Financial Update (Second Quarter 2002)

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The Federal Reserve’s Intraday Credit Policies Evolve With the Times

The U.S. payment system is dynamic, changing with the ebb and flow of the economy and with changes in the banking, payments and regulatory environment. Since one of the key roles of the Federal Reserve is providing payment services to the nation’s depository institutions and to the U.S. Treasury, the Fed has a responsibility to continually re-evaluate its policies with regard to payments.

In a recent Federal Reserve Bulletin article, author Stacy Panigay Coleman of the Board of Governor’s Division of Reserve Bank Operations and Payment Systems reviews the evolution of the Fed’s intraday credit policies, including the potential impact the events of Sept. 11 may have on these policies.

An early assessment of risk
As far back as 1970, according to the author, the Federal Reserve began to assess the risks associated with daylight credit extensions, or “daylight overdrafts,” the credit extended by the Fed during the business day (intraday) to depository institutions. In 1985, notes Coleman, the Federal Reserve developed a risk policy to address the risks that the payment system presents to the banking system and other sectors of the economy.

This 1985 payment system risk policy regulated the use of Federal Reserve intraday credit, the daylight overdrafts that depository institutions incur when their accounts with the Federal Reserve run a negative balance. That is, when settling payments, the Federal Reserve Banks post debits and credits to a depository institution’s Fed account throughout the business day, and if the debits exceed the credits that depository institution will have a negative balance. To make up for this negative balance, the Federal Reserve extends intraday credit to ensure that the payment system continues to run smoothly.

Since adoption of the 1985 policy, the Fed’s methods of controlling daylight overdrafts have further evolved. Initially, the Fed set a maximum or net debit cap for the daylight overdraft position, according to the author. Yet, despite the cap, the amount of daylight credit extended by the Fed continued to grow. From 1986 to 1993 the value of daylight overdrafts increased by an average annual rate of 13 percent, surging dramatically in 1989 even with a reduction in the net debit caps in place.

The Federal Reserve was forced to create an economic incentive to reduce reliance on daylight credit. So, in 1994 the Fed began charging daylight overdraft fees. The fee was set at an annual rate of 24 basis points in the first year and raised to 36 basis points in 1995.

One of the most significant changes in the payment system risk policy allows some depository institutions to pledge collateral to access additional daylight credit.

Millennium review
In early 2000 the Federal Reserve Board of Governors began a review of its daylight credit policies, including an analysis of trends in payment activity and changes in the Board’s payment system risk policy. According to Coleman, while the Board’s review judged the current policy generally effective in controlling risk, the review did identify liquidity pressures among some payment system participants. The Board also acknowledged that recent payment system initiatives such as settlement-day finality for Federal Reserve–processed automated clearinghouse credit transactions put added pressure on the liquidity needs of certain depository institutions at specific times during the day.

On the basis of the Board’s review, in December 2001 the payment system risk policy was modified. One of the most significant changes in the policy allows some depository institutions to pledge collateral to access additional daylight credit. This shift in policy toward collateralization to secure daylight overdrafts may provide additional benefits in light of the events of Sept. 11. Coleman makes the point that requiring full or partial collateralization of an institution’s daylight overdrafts could facilitate the Federal Reserve Banks’ lending through the discount window. In the event of a severe market disruption, a depository institution’s collateral and the appropriate lending agreements would already be in place, making the Fed’s “lender of last resort” discount window loans quicker and easier to process.