Overdraft Cap: What It Means, Example, Types

What Is an Overdraft Cap?

An overdraft cap is the maximum dollar limit that a bank may send to another financial institution (FI) in one day. The cap constrains the amount a bank can overdraw its Federal Reserve account to make Fedwire payments, a real-time gross settlement (RTGS) system of central bank money used by Federal Reserve Banks to transfer funds electronically between member institutions.

The overdraft cap is also known as the net debit cap.

Understanding Overdraft Caps

In the United States, qualifying banks are permitted to overdraw on their Federal Reserve accounts in order to make Fedwire payments to other FIs. Under the daylight overdraft system, some banks can continue withdrawing money even when they have no funds left, as long as by the end of the day, their Federal Reserve account balances are restored back to above zero.

Overdraft limits vary, depending on a bank's financial position. Those that register lots of incoming payments and are deemed to have little difficulty replenishing any borrowed funds by the end of the Fedwire operating day are given quite a bit of leeway. Other institutions, meanwhile, might not be permitted to overdraft their accounts at all.

Overdraft caps are a multiple of each bank's risk-based capital (the cap multiple), the theoretical amount of capital required to absorb the risks involved in its business operations (the capital measure), and are set for a period of one year.

When an institution exceeds its overdraft limit it is referred to as a cap breach. The Federal Reserve is armed with several tools to deal with violations, including counseling measures, amending limits, and, in serious cases, closing accounts. Daylight overdrafts that are not funded by the close of Fedwire are also charged a much higher fee.

Overdraft Cap Example

Bank X has $100 million in assets and a Federal Reserve obligation to hold 10%, or $10 million, in its Federal Reserve account. One day, Bank X needs to fulfill $10.5 million in withdrawals. It doesn't have enough money in its Federal Reserve account to meet this requirement, so it transfers out an overdraft of half a million dollars.

Bank X has an obligation to repay this money by the end of the day. This is allowable, provided that Bank X's overdraft cap is at least $500,000.

Types of Overdraft Cap

As previously mentioned, overdraft caps vary from one bank to another. The Federal Reserve recognizes the following six overdraft cap categories:

• Zero
• Exempt-from-filing
• De minimis
• Average
• Above average
• High

Zero Cap

Zero caps are assigned to institutions that are considered especially weak, don't have access to the discount window, or are incurring daylight overdrafts that don't align with Federal Reserve policy. These institutions are considered to pose the most risk to the Reserve Bank.

Exempt-From-Filing Cap

Institutions in this cap category, the most common of them all, may incur daylight overdrafts of up to $10 million or 20% of their capital, whichever is lesser. In order to be eligible for the exempt-from-filing cap category, the institution must be financially solid and minimize its reliance on the daylight overdraft credit.

De Minimis Cap

Institutions in this category may incur daylight overdrafts of up to 40% of their capital. To qualify, the bank must submit a yearly board of directors (B of D) resolution approving use of the daylight overdraft to this extent.

Self Assessed

Institutions in the average, above average, and high-cap categories are self-assessed. They may incur overdrafts of more than 40% of their capital, but they must also fulfill large self-assessment burdens, including creditworthiness, customer credit policies and controls, and intraday funds management.

Net Debit Cap vs. Max Cap

In addition to the types of overdraft caps described above, the Federal Reserve also sets forth the net debit cap and the maximum (max) cap.

• The net debit cap is the maximum dollar amount of daylight overdrafts that it may incur in its Federal Reserve account, calculated as its cap multiple times its capital measure.
• The max cap applies to financial institutions that have liquidity pressures that leave them unable to meet the net debit cap. Thus, these can exceed their standard overdraft limits (based on net debit cap) by pledging additional collateral.