Self-Evaluation Will Put Overdrafts in New Light

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NEW YORK -- The banking industry is quietly preparing for a government program that could have far-reaching implications for wholesale banking operations and on how the marketplace judges the creditworthiness of individual banks.

The program, effective March 27, limits the size of overdrafts any institution can incur during the day while transferring funds over the government's Fed Wire network and over private payment systems.

To comply, thousands of banks have to rate themselves on the basis of creditworthiness, operational controls, and credit policies. The evaluation determines each institution's permissible level of so-called "daylight overdrafts," which occur when a bank wires out more funds than are in its reserve account or when it has sent more funds over a private network than it has received.

Experts say the risk-reduction policy could affect transaction-processing operations, competitive positioning, corporate customers, and even bank credit ratings. Implementing it will involve senior officials from the operations, credit policy, funds management, and auditing departments right up to the board of directors.

"The daylight overdraft program is a sleeper in the sense that it has not yet attracted a great deal of attention in the banking industry overall and has attracted virtually no attention in the media," George C. Cochran, a senior vice president of the Federal Reserve Bank of Dallas, said at a recent conference. "Yet it is likely to produce a major change in the folkways of the banking business as it has been practiced for the last 25 years."

Under the policy, institutions measuring up poorly to evaluation criteria prescribed by the Federal Reserve Board will be restricted from running up overdrafts, which could limit processing flexibility, and, in some cases, might even prevent corporations from wiring out deposited funds.

"If an institution's cap is low relative to its external and internal needs, its profitability may be negatively affected as customers may be forced to go elswehwer to conduct their business," the American Bankers Association said.

Furthermore, although the self-determined ratings are supposed to be confidential, there will be pressure to make them public, according to David C. Cates, president of Cates Consulting Analysts Inc.

"It is symbolically of great importance to the prestige and general position of a bank where it's going to come out in that creditworthiness evaluation, because there are other audiences that willy-nilly are going to take an interest in it," such as rating agencies, insurance companies, and institutional investors, he said.

On the other hand, banks that fare well in the evaluation process might publicize their high overdraft caps to gain an edge on their competitors. That, in turn, would pressure other banks to give themselves an equivalent rating, whether deserved or not. "They'd have to, for competitive and prestige reasons," Mr. Cates said. "And then what does that do for the credibility of this whole program?"

Such a response would not likely be well received by the Fed. The central bank had initially suggested that bank regulators should impose overdraft limits -- called "sender net-debit caps" -- on individual institutions, but the banking industry balked at the ida, pushing instead for banks to be allowed to voluntarily set their own caps. The Fed relented, but warned that the "failure to take the [voluntary] guidelines and procedures seriously" could lead to "the adoption of regulations designed to impose explicit limits on daylight credit exposure."

The program is also expected to affect short-term funding techniques, with banks scurrying to borrow money upon hitting their cap. "I have no doubt that an intra-day fed funds market will begin to develop," Edward C. Ettin, A Fed staff member, said at a Bank Administration Institute conference last month. …