Senior Financial Officer Survey

The May 1998 Senior Financial Officer
Survey
In recent years, the reserve market and payment system have undergone
significant structural changes. 1 In the reserve market, the proliferation of
retail sweep accounts at banks has led to a dramatic decline in the level of
balances that banks must maintain at the Federal Reserve in order to meet
reserve requirements. Indeed, many institutions are now able to satisfy
their reserve requirement entirely with vault cash. In the past, low levels
of required reserve balances have been associated with increased
volatility in the federal funds rate. But the federal funds rate has not been
especially volatile lately, in part because banks have adapted to the
current low required reserve environment by modifying their reserve
management practices, though a significant number report persisting
difficulties in managing their positions.2 Important changes in the
payment system have been: (i) the imposition of charges for so-called
"daylight overdraft" credit that is extended when depositories overdraw
their Fed account during the course of the business day; and (ii) the
recent extension of operating hours for both Fedwire and CHIPS.
To obtain information on the effects of these developments, the Federal
Reserve conducted a survey of senior financial officers of large
commercial banks in May 1998.3 This document summarizes the findings
of that survey. The survey questions and tabulations of the responses are
included in Appendix A, a glossary of terms is given in Appendix B, and
examples of key reserve concepts are discussed in Appendix C.

Part I: Effects of Recent Changes in Bank Reserves
Part I of the survey included questions covering three basic areas--the
impact of low required reserve balances on bank reserve management
practices, recent changes in banks' behavior in the federal funds market,
and changes in banks' attitudes toward the discount window.
Low Required Fed Account Balances and Bank Reserve
Management Practices
(Questions 1-4)
Question 1 was aimed at determining the added degree of difficulty that

bank funding managers have faced in managing their reserve position in
light of the lower required reserve balances (henceforth, required Fed
account balances).4 Most of the respondents reported that their levels of
required Fed account balances had indeed fallen over the last two years.
About one-third of these institutions reported that the reduction in their
average level of required Fed account balances had not caused them any
increased difficulties in reserve management. Another one-quarter noted
that they had initially experienced some difficulties in reserve
management associated with low required Fed account balances, but also
that they had been able to overcome these difficulties through changes in
their reserve management practices. A significant number of banks said
that their low level of required Fed account balances had presented some
problems and that they still found reserve management more difficult
today than in the past.
Respondents noted several ways in which reserve management had
become more complicated (question 3). A number of respondents said
that low required Fed account balances had reduced the usefulness of
reserve carryover provisions. The Federal Reserve's Regulation D permits
depositories to carry forward surpluses or deficiencies in their reserve
position up to 4 percent of the sum of their total reserve requirement and
clearing balance requirement. The carryover provisions allow an
institution to benefit from a large surplus carried in from a previous
maintenance period by reducing the level of reserves it holds in the
current maintenance period. But if an institution satisfies a large portion
of its reserve requirement with vault cash, it is possible that its maximum
carryover allowance could be large in magnitude relative to its required
Fed account balance. In this case, it may not be able to lower its Fed
account balance much in order to take advantage of a large surplus
carried in because doing so would entail very high risks of incurring an
overnight overdraft.
In a similar vein, many respondents noted that low required Fed account
balances had sometimes made it difficult to benefit fully from positive
"as-of adjustments." Ordinarily, an institution can benefit from such
adjustments--which are used as a means of compensating banks for
accounting or float-related corrections--by lowering the level of its Fed
account balance. Again, for an institution with very low required Fed
account balances, reducing its Fed account balance to take advantage of a
positive as-of adjustment may not be possible because of the heightened
risk of overnight overdrafts as Fed account balances decline.
One way in which banks have responded to such difficulties over time
has been to increase their clearing balance requirement at the Federal
Reserve. Balances held to satisfy this requirement earn implicit interest in
the form of earnings credits that can be used to defray charges for Federal

Reserve priced services.5 Although total clearing balance requirements
have risen considerably during the 1990s, in the past year the aggregate
level of clearing balances has not increased. Many institutions may now
be in a position in which further increases in their clearing balance
requirement would not be profitable. Indeed, many of the respondents
noted that they were not able to increase their clearing balance
requirement much because the current level of their requirements already
generates earnings credits sufficient to cover their typical priced services
charges. Ten assigned a rating of "5" (very significant) to this factor and
another five rated it a "4" (described in this summary as "significant");
nine more assigned a rating of "3" (described here as "moderately
important").
Another significant reserve management difficulty noted by respondents
concerns the treatment of carryover for banks that fully satisfy their
reserve requirement with vault cash--so-called "nonbound" institutions.6
With the proliferation of retail sweep accounts, many depository
institutions now fall in this category, including a number of large
institutions. Such institutions may still hold an excess Fed account
balance or open a clearing balance account in order to facilitate payments
through their Fed account, but these institutions are not eligible for
carryover, and this situation obviously limits their flexibility in managing
reserve balances across maintenance periods. About one-third of the
respondents rated this as a significant or very significant factor
complicating reserve management, and for another one-fifth or so it is
apparently a moderately important consideration.
Another complication for nonbound institutions is that the effective
return they earn on balances held to meet clearing balance requirements
is lowered.7 As a result, they have reduced incentives to expand their
clearing balance requirement. Indeed, anecdotal reports suggest that some
larger banks have chosen to reduce their clearing balance requirement
after they had become nonbound. A total of nine institutions rated this as
a significant or very significant factor complicating reserve management,
and for another six it is a moderately important factor.
To the extent that the various reserve management complications noted
above have impaired banks' ability to arbitrage in the federal funds
market across days in the maintenance period or between maintenance
periods, one might expect to see some pickup in the daily volatility of the
federal funds rate. For example, federal funds rate volatility increased
substantially in early 1991 when required Fed account balances had fallen
very low in the wake of the cut in reserve requirements in late 1990 and
early 1991 (and subsequently returned to prior typical levels).8 On
balance over the last few years, however, there has not been much of a
pickup in funds rate volatility. In part, the lack of substantial increase in

volatility may reflect the fact that banks' reserve management practices
have evolved over time. For example, respondents cited improvements in
their automated systems and increases in the level of their clearing
balance requirements (question 2) as two important ways in which they
had responded to the reserve management complications associated with
low required Fed account balances. The practices of the Federal Reserve
in supplying reserves through open market operations have also evolved
in the last two years. In addition to the usual focus on supplying an
appropriate quantity of reserves on average over the maintenance period,
there is now an increased emphasis on estimating and meeting reserve
needs on each day of the maintenance period, in part through enhanced
reliance by the domestic Trading Desk on overnight--as opposed to term-repurchase agreements.
A number of respondents also noted that low required Fed account
balances had caused them to change their general reserve management
strategy within a maintenance period (question 4). For example, many
institutions reported that they had shifted toward a strategy of "running
short" on reserves for much of the maintenance period and then holding
relatively large reserve positions on the last days of the period in order to
meet reserve requirements. (The Board permits banks to meet their
reserve requirements on average over a two-week maintenance period.)
Given the concerns that respondents had noted in question 3 about the
reduced usefulness of reserve carryover provisions, these responses seem
quite sensible. An institution that builds up a large cumulative reserve
surplus early in the period runs the risk that it will not be able to reduce
that position in the last days of the period. In some cases, institutions can
become "locked in" to a surplus position in the sense that they would
need to run overdrafts in their Fed accounts on the last day or two of the
period in order to eliminate an accumulated surplus. As noted in the
responses to question 3, even if such a surplus could be carried forward, a
bank might not be able to make effective use of the carryover in the
subsequent maintenance period.
Over the latter half of 1997, the aggregate level of excess reserves banks
wished to hold seemed to increase substantially. One hypothesis had been
that this trend might be the result of depositories holding a larger cushion
of excess reserves to reduce the possibility of overdrafts as their level of
required Fed account balances fell. Two banks on the survey indicated
that they had indeed increased their desired level of excess Fed account
balances for this reason (question 2), but most respondents did not report
a significant increase in their desired excess reserves.
Daily Funding Strategies
(Questions 5-7)

These survey questions looked at how banks' intraday behavior in the
federal funds market on both "typical days" and "volatile days" might
have been affected by declines in required Fed account balances. In part,
these questions were motivated by an increased number of instances in
which federal funds have traded quite firm early in the day but ended the
day on a softer note. Such situations have seemed often to coincide with
particular events that can generate sizable payment flows through reserve
accounts, including, for example, settlements for two- and five-year
Treasury note auctions, maintenance period ends, quarter-ends, corporate
tax dates and so forth. One might expect that the larger volume of
payment flows on these days would create heightened uncertainties for
banks about their end-of-day reserve positions and, perhaps, that such
increased uncertainty about end-of-day reserve conditions might lead
some banks to be willing to pay a premium in the federal funds market
early in the day to line up their funding early.
Banks reported in question 5.1 that there was little difference between
typical days and volatile days in terms of how likely they were to be on
the buy or sell side in the federal funds market. Similarly, respondents in
question 5.2 reported little difference in their pattern of federal funds
transactions over the course of a typical day versus that over the course of
a volatile day. Perhaps the premium usually observed in the funds rate on
such days is sufficient to deter the surveyed banks from trying to move
their fed funds purchases earlier in the day.
Responses to question 5.3 indicated that over the last two years, there has
been a marked tendency for trades of federal funds to be more
concentrated toward the end of the day. In question 6, banks reported that
deliveries had become more heavily weighted toward the end of the day
in the last two years as well. Banks said that on both typical and volatile
days, more than 60 percent of their federal funds purchased were not
delivered to their account until after 4 p.m. and that roughly 20 percent
were not delivered until after 6 p.m.
It seems plausible that the shift in federal funds market transactions
toward late in the day might, in part, reflect the combined effects of low
required Fed account balances and payment system risk policies such as
charges for daylight overdraft credit and monitoring of intraday credit
usage against daylight overdraft caps. With a smaller cushion of Fed
account balances, institutions might have a greater incentive to hold on to
their federal funds purchased from the previous day as long as possible in
order to guard against daylight overdraft charges and cap breaches. This
behavior on the part of federal funds buyers, in turn, might lead sellers of
funds to be more cautious in committing to transactions early in the day
until they are sure that funds lent on the previous day will be returned.

Given that most federal funds deliveries seem to be made quite late in the
day, question 7 inquired about banks' need and ability to arrange for an
expedited delivery of federal funds if necessary. Most banks reported that
they either almost never have a need for an expedited delivery of federal
funds or that they are almost never able to arrange such a delivery.
However, several banks reported that they are either sometimes or
frequently able to arrange such early deliveries. Not surprisingly, these
banks reported that they typically have to pay a premium of a few basis
points to arrange an early delivery. Presumably, the maximum premium
that a bank would be willing to pay for an early delivery of federal funds
would be a fraction of the Federal Reserve's fee for daylight overdraft
credit. For example, the maximum premium that a two-hour early
delivery of federal funds purchased should be worth would be the current
daylight overdraft fee of 36 basis points multiplied by 1/12 (2 hrs/24 hrs
per day) or about 3 basis points. Conceivably, an institution might be
willing to pay more than this for an early delivery if it were especially
concerned about the potential for a daylight overdraft cap breach and the
associated nonpecuniary penalties.
Attitudes Toward the Discount Window
(Question 8)
In principle, the discount window should play an important role in
helping the money market adapt to day-to-day imbalances in reserve
supply and demand. However, beginning in the mid-1980s, banks
appeared to become quite reluctant to turn to the discount window out of
concerns that it would be perceived by regulators and others as a sign of
financial weakness.9 As noted in the May 1996 Senior Financial Officer
Survey, many banks remained concerned that discount officers, federal
regulators, and market participants would view turning to the discount
window as a sign of distress.
One might have expected the recent strength in the economy and banking
system to help dispel fears about usage of the discount window. In
addition, the Federal Reserve, in its communications with banks, has
noted that the discount window is available in appropriate circumstances
to meet unexpected funding needs.10 These factors probably help to
explain the responses to question 8. About one-third of the banks reported
that they had become either somewhat or considerably more willing to
borrow from the discount window over the last two years, and none
indicated that they had become less willing to borrow. Of those that
indicated an increased willingness to borrow, most reported that they had
become less concerned that the Federal Reserve and other federal
regulators might view borrowing negatively, and a number reported that
they had become less concerned that the market would view borrowing as
a sign of weakness.

Part II: Effects of Possible Changes in Reserve Market
Structure
Part II of the survey focused on banks' hypothetical responses to various
proposed and imminent changes in reserve market structure. The first set
of questions asked banks to consider the potential effects if the Federal
Reserve were allowed by statute to pay interest on Fed account balances
applied against reserve requirements or on excess Fed account balances.
In addition, banks were asked about their likely response if the Federal
Reserve were allowed to pay interest on reserves and if they could pay
explicit interest on demand deposits. A second set of questions asked
banks about the likely impact on their reserve management practices of
the imminent transition to lagged reserve requirements.11 A third set of
questions asked banks to consider how they might react if the Federal
Reserve were to restructure its discount window as a Lombard credit
facility.12 In this structure, the discount rate would be set above the
expected typical level of short-term market interest rates, but banks
would be subject to little of the administrative scrutiny that currently
comes with borrowing at the discount window.
Payment of Interest on Fed Account Balances and Demand Deposits
(Questions 9-12)
The Federal Reserve has long supported proposals that would allow it to
pay interest on some reserves. One common version of such proposals
would allow the Federal Reserve to pay interest on Fed account balances
applied against reserve requirements (question 10). Presumably, this
policy would sharply reduce the incentives for banks to implement new
retail sweep programs. Several banks said that receiving interest on
required reserves would prompt them to dismantle their sweep programs,
either immediately or eventually, presumably because of the operational
costs associated with such running programs. More than half of the banks
responded, though, that they would continue to seek ways to reduce their
required reserves even if required Fed account balances earned interest
close to the federal funds rate because they believed that they could earn
higher returns on alternative investments. Nonetheless, the results on this
question seem qualitatively different from the responses to a similar
question on the May 1996 Senior Financial Officer Survey. On that
survey, about two-thirds of the respondents indicated that they would
dismantle their retail sweep programs either immediately or over time if
interest were paid on Fed account balances held to meet reserve
requirements.
In other potential responses to the payment of interest on reserves, about

one-half of the banks noted that they would be quite likely to try to
economize on vault cash in order to meet a larger portion of their reserve
requirement with interest-earning Fed account balances. A number of
banks reported that they might develop new types of transaction accounts
designed to lure back customers that had shifted their deposits to money
market mutual funds.13 And a few banks reported that they would be
likely to pursue funding by pledging private securities in repurchase
agreement (RP) transactions. Currently, banks that borrow in the RP
market for less than seven days using anything other than government
and agency securities must classify the liability as a demand deposit that
is subject to reserve requirements. As a result, this form of financing is
not currently attractive to banks because of the costs of holding noninterest-bearing reserves to satisfy the associated reserve requirements.
Question 11 considered how banks might respond if the Federal Reserve
were to pay interest--albeit at a below-market rate--on excess reserves.
Not surprisingly, a number of banks indicated that they might hold
somewhat higher levels of excess reserves. Some banks also indicated
that they might tend to meet a larger portion of their reserve requirement
early in the maintenance period because the cost of winding up with a
large positive excess reserve position would be reduced. However, most
banks expected that receiving interest on excess reserves would not affect
their maintenance period average level of excess reserves or their pattern
of excess reserve holdings over the maintenance period.
In some countries, the payment of interest on excess reserves has been
used as a device to establish a lower bound on the interbank interest rate.
The interest rate on excess reserves acts as a lower bound because banks
would not be inclined to lend reserves in the market at a rate below what
they can earn on balances held at the central bank. Not surprisingly, most
banks indicated in the survey that they would be quite reluctant to lend in
the federal funds market at a rate below that offered by the Federal
Reserve on excess reserves. However, a few banks noted that they might
be willing to sell federal funds at a rate below that offered on excess
reserves if it helped them to reduce an especially large excess Fed
account balance. These institutions expressed concern that a large excess
Fed account balance might be viewed by the Federal Reserve or their
own senior management as a sign of poor account management.
Question 12 asked banks about their likely pricing strategies for demand
deposits in a world in which the Federal Reserve paid interest on Fed
account balances applied against reserve requirements and in which
banks could pay interest on demand deposits. Most banks responded that
it was unlikely that they would pay a single rate on all demand deposit
accounts. Rather, they indicated it was possible or likely that they would
establish a tiered-rate schedule in which accounts with higher balances

would earn higher rates of interest. A number of banks also noted that it
was likely that the highest-tier rate on demand deposits would still be
considerably below the level of market interest rates.
The pricing strategy that banks would adopt in this scenario would have
important implications for how large an increase in demand deposits
might be expected. For example, banks on the survey in aggregate
reported that, over the first quarter of this year, they swept more than $90
billion in demand deposit balances on average at the end of the day into
market instruments such as RPs, Eurodollars, and money market mutual
funds. If banks elected to pay an attractive return on high-balance
demand deposits, commercial customers might choose to unwind some of
their sweep arrangements in favor of simply holding higher demand
deposit balances. The respondents expected that about 30 percent of their
commercial sweep arrangements would unwind in favor of interestbearing demand deposits.14 If so, the resulting increase in demand
deposits and required reserves would be considerable. If 30 percent of the
respondent banks' swept balances were instead held as demand deposits,
the level of demand deposits at the sample banks would rise by about $27
billion which, in turn, would imply about a $2.7 billion dollar rise in their
required reserves. Extrapolating from this figure for the respondent banks
to the entire banking system is difficult. The sample banks account for
about 40 percent of all bank assets and about 35 percent of all bank
demand deposits, but they probably account for a larger share of all
commercial balances swept because the sample includes many of the
largest banks in the country. It seems reasonable to infer that the
aggregate increase in demand deposits might be as large as twice that for
the sample, or roughly $60 billion.15
Another important policy issue associated with allowing banks to pay
interest on demand deposits is the extent to which banks would incur
increased costs and lower profits. The responses to question 9 suggest
how banks' short-run costs might be affected. Respondents noted that
about 60 percent of their total demand deposits were held by businesses.
In addition, about 60 percent of business demand deposits were held
under compensating balance arrangements or under the terms of a
commercial loan agreement. These ratios appear roughly consistent with
historical information from the Demand Deposit Ownership Survey and
from the January 1988 Senior Financial Officer Survey.16 The remaining
40 percent of business demand deposits, which are not held under some
form of contractual agreement, was about evenly split among small,
medium-sized, and large businesses.
Presumably, banks would not have to pay much if any interest on the 25
percent or so of demand deposits currently held by individuals because
these individuals already have the option of establishing interest-bearing

checking accounts and have simply chosen not to do so, perhaps because
fees would make such a change unattractive. Banks might have to pay
interest on business demand deposits, but they would not incur much of
an increased cost in paying explicit interest on the reported 60 percent of
business demand deposits held under compensating balance arrangements
because these balances already earn implicit interest through earnings
credits. Banks might experience some increased costs in paying interest
on the 40 percent or so of business demand deposits that are not held
under compensating balance arrangements. However, as noted above,
about 70 percent of these balances were reported to be held by small and
medium-sized businesses. Such firms probably would not hold very large
demand deposit balances and hence probably would not earn a market
rate of interest on their deposits. Even current business savings account
rates, for example, tend to be well below the level of short-term market
interest rates. Presumably, banks would not pay more on a low-balance
business demand deposit than they currently offer on business savings
deposits.
In summary, it seems that banks would incur a short-run increase in costs
if they were allowed to pay interest on demand deposits. The extent of
this increase, however, would probably be muted considerably by a
tiered-deposit rate schedule and by the fact that a substantial proportion
of demand deposits already earn implicit interest. In the long run, the
effects of allowing banks to pay interest on demand deposits would
almost certainly be salutary by removing a significant regulatory
distortion and by encouraging increased competition and efficiency in the
banking industry.
Lagged Reserve Requirements17
(Question 13)
Recently, the Board approved a proposal to implement a system of lagged
reserve requirements effective with the maintenance period beginning
July 30, 1998.18 About three-quarters of the respondents to question 13
indicated that this plan would appreciably reduce the overall uncertainties
involved in managing their reserve position and would be helpful in
managing reserves more effectively with low required Fed account
balances. These responses are consistent with public comments received
from banks on the Board's proposal to move to a system of lagged reserve
requirements. Less than half of the banks indicated that the reduced
uncertainty with lagged reserve requirements might lead them to hold
somewhat lower excess Fed account balances on average over the
maintenance period and would also lead them to meet a larger portion of
their reserve requirement early in the maintenance period.
Lombard Credit Facility

(Question 14)
From time to time, various observers have considered whether the
Federal Reserve should restructure the discount window as a Lombard
credit facility.19 The discount rate for such a facility would be set above
the expected typical level of short-term market interest rates, and banks
would be able to borrow from it with relatively few administrative
constraints. This structure would tend to place an upper bound on the
federal funds rate because banks would be unwilling to pay a higher rate
on funds purchased in the market than they would pay in borrowing from
the Lombard facility.
About three-quarters of the respondents indicated that they would be
quite willing to borrow from such a facility on any day when the federal
funds rate moved above the Lombard credit rate. However, a few banks
indicated that they would not be willing to use such a facility in these
circumstances. Moreover, about one-quarter of the respondents noted that
they would be concerned that borrowing from such a facility might be
viewed negatively by the Federal Reserve. A somewhat smaller
proportion indicated concerns about perceptions by other market
participants. Many respondents noted that their willingness to use such a
facility would depend, to varying degrees, on overall financial conditions
in the economy and their bank's own financial condition.
Judging from these responses, it seems that even if the discount window
were restructured as a Lombard credit facility, there would still be some
lingering reluctance to borrow from the Federal Reserve, weakening its
effectiveness in setting an upper bound on the federal funds rate. In
addition, a number of administrative and policy concerns would
complicate the actual implementation of this option. As noted previously,
this option is not under active consideration by the Federal Reserve.

Part III: Effects of Recent and Potential Changes in Payment
System Policies
Part III of the survey focused on banks' responses to certain policy and
operational changes in the payment system. Questions 15 and 16 were
aimed at determining the extent and nature of banks' participation in
expanded operating hours of the Fedwire and Clearing House Interbank
Payments System (CHIPS) large-dollar funds transfer systems. Questions
17-19 were targeted at banks that participate in both systems and inquired
about the factors that influence whether banks send large-dollar payments
on Fedwire or CH.IPS. Questions 20-24 asked about banks' responses to
the April 1994 implementation of the 24 basis point daylight overdraft
fee (annual rate) and the fee increase to 36 basis points in April 1995.20

The May 1996 Senior Financial Officer Survey included a question about
banks' response to the daylight overdraft fee. The 1998 survey obtained
more detailed responses on this topic and also attempted to determine
banks' response to a hypothetical further increase in the daylight overdraft
fee.
Expanded Fedwire and CHIPS Operating Hours and Payment
System Choice
(Questions 15-19)
On December 8, 1997, the Fedwire funds transfer system and CHIPS
began operating at 12:30 a.m. ET. Formerly, the systems opened at 8:30
a.m. and 7:00 a.m. ET, respectively.21 The Federal Reserve expected that
the number of banks sending Fedwire transfers during expanded hours
initially would be limited to a small subset of Fedwire participants that
initiate the bulk of Fedwire dollar value, but that eventually more banks
would elect to send transfers during early hours. The survey responses are
consistent with this expectation. Ten banks, representing about onequarter of the survey respondents, indicated that they are sending funds
transfers during expanded Fedwire hours (question 15.1).22 Eleven other
banks indicated they are considering sending transfers during expanded
hours at some future time (question 16.2). Of the survey banks that are
CHIPS participants, over one-half reported sending transfers during
expanded CHIPS hours.
One of the primary determinants of the length of expanded Fedwire
operating hours was the Federal Reserve's desire to provide sufficient
overlap of Fedwire with the banking days in European and Asian
markets. As a result, the Federal Reserve expected that banks would use
expanded hours mainly to send payments related to international
transactions, for example, to settle dollar payment instructions received
from international affiliates or respondent banks. Anecdotal evidence
received from a few large Fedwire users in the weeks following the initial
extension of Fedwire hours, however, indicated that a large number of
transfers sent during expanded hours were domestic commercial
payments. The survey results confirm this evidence in that the majority of
banks reported that their expanded hour Fedwire payment activity is
characterized by a mix of domestic- and international-related payments
(question 15.2). The same result was reported by the majority of CHIPS
participants, although these banks reported sending a slightly greater
volume of international-related payments (question 15.3).23
Banks' use of expanded hours to conduct a variety of payment activity
seems to indicate that a longer operating day has enhanced processing
efficiency for these banks. Indeed, the banks participating in expanded
Fedwire or CHIPS hours rated increased operational efficiency as a fairly

important result of longer operating hours (question 16.1). Banks also
rated enhanced opportunity for payment innovation and the possibility for
earlier settlement of the dollar leg of foreign exchange contracts as
important effects of expanded hours. These effects are consistent with the
Federal Reserve's intended public policy goals for expanded funds
transfer operating hours.24
The degree of substitutability between Fedwire and CHIPS has long been
of interest to the Federal Reserve in the context of payment system risk
policy, as the Federal Reserve is concerned about the extent to which
payment system policies increase implicit Fedwire costs and thus might
prompt banks to shift large-dollar payment volume from Fedwire to
systems that do not settle payments on a real-time basis in central bank
money. Survey questions 17-19 were aimed at determining current usage
of Fedwire and CHIPS by banks that participate on both systems and
factors that influence choice of system.
Banks that use Fedwire and CHIPS indicated that they send about twothirds of their large-dollar payment value on Fedwire compared with
about one-third on CHIPS (question 17). However, banks in the New
York District reported the reverse; they reported sending one-third of
payment dollar value on Fedwire and two-thirds on CHIPS. These
percentages should be interpreted with some degree of caution because
banks' ability to send payments on CHIPS is limited by the extent that
receiving banks are CHIPS participants.
On average, respondents indicated that the most important factors in
choice of system are customer request and type of payment (for example,
fed funds payments, commercial payments, payments for international
transactions) (question 18). Banks rated price and the desire to minimize
daylight overdrafts as the least important factors. This ranking suggests
that the distinguishing characteristics of Fedwire and CHIPS, such as
real-time gross settlement versus net settlement and network size, make
the systems less than perfect substitutes. Another distinguishing
characteristic may be system-enforced limits on payment activity, as over
one-half of CHIPS participants reported that bilateral and net debit limits
constrain their CHIPS payment activity to some degree (question 19). By
contrast, internal Federal Reserve daylight overdraft data indicate that
most large Fedwire participants rarely reach their debit cap limits on any
given day.
Response to Daylight Overdraft Charges
(Questions 20-24)
After the implementation of daylight overdraft charges in April 1994, the
aggregate level of peak and average daylight overdrafts immediately

decreased by 40 percent. The most dramatic and widely expected
response to fees came from the primary dealers in government securities
that modified their financing practices. These modifications resulted in a
decrease in the level and duration of securities-related overdrafts in the
Fed accounts of the banks that provide clearance and settlement services
to the primary dealers.25 The Federal Reserve was interested in other
actions that banks may have taken in response to the fee, in particular
actions that may have affected overdrafts caused by funds transfer
payments. Therefore, the May 1996 survey asked banks the extent to
which they had taken certain measures to reduce daylight overdrafts.
Banks on that survey reported that they had delayed sending funds
transfers and, to a lesser extent, purchased federal funds earlier in the day
as a means of avoiding daylight overdrafts.
Although the 1998 survey contained a longer list of potential actions
taken by banks, responses to the 1998 survey were similar to those in
1996. One-half of the banks stated that daylight overdraft fees affected
their account management practices (question 21) and that the most
significant actions they took in response were to modify federal funds
transactions delivery practices and to delay payments until sufficient
account cover is available (question 22). Also similar to the 1996 survey,
other expected responses, such as increased use of securities netting
arrangements, increased use of term or continuing contract federal funds
and RP contracts, and shift of payment volume from Fedwire to CHIPS,
were not reported as significant actions taken in response to daylight
overdraft fees.26
The 1998 survey also asked to what extent banks had taken certain
actions in response to the 50 percent increase in the fee in April 1995. In
the weeks following the fee increase, the impact on aggregate overdrafts
was unclear. Subsequent econometric analysis indicated that while the
long-run effect of the fee increase on aggregate overdrafts may have been
more significant than initially thought, the impact was not nearly as large
as in 1994.27 The results from the 1998 survey appear to be consistent
with that analysis: Banks reported a slight marginal response to the fee
increase in the form of payment delays, shifting volume from Fedwire to
CHIPS, increased use of term or continuing contract federal funds and RP
contracts, and charging customers for overdrafts. Not surprisingly, banks
reported that all of the potential responses to fees identified would be
more likely if the fee were increased by another 50 percent.
Various analysts have hypothesized that an intraday market for funds
might develop as a result of daylight overdraft fees, as banks might find
borrowing and returning funds during the day from private counterparties
less costly than charges for Federal Reserve intraday credit.28 To date, it
does not appear that such a market is emerging. Respondents reported

that several factors currently impede an intraday funds market. Concerns
about efficiency, in terms of the ability to ensure timely intraday delivery
and receipt of funds, were rated as the most dominant factors (question
23). Transaction and interest costs were also rated as fairly important
barriers to an intraday market. Respondents indicated that a relatively
large increase in the daylight overdraft fee may lead to the development
of such a market (question 24).

Complete report (171 KB PDF)
Notes
1. Many of the reserve market issues addressed in the survey were
discussed by Governor Lawrence H. Meyer on March 3, 1998, in
testimony before the Senate Committee on Banking, Housing, and Urban
Affairs. Return to text
2. Volatility has also been contained by changes in open market
operations to adapt to low reserves. Return to text
3. The Federal Reserve surveyed forty-four large commercial banks, with
respondents selected from each Federal Reserve District. The mean asset
size of the survey banks is $40 billion, and total assets of the survey
banks account for about 40 percent of all commercial bank assets. In
addition, these institutions account for 40 percent of aggregate required
reserves and 36 percent of aggregate balances held at the Federal
Reserve, including required reserve balances, excess reserves, and
required clearing balances. Ninety percent currently have retail sweep
programs in place. Given the nature of the sample, the results are most
indicative of large bank behavior. Return to text
4. Required Fed account balances plunged in early 1991 following the
reduction in the reserve requirement ratio for nontransaction accounts
from 3 percent to zero in December 1990. For the next couple of years,
required Fed account balances grew slightly, followed by a steady decline
brought on by the start of retail sweep account programs in 1994. Return
to text
5. Balances in such accounts also can be lowered in response to a positive
as-of adjustment. Return to text
6. During the first four months of 1998, about three-quarters of the survey
banks were bound on average in a given maintenance period. Return to
text

7. The implicit return that institutions receive on their clearing balance
requirement is equal to the effective federal funds rate over the
maintenance period adjusted by an imputed reserve adjustment factor.
The latter is intended to ensure that the earnings credit rate on a clearing
balance requirement does not exceed the total return that a bank would
earn if it held its clearing account with a correspondent bank rather than
the Federal Reserve. The adjustment includes a "deduction" of 10
percent, representing the assumed marginal reserve requirement of the
correspondent bank, and a "credit" of the bank's own marginal reserve
requirement. Thus, if the bank itself has a 10 percent marginal reserve
requirement, the reserve adjustment factor is equal to one and the bank
earns the full federal funds rate on balances held to satisfy its clearing
balance requirement. However, when an institution becomes "nonbound,"
its marginal reserve requirement is set at zero in the reserve adjustment
factor, and hence it earns only 90 percent of the federal funds rate on
balances held to satisfy its clearing balance requirement. Return to text
8. For a general discussion of this episode and the connection between
low required Fed account balances and funds rate volatility, see the
articles by Joshua N. Feinman, "Reserve Requirements: History, Current
Practice, and Potential Reform," Federal Reserve Bulletin, vol. 79 (June
1993), pp. 569-89, and Cheryl L. Edwards, "Open Market Operations in
the 1990s," Federal Reserve Bulletin, vol. 83 (November 1997), pp. 85974. For analytical discussions of low required Fed account balances and
federal funds rate volatility, see James A. Clouse and Douglas W.
Elmendorf, Declining Required Reserves and the Volatility of the Federal
Funds Rate, Finance and Economics Discussion Series 1997-30 (Board
of Governors of the Federal Reserve System, 1997-30); and also Gordon
H. Sellon Jr. and Stuart E. Weiner, "Monetary Policy Without Reserve
Requirements: Analytical Issues," Economic Review, Federal Reserve
Bank of Kansas City, vol. 96, no. 4 (1996), pp. 5-25. Return to text
9. For a discussion of trends in discount window borrowing behavior, see
James A. Clouse, "Recent Developments in Discount Window Policy,"
Federal Reserve Bulletin, vol. 80 (November 1994), pp. 965-77. Return
to text
10. Banks' reluctance to borrow at the window was especially acute in the
early 1990s. In February 1991, Chairman Greenspan noted in his
semiannual testimony to Congress under the Full Employment and
Balance Growth Act of 1978 (the Humphrey-Hawkins Act) that the
discount window, as always, was available to meet the short-term
liquidity needs of depository institutions in appropriate circumstances.
Given the findings in the May 1996 Senior Financial Officer Survey
indicating that banks remained quite reluctant to turn to the discount
window, Reserve Bank staff have met with officials of many depository

institutions as well as with other federal regulators in an effort to dispel
misperceptions about the use of the discount window. Return to text
11. The notice of proposed rulemaking was published in the Federal
Register, 62 Fed. Reg. 60671 (November 10, 1997). The final rule was
approved by the Board of Governors on March 24, 1998. Under the
lagged reserve requirement system, depositories will maintain reserves
over a two-week maintenance period based upon their average level of
transaction deposits over a two-week computation period. The
maintenance period begins on the third Thursday following the Monday
end of the computation period. Return to text
12. Such a change is not under active consideration by the Federal
Reserve. Return to text
13. Presumably banks would try and lure back household customers, as
the ability to lure back business customers would be limited without
interest on demand deposits. Return to text
14. Even with an attractive rate of interest offered on demand deposits,
there may be reasons for the continuation of commercial sweep
arrangements. For example, firms might be more comfortable sweeping a
large balance into an RP rather than holding it as a demand deposit
because only the first $100,000 in a demand deposit would be insured
while balances in an RP agreement would be fully collateralized.
Moreover, there are apparently important tax considerations for some
firms (and banks) in booking deposits as a deposit at the foreign office of
a U.S. bank rather than as a domestic demand deposit. See, for example,
the discussion in Marcia Stigum, The Money Market (Dow Jones-Irwin,
1990), pp. 276-78 or Banking and Finance in the Cayman Islands (Peat,
Marwick, Mitchell & Co., 1988). On the other hand, as a result of the
depositor preference provisions of the Omnibus Budget Reconciliation
Act of 1993, Eurodollar deposits have a lower priority in bankruptcy
proceedings than domestic deposits, which might be a factor at the
margin that would encourage corporate customers to move overnight
Eurodollar deposits back as domestic demand deposits. In addition, banks
may have some incentives to maintain commercial sweep arrangements
as well. For example, RPs and Eurodollar liabilities are not included in
the assessment base for deposit insurance premiums while demand
deposit balances are. Also, sweeps into money market mutual funds
effectively reduce the size of the bank's balance sheet and hence boost its
regulatory capital ratios. Return to text
15. Of course, the ultimate increase in demand deposits in this scenario
could be considerably higher. For example, interest on demand deposits
might cause businesses to shift funds out of savings accounts or money

funds and into demand deposits. In addition, if banks began to pursue
overnight RP funding using private securities as collateral as noted in
question 10, aggregate demand deposits would increase. Finally, banks
might convert some of their overnight federal funds sold position to
overnight demand deposits. Interbank deposits are not included in the
monetary aggregates, so this conversion would not have any effect on M1
or M2. However, interbank transaction deposits are reservable so the
conversion of overnight federal funds to overnight demand deposits
might boost aggregate required reserves to the extent that the marginal
reserve requirement for banks "lending" overnight demand deposits, and
hence able to deduct such "due from" deposits from reservable liabilities,
was lower on average than the marginal reserve requirement for banks
receiving such "due to" demand deposits. Return to text
16. In the past, the Federal Reserve obtained information on the holders
of demand deposits from the Demand Deposit Ownership Survey
(DDOS), but the DDOS was discontinued in 1990. Results from the
January 1988 Senior Financial Officer Survey were discussed in Patrick
I. Mahoney, "The Recent Behavior of Demand Deposits," Federal
Reserve Bulletin, vol. 74 (April 1988), pp. 195-208. Return to text
17. Discussion and debate over the merits of various forms of reserve
requirements including lagged and contemporaneous reserve
requirements have a long history. See, for example, Joshua N. Feinman,
"Reserve Requirements: History, Current Practice, and Potential
Reform," Federal Reserve Bulletin, vol. 79 (June 1993), pp. 569-89; or
William Poole and Charles Lieberman, "Improving Monetary Control,"
Brookings Papers on Economic Activity (1972:2), pp. 293-335. Return to
text
18. For more information see the notice of final rule in the Federal
Register, 63 Fed. Reg. 15069 (March 30, 1998), which includes a
background discussion. Return to text
19. See for example, John Wenninger, "Alternative Approaches to
Discount Window Lending," in Reduced Reserve Requirements:
Alternatives for the Conduct of Monetary Policy and Reserve
Management (Federal Reserve Bank of New York, 1993), pp. 137-68; or
Milton Friedman, "Monetary Policy: Theory and Practice," Journal of
Money, Credit and Banking, vol. 14 (February 1982), pp. 98-118. Return
to text
20. The daylight overdraft fee is often quoted as an effective annual rate.
The annual rate is converted to an effective rate by multiplying it by the
fraction of the day that Fedwire operates. The current effective rate is 27

basis points (36 x 18/24). Return to text
21. Fedwire and CHIPS closing times (6:30 p.m. and 4:30 p.m. ET,
respectively) did not change. Return to text
22. Internal Federal Reserve data indicate that about 100 Fedwire
participants, representing about one percent of all participants, send
transfers during expanded Fedwire hours. Of these 100, a core group of
about 40 banks send transfers during early hours each day: The remaining
banks participate intermittently. Return to text
23. This result is consistent with historical payment patterns on CHIPS
and Fedwire. Typically, payments related to international transactions are
proportionally more of total transfers on CHIPS than on Fedwire. Return
to text
24. See 59 Fed. Reg. 8981 (February 24, 1994). Return to text
25. For further information, see Heidi Willman Richards, "Daylight
Overdraft Fees and the Federal Reserve's Payment System Risk Policy,"
Federal Reserve Bulletin, vol. 81 (December 1995), pp. 1065-77. Return
to text
26. In securities netting arrangements, such as those provided by the
Government Securities Clearing Corporation and Delta Clearing
Corporation, obligations resulting from the delivery and receipt of
securities transactions among a group of participants are netted down to a
single amount owed to or from each participant in the
arrangement. Return to text
27. See Diana Hancock and James A. Wilcox, "Intraday Management of
Bank Reserves: The Effects of Caps and Fees on Daylight Overdrafts,"
Journal of Money, Credit, and Banking, vol. 28, part 2 (November 1996),
pp. 870-909. Return to text
28. See David B. Humphrey, Payment Systems: Principles, Practice, and
Improvements, Technical Paper 260 (World Bank, February
1995). Return to text
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