Policy on Payments System Risk, 12417-12443 [08-971]

Agencies

• FEDERAL RESERVE SYSTEM

[Federal Register Volume 73, Number 46 (Friday, March 7, 2008)]
[Notices]
[Pages 12417-12443]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 08-971]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1309]


Policy on Payments System Risk

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Policy statement; request for comment.

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SUMMARY: The Board of Governors of the Federal Reserve System (Board) 
requests comment on proposed changes to its Payments System Risk (PSR) 
policy that would adopt a new strategy for providing intraday balances 
and credit to depository institutions and encourage such institutions 
to collateralize their daylight overdrafts. The Board believes changes 
to the Federal Reserve's current strategy for providing intraday 
balances and credit to the banking industry would help loosen liquidity 
constraints and reduce operational risk. Specifically, the Board 
proposes to adopt a policy of supplying intraday balances to healthy 
depository institutions predominantly through explicitly collateralized 
daylight overdrafts provided at a zero fee. The Board would allow 
depository institutions to pledge collateral voluntarily to secure 
daylight overdrafts but would encourage the voluntary pledging of 
collateral to cover daylight overdrafts by raising the fee for 
uncollateralized daylight overdrafts to 50 basis points (annual rate) 
from the current 36 basis points. The Board also proposes to increase 
the biweekly daylight overdraft fee waiver to $150 from $25 to minimize 
the effect of the proposed policy changes on institutions that use 
small amounts of daylight overdrafts (small users). In addition, the 
proposed policy would involve changes to other elements of the PSR 
policy dealing with daylight overdrafts, including adjusting net debit 
caps, streamlining maximum daylight overdraft capacity (max cap) 
procedures for certain foreign banking organizations (FBOs), 
eliminating the current deductible for daylight overdraft fees, and 
increasing the penalty daylight overdraft fee for ineligible 
institutions to 150 basis points (annual rate) from the current 136 
basis points.

DATES: Comments must be received on or before June 4, 2008.

ADDRESSES: You may submit comments, identified by Docket No. OP-1309, 
by any of the following methods:
     Agency Web Site: https://www.federalreserve.gov. Follow the 
instructions for submitting comments at https://www.federalreserve.gov/
generalinfo/foia/ProposedRegs.cfm. 
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: regs.comments@federalreserve.gov. Include the 
docket number in the subject line of the message.
     Fax: (202) 452-3819 or (202) 452-3102.
     Mail: Address to Jennifer J. Johnson, Secretary, Board of 
Governors of the Federal Reserve System, 20th Street and Constitution 
Avenue, NW., Washington, DC 20551.
    All public comments will be made available on the Board's Web site 
at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as 
submitted, unless modified for technical reasons. Accordingly, comments 
will not be edited to remove any identifying or contact information. 
Public comments may also be viewed

[[Page 12418]]

electronically or in paper in Room MP-500 of the Board's Martin 
Building (20th and C Streets, NW.) between 9 a.m. and 5 p.m. on 
weekdays.

FOR FURTHER INFORMATION CONTACT: Jeffrey Marquardt, Deputy Director 
(202-452-2360) or Susan Foley, Assistant Director (202-452-3596), 
Division of Reserve Bank Operations and Payment Systems, Board of 
Governors of the Federal Reserve System; for users of 
Telecommunications Device for the Deaf (``TDD'') only, contact (202) 
263-4869.

SUPPLEMENTARY INFORMATION: 

I. Background

    The Federal Reserve's Payments System Risk (PSR) policy sets out 
the general public policy objectives of safety and efficiency for 
payments and settlement systems. Over the past few years, the Federal 
Reserve has been reviewing the long-term effects of market, 
operational, and policy changes by the financial industry and the 
Federal Reserve on intraday liquidity, operational, and associated 
credit risks in financial markets and the payments system, including 
account overdrafts (daylight overdrafts) at the Federal Reserve Banks 
(Reserve Banks). On June 21, 2006, the Board published for public 
comment the Consultation Paper on Intraday Liquidity Management and the 
Payments System Risk Policy (consultation paper) that sought 
information from financial institutions and other interested parties on 
their experience in managing liquidity, operational, and credit risks 
related to Fedwire funds transfers, especially late-day transfers.\1\ 
The paper included a list of detailed objectives relating to safety and 
efficiency that the Board has previously used to conduct payments 
system risk analysis. An important goal of the consultation process was 
to identify opportunities to improve the safety/efficiency trade-offs 
in the payments system over the long run.
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    \1\ See 71 FR 35679, June 21, 2006.
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    Significant changes to U.S. payments and settlement systems over 
the past twenty-five years have helped reduce systemic risk. In accord 
with U.S. and international risk policies and standards, several of 
these changes have relied increasingly on the use of central bank 
money--in this context, balances that financial institutions and 
private clearing and settlement organizations hold in accounts at 
Reserve Banks--to strengthen the management of credit and liquidity 
risk in private-sector clearing and settlement arrangements. Such 
changes have had the effect of increasing significantly the intraday 
demand for central bank money and hence the demand for daylight 
overdrafts at the Reserve Banks, which are a major source of these 
funds.
    In addition, the combined effect of depository institutions' 
intraday liquidity management strategies, changes at clearing and 
settlement organizations, and late-day market activity has been to 
shift the sending of larger Fedwire funds transfers to later in the 
day. From an operational risk perspective, delaying the sending of 
large payments until late in the day increases the potential magnitude 
of liquidity dislocation and risk in the financial industry if late-in-
the-day operational disruptions should occur. An increase in such risk 
is particularly troublesome in an era of heightened concern about 
operational disruptions generally.
    Given the growing demand for intraday central bank money and 
accompanying daylight overdrafts, as well as the shift of larger 
Fedwire payments to later in the day, the Board believes that 
significant further steps are appropriate to mitigate the growing 
credit exposures of the Reserve Banks, while also improving intraday 
liquidity management for the banking system and augmenting liquidity 
provided. The consultation paper requested views on potential changes 
in market practices, operations, and the Federal Reserve's PSR policy 
that could reduce liquidity, operational, and credit risks. These 
proposed changes would not affect the provisions of part I of the PSR 
policy, which deal with risk management in private-sector systems.

II. Comments and Analysis

    The Board received twenty-three public comment letters in response 
to its consultation paper.\2\ The majority of these letters were from 
commercial banking organizations and from several private-sector 
clearing and settlement systems, industry groups, and trade 
organizations. In addition, the Board received comments from one 
Reserve Bank and one individual. Almost all commenters explicitly 
expressed concern about the operational risk associated with the 
increasing concentration of late-day payments. Most commenters 
identified payment queuing at depository institutions, particularly the 
queuing of payments to settle large money market transactions, as a 
liquidity conservation strategy that contributes to institutions 
sending payments late in the day.\3\ A majority of commenters also 
agreed that some private-sector clearing and settlement systems absorb 
a considerable amount of intraday liquidity in connection with their 
risk-management processes. Further, some commenters identified market 
constraints, such as the late-day settlements of tri-party repo 
transactions, and the processes and settlement procedures of The 
Depository Trust Company (DTC) and The Clearing House Interbank Payment 
System (CHIPS) as important contributors to the concentration of late-
day payments.\4\
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    \2\ Copies of all public comments on the consultation paper can 
be found on the Board's website at https://www.federalreserve.gov/
generalinfo/foia/index.cfm?doc_id=OP%2D1257&doc_ver=1.
    \3\ Payment queuing is a tool used by some depository 
institutions to hold a payment internally until sufficient funds--
available balances or credit line--become available to send the 
payment to the Fedwire funds transfer system or another system. Some 
payments are held in queues because a customer has insufficient 
balances or credit to fund the payments. Other payments may be held 
to manage the level of account daylight overdrafts at the Reserve 
Bank or the associated fees.
    \4\ CHIPS is a real-time final payments system operated by The 
Clearing House Payments Company. In January 2001, The Clearing House 
implemented operational and rule changes to allow all transactions 
settled in CHIPS to be final upon release from a central queuing 
system. DTC is a subsidiary of the Depository Trust and Clearing 
Corporation, which operates six subsidiaries that provide clearance, 
settlement, and information services for many financial instruments, 
including equities, corporate and municipal bonds, government and 
mortgage-backed securities, money market instruments, and over-the-
counter derivatives. DTC provides custody and settlement services 
for corporate and municipal securities and money market instruments. 
DTC is a member of the Federal Reserve System and a clearing agency 
registered with the Securities and Exchange Commission.
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    The comments also addressed the specific market, operational, and 
PSR policy options set forth in the consultation paper. The majority of 
commenters strongly supported greater use of collateral and two-tiered 
pricing of daylight overdrafts by the Federal Reserve under the PSR 
policy.\5\ Several institutions expressed strong support for a zero fee 
for collateralized daylight overdrafts, similar to policies followed by 
other central banks. Most commenters also stressed that they should 
have the ability to use unencumbered collateral already pledged to the 
discount window to support their daylight overdrafts.
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    \5\ In 2001, the Board requested comment on two-tier pricing as 
a long-term PSR policy direction and, based on comments, agreed to 
continue evaluating the benefits and drawbacks of implementing such 
a regime. See 66 FR 30208, June 5, 2001 and 67 FR 54424, August 22, 
2002.
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    Several commenters also strongly supported continued work on 
potential opportunities to conserve liquidity within DTC and CHIPS. 
These comments endorsed the work performed by the Federal Reserve Bank 
of New

[[Page 12419]]

York's Payment Risk Committee (PRC) and Wholesale Customer Advisory 
Group (WCAG) during the consultation period. The PRC and WCAG conducted 
a liquidity survey to understand better the determinants of late-day 
payments.\6\ The results of the survey prompted the formation of four 
workgroups to evaluate liquidity improvement opportunities for CHIPS, 
DTC, tri-party repo payments, and broker-dealer payments.
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    \6\ The Payment Risk Committee (PRC) is sponsored by the Federal 
Reserve Bank of New York and works to identify and analyze issues of 
mutual interest related to risk in payments and settlement. The 
institutions represented on the PRC include Bank of America, Bank of 
New York, Bank of Tokyo-Mitsubishi UFJ, Citibank, Deutsche Bank, 
HSBC, JPMorgan Chase, State Street, UBS, Wachovia, and Wells Fargo. 
The Wholesale Customer Advisory Group (WCAG) advises the Wholesale 
Product Office on business issues and is composed of depository 
institutions that are major users of Fedwire. Institutions 
represented on this group include ABN AMRO, Bank of America, Bank of 
New York, Citibank, Deutsche Bank, HSBC, JPMorgan Chase, Key Bank, 
Mellon Financial, State Street, SunTrust, UBS, U.S. Bank, U.S. 
Central Credit Union, Wachovia, and Wells Fargo.
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    The workgroup focused on CHIPS processing found that the CHIPS 
algorithm can leave a number of large-value payments unresolved in the 
system for significant periods of time, resulting in some institutions 
redirecting payments to the Fedwire funds transfer system at the end of 
the day; these payments are in addition to the daily Fedwire funds 
transfers that are part of the CHIPS' end-of-day funding procedures 
around 5:15 p.m. The workgroup and CHIPS identified possible 
opportunities to release unresolved payments for settlement earlier, 
including changing some of the system controls. The workgroup that 
focused on DTC largely examined the money market instrument clearing 
and settlement processes and the reasons a substantial amount of 
liquidity is transferred to and remains at DTC, especially between 1 
and 3 p.m. This liquidity is then released as part of settlement around 
4:30 p.m. The workgroup and DTC tried to identify ways to reduce the 
length of time of the settlement process, to encourage institutions to 
manage better liquidity at DTC, and to enhance operations and certain 
controls. The other two workgroups on broker-dealer payments and on 
tri-party payments largely focused on documenting processes and 
procedures to educate the PRC and WCAG members so they could better 
understand why these payments are key determinants of late-in-the-day 
payments. The results from each of the workgroups were shared as part 
of the comment process and were cited for continued work by commenters.
    Commenters were split in terms of support for developing a 
liquidity-saving mechanism for the Fedwire funds transfer system.\7\ 
Eight of the thirteen respondents that commented on the possible 
introduction of a liquidity-saving mechanism encouraged further 
exploration of this idea, while the remaining five expressed some 
concerns. Those respondents that were supportive noted that a 
liquidity-saving mechanism could help reduce the length of time that 
large-value payments sit in internal queues at depository institutions. 
One commenter specifically suggested that the Federal Reserve focus on 
a liquidity-saving system for the exchange of broker-dealer and tri-
party repo payments, which are typically large-value payments. Other 
supporters strongly favored a centralized queuing system for all 
Fedwire funds transfer payments and mentioned systems used or under 
development in other countries.\8\ Concerns about developing a 
liquidity-saving mechanism included the possibility that it could 
undermine the real-time gross settlement attribute of the Fedwire funds 
transfer system, create a competitive disadvantage for a private-sector 
payments system, or significantly increase the cost of making Fedwire 
funds transfer payments.
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    \7\ The creation of a liquidity-saving mechanism could involve 
adding new features to the Fedwire funds transfer system that 
depository institutions could use to coordinate better the timing 
and settlement of their payments as well as to economize on the use 
of intraday central bank money, daylight overdrafts, and collateral. 
The existing real-time gross settlement functionality of Fedwire 
would be retained. In particular, a depository institution could 
still designate that a Fedwire funds transfer settle immediately as 
it does today. The new features, for example, could allow depository 
institutions to designate certain types of payments, possibly 
including payments generated by certain types of transactions, to be 
placed into a central queuing system and settled using algorithms 
that allow the liquidity provided by incoming payments to a 
depository institution to be used as far as possible to settle that 
institution's outgoing payments.
    \8\ Versions of liquidity-saving mechanisms are used by CHIPS 
and Target 2 in the European Union. Such features will also be 
included in the new wire transfer systems in Japan and other 
countries.
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    Commenters had different views on the idea of time-of-day pricing, 
which would vary the fee charged for daylight overdrafts through the 
day so that overdrafts incurred earlier in the day would incur a lower 
fee than overdrafts incurred late in the day. While some commenters 
supported time-of-day pricing as an incentive to send funds transfers 
earlier in the day, others requested additional information about the 
idea. Still other commenters pointed out that the effectiveness of 
time-of-day pricing would be constrained by the reality of late 
afternoon trade settlements, such as tri-party repo payments and Fed 
funds loans.
    Commenters expressed limited or no support for the creation of an 
intraday market to exchange liquidity, an expansion of the market for 
early return of Fed funds loans, or throughput requirements for the 
Fedwire funds transfer system. Most respondents thought that an 
intraday market would not be helpful in addressing the late-day 
concentration of payments and would be costly and complex to establish. 
In terms of expanding the market for early return of Fed funds loans, 
several commenters were uncertain about the effects of such a change on 
late-day payments. In addition, a majority of respondents did not 
support the introduction of throughput requirements for the Fedwire 
funds transfer system, primarily because of the potential difficulty of 
administering and enforcing such requirements. Throughput requirements 
are used by some systems around the world to encourage certain 
percentages of payments volume to be submitted by predetermined times. 
Three commenters, however, were somewhat supportive provided the 
throughput requirements were voluntary, implemented jointly with a 
central queue, or in conjunction with brief, intermittent periods when 
institutions could coordinate sending Fedwire funds transfers.
    The Board received several comment letters raising concerns about 
the policy's treatment of the daylight overdrafts of foreign banking 
organizations (FBOs). The commenters stated that the U.S. capital 
equivalency measure used to determine FBO net debit caps and 
deductibles in the calculation of daylight overdraft limits and fees is 
discriminatory and results in a competitive disadvantage for these 
organizations and in their delaying payments. This assertion is based 
on the fact that U.S.-chartered depository institutions receive a net 
debit cap and deductible based on their worldwide capital, while FBOs 
receive a net debit cap based on no more than 35 percent of their 
worldwide capital (referred to as the U.S. capital equivalency) and a 
deductible based on their U.S. capital equivalency.\9\ As a result, 
FBOs are

[[Page 12420]]

eligible for considerably lower daylight overdraft capacity and free 
intraday credit than are U.S.-chartered depository institutions with 
equivalent worldwide capital. The commenters asked the Board to 
calculate FBO deductibles using 100 percent of their worldwide capital, 
as is done for U.S.-chartered institutions. The commenters also 
asserted that the existing formula used to determine the net debit cap 
cannot be justified, particularly in the case of FBOs which are 
considered to be both ``well capitalized'' and ``well managed'' for 
U.S. regulatory (FHC) purposes or which have received the highest rated 
``strength-of-support assessment'' (SOSA 1).\10\
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    \9\ In 2001, the Board modified the criteria to determine 
eligible capital and raised the percent of capital used in 
calculating net debit caps and the deductible. The percent of 
capital used increased from as much as 10 percent to up to 35 
percent. See also 66 FR 30205, June 5, 2001.
    \10\ For an FBO, the policy incorporates the SOSA rankings and 
FHC status in determining U.S. capital equivalency. The SOSA ranking 
is composed of four factors, including the FBO's financial condition 
and prospects, the system of supervision in the FBO's home country, 
the record of the home country's government in support of the 
banking system or other sources of support for the FBO; and transfer 
risk concerns. The SOSA ranking is based on a scale of 1 through 3, 
with 1 representing the lowest level of supervisory concern.
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    Finally, the Board received a few other comments. One responder 
suggested changing the posting rules for automated clearinghouse (ACH) 
debit transfers so that settlements from credit and debit transfers are 
posted simultaneously with only the net amount of funds increasing or 
decreasing the balances of depository institutions held at Reserve 
Banks.\11\ The Board has issued a separate Federal Register notice 
requesting comment on shifting from 11 a.m. to 8:30 a.m., eastern time, 
the posting time for commercial and government ACH debit transfers that 
are processed by the Reserve Banks' FedACH service.\12\ The earlier 
posting time would make the postings of commercial and government ACH 
debit and credit transfers simultaneous.
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    \11\ Currently FedACH credit transfer and debit transfer 
transactions post at 8:30 a.m. and 11 a.m. eastern time, 
respectively.
    \12\ All times referenced are eastern time.
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    Some commenters raised ideas for changes other than those suggested 
in the consultation paper, including lowering fees for securities-
related daylight overdrafts, allowing individual banks to coordinate 
informally the sending of Fedwire funds transfers, and reducing the 
maximum payment size allowed through the Fedwire funds transfer system. 
Finally, several commenters addressed a question in the consultation 
paper about the payment of interest on reserves and the possible effect 
on depository institutions' intraday liquidity management. Most 
responders believed that the Federal Reserve's payment of interest on 
reserve balances would not affect intraday liquidity management or 
stated that its effect on liquidity was unknown without further 
information.
    Overall, the public comment letters and the extensive PRC and WCAG 
investigations into intraday liquidity and late-day payments issues 
validate a number of concerns raised in the consultation paper. It has 
also become clear that no single policy or operational change would 
address all of the intraday liquidity, risk, and payments issues that 
the Board and the industry have identified. However, a series of steps 
by both the private sector and the Federal Reserve could help.
    To address the combination of intraday liquidity, operational, and 
credit risks in the wholesale payments system, the Board believes that 
the Federal Reserve and industry should pursue a four-pronged strategy. 
The Board should review its PSR policy and consider adjusting the terms 
and pricing of daylight overdrafts. The Reserve Banks should work with 
the industry and investigate options for developing a liquidity-saving 
mechanism for the Fedwire funds transfer system. Additionally, working 
with the PRC, CHIPS and The Depository Trust and Clearing Corporation 
should explore opportunities for improving payments processing and 
liquidity use in their systems and processes relating to large-value 
funds and securities settlement, respectively. This request for comment 
focuses on the Board's PSR policy and recommends changes in strategy, 
terms, and pricing for the provision of intraday credit by the Reserve 
Banks.

III. New Strategy for PSR Policy

    The current policy of providing uncollateralized daylight 
overdrafts at an administered fee grew out of a Board study in the late 
1980s that reviewed options for reducing the volume of intraday credit 
provided by the Reserve Banks. A fundamental premise of this work was 
that intraday credit is a necessary but undesirable aspect of the 
payments system and should be reduced whenever possible. This premise 
is expressed in the introduction to the current PSR policy as follows:

    [T]he Board expects depository institutions to manage their 
Federal Reserve accounts effectively and minimize their use of 
Federal Reserve daylight credit. Although some intraday credit may 
be necessary, the Board expects that, as a result of this policy, 
relatively few institutions will consistently rely on intraday 
credit supplied by the Federal Reserve to conduct their 
business.\13\
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    \13\ See the Policy on Payment System Risk https://
www.federalreserve.gov/paymentsystems/psr/policy07.pdf, pg. 2.

    In reviewing the current PSR policy, the Board identified five 
major concerns related to risk and efficiency that together suggest 
that a change in the Federal Reserve's approach to the provision of 
daylight overdrafts is warranted at this time.\14\ First, the data 
indicate a long-term trend of declining end-of-day balances held in 
Federal Reserve accounts which, in turn, implies an increasing need by 
institutions for daylight credit from the Reserve Banks to fund 
payments-system transactions. Second, the Board notes that some 
financial utilities can absorb large amounts of intraday funding from 
participants to meet their risk management requirements. These funding 
requirements result in large transfers of balances from participants' 
Federal Reserve accounts that often are not reversed until the late 
afternoon. Third, data, as well as comments on the consultation paper, 
make clear that many large depository institutions hold a significant 
number of large-value payments in ``liquidity queues'' primarily to 
avoid daylight overdraft fees; such queuing can delay payments across 
the financial markets. Fourth, data show that Reserve Banks' credit 
exposure has increased over time in real terms despite Reserve Banks 
charging fees. On certain days, the peak overdraft of the banking 
system can exceed $210 billion. In 2007, the average daily overdraft of 
the banking system as a whole was approximately $60 billion and the 
average daily peak overdraft was approximately $160 billion. Finally, 
daylight overdraft fees paid by the banking system have continued to 
rise, increasing the cost burden of the PSR policy on the industry. 
Daylight overdraft fees for 2007 totaled approximately $65 million, 
compared with $32.2 million in 2003. Because there are systemic reasons 
for the increased demand for intraday balances and credit as well as 
evidence that the current pricing approach is creating liquidity queues 
and increasing late-day operational risk, the Board concluded that its 
current strategy of seeking to minimize daylight overdrafts should be 
reassessed.
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    \14\ Please see appendix I for a full discussion of these 
issues.
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    The Board also notes that thinking about the role of central banks 
in providing intraday balances to the payments system has evolved 
significantly over the past twenty years.

[[Page 12421]]

A 2003 study by the G-10 Committee on Payments and Settlements Systems 
summarized this change in perspective and explicitly recognized that 
central banks have an important role in providing intraday (central 
bank money) balances to foster the smooth operation and settlement of 
payments systems.\15\ In essence, this view is an extension to the 
intraday market of the traditional role of central banks in supplying 
overnight balances to the banking industry to meet financial market 
demand for liquidity and operating balances. While some of the demand 
of the banking industry for intraday balances can be met by overnight 
balances, when the level of those balances is inadequate, a central 
bank will need to supply additional funds through the temporary 
provision of intraday funds, which could include using mechanisms such 
as daylight overdraft facilities.
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    \15\ ``Because the settlement of each payment involves a direct 
transfer of the settlement asset, [real time gross settlement] 
systems require substantially more of the asset to ensure smooth 
payment flows. To enable this, most central banks provide intraday 
credit to banks participating in these systems in quantities which 
in some cases dwarf the banks' overnight balances or their overnight 
borrowing from the central bank.'' See ``The Role of Central Bank 
Money in the Payment System,'' Committee on Payment and Settlement 
Systems, August 2003 at https://www.bis.org/publ/cpss55.pdf.
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    The Board believes that a new strategy would enhance intraday 
liquidity management while controlling risk to the Reserve Banks and 
would build on the Board's 2001 proposal to consider two-tiered pricing 
for daylight overdrafts.\16\ This strategy would
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    \16\ The strategy is consistent with the public policy 
objectives in the current PSR policy to foster the safety and 
efficiency of payments and settlement systems as well as the version 
of these objectives used in developing the Board's original pricing 
proposals in 1988. At that time, the safety objectives were stated 
as low direct credit risk to the Federal Reserve, low direct credit 
risk to the private sector, low systemic risk, and rapid final 
payments. The efficiency objectives were stated as a low operating 
expense of making payments, equitable treatment of all service 
providers and users in the payments system, effective tools for 
implementing monetary policy, and low transaction costs in the 
Treasury market. See ``Controlling Risk in the Payment System,'' 
Report of the Task Force on Controlling Payments System Risk to the 
Payments System Policy Committee of the Federal Reserve System, 
Board of Governors of the Federal Reserve System, August 1988.
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    (1) Explicitly recognize that the Federal Reserve has an important 
role in providing intraday balances to foster the smooth operation of 
the payments system.
    (2) Provide temporary, intraday balances to healthy depository 
institutions predominantly through collateralized intraday overdrafts.
    (3) Reduce over time the reliance of the banking industry on 
uncollateralized daylight credit if this can be done without 
significantly disrupting the operation of the payments system or 
causing other unintended adverse consequences.
    In brief, the rationale for the new strategy is that modern 
payments and settlement systems, including Fedwire, CHIPS, CLS, and 
DTC, require significant amounts of intraday balances or liquidity for 
smooth operations and that the role of a central bank is to meet 
reasonable market needs of participants in these systems for this 
liquidity.\17\ In addition, under current policies, overnight balances 
are not sufficient to address these needs and, as a result, temporary, 
intraday balances through intraday credit must be provided by daylight 
overdrafts.\18\ Intraday credit is now widely and explicitly provided 
by central banks to support the operation of payments and settlement 
systems, including by the Eurosystem, Bank of Japan, and Bank of 
England. Typically this daylight credit is collateralized, but no fee 
is charged.
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    \17\ See The Role of Central Bank Money in the Payment System, 
Committee on Payment and Settlement Systems, August 2003. (https://
www.bis.org/publ/cpss55.pdf).
    \18\ Policy decisions that will be made to exercise the Federal 
Reserve's new statutory authority to pay interest on reserves 
beginning in October 2011 could increase the level of overnight 
balances held at the Reserve Banks and consequently reduce the 
demand for daylight overdrafts to provide intraday balances.
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    The proposed new strategy would explicitly use collateral augmented 
by the framework of net debit caps to control credit risk to the 
Reserve Banks in providing daylight overdrafts and would link the fees 
charged for daylight overdrafts to the amount of collateral provided. 
The same collateral eligibility criteria and haircuts would be used for 
both overnight and intraday credit. Unencumbered collateral pledged for 
discount window or PSR purposes could be used to support intraday 
credit provided at the reduced daylight overdraft fee. The benefits of 
encouraging the pledge of collateral would extend beyond the reduced 
intraday credit exposure of the Reserve Banks and would include 
enhanced emergency preparedness. Under the proposed policy, eligible 
institutions would have an additional incentive to sign borrowing 
documents with the Reserve Banks and pledge collateral, which would 
enable such institutions to borrow from the discount window, if needed.
    Controlling credit risk by taking collateral is a time-honored 
risk-management technique. It is used explicitly in some cases today by 
the Reserve Banks in the daylight overdraft program.\19\ Moreover, 
under Operating Circular 10, depository institutions grant Reserve 
Banks a lien on collateral pledged to the Reserve Bank as well as any 
other property in the possession or control of, or maintained with, any 
Reserve Bank, to secure discount window loans and any other 
obligations, such as daylight overdrafts, owing to any Reserve 
Bank.\20\
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    \19\ Pledging collateral is generally limited to securing 
maximum capacity (overdraft capacity above the net debit cap) or 
protecting Reserve Banks against risk from problem depository 
institutions.
    \20\ Under Operating Circular 1, depository institutions also 
grant Reserve Banks a lien on certain assets to secure any 
obligation owing to any Reserve Bank: ``To secure any overdraft in 
the master account, as well as any other obligation, now existing or 
arising in the future, of the account holder to any Reserve Bank, 
the account holder grants to the Reserve Bank all the account 
holder's right, title, and interest in property, whether now owned 
or hereafter acquired, in the possession or control of, or 
maintained with, any Reserve Bank.''
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    The new strategy would retain a net debit cap regime for all 
depository institutions.\21\ The net debit cap would focus on 
addressing low-probability risks and not unduly constraining normal 
demands for balances and credit. Industry best practices and 
supervisory guidance support the use of borrowing limits, or caps, even 
for collateralized risk exposures as a prudent credit risk management 
tool. Caps also serve as a useful mechanism for both Reserve Banks and 
institutions in terms of setting benchmarks for the maximum expected 
usage of daylight credit and supporting collateral.
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    \21\ The current cap is a function of qualifying capital, which 
varies based on the entity type. The qualifying capital is mutipled 
by the cap mutliplier for cap categories to determine each 
institution's limit. One limit applies for single-day use and 
another for two-week average use, but these limits generally are not 
binding. If an institution exceeds its cap, the Reserve Bank will 
counsel the institution ex post. For additional information, see the 
Guide to the Federal Reserve's Payments System Risk Policy at http:/
/www.federalreserve.gov/paymentsystems/psr/guide.pdf.
---------------------------------------------------------------------------

    The new strategy also reflects the Board's sensitivity to avoiding 
sudden and disruptive changes in policy that would not be in the public 
interest and would not advance efforts to improve payments system 
efficiency and safety. Hence, an element of the new strategy is to move 
toward a greater use of collateral in a way that minimizes the cost and 
administrative burden of the policy on most users of daylight 
overdrafts. As a general matter, the Board believes that requiring 
depository institutions to pledge collateral to support daylight 
overdrafts would be consistent with reducing Reserve Bank credit risk, 
with existing discount window practices, and with the policies

[[Page 12422]]

of other central banks. The Board is concerned, however, about the 
potential implications of moving to a mandatory collateral regime at 
this time, because of the uncertain effects such a move might have on 
intraday liquidity and operational risk, as well as the burden on the 
banking industry.\22\ The Board will continue to monitor developments 
over time and to evaluate the costs and benefits of moving further 
toward a collateralized structure.
---------------------------------------------------------------------------

    \22\ Historically, the Board has sought to minimize the cost and 
administrative burden of the PSR policy on institutions that do not 
rely significantly on the use of daylight overdrafts to make 
payments.
---------------------------------------------------------------------------

IV. Discussion of Proposed PSR Policy Changes

    To implement this new strategy, the Federal Reserve System will 
need to adjust its current terms and fees for providing daylight 
overdrafts. The Board believes that the following points summarize in 
broad terms the elements of a new PSR policy that would be consistent 
with such a change in strategy:
     Explicitly encourage the pledging of collateral to support 
intraday credit and apply unencumbered discount window collateral to 
intraday credit.
     Eliminate the fee for collateralized intraday credit.
     Increase the fee for uncollateralized intraday credit.
     Retain a modified version of the single-day daylight 
overdraft cap to limit the ultimate size of Reserve Bank risk 
exposures.
     Adopt measures to limit the impact of policy changes on 
depository institutions that are relatively small users of intraday 
credit.

Table 1 summarizes the specific elements of the current and proposed 
PSR policy.

Table 1.--Summary of Key Elements of the Current and Proposed PSR Policy
                                  \23\
------------------------------------------------------------------------
                                 Current policy        Proposed policy
------------------------------------------------------------------------
Collateral..................  Required for problem  Additional provision
                               institutions \24\     that explicitly
                               and institutions      applies collateral
                               with max caps.        pledged by healthy
                               Collateral            institutions to
                               eligibility and       daylight overdrafts
                               margins same as       in their Reserve
                               discount window.      Bank accounts.
Fee for collateralized        36 basis points.....  Zero fee.
 daylight overdrafts.
Fee for uncollateralized      36 basis points.....  Increase to 50 basis
 daylight overdrafts.                                points.
Deductible..................  10 percent of an      Replaced by zero fee
                               institution's         for collateralized
                               capital measure.      daylight overdrafts
                                                     and increased fee
                                                     waiver.
Fee waiver..................  Up to $25 biweekly..  $150 biweekly.\25\
Net debit cap...............  Two-week average      Two-week average
                               limit and higher      limit is
                               single-day limit.     eliminated;
                                                     adjusted policy for
                                                     single-day limit.
Max cap.....................  Additional            Streamlined process
                               collateralized        for certain FBOs up
                               capacity above net    to a limit; minor
                               debit cap for self-   changes for all
                               assessed              institutions.
                               institutions.
Penalty fee for ineligible    136 bps.............  Increase to 150 bps.
 institutions.
------------------------------------------------------------------------

    To assist institutions in understanding the effect of the proposed 
policy on their daylight overdraft fees, the Board has developed a 
simplified fee calculator. The calculator enables institutions to 
provide daylight overdraft and collateral data to estimate their 
daylight overdraft fees under the proposed policy. The calculator is 
located on the Board's Web site at https://www.federalreserve.gov/apps/
RPFCalc/.
---------------------------------------------------------------------------

    \23\ Access to daylight credit would continue to be available 
only to institutions with regular access to the discount window as 
is the case today.
    \24\ Problem institutions are institutions that are in weak 
financial condition and should refrain from incurring daylight 
overdrafts and institutions that chronically incur daylight 
overdrafts in excess of their net debit caps in violation of the PSR 
policy.
    \25\ The proposed $150 waiver would be subtracted from the gross 
fees (in a two-week reserve-maintenance period) assessed on any 
depository institution eligible to incur daylight overdrafts. This 
procedure differs from the current policy in which the waiver only 
eliminates gross fees of institutions that have charges less than or 
equal to $25 in a two-week period.
---------------------------------------------------------------------------

    A. Collateral. To help meet institutions' demand for intraday 
balances while mitigating Reserve Bank credit risk, the Board would 
adopt a policy of supplying intraday balances predominately through 
explicitly collateralized daylight overdrafts provided by Reserve Banks 
to healthy depository institutions at a zero fee. To avoid disrupting 
the operation of the payments system and increasing the cost burden on 
a large number of smaller users of daylight overdrafts, the Board would 
allow the use of collateral to be voluntary, but a system of two-tiered 
fees would be adopted to encourage the industry to make greater use of 
collateral. Unencumbered discount window collateral would explicitly 
collateralize daylight overdrafts, and collateralized overdrafts would 
be charged a zero fee. Collateral eligibility and margins would remain 
the same for PSR policy purposes as for the discount window.\26\ In 
addition, the pledging of in-transit securities would remain an 
eligible collateral option for PSR purposes at Reserve Banks' 
discretion.\27\
---------------------------------------------------------------------------

    \26\ See https://www.frbdiscountwindow.org/ for information on 
the discount window and PSR collateral acceptance policy and 
collateral margins.
    \27\ In-transit securities are book-entry securities transferred 
over the Fedwire securities system that have been purchased by a 
depository institution but not yet paid for or owned by the 
institution's customers.
---------------------------------------------------------------------------

    Of the twenty-three responses to the consultation paper, fourteen 
commenters addressed the question regarding greater use of collateral 
to cover daylight overdrafts. All fourteen commenters supported greater 
use of collateral (particularly to obtain a lower daylight overdraft 
fee). A number of the respondents specifically argued for voluntary or 
partial collateralization of intraday credit. Several respondents also 
commented that collateralized overdrafts should be free of charge or 
subject to an adjusted daylight overdraft fee. Most commenters stated 
that their support for greater use of collateral was contingent upon 
being able to use unencumbered discount window collateral to support 
intraday credit.
    The Board considered whether it should require collateralization of 
all daylight overdrafts at this time. The Board generally believes that 
requiring depository institutions to pledge collateral to support 
daylight overdrafts

[[Page 12423]]

would be consistent with reducing Reserve Bank credit risk, existing 
discount window practices, and the policies of other central banks. 
However, the potential effect on intraday liquidity and operational 
risk, along with the burden on the banking industry of a move to 
mandatory collateral, suggests caution. For example, requiring 
collateral could result in institutions being subject to rejected 
payments or high ``penalty'' fees if they exceed the amount of pledged 
collateral, could increase payment queuing by institutions without 
sufficient collateral to pledge, and could add significant compliance 
costs to the banking industry. Indeed, one respondent specifically 
stated in its comment letter that it was not supportive of moving to a 
mandatory collateral regime for daylight overdrafts even at a zero fee. 
For all these reasons, at this time, the Board is proposing a voluntary 
collateral regime for daylight overdrafts.
    The Board has long recognized that accepting collateral from 
institutions would help control intraday credit risk to Reserve Banks. 
Moving towards greater collateralization of daylight overdrafts was 
hampered in the past by concerns about administration costs to 
depository institutions, incentive effects, and other unintended 
consequences. Most of these concerns have been addressed over time.
    In the early 1980s, the aggregate amount of collateral pledged to 
the discount window was quite low relative to intraday credit extended, 
and many depository institutions had not signed the necessary legal 
agreements with their Reserve Banks. During early PSR policy 
consultations, there was also concern about the administrative costs of 
pledging and monitoring additional collateral and about the possibility 
that Fedwire or other payments could be disrupted if a depository 
institution did not have sufficient collateral at a particular point 
during the day. Since the 1980s, however, the quantity of collateral 
pledged to the discount window has increased dramatically. In 
particular, pledges to the discount window began to increase as a 
result of industry and Federal Reserve actions to address contingencies 
prior to the century date change and following September 11th.\28\ As 
of year-end 2007, more than $980 billion in assets were pledged for 
discount window and PSR purposes, most of which was unencumbered by 
outstanding discount window loans.\29\
---------------------------------------------------------------------------

    \28\ In the early 1990s, the Reserve Banks began standardizing 
policies regarding eligible asset types, acceptance criteria, and 
valuation. By the mid 1990s, the Reserve Banks allowed multiparty 
pledges through DTC. In the late 1990s, the Reserve Banks began 
using market pricing for securities valuation, started allowing for 
nonbank custodian and foreign custodian (Clearstream and Euroclear) 
arrangements, and began accepting a broader array of asset types of 
collateral. New types of eligible assets since that time have 
included non-AAA ABS, AAA collateralized debt obligations, 
commercial mortgage-backed securities, trust preferred securities, 
credit union mutual funds, GSE stock, STRIPS, German jumbo 
Pfandbriefe, and certain other foreign currency-denominated assets.
    \29\ This collateral value reflects lendable value based on the 
Reserve Banks' margins and does not include pledges of in-transit 
securities.
---------------------------------------------------------------------------

    Most of the largest users of daylight overdrafts have sufficient 
unencumbered collateral pledged to the Reserve Banks to cover their 
average level of daylight overdrafts. In addition, as table 1 
indicates, during the fourth quarter of 2007, fifteen of the twenty 
largest users of intraday credit would have been able to cover the 
average peak amount of daylight overdrafts using existing pledged 
collateral. In particular, the maximum peak overdrafts of eight of 
these institutions would have been covered by their current collateral 
pledges. It is highly likely that additional collateral would be 
pledged to cover intraday credit if appropriate incentives existed.

   Table 2.--The Number of Top Daylight Overdrafters Able To Collateralize Borrowings With Existing Collateral
                                                     Pledges
                                                    [Q4 2007]
----------------------------------------------------------------------------------------------------------------
                                                                     Number of institutions that have existing
                                                    Cumulative                 collateral to cover:
                                                    percent of   -----------------------------------------------
                                                      average                                      Maximum daily
                                                     daylight         Average      Average peak       peak of
                                                    overdrafts       daylight       of daylight      daylight
                                                                   overdrafts *    overdrafts *     overdrafts
----------------------------------------------------------------------------------------------------------------
Top 10..........................................              75               8               7               3
Top 20..........................................              84              18              15               8
Top 50..........................................              94              46              40              28
Top 100.........................................              97              91              68              47
Top 200.........................................              98             174             119             80
----------------------------------------------------------------------------------------------------------------
* The data are quarterly averages of daily data.

    One issue that has not changed since the 1980s is that a 
substantial number of depository institutions, mainly smaller 
institutions, use intraday credit but have not signed borrowing 
agreements with their Reserve Banks (about 1,500 of 4,400 institutions 
that make some use of intraday credit). In addition, another 1,700 
institutions that use intraday credit have borrowing agreements, but 
have not pledged any collateral to the Reserve Banks. Thus, the Board 
recognizes that the policy needs to avoid imposing an undue burden on 
small users of daylight credit or on the Reserve Banks. The new fee 
waiver is intended to minimize the burden on small users of the 
proposed policy changes.
    Another historical administrative concern has been the cost and 
practicality of Reserve Banks' perfecting their security interests in 
collateral and monitoring that collateral to manage their credit risk. 
Today, it is a routine matter for a Reserve Bank to file a Uniform 
Commercial Code financing statement with state authorities to perfect 
its security interest in any and all bank assets that are pledged. The 
Reserve Banks have implemented automated systems to track collateral 
held at the Reserve Banks, by third-party custodians, and by the 
borrowers themselves. In addition, the Reserve Banks monitor borrower 
eligibility to participate in a borrower-in-custody program. On 
balance, although improvements can always be made in procedures and 
systems, significant improvements have been made over time that address 
the earlier administrative concerns about explicitly collateralizing 
the daylight overdrafts of

[[Page 12424]]

depository institutions that routinely use large amounts of intraday 
credit.
    In the past, the Board also had concerns that accepting collateral 
to address Reserve Bank credit risk for daylight overdrafts would not 
provide strong incentives to reduce the level of intraday credit. In 
particular, there was concern that because of the wide range of 
collateral accepted by the Reserve Banks, depository institutions would 
have weak incentives to reduce their use of intraday credit. Under the 
new strategy, the purpose of Reserve Banks accepting collateral is not 
to control the level of overdrafts per se, but to mitigate credit risk 
to the Reserve Banks when they provide intraday balances and credit 
needed for the smooth operation of the payments system.
    Additionally, there was concern that reliance on collateral alone 
might result in Reserve Banks providing excessive amounts of credit to 
particular depository institutions and present the Reserve Banks with 
reputational and residual credit risks. Although the Board proposes to 
relax some aspects of the net debit cap program, caps on total intraday 
credit extensions would remain in place to help address these risks. 
Eliminating the two-week average net debit cap and retaining the higher 
single-day cap for healthy depository institutions has the effect of 
raising caps approximately 50 percent from the current policy. This 
increase coupled with the incentive to collateralize daylight 
overdrafts is consistent with the strategy of providing additional 
balances and credit for the payments system. Other central banks that 
provide collateralized intraday credit at a zero price have not 
reported problems with excessive growth in the level of intraday 
credit.
    The Board's main concern about unintended consequences has been 
that by taking collateral, the Reserve Banks could be inadvertently 
shifting credit risk to unsecured and uninsured creditors of an 
institution or to the Federal Deposit Insurance Corporation's (FDIC) 
deposit insurance fund. With regard to unsecured creditors of a 
depository institution, the concern is whether these creditors would 
know about the institution's pledge to a Reserve Bank and have an 
opportunity to reduce their exposure to the depository institution, 
increase compensation for increased risk, or take other appropriate 
action. The public filing of financing statements by Reserve Banks and 
the existence of automated services for searching for liens mitigates 
this concern.
    The Board's concerns about the implications for the FDIC's 
insurance fund predate changes in Reserve Bank collateral 
administration practices and the FDIC's adoption of ``least cost'' 
resolution policies pursuant to the FDIC Improvement Act of 1991. The 
Board believes that the evolution of the PSR policy and related 
procedures have helped to address its concerns. Under the current PSR 
policy, an ``institution must be financially healthy and have regular 
access to the discount window'' in order to qualify to receive daylight 
credit from its Reserve Bank.\30\ Under the implementation scheme for 
net debit caps, a financially healthy institution is essentially 
defined as at least an adequately capitalized depository institution 
that has a supervisory rating of CAMELS-3 or higher.\31\ Moreover, a 
Reserve Bank may ``limit or prohibit an institution's use of Federal 
Reserve intraday credit if * * * the institution's use of daylight 
credit is deemed by the institution's supervisor to be unsafe or 
unsound.'' \32\ Thus, if supervisory issues arise with an institution, 
supervisors, including the OCC and FDIC, would be and have been 
consulted about the financial condition of an institution that is using 
or seeking to use intraday credit. In some circumstances, Reserve Banks 
impose real-time controls to reject outgoing Fedwire funds transfers 
that would cause a depository institution's account to exceed a limit, 
including a limit of zero.\33\ While residual risks may exist, PSR 
policies and procedures as well as FDIC legislation have been 
significantly enhanced in ways that help control both risk to the 
Reserve Banks and to the FDIC insurance fund.
---------------------------------------------------------------------------

    \30\ See the Payment System Risk Policy at https://
www.federalreserve.gov/paymentsystems/psr/policy07.pdf, p. 22.
    \31\ The CAMELS ratings apply to commercial banks, savings and 
loan associations, natural person credit unions, and bankers' banks. 
Other supervisory rating structures apply for FBOs and corporate 
credit unions. The Reserve Banks use these supervisory ratings and 
other factors to determine credit risk and whether they will extend 
daylight overdraft capacity.
    \32\ See the Policy on Payment System Risk at https://
www.federalreserve.gov/paymentsystems/psr/policy07.pdf, p.23.
    \33\ The Reserve Banks use real-time monitoring to prevent 
selected institutions from effecting certain transactions--outgoing 
Fedwire funds transfers, National Settlement Services transactions, 
or automated clearing house (ACH) credit originations--if their 
accounts lack sufficient funds to cover the payments. Generally, a 
Reserve Bank will apply real-time monitoring to an institution's 
position when the Reserve Bank believes that it faces a greater 
level of risk exposure, for example from problem institutions or 
institutions with chronic overdrafts in excess of what the Reserve 
Bank determines is prudent.
---------------------------------------------------------------------------

    On balance, the Board believes that explicitly accepting collateral 
for daylight overdrafts on a voluntary basis offers important 
improvements in policy. In particular, collateralized daylight 
overdrafts will support liquidity and operational risk reduction for 
the payments system, long-term credit risk reduction for the Reserve 
Banks, and a more-reasonable cost burden on the industry.
    B. Fees for collateralized daylight overdrafts. The Board proposes 
lowering the fee to zero for collateralized daylight overdrafts to 
encourage institutions to pledge collateral and to reduce payments held 
in liquidity-management queues. The value of unencumbered collateral 
pledged at the Reserve Banks for PSR or discount window purposes would 
be applied in the determination of daylight overdraft fees assessed to 
institutions.
    Of the twelve commenters that addressed two-tier pricing with a 
lower fee for collateralized overdrafts, most were highly supportive, 
particularly if the fee on collateralized daylight credit were zero. 
The other commenters raised questions or issues for the Board's 
consideration. For instance, one commenter that supported two-tier 
pricing expressed some concern about the potential cost and complexity 
of implementing a two-tier pricing system. Another mentioned the 
likelihood that two-tier pricing would increase the level of daylight 
overdrafts. In addition, several institutions specifically requested 
that all unencumbered collateral pledged to the Reserve Bank for 
discount window or PSR purposes be considered in calculating an 
institution's fees.
    The Board has previously raised the possibility of a two-tier 
pricing system for collateralized and uncollateralized daylight 
overdrafts. In 2001, the Board requested comment on two-tier pricing as 
a long-term PSR policy direction. \34\ Then, as now, most commenters 
were supportive of such a regime. In August 2002, the Board stated that 
it would continue to study two-tier pricing for collateralized and 
uncollateralized overdrafts.\35\ The Board also specified that the 
Reserve Banks would charge the collateralized rate on daylight 
overdrafts up to the value of collateral pledged and then apply the 
uncollateralized rate to the remaining daylight overdrafts.
---------------------------------------------------------------------------

    \34\ 66 FR 30208, June 5, 2001.
    \35\ 67 FR 54424, August 22, 2002.
---------------------------------------------------------------------------

    To determine a collateralized fee, the Board has reviewed 
historical papers and discussions of overdraft pricing, industry 
comments and discussions surrounding the consultation paper, and the 
practices of other major central banks. There is no definitive economic 
literature on whether there is a nonzero intraday rate of interest that 
should be

[[Page 12425]]

used in calculating fees for collateralized intraday central bank 
credit. There are different views. One view argues that it would be 
anomalous if the general term structure of interest rates contained a 
major discontinuity between the overnight rate and the intraday rate 
but without showing how to determine the existence and level of an 
intraday rate. Another view essentially holds that intraday balances 
provided by central banks should be priced at the marginal social cost 
of production, which is approximately zero for central banks. This view 
is reinforced by recent academic work suggesting that the role of 
central bank intraday balances and credit is to help coordinate the 
settlement of payments and not ultimately to finance underlying real 
economic activity.
    From the economic literature, a reasonable perspective is that 
central banks should target a rate for providing collateralized 
daylight balances and credit that advances the policy objectives of the 
central bank. Further, because there is no evidence from other 
countries that intraday rates affect central bank macroeconomic goals, 
such as inflation or unemployment, a central bank has the flexibility 
to set an intraday rate to advance its payments system objectives of 
safety and efficiency. This is the intraday credit pricing strategy 
generally followed by other major central banks, and there have not 
been any reported effects on the central banks' ability to achieve 
their monetary policy objectives.
    The Board'