The minutes of the July/August Federal Open Market Committee (FOMC) meeting indicate the Federal Reserve will renew this autumn its consideration of how to implement monetary policy in the future. The Fed will essentially be deciding whether to conduct policy using a large balance sheet with excess reserves abundant, or a smaller balance sheet with excess reserves scarce. The Fed has noted that an important reason why they may choose to operate policy with a large balance sheet is that, when excess reserves are abundant, the payment system operates more efficiently (see Bech, Martin, and McAndrews (2012) and McAndrews and Kroeger (2016) ). Specifically, when banks and GSEs (only U.S. depository institutions (mostly banks), U.S. branches and agencies of foreign banks, and GSEs have accounts at the Federal Reserve) have a lot of money in their account at the beginning of the day, they are less likely to hold back payments to others while waiting for payments from others to arrive. When banks “throttle” payments in this way, there is the potential for systemic risk in the event of an intraday failure by a participant.
As a result, now seems like a particularly bad time for the Board to make a major change to its Payment System Risk (PSR) policy, which imposes limits and fees on intrabank payments over the Fed’s payment platforms. But last December, the Board proposed lowering significantly the “net debit caps” of the U.S. branches and agencies of foreign banking organizations (FBOs). Net debit caps are the maximum amount of uncollateralized daylight overdraft an institution can incur in its Federal Reserve account. The Fed allows accountholders to run daylight overdrafts because intraday credit “…foster[s] the smooth operation and timely completion of money settlement processes among financial institutions and between financial institutions and FMIs.” U.S. branches and agencies conduct dollar-clearing for their global parent institution. As a result, restrictions on their access to intraday credit at the Fed can have an impact on the payment and settlement of financial transactions worldwide, increasing operational risk.
First, the extraordinary abundance of reserve balances will make it difficult for the Fed to assess the likely impact of its proposed change. The policy would lower the average of all the FBO net debit caps by 57 percent, while 17 FBOs most impacted by the cap would see their caps lowered by an average of 71 percent. While this would seem to be a dramatic change, the Fed noted in its proposal that very few FBOs have used their net debit cap capacity since 2015, and any usage has been small. Of course, the plentitude of reserves certainly was a major driver of that result.
The Fed did attempt to calculate what impact the policy would have had between 2003 and 2007, before QE inflated the Fed’s balance sheet. The Board concludes that…
only four of the 29 FBOs that currently maintain a cap category higher than exempt-from-filing regularly incurred daylight overdrafts that exceeded their projected net debit caps, while five of the 29 FBOs incurred daylight overdrafts that exceeded their projected net debit caps in limited instances. (p. 58768)
While the Fed presents these findings as suggesting limited impact, net debit caps are intended to cover tail events and so would only be expected to be used rarely. So, if more than one third of the FBOs would have been constrained some or most of the time during that time, the proposal would have meaningfully curtailed daylight credit capacity in the event of stress.
Second, tighter net debit caps will force FBOs to throttle payments, pushing payments activity later in the day and raising liquidity and operational risks in the markets. For example, on March 24, 2011 the Fed raised the fee on daylight overdrafts (an action similar to lowering the cap) and, as reported by McAndrews and Kroeger (table 1), payments activity shifted a half hour later in the day. That shift was among the largest and most significant they find in their study on the timing of payments. Thus, the benefits of a large Fed balance sheet in terms of improved payment system performance would be undercut by the proposed PSR policy change.
Lastly, if adopted, the PSR proposal would constrain future monetary policy options for the Fed. Indeed, whether a conscious decision or not, it would join a long list of actions the Board has already taken that skew the choice between a large and small balance sheet toward the former. If FBOs’ daylight credit capacity is reduced, then they will have to start the day with higher balances. To provide those balances the Fed will have to maintain a larger balance sheet. Similarly, the Fed has required banks to hold excess balances to meet liquidity requirements, enabled the Treasury to maintain a more variable account, and is contemplating targeting a broader range of money market rates, all changes that make a large-balance-sheet implementation framework necessary (for a further discussion see my recent remarks here.)
As the Fed allows its balance sheet to gradually decline, it is watching carefully for signs of reserve scarcity. When it reaches that juncture, it will gain important information about the costs and benefits of the different frameworks it is considering. As discussed here, there are some signs of such scarcity already. Rather than adding volatility to the demand for excess reserves by materially changing FBOs’ daylight credit capacity (and so opening balance needs), the Board should first determine where reserve scarcity kicks in and settle on a monetary policy implementation framework. There is no reason why they can’t wait – the current PSR policy was first proposed in 2008 and not adopted until 2011; so there is precedent for deliberation in this area. Given all the balls the Fed currently has in the air, now seems a bad time to toss another into the mix.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.