(This is a complicated subject, so my apologies if anything is unclear or out of order.)
The Free Library provides background on daylight overdrafts.
(emphasis mine) [my comment]
Daylight overdrafts are a form of intraday credit in which a holder of a deposit account at a bank or other depository institution runs a negative balance in its account during the day but ends the day with a balance equal to or greater than zero. An example of a daylight overdraft is the case in which a deposit account holder (1) makes withdrawals from the account in the early part of the day that exceed the account's opening cash balance and (2) does not make deposits sufficient to cover the withdrawals until later in the day. When the customer's withdrawals require its bank to send payments through Federal Reserve systems, this type of customer activity can, in turn, cause daylight overdrafts in the Federal Reserve account of the customer's bank. In addition, the bank's own activity, such as federal funds borrowing and lending and the associated payment activity, can also cause daylight overdrafts.
Historically, intraday credit extensions went largely unmeasured because attention within the banking industry was focused mainly on processing payments rather than on managing associated intraday risks. In addition, nearly unlimited intraday credit was available from the Federal Reserve at no cost. Banks normally accumulated payment instructions during the day and posted them to customers' accounts at the close of the banking day, a practice that can be viewed as reasonable and cost-effective given the operational and legal infrastructure at that time. As a result, however, settlement conventions related to the transactions most often characterized by same-day settlement — such as financing in the markets for federal funds and repurchase agreements — came to be based upon the availability of unlimited, free intraday overdraft credit from the Federal Reserve. [I will go into link between daylight overdrafts and repurchase agreements further below.]
Daylight overdrafts in accounts at Federal Reserve Banks in fact arise from a variety of causes. The Federal Reserve's original overdraft policies were focused on intraday credit resulting from the transfer of funds through Fedwire, the Federal Reserve's electronic, real-time funds transfer system often used for large-value interbank payments. Overdrafts are, however, also caused by payments of banks and their customers that arise from transfers of government securities via Fedwire as well as from non-Fedwire transactions such as automated clearinghouse (ACH ) payments, checks, and other payment activity posted directly to depository institution accounts at the Federal Reserve.
For many institutions, payments made on a given day may exceed that day's opening balance (the previous day's overnight balance) with the Federal Reserve. Indeed, in 1994, the total value of funds and securities transfers through Fedwire, ACH payments processed by the Federal Reserve, and checks cleared through the Federal Reserve averaged $1.5 trillion per day; in contrast, the average daily opening balance of all depository institution accounts at the Federal Reserve that year was $32 billion (depository institutions maintain balances to satisfy reserve requirements as well as to clear payments). Many of these payments were covered by funds in the accounts, but a significant portion were not. In 1994, for example, direct measures of daylight overdrafts show that the Federal Reserve extended about $50 billion in intraday overdraft credit on average during the day (table 1); and on any given day an average of about 2,400 institutions incurred daylight overdrafts in their accounts at the Federal Reserve out of a total of nearly 11,000 institutions with such accounts.
Concerns about the magnitude of the credit risk borne by the Federal Reserve in regard to daylight overdrafts were heightened in the early 1980s. During that time, the Reserve Banks began to monitor the intraday account balances of institutions routinely and to collect data on institutions with the largest daylight overdrafts. These data indicated that aggregate daylight overdrafts on any given day often ran into the billions of dollars; furthermore, overdrafts for a small group of institutions often exceeded their capital by several times.
... Although the Fedwire system is capable of automatically blocking funds transfers that would create an overdraft (and is currently used to do so in certain circumstances ), the Federal Reserve did not endorse (indorse) an outright prohibition of daylight overdrafts as a necessary or desirable policy outcome. Indeed, concerns expressed then as well as now are that the prohibition of all overdrafts could seriously disrupt the U.S. money markets, especially the markets for federal funds and government securities.
Why did the Federal Reserve allow daylight overdrafts? The answer should be obvious: to keep an increasingly insolvent financial system afloat!
The chart below show how bank failures mysteriously dropped off after the Fed allowed banks to run negative balances in its accounts in 1977.
Daylight overdrafts became official policy in 1977
Daylight overdrafts of reserve deposit accounts can be viewed as a third means of extending central bank credit, which was not contemplated in an Act drafted before the development of sti cated telecommunication networks. Daylight overdrafts not only are free, but also are uncollateralized. That this third means of extending credit is not mentioned specificaliy as requiring collateral in the Federal Reserve Act probably reflects an historical understanding that such overdrafts would not take place. For example, the first operating letter of the Federal Reserve Bank of Cleveland governing transfers of funds, when adopted in 1939, said, "Collected funds on deposit --are available for telegraphic or mail transfer "Telegraphic transfers ... of bank balances would be processed, where "The term 'bank
balances' shall be construed to mean an accumulation of funds comprising an established account maintained by a member bank ... (emphasis added).
When Subpart B of Regulation J was first adopted, August 1, 1977, however, the fact of daylight overdrafts was clearly recognized by providing that, if a bank did not have a sufficient ..balance of actually and finally collected funds" to cover transfers during a day, the Reserve Bank claimed a security interest in any or all of the bank's assets in the possession of, or held for the account of, the Reserve Bank. Notwithstanding that claim, the Reserve Bank also could refuse to act on a transfer request "...at any time when such Federal Reserve Bank has reason to believe that the balance maintained or used by such transfer is not sufficient to cover such item." Purists may be forgiven for questioning whether the treatment of daylight overdrafts, even as protected by these regulatory provisions, is fully consonant with provisions of the Federal Reserve Act.
Objectives Underlying Payment System Risk (PSR) Policy
Entering into PSR policy debate requires a clear notion of policy objectives. To date, Federal Reserve PSR policy has been fashioned with the explicit objective of reducing PSR, quantified as daylight overdraft exposure plus net daylight credit drawn on CHIPS.
Historical background suggests that existing PSR policy was a reaction to mushrooming PSR exposure associated with the telecommunications revolution in the payment mechanism (see appendix). For example, in 1947, reserve deposit balances represented 700 percent of (seven times) the value of daily debits (Fedwire, checks, to member bank reserve accounts) by 1983, balances were a minuscule 4 percent of daily debits.' That is, in 1947, the average bank could make all necessary payments for seven successive business days without ever receiving a single offsetting payment before exhausting its initial reserve deposit balance. By 1983, the average bank could meet demands for payment for only 20 minutes of a single eight-hour business day before it would have had to receive some offsetting payments, or go into overdraft. Over the course of 35 years, the Federal Reserve apparently moved from a cash-in-advance system, in which payments involved no risk, to a largely automatic daylight credit system, in which the Federal Reserve is exposed to upwards of $50 billion of daily credit risk on alone, plus another $60 billion on the book-entry system, while CHIPS participants extend about $45 billion.
1) In 1947, the average bank could make all necessary payments for seven successive business days without ever receiving a single offsetting payment before exhausting its initial reserve deposit balance.
2) By 1983, the average bank could meet demands for payment for only 20 minutes of a single eight-hour business day before it would have had to receive some offsetting payments, or go into overdraft.
3) Over the course of 35 years, the Federal Reserve apparently moved from a cash-in-advance system, in which payments involved no risk, to a largely automatic daylight credit system.
The chart below compares reserves balances (cash owned by banks) to the money supply (amount banks owe in term of deposits, etc...).
The reason why banks were running out of cash: INFLATION
High inflation destroys financials systems. The high Inflation which pushed the US financial system into insolvency in the 1970s was caused by government budget deficits and rapid increases in the money supply beginning in 1961.
The refusal of the administration of U.S. President Lyndon B. Johnson to pay for the Vietnam War and its Great Society programs through taxation resulted huge budgets deficits and rampant inflation. The high interest rates caused by this inflation devastated US financial institutions.
The 1970s Interest Rate Crisis
The FDIC reports that the early thrift crisis was an interest rate crisis.
As was mentioned earlier, the early thrift crisis was an interest rate crisis. There weren't troubled assets as such, but thrifts had a lot of fixed rate loans on their books and were paying more for deposits than they were receiving for loans. So, they were going broke with literally no problem assets. ...
The FDIC illustrates the problems caused by the interest rate crisis.
During the 1970s, banks became vulnerable to high and rising interest rates. On February 16, 1971, the $110 million Birmingham-Bloomfield Bank (BBB), Birmingham, Michigan (a suburb of Detroit), was the first $100+ million failure handled by the FDIC. BBB had invested heavily in long-term municipal bonds, relying considerably on purchased deposits, in anticipation of expected interest rate declines. When interest rates rose, the bank incurred losses and found itself locked into low-yielding, depreciated securities. The experience of BBB did not prevent other banks from subsequently getting into situations in which they became vulnerable to high and rising interest rates.
In the late 1960s and early 1970s, First Penn grew rapidly. From 1967 to 1976, assets increased from $2.1 billion to more than $6 billion, but many of the assets became non-performing loans.6 The bank resolved a substantial number of loans, but some problems remained. Beginning in 1976, the bank used short-term deposit liabilities to make large purchases of long-term, fixed-rate U.S. government securities. Also, in an attempt to stabilize future income at what the ban k thought would be high rates, First Penn bought its securities when those investments were earning interests of 7 to 8 percent. By 1979, it held more than $1 billion in Treasury bonds. About half the portfolio of Treasury issues had maturities of more than 10 years; some 30-year bonds had maturities of 2007 and were paying 7.6 to 7.9 percent a year. But interest rates kept increasing, and First Penn was paying as much as 15.5 percent on deposits by May 1980.7 The income from fixed rates on the bonds could not keep pace with the cost First Penn needed to pay on its deposit funds, and the bonds became a burden. As interest rates climbed, the market value of the bonds fell to $300 million less than their face value.
How Washington dealt with Interest Rate Crisis: repurchase agreements
Regulators and politicians in Washington were faced with a problem in the 1970s:
A) Insolvent banks like First Penn were running out of cash. Everyone knew it and nobody wanted to lend to them, even with collateral.
B) If banks like First Penn sold their low yielding bonds and other assets to raise cash, it would trigger a write-downs which would expose their insolvency, forcing FDIC takeovers and causing politically/financially costly fallout for politicians/regulators.
Washington's solution was basically outright fraud: allow the banks to sell their assets and pretend they didn't. It was called repurchase agreements.
UN Stats reports about Repurchase Agreements.
A securities repurchase agreement (repo) is an arrangement involving the sale of securities at a specified price with a commitment to repurchase the same or similar securities at a fixed price on a specified future date. Margin payments may also be made3. A repo viewed from the point of view of the cash provider is called a reverse repo. When the funds are repaid (along with an interest payment) the securities are returned to the "cash taker"4. The provision of the funds earns the cash provider interest that is related to the current interbank rate (determined at the outset of the transaction) and not the rate of interest earned on the security "repoed." Full, unfettered ownership passes to the "cash provider" but the market risk — the benefits (and risks) of ownership5 (such as the right to holding gains (and losses) and receipt of the property/investment income attached to the security — are retained by the cash taker as if no change of ownership had occurred, in the same manner as when collateral is usually provided. "Full, unfettered ownership" means that the cash provider acquires ownership of the security and may sell it.
4 Terms such as "borrower", "lender", "purchaser" or "seller" may be misleading in this context, given the nature of these transactions. Accordingly, this paper uses the more neutral terms of "cash provider" and "cash taker" in discussing repos, in line with those used by Simon Grey (1998) Repo of Government Securities.
5 Except the right to sell
Repos are usually undertaken as a liquidity management tool, and they are often used by central banks as part of their monetary policy. The benchmark interest in some countries is the repo rate. Securities lending is frequently undertaken to allow a broker to make delivery of a security that it may have sold short.
In the 1993 SNA and BPM5, because it was understood that the cash provider did not often have the right to on-sell a security acquired under a reverse repo, it was recommended that repos/reverse repos should be treated as collateralized loans. (Securities lending without cash collateral is not discussed in either document.) However, since 1993, the right to on-sell has become almost universal, and is very frequently exercised. It is this development that has caused the most difficulty in the classification of repos, as the recipient of the security that has been repoed (or lent) will not take it on to its balance sheet, and should the security be on-sold outright, it will result in a negative asset in the instrument involved being recorded7.
In view of the problems that repos and securities lending both pose for statistical measurement — that the ownership change is not recognized, and the two parties can claim ownership to the same security at the same time — the IMF Committee on Balance of Payments Statistics has given extensive consideration to the issue, at many meetings between 1995 and 2003.
Interaction between Daylight Overdrafts and Repurchase Agreements
Here is how the system now works:
A) Insolvent banks pledge their assets to the Federal Reserve during the day in exchange for running enoumous daylight overdrafts.
B) Each night insolvent banks used their assets pledged at the Fed to obtain loans on the "repo" market and pay down their daylight overdrafts.
C) Each morning, insolvent banks repay repo loans with daylight overdrafts, and so on...
At no point in time do these insolvent banks "own" these pledged assets in any sense of the word: at all times the pledged assets are in control of either the Fed or the repo counterparty. Despite this, insolvent banks are allowed to keep all pledged assets on their balance sheet as though they were owned outright.
The Free Library reports how the Federal Reserve allows financial institutions to pledge collateral against their use of daylight overdrafts.
EXPERIENCE WITH THE PAYMENT SYSTEM RISK POLICY: 1986-93
... The peak daylight overdraft can be viewed as the Federal Reserve's maximum intraday credit exposure to all institutions combined, at any particular time during the day; and the average per-minute daylight overdraft is the Federal Reserve's average exposure to all institutions over the course of the day (and is the base upon which daylight overdraft fees are assessed).(7) During the 1986-93 period, peak and average overdrafts both grew at an average annual rate of about 12 percent; in fact, beginning in 1989, overdrafts increased dramatically despite the fact that cap levels had been reduced the year before.
Securities activity on Fedwire appears to have generated much of the rise in overdrafts. Overdrafts related to securities transfers were monitored separately because they were afforded special treatment under the net debt cap policy (as discussed below). Although the method of allocating total daylight overdrafts into a securities-related portion and a funds-related portion is based on an accounting procedure that can be viewed as somewhat arbitrary, the distinction between the two is important to an understanding of the major trends in overdrafts during this period.
Concerns that caps on securities-related overd rafts might disrupt the government securities market led the Federal Reserve to apply net debit caps at the outset to only the portion of daylight overdrafts not related to transfers of securities through Fedwire. Between 1986 and 1993, the size of securities-related daylight overdrafts more than doubled (chart 2), and their proportion of total overdrafts swelled from about one-half to about two-thirds. In early 1988, the Federal Reserve adopted a $50 million limit on the size of securities transfers to discourage "position building" by dealers, a practice that had contributed to overdrafts.(8) Securities-related overdrafts continued to rise, however. In 1991, the Federal Reserve began including securities-related overdrafts within the measure of overdrafts subject to a cap. But the Federal Reserve allowed financially
healthy institutions to exclude securities-related overdrafts from the cap by pledging collateral against those overdrafts, and it mandated pledging of collateral for institutions that breached their cap as a result of frequent and material securities-related overdrafts. Indeed, pledging collateral became standard practice among the small group of securities clearing banks whose customers' activity generated substantial daylight overdrafts. Thus, even after 1991, net debit caps did not have a significant effect on the majority of overdrafts related to securities transfers.
The most likely cause of the sharp rise in securities-related daylight overdrafts during the 1989-93 period was increased activity in the market for repurchase agreements (RPs). Securities dealers commonly use RPs for overnight or very short term financing of the securities they hold. In the case of overnight RPs, the borrower of funds (or the borrower's clearing bank in the case of nonbank dealers) typically delivers securities used as collateral to the lender in the afternoon and at the same time receives funds in return. In the morning the lender of funds returns the securities (collateral) to the borrower (or its bank) and receives its funds in exchange. When the borrower and the lender do not use the same clearing bank, this process involves tranfers of securities against payment via the Fedwire securities transfer system and typically generates overdrafts in the Federal Reserve accounts of the clearing banks. These overdrafts start in the morning and extend into the afternoon, when new RPs are arranged and settled.
No comprehensive measures of RP market activity are available, but data collected by the Federal Reserve on RP positions of primary dealers in U.S. government securities provides an approximate picture of trends in this market. Indeed, the correlation between the growth in dealer RP positions and securities-related daylight overdrafts over the 1989-93 period has been fairly close (chart 3).
The New York Fed reports that a large portion of that percentage consists of overnight contracts.
... When the term is one day, the agreement is referred to as an overnight RP (or "repo" in common parlance); a loan for more than one day is called a term repo. (About 70 percent of RP activity is for contracts maturing within a month, and a large portion of that percentage consists of overnight contracts.) ...
Conclusion: The moral of all this is that:
A) It was out of control money printing by Washington that drove banks into insolvency, not any action on the part of Wall Street.
B) It was Washington that turned the financial system into a ponzi scheme using repurchase agreements and daylight overdrafts rather than deal with the insolvency its money printing created.
I will write in more detail about the fraud of net settlement, daylight overdrafts, and repurchase agreements in later entries.