3

R. 44lton Gilbert

P. Alton Gilbert is an assistant vice president at the FederalPesenie Bank of St. Louis. Dawn M. Peterson provided researchassistance.

Payments System Risk: What Is Itand What Will Happen If We TryTo Reduce It?

0TH commercial banks and the Federal Re-serve assume a certain amount of risk in partici-

rating in the payments system. This paper pro-vides an introduction to payments system risk andthe public policy issues involved in limiting therisk. Using simple balance sheet entries to illus-trate, the paper will examine how policies in-tended to reduce payments system risk would

affect banks and bank customers.

PAYMENTS SYSTEM RISK: WHAT ISIT?

Many banks overdraw their reserve accounts atthe Federal Reserve during part of each businessday as they process payments within the pay-ments system. The Federal Reserve is concernedabout the extent of this intraday credit for severalreasons. First of all, since it does not charge inter-est on the inti-aday credit it extends, it is providingthis overdraft facility at no cost to banks and, thus,may he overused by banks. Second, and more im-portant, it is possible, though unlikely, that a bankcould fail while its reserve account is overdr-awn.In this event, the Federal Reserve would become ageneral creditor of the failed bank. Finally, the Fed

is concerned with the risk that banks assumethrough their participation in private wire transfersystems. Current Federal Reserve policy is de-

signed to limit the risk assumed by Reserve Banksas well as commercial banks who participate inprivate systems for their electronic payments. Seeappendix 1 for a description of that policy.)

Federal Reserve Iiavlight Overdrn/iRisk anti the Operation of Fedwire

While various types of transactions affect thereserve balances of banks, daylight overdt-afts gen-erally reflect large transactions through Fedwire,the wire transfer system operated by the FederalReserve System. Institutions with reserve or clear-ing accounts at a Reserve Bank may transfer theirreserve balances to other institutions that have

similar accounts. These transfer-s, which averaged$605 billion per business day in 1987, areprocessed electronically thi-ough Fedwire.

Federal Reserve Banks transfer reserves to re-ceiving banks even if the reserve balance of thesending bank is insufficient to cover the transfers.Transfers over Fedwire are “final” when the receiv-ing banks are notified of the transfers. Thus, if asending bank should fail while its reserve accountwas over-drawn, the Federal Reserve would have

no claim on banks that received reserves fi-omn thefailed bank over Fedwire.

U.S. Treasury and agency securities also aretransferred among banks over Fedwire. Ownership

JANUARY/FEBRUARY 1989

4

records of these securities are maintained in eachFederal Reserve Bank’s computer system. Bankscan transfer securities held in their names to otherinstitutions through these computers, a systemcalled “book-entry.” A transfer of securities inbook-envy form can be arranged either in con-junction with a transfer of reserves of equal valueor as a separate transaction. Such securities trans-actions contribute to daylight overdrafts, sincetypically the reserve accounts of banks are debitedwhen their book-entry securities accounts arecredited. Transfers of book-entry securities overFedwire averaged $312 billion per day in 1987.

The Federal Reserve measures its exposure topayments system risk by simply summing themaximum daylight overdraft each day across allbanks. In 1987, the Fed’s exposure to daylight

overdrafts averaged $112 billion, approximately 53percent of which can be attributed to transactionsinvolving book-entry government securities.’ Somespecific features of this risk measure should benoted. First, unlike conventional risk measures,the Federal Reserve’s measure does not incorpo-rate the probability that a bank will fail while in anoverdraft position or the probability of Fed lossesin such situations Since the Federal Reserve hasnever incurred a loss on daylight overdrafts, theprobability of losses in the future are quite low.

Second, it exceeds the actual sum of reserveaccount overdrafts at any point during the day;the maximum overdrafts of individual banks typi-cally occur at different times during the day.Third, it represents the loss that the Federal Re-serve would incur on a given day if all banks withoverdrawn reserve accounts failed when their

overdrafts were at maximum levels and the Fed-eral Reserve recovered nothing.

Systemic Risk and the Operation ofCHIPS

The Clearing House Interbank Payments System(CHIPS) is an electronic payment system operatedby the NewYork Clearing House. It currently is the

only private electronic payment system in opera-tion in the United States. CHIPS has about 140members, which include U.S-chartered banks and

foreign banks. Members of CHIPS send and receivepayment messages during the day; no funds areactually transferred to cover these payment mes-sages, however, until the end of the day. Net obli-gations are settled at day’s end through Fedwiretransfers in the reserve accounts of CHIPS partici-pants. Banks in net debit positions on CHIPS atthe end of the day (value of payment messagessent exceeds the value of payment messages re-ceived) transfer funds from their accounts at Re-serve Banks to a reserve account maintained bythe clearing house at the Federal Reserve Bank ofNew York, while banks in net credit positions re-ceive reserve transfers from that account. Thevalue of payment messages processed by CHIPSaveraged $555 billion per day in 1987.

Systemic risk refers to the risk that the failure ofone bank will cause one or more other banks tofail. One way that this could happen is throughparticipation in CHIPS. Ifa bank fails while in a netdebit position on CHIPS, other- CHIPS participantscould suffer losses as well, depending on the pro-cedures in force for dealing with such a default.Payments over Fedwire, in contrast, involve nosystemic risk. The Federal Reserve would absorbany losses resulting from failures by banks withoverdrawn reserve accounts -

The Federal Reserve measures the paymentssystem risk assumed by CHIPS participants as thesum of their maximum net debit positions duringthe day on CHIPS. This measure averaged $43.7billion in 1987.

To relate this measure to systemic risk is dif-ficult, however; under current CHIPS rules, pay-ment messages do not reflect intraday extensionsof credit among banks but provisional paymentswhich may be unwound at the end of the day. If abank could not cover its net debit position onCHIPS at the end of the day, all payment messagesto and from that bank would be canceled; new netdebit and credit positions would then be calcu-lated for the remaining CHIPS participants, andpayments would be made to cover these revisedpositions. Unwinding CHIPS payments because ofa defaulting bank, however, could expose the re-maining CHIPS participants to losses if their de-

‘Daylight overdrafts attributed to transactions in book-entrysecurities are calculated as follows. A bank is in a net creditposition on book-entry securities transfers if the value of securi-ties transferred to the bank’s book-entry securities accountexceeds the value of securities transferred out of that accountto other banks. The book-entry overdraft of a bank for each dayequals its largest net credit position on securities transfers thatoccurs while the reserve account of the bank is overdrawn.

‘In conventional definitions, risk is specified in terms of theprobability distribution of returns on an investment. Under onedefinition, risk may be measured as the variance of the distribu-tion of returns. See Rothschild and Stiglitz (1970).

FEDERAL RESERVE BANK OF ST. LOUIS

positors had withdrawn balances credited to theiraccounts during the day based on payment mes-sages from the defaulting bank. These banks inturn may be unable to recover the funds with-drawn by their depositors during the day.’

Federal Reserve Policy on PaymentsSystem Risk

In recent years, the Federal Reserve Board has

taken actions to limit its own risk and the systemicrisk involved in CHIPS. The Federal Reserve in-duced CHIPS to require each bank in its system toestablish bilateral net debit limits with each otherCHIPS participant, beginning in 1984. Under an-other program that went into effect in March 1986,the Federal Reserve requires banks to set limits ontheir daylight overdrafts across Fedwire andCHIPS. (See appendix 1 for details of these poli-cies .1 The Fed is currently studying proposals toestablish an explicit or implicit price for daylightoverdrafts of reserve accounts.

HOW PAYMENTS AFFECT RISK

This section uses simple balance sheets of hy-pothetical banks to illustrate how transactionsthrough the payments system affect the exposureof the Federal Reserve and commercial banks topotential losses. The illustrations involve federalfunds transactions and transactions among CHIPSparticipants. Appendix 2 illustrates how the pay-ment practices of banks that serve governmentsecurities dealers and those that issue and redeemcommercial paper affect their reserve overdrafts.

Federal Funds Transactions

Banks that borrow federal funds overnight areconcerned primarily about their reserve balancesas of the end of the day, rather than during theday, for two reasons. First, the Federal Reserve ismore tolerant of daylight overdrafts of reserveaccounts than of negative reserve balances at theclose of business. Second, the intraday reservebalances do not count toward meeting reserverequirements; only those balances held at the endof the business day do.

Banks that borrow overnight federal funds typi-cally receive reserves from the lending banks overFedwire late in the day; they return the requisitereserve balances the following morning. Such

5

transfers can cause the borrowing banks to over-draw their reserve balances during the day.

The balance sheet entries in table I illustratehow federal funds transactions affect the riskborne by the Federal Reserve - Each bank beginsthe day with deposits of $100 and reserves of $10.With a 10 percent reserve ratio, excess reserves arezero. During the previous business day, Bank Aborrowed $25 from Bank B through the federalfunds market. Before the end of business on theprevious day, Bank B transferred $25 over Fedwirefrom its reserve account to the account of Bank A.

This transaction created a liability for Bank A (fed-eral funds purchased) and shifted $25 of the assetsof Bank B from reserve balances to federal fundssold.

The first transaction by Bank A in the currentday is a transfer of $25 from its reserve account tothe reserve account of Bank B, returning the fundsit had borrowed overnight; this eliminates theliability of federal funds purchased by Bank A.Since the balance in the reserve account of Bank Awas only $10 at the start of the day, the transfer of$25 makes its reserve account overdrawn by $15.This presents no problem for Bank A, howet?er,since it plans to borrow $25 through the federalfunds market later in the day to eliminate its re-serve overdraft and meet its reserve requirementof $10.

If Rank A borrows the $25 in the federal fundsmarket, the lending bank(s) will transfer the re-serves to the account of Bank A in the afternoon.Given the time gap between the transfer of fundsto lending banks in the morning and the transferof reserves to Bank A in the afternoon, the FederalReserve effectively lends $15 to Bank A during partof the business day by permitting the reserveoverdraft.

The Fed is a general creditor of Bank A while itsreserve account is overdrawn. To illustrate the riskit assumes in permitting daylight overdrafts, sup-pose that participants in the federal funds marketfind out that the value of Bank A’s assets have de-clined by $15 just after Bank A transfers $25 toBank B. After this information becomes known,Bank A will be unable to borrow reserves in thefederal funds market at prevailing market rates.The agency that chartered Bank A must decidewhether it is solvent - If Bank A is declared solventand has assets to pledge as collateral, it could

‘The legal status of claims by the banks against their depositorsin such situations is currently unclear. See Mengle (1989).

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Ifthe Federal Reserve had known that Bank Awas in poor financial condition, it would haverequired the bank to pledge collateral against itsoverdrafts.’ By requiring collateral, the Fed shiftsthe risk to other parties. Suppose, in this case, thatBank A had pledged $15 of its riskiess assets to theFeder-al Reserve to cover its overdrafts. When thebank fails, the Fed would hold the $15 in collateral

Transactions Among GHJPSParticipants

In the case illustrated in table 1, the FederalReserve assumes the risk. Banks also assume riskby participating in CHIPS. The interbank risk expo-sures created through the processing of paymentmessages through CHIPS are illustrated in table 2.

In the first transaction of the day, a depositor ofBank A sends $25 to a depositor of Bank B in the

‘Task Force (1988), pp. 65—69

receive a loan from the Federal Reserve to cover itsreserve overdraft. If the supeMsory agency de-clares Bank A insolvent, it will be closed. If Bank Ais closed and liquidated, the depositors get fir-stclaim on the Silo of “other assets.” In this case,the Federal Reserve will receive $10 against the $15overdraft of the reserve account and) thus, willlose $5.

to cover any losses. The loss of $5 would he borneby uninsured depositors or the Feder-al DepositInsurance Corporation FOIC). Thus, requiringcollateral against reserve over-drafts does not nec-essarily protect the public sector; it may simplyshift the loss from the Federal Reserve to the FDIC.

FEDERAL RESERVE BANK OF ST. Louts

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form of a wire tr’ansfer over CHIPS. Bank A debitsthe deposit account of that customer for $25. Be-cause banks do not report their balance sheets onan intraday basis, there is no official term for theoffsetting liability entry in this transaction. In thiscase,we will call it “reserves payable.” For Bank B,deposit liabilities and an asset item called ‘re-serves receivable” each increase by $25.

In the next transaction, a depositor of Bank Bdirects it to send $25 to a customer of Bank C.After the second transaction, Bank B is even withCHIPS. If there were no more transactions overCHIPS that day involving Bank B, the settlementfor CHIPS transactions would have a zero impacton the reserve account of Bank B. Bank A, in con-trast, would have its reserve account debited for$25, while Bank C would have its account creditedby $25. Bank A would have to increase its reservebalance before the time for settlement of CHIPSpayments to facilitate settlement.

Suppose that, before the end of the day, adversepublicity prevents Bank A from borrowing $25 inthe federal funds market. This situation couldcreate a liquidity problem for Bank B - If Bank Acannot obtain sufficient reserves to cover its netdebit position on CHIPS, current rnles call forunwinding all transactions involving Bank A andsettling the transactions among the remainingCHIPS participants. This settlement would involvea transfer of $25 in reserves from Bank B to Bank C.Such a net settlement cannot take place, however,because Bank B has only $10 in its reserve ac-count. Thus, unless the Federal Reserve lends $25to Bank A or Bank B, all CHIPS transactions for theday would be canceled.

Simulation exercises indicate that the unwind-ing of transactions with one large CHIPS partici-pant that cannot meet its payment obligationswould make a high percentage of other partici-pants unable to meet their commitments on

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8

CHIPS without additional reserves.’ In these exer-cises, some banks that become illiquid have nodirect transactions with the defaulting bank. Thus,as illustrated in table 2, a default by Bank A keepsBank C from receiving its payments over CHIPS,because the default by Bank A makes Bank Billiquid.

As the central hank, the Federal Reserve is re-

sponsible for preventing such a liquidity crisis. Inour example, the Fed could lend reserves either toBank A or Bank B. If it considers Bank A to be sol-vent, it could lend the $25 and take collateral. The$25 added to the reserve account of Bank A facili-tates the net settlement on CHIPS. If Bank A turnsout to be insolvent, the collateral protects the Fed-eral Reserve from loss, transferring it instead to thegeneral creditors and the FDIC.

Alternatively, the Federal Reserve could preventa liquidity crisis by lending $25 to Bank B, allowingBank B to meet its required reserves and CHIPSobligation to Bank C. Even if the Fed prevents aliquidity crisis by lending $25 to Bank B, the de-fault of Bank A could make Bank B insolvent. Thisis an example of systemic risk involved in the op-eration of the payments system. Suppose that thetransfer of $25 fr’om Bank B to Bank C is initiatedby the depositor of Bank B who received $25 fromBank A. Bank B makes this transfer’ before discov-ering the default by Bank A. At ths time, it is notclear whether the courts would permit Bank B toregain these funds from its depositor? If Bank B’sloss exceeds $10, it is bankrupt.

Suppose, instead, that this depositor- of Bank Bholds the extra $25 in its demand deposit accountat Bank B until the end of the day. The transfer ofreserves from Bank B to Bank C was initiated by a

different depositor of Bank B. When Bank A’s de-fault is discovered, Bank B could cancel the $25 inreserves receivable and reverse the $25 credit to itsdemand deposit liabilities. In this case, the un-winding of the CHIPS transaction has no adverseeffect on the net worth of Bank B,

THE EFFECTS OF POSSIBLECHANGES IN POLICY

Changes in policy on payments system risk arebeing discussed within the Federal Reserve Sys-tem and the private sector. This section illustratesthe effects of two possible policy changes: explicitfees on reserve account overdrafts and interest-earning r-eserve balances required to cover part orall of daylight overdrafts?

Federal Reserve policymakers have indicatedthat such changes would be adopted only afterCHIPS has developed arrangements for ensuringthe execution of payments on that system thatthey consider acceptable.s This section also illus-trates the implications of such an arrangement forbanks.

Explicit Pricing of Daylight Overdraftsof Reserve Accounts

One way to reduce Federal Reserve risk wouldbe to charge a fee on daylight overdrafts. If the feewere high enough, banks would reduce the size oftheir overdrafts by changing their practices for’making payments.

Responses ofBanks to Pricing Daylight Over-drafts — Perhaps the easiest and least expensivechange for most of the relatively large banks wouldinvolve routing more of their wire transfers offunds through CHIPS rather than Fedwire. Thereare other ways for banks to reduce their reserveaccount overdrafts. They could purchase more oftheir federal funds as term federal funds or underrollover arrangements that involve paying a dailyrate but eliminating the daily transfer of ieservebalances. Pricing total daylight overdrafts of re-

serve balances (including book-entry overdrafts)would impose costs on the clearing banks, whichthey would pass on to the government securitiesdealers they serve. The dealer-s could reduce book-entry daylight overdrafts by building smaller- in-ventories of securities dur-ing the day or’ holdinglarger inventor-ies overnight. Banks that act as

agents in issuing commer-cial paper could charge

‘Humphrey (1986).‘Mengle (1989).‘For discussions of these possible changes from Federal Re-serve sources, see Belton, et al. (1987), Corrigan (1987),Johnson (1988), Task Force (1988) and Mengle, et at. (1987).For discussions of these issues by those in the private sector,see Flannery (1987), Faulhaber, et at. (1989) and Large DollarPayments System Advisory Group (1988). Governor Wayne D.Angell of the Federal Reserve Board has proposed anotherapproach to revising policy on payments system risk. Under

the Angell proposal, the Federal Reserve would prohibit day-light overdrafts. Transfers of reserves that would make thereserve balance of a bank negative would be funded as dis-count window loans. To provide banks incentives to holdenough reserves to prevent overdrafts, the Federal Reservewould pay interest on excess reserves, but at a rate below thediscount rate. See VanHoose (1988).

‘Johnson (1988), p. 15.

FEDERAL RESERVE BANK OF ST. LOUIS

9

issuers for the fees on overdrafts or delay pay-ments to issuers until they receive payments frompurchasers.

Effects in Financial Markets — Pricing daylightoverdrafts could have a variety of indirect effects inthe financial markets. Banks that lend in the over’-

night federal funds market could find that theirreserves are being returned later the following day.The time value of intraday reserves might lead tothe development of an intraday federal funds mar-ket, with lenders making reserve balances availableto borrowers for only part of the business day.Some analysts think this could lead to greatervariability in an overnight federal funds rate and

other interest i-ates.°

Banks could limit the size of their- daylight over-drafts by delaying wire transfers of funds for- de-positors that do not demand immediate delivery

of funds; or, the might charge an extra fee to de-positors that demand immediate delivery.

Clearing banks would charge government secu-rities dealers for the cost of the fee on daylightoverdr-afts. Government securities dealers, in turn,would increase the transaction costs of buying

and selling gover-nment securities. Interest rateson government securities would rise somewhatrelative to yields on alternative investments, in-creasing the Treasury’s cost of servicing the na-tional debt.

How banks react to daylight overdraft fees couldaffect market yields on other financial instru-ments. For instance, the fee on overdrafts wouldincrease the costs to banks acting as agents forfir-ms that issue cornmner-cial paper. The r-esponsesby the agent banks could increase the costs tofir’ms of raising funds by issuing commercialpaper.”

Supplemental Balance Requirement

The Federal Reserve could impose an implicitprice on daylight overdrafts by requiring the banks

that overdraw their reserve accounts to hold sup-plemental reserve balances. These requirementswould be set to cover part or all of their daylightoverdrafts. The suggested interest rate to be paidon the supplemental balances would be slightlybelow the federal funds rate, thus creating an op-portunity cost of holding supplemental reserves.This cost would have the same implications for

bank behavior and financial markets as an equalexplicit fee on daylight overdrafts.

The implications of a supplemental reserve re-quir-ement can be examined by adjusting the bal-ance sheet entries in table 1. In this case, Bank Awould be required to increase its average end-of-day reserve balance by $15. A reserve balance of$25 at the start of the day would eliminate the riskof Federal Reserve loss because Bank A’s reservebalance would not fall below zeio after the $25

transfer.

The method by which Bank A r’aises the $15

supplemental balance affects the distribution ofpotential losses among participants in the banking

industry. Suppose, for example, Bank A sold someassets to obtain the $15 in additional reserves. Thisresponse would raise the risk-adjusted capitalr-atio of Bank A, unless it shifted the remaining$110 of other- assets into categories with higher-risk weights. A rise in Bank A’s risk-adjusted capi-

tal ratio would reduce the FDIC’s potentiallosses.”

Suppose, instead, that Bank A r’aises the 515 insupplemental reserves by increasing federallyinsured deposits from $100 to $115. This responsewould increase the potential losses faced by theFDIC.”

Bank A also could raise the additional $15 in theterm federal funds market. The claims of thoseselling term federal funds to Bank A would hesubordinate to the claims of Bank A’s depositors.Thus, the supplemental balance requirementwould shift risk to those banks supplying the term

‘Task Force (1988), pp. 103—14.‘°Toillustrate the potential effects on the cost of issuing commer-

cial paper, suppose the Federal Reserve charges 100 basispoints at an annual rate on the maximum daylight overdraft ofeach bank. See Mengle, et al. (1987) for the basis for such arate. If an agent bank continues the timing of payments de-scribed in appendix 2 in issuing and redeeming commercialpaper, the overdrafts fee would cost $54.79 per $1 million ofcommercial paper issued and redeemed. If the banks pass thiscost on to the issuers, the annual cost of raising funds byissuing commercial paper every 30 days would rise by 7 basispoints.

“A risk-based capital ratio is calculated as a measure of capitaldivided by weighted assets, with weights assigned as approxi~

mations to relative risk. Reserves have a weight of zero. See“Proposals for International Convergence” (1988).

“Assume that these additional federally insured deposits have azero reserve requirement. To illustrate the implications forFDIC risk, suppose that after Bank A transfers $25 to Bank B,there is a public announcement of events that reduce the valueof the assets of Bank A by $15. Bank A fails and the FDICbecomes the receiver. As receiver, the FDIC obtains assetsworth $110 and assumes liabilities of $115, for a net loss of $5.In this case, therefore, the supplemental balance requirementshifts risk from the Federal Reserve to the FDIC.

10

federal funds, increasing the systemic risk in thebanking system.

Of course, supplemental balance requirementsalso would give banks an incentive to reduce thesize of the intraday movements in their reservebalances, since the interest rate paid on the bal-ances would be below the marginal return onother assets and below the interest rate on federal

funds. The supplemental balance requirementwould be i-educed to the extent that a bank keptits reserve balance positive throughout the busi-ness day. Suppose, for instance, that Bank Achanges its intraday pattern of payments so that,with the supplemental requirement of $15, itsreserve balance never falls below $5. The FederalReserve might reduce its supplemental balancerequirement to $10, thus reducing the opportunitycost of Bank A.

Provisions for Settlement flnalitr ofPayments over CHIPS

Settlement finality would involve procedures forensuring the execution of payments (avoid un-winding payments involving a defaulting bank)and the allocation of losses in the event of a de-fault by a CHIPS participant.” If losses are spr-eadwidely among CHIPS participants, the failurvt of aCHIPS participant to meet its payment obligationwould probably not cause other banks to fail.

The implications of settlement finality arrange-ments for payments system risk are illustratedusing the balance sheet entries in table 2. In this

illustration, CHIPS is presumed to have formed abankers’ bank, which is a cooperative venture thatperforms banking services for CHIPS members.This institution processes payment messages forits members as debit and credit entries to their

demand deposit accounts at the bankers’ bank.’1

The illustration is based on some general princi-ples of settlement finality arrangements that havebeen consider-ed for several years.”

The hypothetical ar-r’angement requires mem-bers of CHIPS as a group to pledge enough collat-eral with their bankers’ bank to cover the largest

net debit position of any one participant. This isbased on the idea that a default by one large par-

ticipant would disrupt the oper-ation of CHIPS.Since there has never been a default by a CHIPSparticipant, however, a default by one large partic-ipant is an unlikely event. Collateral requirements

for CHIPS participants in excess of the largest netdebit of an individual CHIPS participant could heinterpreted as an excessive degree of precaution.

In table 2, the largest net debit position is $25.To cover this position (and to allow some marginfor- error), CHIPS requires each of the three banksto pledge $10 of their interest-earning assets withCHIPS in the form of Treasury securities.

Suppose that after CHIPS processes the transac-tions described in table 2, an announcement indi-cates a $15 loss in the value of Bank A’s assets.tinder the settlement finality arrangement, CHIPSwould use the collateral posted by its participantsto raise $25, either by selling part of the collateral

“Discussions of the finality of payments on private wire transfersystems mention three aspects of finality. Sender finalitymakes each message over the payments system final whensent. Payment messages cannot be canceled later in the day.The rules for payment messages on CHIPS include senderfinality.

Settlement finality refers to procedures that would ensure thesettlement of payments if a participant defaults on its net debitat the end of the day. CHIPS does not have settlement finalityprocedures in place at this time. Under current procedures,CHIPS would cancel all payments by the bank that defaults, aswell as all payments to that bank, and calculate new net debitor credit positions for the remaining participants. This sectionillustrates the implications of adopting a form of settlementfinality.

Under receiver finality, credits to the deposit accounts of thecustomers of CHIPS participants would be final when thereceiving banks receive payments messages over CHIPS. If asending bank defaults, the receiving bank would have norecourse to its depositors. CHIPS rules do not include receiverfinality. For additional discussion of these aspects of the finalityof payments, see Humphrey (1986) and Belton, et al. (1987).

“CHIPS has considered developing a bankers’ bank to ensurethat payment obligations over CHIPS would be treated as netrather than gross obligations in the case of a default by aCHIPS participant. See Kantrow (1988)-To illustrate the signifi-

cance of the distinction between gross and net obligations,suppose a bank fails while it is in a net credit position onCHIPS payments. If CHIPS obligations are treated legally asnet obligations, CHIPS participants would make a payment tothe receiver of the failed bank for the amount of the net debitposition. The receiver of the failed bank might sue CHIPSparticipants based on gross obligations. Under a successfulsuit by the receiver, those that had sent payment messages tothe failed bank would have to pay the gross amount of thosepayments, and those who received payment messages fromthe failed bank would become its general creditors for theamount of the gross transfers from the failed bank. This treat-ment of CHIPS participants would increase the recovery rate ofthe failed bank’s other general creditors. There have been nosuch cases to indicate whether the courts would uphold pay-ments to the receiver based on gross payments.

Suppose, in contrast, that CHIPS payments are processedthrough demand deposit accounts at the bankers’ bank forCHIPS. Under that arrangement, the only claim of the receiverof the failed bank would be for the positive balance of the failedbank in its demand deposit account at the bankers’ bank.

“Mengle (1989).

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11

or using the securities as collateral for a loan atthe Federal Reserve discount window. CHIPSwould then transfer the $25 to the reserve account

of Bank B, facilitating the payment from Bank B toBank C. In turn, the bankers’ bank of CHIPS wouldhold the $10 in collateral posted by Bank A andhave a $15 claim against Bank A as a general credi-tor-. Losses on the $15 claim against Bank A wouldthus he spread between Bank B and Bank C. Nei-ther bank would be forced into bankruptcy by acomplete loss on the $15 claim.

From the Federal Reserve’s perspective, thissettlement finality arrangement is better than theprocedure that currently would be used to dealwith a default by a CHIPS participant — unwind-ing payments involving the bank. If this settlementfinality arrangement were in place, the unwindingof payments, which would disrupt the flow ofpayments in the economy, could be avoided. Ifadiscount window loan was necessary to avoid aliquidity crisis in the banking system, the collat-

eral would be available through the CHIPS organi-zation. The Federal Reserve would not have todecide which banks should receive discount win-

dow loans.

By making the risk to CHIPS participants moreexplicit, the arrangement would give CHIPS partic-ipants stronger incentives to exclude banks inrelatively poor- financial condition fiom their sys-tem. Banks that are excluded would route theirwrre transfers through Fedwire, thus reducingsystemic risk. Finally, the spreading of potentiallosses would limit the chances of the failure of onebank causing others to fail. It is not possible todetermine whether the risk of bank failure is lowerunder current CHIPS pr-ocedures or under thisproposed procedure for settlement finality. Such acomparison depends on the extent to which de-positors of CHIPS participants draw down theintraday credits to their demand deposit accountsand the success that banks would have in collect-ing from those depositors in case of a default by aCHIPS participant.

CONCLUSIONS

All banks assume some risk by participating inthe payments system. The payment pr-actices thatgenerate this risk were developed in an environ-ment in which ther-e was no interest charge onintraday credit amid, until recently, no constraintson the magnitude of intraday credit. There havebeen no losses to the Federal Reserve or’ to mcm-

hers of private wire transfer systems resulting fromthe daylight credit exposures. The Federal Re-serve, however’, has adopted a policy on paymentssystem risk which includes limits on the daylightover-drafts of individual banks.

The Fed has been considering possible changesin its policy to reduce its own risk and provideincentives for banks to change the payment prac-tices that tend to create the intraday risk expo-sures. One proposed approach involves a fee ondaylight overdrafts of reserve accounts. A secondappr-oach, which involves an implicit price ondaylight overdrafts, requir-es additional reservebalances at the banks which regularly overdr’awtheir- reserve accounts during the day. The FederalReserve would pay interest on these supplementalreserve balances at a rate just below the federalfunds rate, tinder either-approach, CHIPS wouldbe required to work out an arrangement that issatisfactory to the Federal Reserve to ensur-e thefinality of its payments.

The objective of changing the policy on pay-ments system risk is to reduce the risk of the Fed-eral Reserve without creating a large increase in

systemic risk — the risk that the failure of onebank will cause the failtrr-e of other banks, thusdisr-upting the operation of the payments system.The type of settlement finality ar-rangement de-sired by the Federal Reserve would ensure theexecution of payments overCHIPS in the event ofa default by a CHIPS participant and spread anylosses so widely among other CHIPS par-ticipantsthat one bank failure is unlikely to lead to the fail-ure of other CFIIPS participants.

REFERENCES

Association of Reserve City Bankers. Report ofthe WorkingGroup of the Association of Reserve City Bankers on Book-Entry Daylight Overdrafts (June 1986).

Belton, Terrence M., et al. “Daylight Overdrafts and PaymentsSystem Risk,” Federal Reserve Bulletin (November 1987), pp.839—52.

Corrigan, E. Gerald. Financial Market Structure: A Longer View(Federal Reserve Bank of New York, January 1987).

Faulhaber, Gerald R., Almarin Phillips, and Anthony M. Santo-mero. “Payment Risk, Network Risk and the Role of theFed,” in David B. Humphrey, ed., U.S. Payment System:Efficiency, Risk and the Ro/e of the Federal Reserve System(Kluwer, 1989).

Flannery, Mark J. “Paymetits System Risk and Public Policy,”Mimeo, University of North Carolina at Chapel Hill, November30,1987.

Humphrey, David B. “Payments Finality and Risk of SettlementFailure,” in Anthony Saunders and Lawrence J. White, ed.,Technology and the Regulation ofFinancial Markets (Lexing’ton Books, 1986).

JANuARY/FEBRuARY IRaft

12

Johnson, Manuel H. “Challenges to the Federal Reserve in thePayments Mechanism,” Issues in Bank Regulation (Summer1988), pp. 13—16.

Kantrow, Yvette D. “Big NY Banks May Spin Off Chips Net-work,” American Banker (June 27, 1988), pp. 1, 23.

Large-Dollar Payments System Advisory Group. A StrategicPlan for Managing Risk in the Payments System, Report to thePayments System Policy Committee of the Federal ReserveSystem, Board of Governors of the Federal Reserve System,August 1988.

Mengle, David L. “Legal and Regulatory Reform in ElectronicPayments: An Evaluation of Finality of Payment Rules,” inDavid B. Humphrey, ed., U.S. Payment System: Efficiency,Risk and the Role of the Federal Reserve System (Kluwer,1989).

Appendix I

Mengle, David L., David B. Humphrey, and Bruce J. Sum’mers. “Intraday Credit: Risk, Value and Pricing,” FederalReserve Bank of Richmond Economic Review (January/February 1987), pp. 3—14.

“Proposals for International Convergence of Capital Measure-ment and Capital Standards.” Issues in Bank Regulation(Winter 1988), pp. 3—12.

Rothschild, Michael, and Joseph E. Stiglitz. “Increasing Risk: I.A Definition,” Journal ofEconomic Theory (September 1970),pp. 225—43.

Task Force on Controlling Payments System Risk. ControllingRisk in the Payments System, Report to the Payments SystemPolicy Committee of the Federal Reserve System, Board ofGovernors of the Federal Reserve System, August 1988.

VanHoose, David. “The Angell Proposal: An Overview,” staffpaper, Board of Governors of the Federal Reserve System(June 1988).

Current Federal Reserve Policy on PaymentsSystem Risk

Currently, the Federal Reserve uses specificlimits on daylight overdrafts of reserve accountsand net debit positions on private wire transfersystems to reduce payments system risk. The lim-its on net debit positions apply to any private wiretransfer system that settles the net positions of itsparticipants through transfers of balances in re-serve or clearing accounts at Reserve Banks. SinceCHIPS is the only such system in operation, thefollowing description refers only to it, but wouldapply to any such systemn developed in the future.1

Bilateral Net Credit Limits on CHIPS

The Federal Reserve requires each participanton CHIPS to set a limit on its net credit position onmessage transfers with each of the other’ partici-pants in the system. Funds transfer- messages thatviolate these bilateral net credit limits are rejectedby the computer- system that processes paymentmessages. CHIPS participants have had bilateralcredit limits since October 1984.

Sender Net Debit Caps on CHIPS

The Federal Reserve requires CHIPS to establishlimits on the net debit positions of each partici-

pant with all other participants on the systemCHIPS sets this liniit for each participant at 5 per-cent of the sum of all bilateral credit limits for thatparticipant extended by all other CHIPS partici-pants.2 CHIPS established these sender net debitcaps in October 1985.

Cross-System Caps

Each bank that occasionally has daylight reserveoverdrafts is required to adopt a cap on its cross-

system daylight overdraft. Cross-system refers tothe daylight overdraft position on Fedwir-e andCHIPS. The relevant over-draft position for this capis the sum of a bank’s funds-related overdraft of itsreserve account and its net debit position onCHIPS at each moment during the day. Each banksets its cap by placing itself in one of the possiblecategories indicated in table Al; banks are directedto consider their- creditworthiness, credit policiesand operational control and procedures. Eachpossible rating has corresponding caps for’ boththe one day and two-week average maximum day-light overdraft, each as a percentage of primaryadjusted capital. These percentages have been

‘For an analysis of the effects of these credit limits on daylightoverdrafts and the operation of the payments system, see Bel-ton, et al. (1987).

‘There are additional details involved in determining these limits.See Belton, et al. (1987).

FEDERAL RESERVE BANK OF ST. LOUIS

Table AlCaps on Daylight Overdrafts Across Payments Systems(multiples of adjusted primary capital)

Self- Cap Period caps in effectassessment applied March 27.1986 to January 14. 1988 May 19.1988

category to January 13, 1988 to May 18, 1988 to present

High Two-weekaverage 2000 1 700 1.500

Single day 3 000 2 550 2 250

Above Two-weekaverage average 1.500 1 275 1 125

Single day 2 500 2.125 1.875

Average Two-weekaverage 1.000 0.850 0.750Single day 1500 1275 1.125

Limited Two-week

average 0 500 0 425 0 375Single day 0500 0.425 0.375

NOTE: Adjusted primary capital for U.S -chartered banks is the sum of primary capital less all intangibleassets and deferred net losses on loans and other assets sold

SOURCE: Federal Reserve Bulletin (November 1987). p 843

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Table A2Risk Created by Transferring Depositor’s Funds over FedwireBalance sheets at start of day:

Bank A Bank B

Reserves $10 Deposts 5100 Reserves S 10 Deoosils 5100

Other Net Other Net-assets 100 worth IQ assems 100 won

1: 10

Bank A sends $25 of depositor’s money to Bank B over Fedwure:

Bank A Bank B

A few banks incur lan-ge daylight overdrafts be-cause of the transactions they conduct for cus-tomers that deal in U.S. gover-nment securities.These tr’ansactions warrant special examination. Afew large banks (called clearing banks) specializein serving government securities dealers; thesebanks generate a large share of the total daylightoverdr-afts of bank reserve accounts. in the secondquarter of 1988 for example, four clearing banksaccounted for about 70 percent of the daylightoverdrafts attributable to transactions in book-

entry securities.

Business Practices of Dealers and ClearingBanks — Government securities dealers who buyand sell securities for their customers have no

direct access to the book-entry system for’ transfer-ring ownership of government securities. Instead,they maintain book-entry securities accounts anddemand deposit accounts with commercial banks

Daylight overdrafts of the clearing banks’ reserveaccounts reflect the practices of the governmentsecurities dealers in managing their inventories ofgovernments securities. Dealen’s hold large inven-tories of securities during the day to meet theanticipated demands of their customers. To mini-mize the cost of holding the inventories, the deal-ers sell most of their secum-ities by the end of the

day through repurchase agreements. The inves-tors who enter into these agreements “own” thesecur’ities overnight and “resell” them to dealersearly the next day. Thus, the dealers build their’inventories of government securities in the mon-n-ing of each business day by receiving securitiesreturned by the overnight repo investors and buy-ing additional securities offered for sale.’

The following featur-es of the business practicesof government securities dealers explain why theygenen-ally wait until early afternoon to begin run-

For a more complete discussion of the practices of clearingbanks and dealers, see Association of Reserve City Bankers(1986).

Securities Transfers that serve as their clearing banks for securitiestransfers.

FEDERAL RESERVE BANK OF ST. LOUIS

15

ning down their inventory of securities. Salesmenfor a dealer make commitments to deliver specificsecurities to its customers by the end of the day.

The dealer is then vulnerable to losses if it cannotfulfillthese commitments. The customer-s receiveinter-est on the pr’ornised securities for that day,even if the dealer does not make delivery. The

customer’s, however, make payments to the deal-ers only when the securities are delivered. The

dealer would fail to make delivery if it could notlocate the desired secun’ities in its inventory or inthe market, or if it sent the wrong securities to acustomer’ and had them returned. Each dealer

attempts to minimize the probability of such‘fails” by waiting until earls’ after-noon to dim-ect itsclearing bank to send its securities to the book-entry accounts of the banks that serve the cus-tomers that have bought them.

Another reason the dealers hold their securitiesuntil early afternoon involves potential profitsfrom special orders. On some days, certain issuesof government securities ar’e in relatively highdemand. The dealers can make larger profits ifthey have securities available to meet these specialorders. In contrast to the specific requirements forspecial orders, dealers may substitute a wide vari-ety of securities as acceptable collateral for repos.

Effects on lntraday Reserve Balances —

These dealer practices affect the intraday patterns

of their demand deposit balances and the reservebalances of the clearing banks that senve them.When a m’epo investor’ retur-ns the securities to thedealer-, then-c is an increase in the securities ac-

count of the dealer- at its clearing bank and anequal reduction in its demand deposit account.On the books of the Federal Reserve, there is anincrease in the securities in the book-entry ac-count of the clearing bank and a n’eduction in ther-eserve account of the cican-ing hank. The sametransactions occur’ when the dealer buys securi-ties to hold in its inventory that day. The dealerbuilds its inventory of securities by oven-dr-awingits demand deposit account during the day. The

dealers do not control the timing of these inflowsof securities to their’ accounts and the outflowsfrom their demand deposit accounts, since theparty that holds the securities initiates the transferof securities and r-esen’ves through the F’edwir’esystem.

The process of overdrawing r’eserve and deposit

accounts is reversed later’ in the day as the dealer-ssell their inventor-ies of securities. The reserve

accounts of the clearing banks rise as the book-entry securities are transferred to the accounts ofother banks and reserve balances are simultane-ously transferred to the accounts of the clearingbanks. The timing of tr’ansactions in book-entrysecurities for the dealers causes the reserve ac-counts of the clearing banks to be overdrawn bybillions of dollar-s during part of the day.

Implications for Risk— The clearing banksextend credit to government securities dealersduring the day by allowing them to overdraw their

demand deposit accounts. The banks limit theirrisk by obtaining a lien against the securities heldfor’ the account of the dealers. Thus, a clearingbank could claim the securities credited to the

account of a dealer’ to cover any losses on its de-posit overdraft

The Federal Reserve has considered variousmethods of establishing liens against the securi-ties in the book-entry accounts of banks but hasnot initiated such collateral arrangements. Thus,the Fed is vulnerable to losses on the full amountof a bank’s reserve oven-draft, whether the overdraftwas generated through funds transfers or transac-tions in book-entry securities?

The risk implications of book’entry overdraftscan be illustrated by examining the balance sheetentries in table AZ. Bank A is a clearing bank for’ agovernments securities dealer. The dealer receives$25 in book-entry securities and has its demand

deposit account debited by $25, leaving it over-drawn at that time. Suppose the dealer goes bank-rupt after this transaction is completed. Bank Aclaims the $25 in securities that were credited to

the securities account of the dealer to cover anypossible losses on the deposit overdraft. The bankis spared any losses, and the Federal Reserve suf-fers no losses.

‘Ibis hook-entry daylight oven-dr-aft, however,does leave the Federal Reserve vulnerable to a losson the reserve overdraft. Suppose that after’ thedealer’ receives the $25 in book-entry securities,there is an announcement that implies a $15 lossin the value of the other assets of Bank A, as in theother illustrations. Under current an’angements,the Fed has no claim on the $25 in book-entry

securities that had been transferred to Bank A, tooffset its $5 loss. Thus, collateral agreements be-tween clearing banks and the dealer’s make Fed-

er-al Reserve losses due to defaults by governmentsecurities dealer-s unlikely, but the daylight reserve

2Task Force (1988), p. 69. ~TaskForce (1988), p. 70—72.

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overdn’afts of the clearing banks expose the Fed topotential losses in the event of large, unantici-pated declines in the value of the assets of theclearing banks themselves.

A lien by the Federal Reserve against the book-entry securities in the accounts of the clearingbanks might have little practical significance inlimiting Fed risk. Suppose the public learns duringthe day that a clearing bank maybe bankrupt.

Would the Federal Reserve suddenly seize thebook-entry securities in the account of the clear-

ing bank? Doing so would disrupt the business ofthe government securities dealer’s served by thecleaning bank and, given the high concentration ofbusiness among clearing banks, would disrupttrading in the whole government securities mar-ket. The Fed and the other federal supervisoryauthorities have been reluctant to close large com-

4Fon a discussion of how daylight overdrafts reflect transactionsin commercial paperand other financial instruments, seeLarge-Dollar Payments System Advisory Group (1988).

mercial banks because of their effects on other-

depository institutions arid the financial marketsin general. A lien on the book-entry securities ofbanks might make the supervisory authoritiesmore reluctant to close a large hank that alsoserves as a clearing bank for’ government securitiesdealers.

Issuing and Redeeming CommercialPaper

The timing of payments by banks involved inissuing and redeeming commercial paper- cn-eatesreserve over-drafts.4 Several banks act as agents forfirms that issue commercial paper’. The agentbanks collect funds from those purchasing thecommercial paper- and transfer’ them to the ac-counts of those firms issuing the paper. When thepaper’ matures, the agent banks collect fr’om the

FEDERAL RESERVE BANK OF ST. LOUIS

17

paper issuers and make payments to the holdersof the paper.

When a firm issues commercial paper, the agentbank generally pays the firm before it receivespayment from those buying the paper. During theperiod between the payment to the issuer and thereceipts from the purchasers, the reserve accountof the agent bank falls by the amount of the fundsraised by issuing the commercial paper. The re-

serve balance of the agent bank also falls by theface amount of the issue when the paper matures;the agent bank generally makes payment to thoseholding the paper before receiving payment fromthe issuer’.

The effects of these transactions on the balance

sheet of the agent bank are illustrated in table A3.

A firm raises $25 by issuing commercial paper.Bank A is the agent bank, and both the issuer andpurchaser’ of the paper have their demand depositaccounts at Bank B. Early in the day on which thecommer-cial paper is issued, Bank A transfer’s $25to Bank B, to be credited to the demand depositaccount of the issuer. After- that transaction, thereserve account of Bank A is overdrawn by $15. Inthis example, the offsetting transaction is a $25increase in an account called “reserves r’eceiv-able.” Later that day, the purchaser of the paperarranges for Bank B to send $25 to Bank A overFedwire, eliminating the reserve overdraft by theend of the day. As in the other balance sheets, theFederal Reserve is a general creditor of Bank Awhile its reserve account is overdrawn.

JANUARYIFEBRUARV 1989