Jul 24

Daylight overdraft (FRM in the news)

by David Harper, CFA, FRM, CIPM

FRM |

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  • 2008 FRM AIM: "List various operational risks that emerge in an electronic payments system…"

Saunders (Technology and other risks, chapter 14) says "some analysts and regulators view settlement, or daylight, overdraft risk as one of the greatest potential sources of instability in the financial markets today."

Antoine Martin (of New York Fed) and David Mills share a helpful primer in The Case of Daylight Overdrafts in Fedwire. What's the daylight overdraft?

The Federal Reserve [provides] intraday liquidity, which allows qualifying banks to overdraw on their Fed accounts in order to make payments via Fedwire. Banks can acquire overdrafts throughout the day to make payments, but must ensure that their accounts are not in a negative position at the end of the day. The Federal Reserve's provision of liquidity through daylight overdrafts can be interpreted as very-short-term credit.

How does the Fed manage its exposure to this credit risk?

  • Overdraft fees
  • Reputation monitoring
  • Collateral

Overdraft fees

The Fed currently charges a twenty-four-hour rate of 36 basis points less a deductible. "This price, though small, is meant to provide an incentive for banks to minimize their use of daylight overdrafts." 

Reputation monitoring

Each bank also has a net debit cap; i.e., a maximum dollar overdraft. The Federal "also monitors a bank's use of its daylight overdrafts against the cap, providing an opportunity for banks to establish reputations with their regional Federal Reserve Bank. In most instances, banks that exceed their cap limit are required to explain the reason to the Fed and then be counseled to prevent it from happening again."

Collateral

The Fed uses collateral in two situations:

  • Collateral is required "from problem institutions to cover any incidental overdrafts."
  • Banks can pledge collateral if they wish to increase their net debit caps (the amount and type of collateral pledged are negotiated)

According to the authors, collateral "plays an insurance role for the Fed …and also plays an incentive role for the bank to control its overdrafts and avoid risky behavior… thus the collateral also overcomes certain moral hazard concerns"

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