A daylight overdraft, also called an intraday overdraft, occurs when an account is overdrawn at some point during the business day but returns to a zero or positive balance before the close. The term is most associated with the accounts that banks hold at the Federal Reserve: when a bank sends out more in payments than it has received so far that day, its account goes negative, and the Federal Reserve is in effect lending it the difference for a few hours.
Daylight overdrafts are a normal feature of modern payment systems, not a sign of distress. Payments flow in and out at different times, and without intraday credit banks would have to hold far larger balances or delay outgoing payments until incoming funds arrived. The overdraft does, however, expose the lender to loss if the borrower fails before repaying, which is why central banks limit and price it.
How daylight overdrafts arise
In a real-time gross settlement system such as the Fedwire Funds Service, each payment is settled individually and finally the moment it is processed. A bank that sends a large wire early in the day, expecting receipts in the afternoon, will be short in the meantime. Securities settlement has the same effect: a dealer bank that takes delivery of government securities pays for them at once and may not deliver them onward, and be paid, until later.
Timing conventions in other services add to the pattern. Settlement for check and Automated Clearing House transactions is posted to accounts at set times, so a bank's balance moves in steps through the day. The Federal Reserve tracks the balance in each institution's master account continuously using these posting rules.
Federal Reserve policy
The Federal Reserve's approach is set out in its Policy on Payment System Risk. It aims to keep payments flowing smoothly while containing the credit risk the Reserve Banks assume.
- Net debit caps. Each institution has a ceiling on its uncollateralized daylight overdrafts, expressed as a multiple of its capital. The cap category depends on the institution's financial condition and on a self-assessment of its controls; some institutions have a cap of zero.
- Collateral. Overdrafts covered by collateral pledged to the Reserve Bank incur no fee. Institutions can also obtain capacity above their cap if it is fully collateralized.
- Fees. Uncollateralized overdrafts are charged a fee calculated on the average overdraft through the day, at an annual rate of 50 basis points, with a waiver for small amounts.
- Monitoring. Reserve Banks watch accounts in real time and can reject or hold payments from institutions considered higher risk if they would create an overdraft.
The present structure dates from 2011, when the policy was revised to encourage the pledging of collateral by making collateralized overdrafts free. Fees on daylight overdrafts were first introduced in 1994, after concern in the 1980s about the scale of unpriced intraday credit.
Why it matters
Intraday credit from the central bank removes a source of gridlock. Without it, each bank would wait to be paid before paying others, and payments would bunch at the end of the day. But the central bank bears settlement risk on the credit it extends: Fedwire payments are final, so if a bank failed while overdrawn, the Reserve Bank would have a claim on the failed bank and not on the recipients of its payments. Caps, collateral and fees are intended to give banks a reason to manage their intraday liquidity carefully without discouraging them from making payments promptly.
The level of reserves in the banking system has a strong influence on usage. When reserves were scarce before 2008, daylight overdrafts were large. After the Federal Reserve's asset purchases left banks with abundant balances, average overdrafts fell to a small fraction of their earlier level, since most banks could fund their outgoing payments from balances already held.
Other systems
Other central banks handle the same need differently. In the Eurosystem's T2 system, intraday credit is provided free of interest but only against eligible collateral, so there is no uncollateralized overdraft. The Bank of England similarly provides intraday liquidity through repurchase transactions against high-quality assets. Many systems also include a liquidity-saving mechanism that queues and offsets payments so that less credit is needed.
Private systems that settle on a net basis avoid central bank overdrafts by design but create exposures among their members, which they control with limits and prefunding. CHIPS, the private large-value system for dollar payments, requires participants to fund their positions in advance.
Daylight overdrafts for bank customers
Commercial banks extend the same kind of credit to their own customers. A corporate treasury, broker-dealer, payment company or correspondent bank may be allowed to send payments during the day in excess of its balance, up to an intraday limit, on the understanding that expected receipts will cover the position by the close. Banks set these limits through their credit process, monitor them in real time and may charge for them. A position that is not covered by the end of the day becomes an overnight overdraft, usually at a penalty rate. Supervisory standards on intraday liquidity monitoring require banks to measure both the credit they use and the credit they extend.