Daylight overdrafts and payments system risks

During the last several years, the banking community has become increasingly aware of the risks faced by participants on electronic funds transfer (EFT) networks. Of particular concern have been the volume and incidence of daylight overdrafts on Fedwire and the risk of systemic failure due to the failure of a participant on one of the private EFT networks. In this article, David L. Mengle develops an economic framework for analyzing the risks borne by network participants, and then discusses several alternative risk reduction measures. Mengle argues that, on Fedwire, pricing of daylight overdrafts would create incentives for banks to reduce such overdrafts and would serve to lower the risk now assumed by the public. On the private networks, he suggests that a discount window lending policy to avert system failure could be structured to give banks incentives to limit risk exposure. Although current policies seek to reduce risks by placing direct controls on daylight overdrafts, it may be advisable to supplement these policies with measures that force banks to face the costs they impose on the rest of the payments system.