What Is Daylight Overdraft?

A daylight overdraft occurs when a bank withdraws more money than it has in its Federal Reserve account in order to make a payment; the overdraft must be settled by the end of the business day. 

Key Takeaways

  • With a daylight overdraft, a bank transfers net more out in a day than it has in its reserves, an action taken because it needs to make a payment.
  • Typically, banks settle reserve imbalances in the overnight lending market, but a daylight overdraft occurs during normal business hours.
  • Some banks are allowed by the Federal Reserve to overdraft provided that incoming payments will enable them to repay the funds by day's end.
  • A bank's financial position determines whether it will be allowed by the Federal Reserve to overdraft at all, let alone by how much.

Understanding Daylight Overdraft

The Federal Reserve Banks operate Fedwire, a payment system that enables fund settlement among thousands of banks. Some of these banks are permitted to overdraw their accounts based on the understanding that incoming payments will enable them to replenish the funds by the end of the day. These overdrafts are known as intraday or daylight overdrafts.

The Fed assigns different daylight overdraft limits based on a bank's financial position. Some banks are not permitted to overdraw their accounts at all, while others can overdraw by 187.5% of their capital measures, a metric the Fed uses to analyze a bank's ability to satisfy risk-based capital standards.

Banks are charged for daylight overdrafts as a means of discouraging them from becoming overly reliant on such protections. While daylight overdrafts help to increase the financial system's liquidity and efficiency, they could also potentially pose a systemic risk. The risk is that too many banks overdraw their accounts at the same time, which would impact the flow of money through the financial system and the economy. When a bank incurs too many daylight overdrafts, the Federal Reserve may step in and impose additional oversight.

Normally, banks will wait until the close of business to settle reserve imbalances. Lending facilities provide financial institutions with access to funds in order to satisfy reserve requirements, using the overnight lending market. Central banks may also use lending facilities to increase liquidity over longer periods. They generally accomplish this by using term auction facilities.

The Federal Reserve charges a fee when a bank incurs a daylight overdraft, as a way to discourage banks from taking such an action too often.

Daylight Overdraft Example

Hypothetically, Bank ABC could have $250 million in assets, with the Federal Reserve requiring that the bank keep 10%, or $25 million, in reserves. But on a given day, the bank may have to transfer $30 million from its various accounts. If it transfers that amount, it has created a $5 million daylight overdraft that it must cover by the end of the day through borrowing from the Federal Reserve, in exchange for a fee.

Daylight Overdraft for Individuals

Banking customers are also often granted personal "daylight overdrafts," usually without a fee. If a customer does not have enough funds in their account to cover a charge during the course of a day, some banks will allow the charge to go through anyway. Provided that the funds are replaced by the end of the day, there is typically no charge. If the funds are not replaced, the bank will charge an overdraft fee, often $35 per transaction.