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A key concern of all lenders is credit risk—the risk of borrowers failing to fully repay loans as expected.
Central banks engage in credit arrangements as lenders to banks, so they can be exposed to this type of risk.
In Fedwire, the Federal Reserve extends daylight overdrafts to banks, an activity that exposes it to some credit risk during the day. Overdrafts are essentially very-short-term credit that enable banks to obtain intraday liquidity by overdrawing on their Fed accounts.
The Federal Reserve’s Payments System Risk policy provides a framework by which the central bank manages its credit risk exposure. The Fed uses a variety of management tools, including overdraft fees, monitoring, an awareness of banks’ reputations, and collateral requirements.
Martin and Mills consider a proposed change to the policy that would allow for an increased use of collateral as a credit risk management tool. Under the proposed change, the Fed would supply intraday balances to healthy banks through collateralized and uncollateralized overdrafts; banks would be able to pledge collateral voluntarily to support intraday overdrafts.
The study outlines potential benefits, as well as costs, associated with the proposal from the perspective of the Fed, banks, and the financial system.
The authors conclude that it may be desirable to use a combination of tools to manage the credit risk associated with the provision of liquidity. However, the relative role of each tool in enforcing credit arrangements should depend on the details of the contractual relationship considered.
About the Authors
Antoine Martin is a research officer at the Federal Reserve Bank of New York; David C. Mills is an economist at the Board of Governors of the Federal Reserve System.
The views expressed in this summary are those of the authors and do not necessarily reflect the position of the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, or the Federal Reserve System.