Mooning over daylight overdrafts

Every few days for the last month or so I've been refreshing a Federal Reserve page that shows data about daylight overdrafts. For some reason the Fed only updates it every few months. I had been getting quite curious to see what happened during the great September interest rate spike. Well, finally the Fed has uploaded the data.

If you don't know about the September rate spike, I'd suggest reading Nathan Tankus's tweet, listening to David Beckworth's podcast with Bill Nelson, or picking through this blog post from Stephen Cecchetti and Kermit Schoenholtz. In short, there was a sudden increase in the demand for Fed balances (also known as reserves), and the Fed was slow to react by increasing the supply of balances. And so the rate at which banks were willing to borrow balances spiked to desperation levels.

Why did the demand for balances increase?

That's where daylight overdrafts can inform us. By way of background, the Fed has had a long-standing policy of providing banks with daylight overdrafts. These are loans that last a few minutes or hours and are always paid back by the end of the day.

Why overdrafts? Banks often have to make large and unexpected payments to other banks on behalf of their customers. To facilitate this, banks keep balances on hand in payments accounts held at the Fed. For instance, say that Microsoft wants its bank to wire $200 million to Google. Microsoft's bank tells the Fed to debit its account and credit the account of Google's bank by $200 million.

But say Microsoft's bank only has $50 million in its Fed account. How can it make good on Microsoft's request? No problem. It gets a $150 million overdraft from the Fed. Combined with the $50 million it already had, it can now make the $200 million payment to Google's bank. Microsoft and Google are square, but Microsoft's bank still owes the Fed $150 million. Over the course of the day, Microsoft's bank may get enough incoming payments from other banks to settle up. (Or it may have to sell some assets to pay back its overdraft, or borrow from another bank to make good with the Fed).

Banks have to pay a fee for each minute that they borrow from the Fed. They can avoid this fee by providing collateral to secure the loan. Collateralization protects the Fed from fallout should a bank that is in overdraft go bankrupt. Either way, overdrafts are costly to banks. Fees must be coughed up or collateral sacrificed.

In the 2000s, the Fed kept a tight lid on the supply of balances it issued. Banks couldn't keep very much money in their Fed accounts--there just wasn't that much of it. So there was a big demand to get daylight overdrafts from the Fed to facilitate payments like the one between Microsoft and Google.

But during the credit crisis, the Fed created a massive amount of balances. Suddenly, banks could (and did) keep a lot of money at the Fed. And so when Microsoft wanted to pay Google $200 million, Microsoft's bank just didn't have to rely on overdrafts anymore. Odds were that it already had the money in its account. Overdraft usage cratered, as the chart below illustrates. Whereas peak Fed daylight overdrafts typically came in near $250 billion in 2008, by 2013 peak borrowing by banks typically registered below $10 billion.

(Note, to bring out the data I have used a log scale for this chart, which may not entirely convey the degree to which overdraft usage collapsed.)

Which leads back to the September jump in demand for Fed balances. One potential explanation is that banks are concerned about holding sufficient liquidity in anticipation of customer payment requests. Perhaps banks are running into more situations in which they can't immediately satisfy Microsoft's request to pay $200 million to Google, and so they want to build up the amount of balances they keep in their accounts at the Fed.

But if this was the case, we'd also expect to see a big jump in overdrafts. After all, overdrafts are an alternative way for Microsoft's bank to satisfy Microsoft's payment requests. The chart above shows that peak daylight overdrafts clocked in at $19 billion during the two-week period ending September 25, the highest level since 2013. But that's still a tiny amount compared to $250 billion in 2008.

So the big jump in the demand for Fed balances probably arises from something other than a desire on the part of banks to facilitate routine intraday payments flow. Banks still aren't making much use of daylight overdrafts, a good indication that they still have plenty of balances on hand for transactional purposes. Other motivations must be behind the demand for Fed balances, presumably various regulations that might not have existed in 2008 or increase supervisory expectations.

Should we have to line up for money or not?

I finally had some time to read George Selgin's excellent Floored! over the Christmas holiday.

Some family members saw me reading the book and asked me what it was about. The subject that George is tackling—two types of central bank operating systems—is quite technical, so I wasn't sure how to break it down for them. But in hindsight, here's how I would go about it. I'm going to explain what the issues are in terms of an instrument we all use and understand: good ol' fashioned banknotes. 

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Imagine that when you go to your bank this morning to withdraw $200 in cash, you can only get $100 out of the ATM. The bank manager says that it is expecting another shipment of cash later in the day, so come back then. But be early, he warns, since a lineup is sure to develop.

What explains this odd situation? The central bank has started to ration the amount of banknotes it issues. For instance, the Bank of Canada currently supplies Canadians with $85 billion in banknotes. But say it has decided to only provide half that, $45 billion.

A world in which banknotes are rationed would be very different from our actual world. When we march up to an ATM, we are accustomed to getting as much cash as we want. If everyone in my neighbourhood were to suddenly decide that they wanted to cash out their bank accounts, the Bank of Canada will print whatever amount of currency is necessary to meet that demand. Central bank don't keep cash scarce, they keep it plentiful.

Strange things happen in a world with rationed cash. Imagine that everyone wants to hold $200 in banknotes in their wallet but can only get $100 from the ATM. Further, assume that people need to hold a bit of cash because certain transactions can only be consummated with banknotes. To cope with this chronic cash shortage, a spare-cash market will emerge. For a fee, those who have a bit of extra cash on hand will lend to those who are short.

The spare-cash market would look a bit like this. To top her existing cash balance of $100 up to her desired $200, Jill makes a deal with Joe to lend her $100 in cash. She provides security for the loan by transferring $100 from her bank account to Joe's bank account. A day later Jill repays Joe with $100 in banknotes, and he returns her $100 security deposit, less a $1 fee. Jill has effectively paid $101 to get $100. Or put differently, she has paid Joe 1% in interest to get $100 in cash for a day.

We could even imagine informal person-to-person trading posts springing up outside of popular ATMs where those who are short of cash meet up with lenders like Joe who specialize in locating and lending spare cash. An Uber-style app would be created where the credit history of borrowers are documented, reducing the risk to lenders. People might be able to order up cash from home, delivered by bike courier.

The spare-cash market that I've just described is not a market we are accustomed to. As I said earlier, central banks keep cash plentiful. But it's similar to another market we are all familiar with: the secondary market for concert tickets. Tickets are necessarily rationed because there are only so many seats in a concert venue. Professional ticket scalpers line up ahead of time and buy these tickets so they can on-sell them at a premium.

Like the scalped ticket market, the spare-cash market is a natural response to scarcity. Those who can't spare enough time to stand in an ATM queue but need banknotes, like Jill, can pay those with spare time to stand in line, like Joe. Both are made better of. Joe's lot has improved because he earns more standing in ATM lines and lending cash than he did in his previous occupation. Jill is better off because she attains her desired amount of cash.

Once cash stops being a free good, cash payment delays emerge. Say that Jill prefers to go shopping in the morning for groceries and other necessities, before her hair dressing salon opens. But because acquiring cash is costly, she sometimes delays her shopping trip till later in the day, in the hope that someone might walk into her salon and pay with cash. That way she can avoid paying interest to Joe. 

However, if over the course of the day no one pays Jill with banknotes, she will have to borrow in the spare-cash market at the last minute. If everyone is following the same strategy as Jill, there will be an end-of-day spike in cash demand. Joe may run out of cash to provide his customers, and so Jill may have to go without food that night.

So now that we've outlined the contours of a world where cash is rationed and ATM lineups develop, would it be preferable to a world in which cash is plentiful and there are no lineups?

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Let me start by arguing why an alternative world in which cash is rationed might be more desirable than our current world with plentiful cash.

Thanks to cash rationing, Joe and Jill are forced to transact with each other. Perhaps a 'citizen-lender' like Joe can get additional incites insights into Jill's capacity to bear credit, the sorts of incites insights that a banker cannot. This extra bit of person-to-person monitoring may prevent folks like Jill from over- or underborrowing. 

This oversight function that Joe fulfills never emerges in the plentiful cash world since the two aren't forced into an economic relationship. And thus the credit market in a plentiful cash world may be less efficient than it would be if cash were rationed.

Now let me argue the opposite, why the world of plentiful cash may be superior.

There is an underlying logic to rationing concert tickets. A venue has just x seats, and so only x tickets can be sold. But there is no equivalent reason for a central bank to limit the size of its banknote issue. It does not face a capacity restraint, and the extra cost involved in printing new banknotes is tiny. And so any decision to ration cash is a purely arbitrary one.

Under rationing, citizens are forced to engage in a host of time-consuming activities that they wouldn't otherwise have to engage in, including locating a reliable cash lender, providing personal and potentially intrusive credit data to this lender, and then setting up an appointment to settle the debt at a later date. To avoid the hassles and expenses of dealing in the spare-cash market, folks like Jill may try to avoid making cash trades until later in the day, but that means she can't follow her preferred shopping schedule. 

If cash were plentiful, the millions of citizen-hours spent in coping with these annoyances would be freed up for alternative uses. Jill might be able to enjoy the extra minutes she now has with her children, or work on upgrading her salon. Instead of paying for Joe to stand in an ATM line-up, she can hire him to help in the construction, surely a much more socially useful activity than lining up.   

So which world do you prefer? Joe's extra credit monitoring is certainly beneficial. But does it outweigh all of the costs and nuisances that a cash shortage imposes on people's lives? This is a tough calculation to make. If you support cash rationing because you like the fact that it leads to a secondary market in cash loans (and thus more credit monitoring), why not create shortages in other financial markets, say by forcing banks to also ration deposits?

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Let's wrap this all up. We've explored the difference between a world in which cash is rationed and one in which it is plentiful.

But George's book isn't about cash, it's about another instrument issued by central banks: reserves. Unlike cash, reserves are an exclusive financial instrument. Only banks can hold them. Since reserves aren't part of our day-to-day experience, I've tried to explain things in terms of banknotes, a far more mundane central bank-issued instrument. 

George argues in his book for rationing reserves. It would be as-if he were arguing for the rationing of cash in the scenario I sketched out above. Note that I am not saying that George wants cash to be rationed (as a free banker he would probably be against it), but I am saying that many of his arguments in favor of reserve rationing can be recast in terms of a banknote rationing.

In particular, George speaks favorably of the secondary market in reserves that springs up thanks to rationing. In the U.S., this is usually referred to as the fed funds market, but more generally it is known as the interbank market. The interbank market is exactly like the spare-cash market that I've described above. Just as Joe lends to Jill in the spare-cash market, banks lend reserves to each other in the interbank market. George provides much evidence that the self-monitoring that banks engage in by transacting in the interbank market is a valuable function. 

What George doesn't touch on is that this increase in the amount of credit monitoring, far from being free, comes at the cost. Like Jill, banks must spend time and resources coping with a perpetual reserve scarcity. If this artificial shortage was removed, banks could stop allocating internal resources to this coping effort and deploy it instead to other uses. In the same way that plentiful money meant that Jill could hire Joe to upgrade her salon rather than paying him to stand in line, a bank can move employees from its defunct fed funds department to bolster its lending department, or customer service, or technology effort.

The question shouldn't be: do we want interbank peer monitoring? Rather, do we want interbank peer monitoring at all costs? I think this makes the calculation much more difficult.