SRC Insights: Fourth Quarter 2010

Revisions to Payment System Risk Policy to be Implemented in 2011

by Jay Karlyn, PSR Specialist, and Glenn Fuir, Manager

On September 30, 2010, the Federal Reserve Board (Board) announced that it will implement changes to its Payment System Risk (PSR) policy on March 24, 2011.¹ The changes were approved in late 2008 to reflect the need for Federal Reserve Banks (Reserve Banks) to provide intraday credit to improve intraday liquidity management and payment flows for the banking system while continuing to mitigate credit exposures stemming from daylight overdrafts.² The purpose of this article is to serve as a refresher on the administration of payment system risk by the Reserve Banks and to highlight the impacts of upcoming PSR policy changes scheduled to take effect on March 24.

One of the primary objectives of the PSR policy was to implement a program to oversee the use of intraday credit by the Federal Reserve and to define the methodology that Reserve Banks must use to minimize their credit risk exposures. The revised PSR policy allows Reserve Banks to mitigate credit risk by:

Providing intraday credit to healthy institutions (those that satisfy safety and soundness requirements)
Establishing limits on the amount of Federal Reserve intraday credit that an institution may use
Allowing Reserve Banks to place risk controls on account activity to protect themselves from the risk of loss
Giving institutions incentive to voluntarily pledge collateral to secure daylight overdrafts through a revised fee structure

Provision of Intraday Credit to Healthy Institutions

A daylight overdraft occurs whenever an institution fails to maintain a sufficient balance in its Federal Reserve account throughout the day to cover payment activities, such as funds transfers, incoming book-entry securities transfers, ACH transactions, and check payments. The Federal Reserve acknowledges the appropriateness of providing a certain level of intraday credit in order to ensure that the payments and securities settlement systems function smoothly. By providing intraday credit or allowing depository institutions (DIs) to incur daylight overdrafts, the Federal Reserve can help avoid payment system gridlock. This has become increasingly important as large dollar transactions are being pushed to later in the day.

Under the revised PSR policy, Reserve Banks will provide intraday credit to healthy depository institutions (DIs) for no fee for daylight overdrafts that are collateralized. Otherwise, institutions that incur uncollateralized daylight overdrafts will be charged 50 basis points. Additionally, the new PSR policy seeks to minimize the impact on institutions that use small amounts of daylight credit; therefore, a biweekly daylight overdraft fee waiver of $150 will take effect.

Limits on the Amount of Federal Reserve Intraday Credit

The revised PSR policy will maintain the utilization of an institution's single-day net debit cap; however, it will now apply to the sum total of both collateralized and uncollateralized daylight overdrafts. A net debit cap refers to the maximum allowable daylight overdraft (in dollar terms) that a DI's Federal Reserve account may have at any point in time. The dollar value of a DI's net debit cap is determined by multiplying the DI's risk-based capital by the multiple from its assigned cap category. Six cap categories are defined in the PSR policy: zero, exempt-from-filing, de minimis, average, above average, and high. Aside from the zero cap, daylight overdraft cap levels range from 0.2 times the DI's risk-based capital for an exempt cap (i.e., up to $10 million) to 2.25 times risk-based capital for a high cap.

Under the new PSR policy, the more narrowly defined two-week average cap multiples previously in effect will be eliminated, allowing institutions with average, above average, or high caps to utilize their full daylight overdraft capacity every day. As in the past, in order to qualify for a net debit cap of average, above average, or high, a healthy institution must perform a comprehensive self-assessment covering four separate components: 1) creditworthiness, 2) intraday funds management and controls, 3) customer credit policies and controls, and 4) operating controls and contingency procedures. The self-assessment process requires the institution to evaluate each of the aforementioned components and establish a recommended cap based on the internal assessment. The recommended cap should be reviewed and approved by the DI's board of directors and is subject to review for appropriateness by the Reserve Bank.

If a DI has unusual liquidity pressures or processes high transaction volumes (such as with a mortgage servicing operation), that institution may need to utilize daylight overdraft capacity beyond its established net debit cap. If this occurs, the existing PSR policy allows a DI to apply for “maximum daylight overdraft capacity” (max cap). Justification is required for a max cap, and in this case, the DI would be required to pledge collateral to specifically cover daylight overdraft activity in excess of its net debit cap. Under the new policy, the previous guideline that required institutions to investigate acceptable alternatives to address their increased liquidity needs before considering a max cap will be eliminated, although the process for establishing a max cap will remain the same.

Primary Risk Controls Included in Intraday Credit Policy

On a daily basis, Federal Reserve Banks offer payment services to DI customers and, as a result, may be exposed to risk of loss when they process payments for institutions that hold accounts with them. As previously mentioned, intraday credit is primarily used by depository institutions to cover temporary shortages in their Federal Reserve accounts caused by outgoing Fedwire transfers, incoming book-entry securities transfers, processed checks, and ACH transactions. Whenever a Reserve Bank processes these transactions, it becomes susceptible to a direct risk of loss caused by a depository institution that is unable to eliminate its daylight overdraft position before the end of the business day.

The PSR policy has always enabled Reserve Banks to control credit risk exposures associated with daylight overdrafts in a number of ways. First, institutions must meet safety and soundness requirements, which are usually substantiated through the examination process. Secondly, daylight overdraft caps control the amount of intraday credit an institution may utilize. Moreover, Reserve Banks are permitted to limit their intraday credit risk exposures by implementing other account controls, as necessary. For instance, a Reserve Bank may require a particular DI to prefund certain debit transactions, pledge collateral, or maintain a minimum clearing account balance. Reserve Banks may also impose zero caps on certain institutions and are permitted to reject Fedwire funds transfers, ACH credit originations, or net settlement system transactions that would cause or increase a DI's daylight overdraft position.

As a reminder, it is especially important for individuals who manage an institution's daily cash position to be attentive to payment activities throughout the day and their effects on the Reserve Bank account balance. Institutions that exceed their net debit caps will face restrictions placed on them by Reserve Banks, thereby limiting their flexibility to conduct daily payment operations.

Collateral and Revised Fee Structure

The revised PSR policy introduces voluntary collateralization of daylight credit. Collateralizing daylight overdrafts benefits both Reserve Banks and DIs. Collateral mitigates the credit risk Reserve Banks incur by extending daylight credit, and it allows DIs to eliminate or minimize the fee paid for daylight credit. The collateral acceptance criteria and margins applicable for daylight credit purposes are the same as those currently used for the discount window.³

The revised PSR policy introduces major changes to daylight overdraft pricing, as follows:⁴

A zero fee will apply to collateralized daylight overdrafts for institutions with regular access to the discount window.
A 50 basis point fee will apply to uncollateralized daylight overdrafts for institutions with regular access to the discount window.
A 150 basis point penalty fee will be assessed for daylight overdrafts incurred by institutions that do not have regular access to the discount window and are not eligible for intraday credit (also referred to as penalty fee institutions).
A fee waiver of $150 (per reserve maintenance period) will be subtracted from an institution's gross fees, excluding institutions subject to the penalty fee.

In the fee calculation, the value of unencumbered collateral pledged to the Reserve Banks (i.e., collateral not supporting discount window loans) will reduce negative account balances to determine the institution's uncollateralized overdraft position. This represents a change from the existing policy because collateral is not currently considered in the determination of daylight overdraft amounts. Furthermore, individual daylight overdraft fees incurred during a reserve maintenance period will be added together and reduced by the $150 fee waiver.

See the illustrative Comparison of Overdraft Charges table for a more detailed view of the impact of the policy changes.

VIEW LARGER IMAGE

In this table, the DI would incur a lower overdraft charge for the maintenance period under the revised PSR policy due to a reduced average overdraft balance (net of the applied collateral) and due to the $150 fee waiver. If, in the example shown, all overdraft balances had been collateralized, then no fees would have been charged to the DI's account under the revised policy.

Final Thoughts

The impending PSR policy changes addressed in this article represent a strategic change for the Federal Reserve Board. As in the past, Reserve Banks will continue to provide institutions with the needed flexibility to manage payment flows in the banking system while simultaneously mitigating credit risk exposures emanating from daylight overdrafts. However beginning on March 24, 2011, healthy institutions seeking to reduce daylight overdraft charges will be permitted to voluntarily apply unencumbered collateral against negative balances incurred during each processing day.

For more information on the revised PSR policy, please contact PSR Specialist Jay Karlyn (jay.karlyn@phil.frb.org) at (215) 574-6216. Frequently Asked Questions are available on the Federal Reserve Bank Discount Window & Payment System Risk Website. External Link

Summary of Key PSR Policy Changes, effective March 24, 2011
	Existing Policy	Revised Policy
Collateral	Required for problem institutions and institutions with max caps only. Collateral eligibility and margins same as discount window.	Additional provision that explicitly applies collateral pledged by healthy institutions to daylight overdrafts in their Reserve Bank accounts
Fee for collateralized daylight overdrafts	36 basis points	Zero fee
Fee for uncollateralized daylight overdrafts	36 basis points	50 basis points
Deductible	10 percent of an institution's capital measure.	Deductible is eliminated. Replaced by zero fee for collateralized daylight overdrafts and increased fee waiver.
Fee waiver	Up to $25 biweekly if total charges are less than or equal to $25	$150 biweekly
Net debit cap	Two-week average limit and higher single-day limit	Two-week average limit is eliminated; adjusted policy for single-day limit
Max cap	Additional collateralized capacity above net debit cap for self-assessed institutions	Streamlined process for certain FBOs up to a limit; minor changes for all institutions
Penalty fee for ineligible institutions	136 bps	150 bps

¹ Board of Governors website.
² Board of Governors website.
³ Collateral Guidelines and a listing of the most commonly pledged asset types are
available online.
⁴ Source: Federal Reserve Bank Discount Window website.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.