An Economic Perspective on the Enforcement of Credit Arrangements: The Case of Daylight Overdrafts in Fedwire

redit arrangements between a borrower and a lender are a prevalent part of the economy. A fundamental concern for any lender is the risk that the borrower fails to fully repay the loan as expected, a type of risk called credit risk. Thus, lenders want credit arrangements that are designed to compensate them for— and help them effectively manage—credit risk. In certain situations, central banks engage in credit arrangements as lenders to banks. For example, the Federal Reserve offers certain banks overnight loans at the discount window. Additionally, it provides liquidity to many banks during the day whenever those banks must overdraw on their Federal Reserve accounts in order to make payments and settle securities. This extension of daylight overdrafts by the Fed can be interpreted as very-short-term credit, so the central bank is exposed to credit risk that it must manage. This article discusses how the Federal Reserve manages its credit risk exposure from daylight overdrafts. We first present a simple economic framework for thinking about the causes of credit risk and the possible tools that lenders have to help them