Daylight overdraft

A daylight overdraft (also called intraday overdraft) occurs where a bank account is allowed to go overdrawn during the day but is brought back into credit by close of business.

An example of a daylight overdraft is making a $100 deposit at an automated teller machine (ATM) which allows for instant withdrawal of the first $100 deposited. This ATM transaction will post the next day; however if one were to transfer the funds from this account to another account using other means (such as the Internet or telephone) the funds would be withdrawn that day and would post the account negative the next day.

Federal Reserve

In the United States, the Federal Reserve operates a system in which “allows qualifying banks to overdraw on their Federal Reserve accounts in order to make payments via Fedwire.[1] Banks can acquire overdrafts throughout the day to make payments, but must ensure that their accounts are not in a negative position at the end of the day.”[2]

Occasionally, banks may not have enough money in their Federal Reserve accounts to fulfill their withdrawals. For example, assume Bank A has $10 million as their assets and the Federal Reserve requires 10% of their assets as their reserves, which is $1 million. If one day, Bank A needs to transfer out $1.5 million during the day, Bank A is running a daylight overdraft during that day. By the end of that particular day, Bank A has an obligation to pay back the Federal Reserve.

A fee is not imposed on collateralized daylight overdrafts, but a 50-basis-point fee is taken on uncollateralized ones.[3]

History

The history of the daylight overdraft began in 1985 when the Federal Reserve established policies on large amount transfers between different banks, which allow banks to operate smoothly.[4]

Problems

There are some flaws associated with the system. Sometimes banks are not able to repay the amount that they overdrew during the day since daylight overdraft is ultimately making transactions with funds that are not there at the time the settlement occurs. Banks which need to pay back the Federal Reserve, but do not have enough funds to do so, have an option to borrow the funds from other banks. However, borrowing from other banks is not always an option. This credit risk is a systemic risk.[5][2]

Risk management

The Federal Reserve can take several actions to deal with the risks associated with lending out reserves during the day.

Firstly, the Federal Reserve can monitor[2] a bank borrowing money by what kind of project they are using the reserves for, and by considering the value of other assets that the bank owns.

Secondly, the Federal Reserve can ask for collateral[2] from potential borrowers. In this scenario, collateral works as an insurance for the Federal Reserve in case that the borrower is not able to return the overdraft that occurred during the day.

Thirdly, the Federal Reserve might require the daylight overdraft fee[2] to reduce some risks associated with the overdraft during the day. The banks would not borrow more than the amount that they need in order to avoid a larger fee.

Net debit cap

Banks who are eligible for daylight overdrafts get a net debit cap.[2] Different organizations hold different net debit caps because it is set by specific regulations and guidelines set up by the Federal Reserve. Along with the policies that the Federal Reserve can ask, net debit cap helps the Federal Reserve to reduce the risks that they might face with the daylight overdrafts.

Net Debit Cap = Cap Multiple × Capital Measure[4]

Conclusion

Overall, the daylight overdraft is a system that is useful for the banks; however, it comes with costs for the Federal Reserve as a lender. With proper regulations and policies, the daylight overdraft system will allow the banks to operate more efficiently.

References
  1. Evanoff, Douglas. "Daylight Overdrafts: Rationale and Risks". Economic Perspectives. 12 (3): 18–29.
  2. Martin, Antoine. "An Economic Perspective on the Enforcement of Credit Arrangements". FRBNY Economic Policy Review.
  3. "Archived copy". FederalReserve.gov. Archived from the original on 2012-09-21. Retrieved 2012-09-23.CS1 maint: archived copy as title (link)
  4. "Payment System Risk". Board of Governors of the Federal Reserve System. Retrieved 18 April 2016.
  5. Mengle, David. "Daylight Overdrafts and Payments System Risks". Economic Review: 14–27.
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