a t work t o l i m i t supply. Members of CHIPS can and d o
s e t d o l l a r l i m i t s on t h e i r n e t c r e d i t p o s i t i o n s w i t h respect t o o t h e r
members d u r i n g a day i n r e a l time. Federal Reserve r u l e s s i n c e 1986 have
s e t an upper l i m i t on any bank's cross system n e t d e b i t , although t h e
l i m i t s do n o t appear t o have been a c o n s t r a i n t on most banks and are n o t
administered i n r e a l time.
These proposals a r e described i n Van Hoose (19881, t h e Angel1 proposal of
a p e n a l t y r a t e ; Hamdani and Wenni nger (1 988>, suppl emental balances ; and
Large- Dollar Payments System Advisory Group (19881, p r i c i n g .
The phrase i s from Mengle (1988), who provides a u s e f u l d i s c u s s i o n of
f i n a l i t y issues.
Humphrey (1986) provides s i m u l a t i o n s o f such c h a i n r e a c t i o n s .
See M i 1ano

( 1988).

Federal Reserve Bank o f Cleveland, Operating L e t t e r #9, August 1, 1939.
Annual Report, Board o f Governors o f t h e Federal Reserve System, 1947;
1 983.
This argument i s d i f f e r e n t from t h a t i n Van Hoose (19881, where n e i t h e r a
bank nor i t s Federal Reserve Bank knows about a day1 i g h t o v e r d r a f t u n t i 1
a f t e r the f a c t . While the Federal Reserve has no immediate program t o
i n t e g r a t e r e a l - t i m e m o n i t o r i n g i n t o Fedwire operations, banks should be
a b l e t o monitor t h e i r p o s i t i o n s i n r e a l time b o t h from t h e i r own
i n f o r m a t i o n and by u s i n g t h e Federal Reserve r e a l - t i m e Automated Balance
M o n i t o r i n g System.
Simmons (1987) c o n t a i n s an extensive d i s c u s s i o n o f d a y l i g h t funds market
possi b i 1i t i e s .
Humphrey ( 1 987) and Large-Do1 l a r Payments System Advi sory Group ( 1 988)
c o n t a i n d e t a i l e d explanations o f a number o f such p o t e n t i a l m o d i f i c a t i o n s .
12.

The a r b i t r a g e d r e l a t i o n s h i p i s explained i n Van Hoose (1988).

13.

David Humphrey has pointed o u t t h a t , a t t h i s common r a t e , the s t a t e d
p r i c e f o r a dayl i g h t o v e r d r a f t i n the p r i c i n g proposal would have t o be
about 40 percent higher than a and (RF-RON) i f TI i s t o equal CR.
The reason i s t h a t i n t e r e s t r a t e s apply t o a 365-day year, b u t the p r i c e
charged f o r a d a y l i g h t o v e r d r a f t applies o n l y t o about 255 business days.

14.

Two s i t u a t i o n s might g i v e r i s e t o o v e r d r a f t s . One i s closed markets,
mentioned previously. The other would a r i s e i f v a r i a t i o n s i n the funds
r a t e brought i t up t o the l e v e l o f the discount r a t e , removing i t s
penalty f e a t u r e . W i t h t h e penal t y removed, banks would be i n d i f f e r e n t
between dayl i g h t o v e r d r a f t loans and purchases o f 24-hour funds. E i t h e r
would fund a p o t e n t i a l n e t d e b i t and earn i n t e r e s t a t the o v e r n i g h t r a t e .

15.

The aphorism i s from M c E l l i g o t l s Pool, i n which a boy f i s h e s i n a mud
puddle, f a n t a s i z i n g t h a t i t has a hidden connection t o the seven seas.

16.

I n t e r n a t i o n a l Financing Review, Issue 751, November 19, 1988, p. 3774.
Neither i s i t p o s s i b l e t o use a pure p r i v a t e market s o l u t i o n as a
paradigm f o r p u b l i c p r o v i s i o n , as some have t r i e d t o do (Van Hoose
C19881; Task Force on Control 1 i n g Payments System Risk C19881). The f a c t
i s t h a t the U.S. payment system i s based on f i a t money produced'by t h e
Federal Reserve. One question i s o f the terms ( t h e Federal Reserve p r i c e
for d a y l i g h t c r e d i t ) on which t h a t f i a t money should be supplied through
Federal Reserve c r e d i t d u r i n g a day, i n a d d i t i o n t o the monetary pol i c y
s p e c i f i c a t i o n o f t h e terms on which i t should be supplied from day t o
day. The o t h e r question i s o f the terms on which p r i v a t e i n s t i t u t i o n s
should be allowed t o provide competing p r i v a t e c r e d i t d u r i n g the day.
The two questions are obviously r e l a t e d , and t h e i r answers w i l l determine
the m i x o f pub1i c and p r i v a t e c r e d i t used t o f a c i 1i t a t e payments. The
appropriate m i x cannot be determined by reference t o the terms on which a
s i n g l e element o f t h e m i x would be provided i n a world without t h e o t h e r .

-

43

-

Appendi x

Confronting the payment system r i s k problem o f day1i g h t c r e d i t became
unavoidable i n the l a t e 1970s under the pressures o f t e c h n o l o g i c a l change and
of the demand f o r same-day n e t settlement service f o r p r i v a t e large- value
payment networks.

O r i g i n a l l y , s t a r t i n g i n 1918, telegraph, telephone, o r mai 1

messages t o the Federal Reserve were the o n l y mechanisms f o r t r a n s f e r r i n g
ownership o f reserve deposit balances between banks w i t h same-day f i n a l it y .
Other devices were o f f i c i a l checks and an e a r l y version o f CHIPS, r e q u i r i n g a t
l e a s t a one-day p e r i o d f o r c l e a r i n g and f i n a l i t y , o r i n t e r b a n k messages t h a t
simply i n s t r u c t e d a bank t o use Fedwire t o t r a n s f e r funds.
Development o f new computer-to-computer telecommunications technology f o r
Fedwire and CHIPS payments, and f o r interbank message systems, suggested a new
possibility.

P r i v a t e n e t settlement systems l i k e CHIPS and Bankwire's

then-proposed Cashwire might c l e a r payment messages among a s e t o f
p a r t i c i p a n t s d u r i n g the day and present a balanced s e t o f n e t d e b i t and c r e d i t
p o s i t i o n s t o the Fed f o r settlement a t the end o f the same day, achieving
same-day settlement f i n a l i t y .

This o f f e r e d the dual advantages o f reducing

t h e c o s t l y o v e r n i g h t f l o a t f i n a n c i n g o f banks i n n e t d e b i t p o s i t i o n by those
i n n e t c r e d i t p o s i t i o n , and o f shortening the l e n g t h o f time d u r i n g which
b i l a t e r a l c r e d i t p o s i t i o n s exposed banks t o c r e d i t r i s k .

(The Canadian

banking system went a d i f f e r e n t r o u t e , c o n t i n u i n g t o use paper checks even f o r
s e c u r i t i e s market t r a n s a c t i o n s , b u t e l i m i n a t i n g o v e r n i g h t f l o a t by making ex
p o s t adjustments o f p r i o r - d a y balances a t the Bank o f Canada f o r settlement;
d u r a t i o n o f r i s k exposure i n c l o c k time was n o t reduced, however.)

Operating d e t a i 1s o f telecommunication devices, accounting system
m o d i f i c a t i o n s , backup f a c i l i t i e s , and d a i l y time schedules were l a i d o u t
q u i c k l y , b u t the e n t e r p r i se foundered on the "unpostable debi t " - - t h a t

i s, what

t o do i f one o f t h e p a r t i c i p a n t s d i d n o t have s u f f i c i e n t funds i n i t s reserve
account t o cover i t s n e t d e b i t on a p r i v a t e network a t settlement hour.

Some

found t h i s an operational inconvenience t h a t should be ignored: from an
operations perspective, i t was no problem as long as the accounting system was
designed t o accept negative numbers.

A f t e r a1 1, Fedwire d i d n o t check t o see

whether a bank had s u f f i c i e n t funds t o cover a w i r e t r a n s f e r request, so why
should a n e t settlement message be t r e a t e d any d i f f e r e n t l y ?

Others found i t

scandalous, o r a t l e a s t t r o u b l i n g , t o design a system i n which the c e n t r a l
bank automatical l y would guarantee a p r i v a t e settlement by accepting an
unpostable d e b i t as an o f f s e t t o i r r e v o c a b l e c r e d i t s .

The issue remained

unresolved f o r several years, b u t two developments forced some a c t i o n .
One o f these developments was the increased incidence o f o v e r n i g h t
o v e r d r a f t s o f reserve accounts and adoption o f the c u r r e n t Federal Reserve
overnight overdraft policy.
traffic,

High i n t e r e s t r a t e s , mushrooming w i r e t r a n s f e r

and decl i n i n g reserve requirements were making reserve d e p o s i t

accounts a l e s s and l e s s e f f e c t i v e b u f f e r stock i n banks 1 d a i l y reserve
management.

With no o v e r n i g h t o v e r d r a f t pol i c y o t h e r than Regulation D ( t h a t

banks mai n t a i n an average r e q u i r e d balance over a reserve maintenance p e r i o d ) ,
concern was mounting t h a t banks might abuse the Federal Reserve by running
o v e r n i g h t o v e r d r a f t s when e s p e c i a l l y p r o f i t a b l e o p p o r t u n i t i e s arose.

(An

egregious example was an occasion on which the Open Market Desk d i d a l a r g e
l a t e - in-the-day matched salelpurchase t r a n s a c t i o n t o d r a i n reserves o n l y t o
f i n d t h a t t h e counterparty bank "happened" t o r u n an e q u i v a l e n t o v e r n i g h t
overdraft.)

The second development was a carefully constructed survey that revealed
the extent of dayl ight overdrafts. Developing an overnight overdraft pol icy
led to more widespread realization within the Federal Reserve that dayl ight
overdrafts were a fact of 1 ife. There was no way to prevent dayl ight
overdrafts, but neither was there a way to know how widespread the practice
was. The survey served as a factual foundation for debating and developing
the current PSR pol icy: self-set 1 imi ts on cross system net debit positions,
bi lateral credit 1 imi ts and mu1 ti lateral debit 1 imi ts on private systems, wi th
a stated Federal Reserve intention to ratchet-down the debit limits over time.

References
1.

2.

Board o f Governors o f the Federal Reserve System. " Control 1i n g Risk i n
t h e Payments System." Report o f the Task Force on C o n t r o l l i n g Payments
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. "A S t r a t e g i c Plan f o r Managing Risk i n the Payments
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Humphrey, David 0 . "Payments System Risk, Market F a i l u r e , and P u b l i c
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6.

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!

I

"The Angel 1 Proposal :

An Overview," mimeo,