(As an aside, I believe that the British English spelling would be overdraught. In this case, the Canadian English spelling matches the American -- overdraft. One of the joys of being Canadian is that you can convince people on both sides of the Atlantic that you cannot spell, even when you are correct by domestic standards...)
What Is An Overdraft?A person or a business overdraws their bank account if they somehow withdraw more money than they had in the account in the first place. For the depositor, it looks like they have a negative bank account balance. (My quick scan of the topic suggests that the customer would either set off this negative balance versus positive balances, or else treat it as a liability. Note that nothing in this article constitutes accounting advice, yadda, yadda, yadda.) This would normally be prohibited, but it could happen as a result of unusual events.
The exception is the case when the customer negotiates an overdraft with the bank (before the event of the negative balance).
- In North America, the only time you tend to see this is when customers get overdraft protection; they can overdraw up to a certain limit. These negative balances typically incur a penalty interest rate, but the rate will be cheaper than the penalty for a cheque (see what I said about Canadian spelling) bouncing due to non-sufficient funds.
- In the United Kingdom, I believe that it is (or at least it was) an accepted practice for overdrafts to be used instead of bank loans. The amount of the overdraft was set in advance, but the expectation is that the overdraft would be drawn upon, and so the interest rate was a "normal" rate of interest for that business.
The interesting part is that the deposit balance can flip sign.
Credit lines appear very similar, but they are more obviously loans. They are a separate account, and if you draw upon them, you generally need to transfer the balance out of the credit line account to your regular account. (It might be possible to write cheques against the credit line, but I believe the fees would be much higher than for a regular account.)
Since they are in a separate account, the balance will generally always be positive, and so there is no problem with accounting for drawn credit lines as loans.
What is interesting about credit lines is when they are undrawn. They effectively are an option by the bank customer to draw on bank liquidity, up to a certain amount. Therefore, although they do not show up on the balance sheet, they are effectively a contingent liability. (Although an asset is created when they are drawn upon, the need to supply liquidity upon demand is not to the bank's advantage.) This means that the accounting for credit lines is simple (they are at most of an off balance sheet memo item), their regulatory impact is much less simple. The liquidity issues that they pose are not easily modelled in mainstream economics and finance, which assume an infinite capacity to finance positions.
I am not an expert on the subject, but regulators watch bank's credit lines, as they are one of the means by which a bank can blow itself up.
These liquidity options are not just of theoretical interest; they are what allows the non-bank financial system to function. Commercial paper (and securities dealing) only works if the issuers have backup credit lines at banks.
Why do issuers need lines from banks, and not from other institutions? Because banks can call on the lender-of-last-resort, the central bank. Hyman Minsky explained in Chapter 3 of Stabilizing an Unstable Economy how Manufacturers Hanover Trust -- a large New York Bank -- refrained from normally lending to bond dealers, but would step in only during an emergency. It was a credible backstop, as "It was understood that if Manufacturers Hanover ran a reserves deficiency because it financed bond dealers, Manufacturers Hanover would have access to the discount window of the Federal Reserve." (page 82).
Therefore, even if the financing is supplied by the non-bank financial system, the formal banking system is still required to backstop its liquidity needs.
Accounting For Overdrafts (For Banks)
I have not validated this against the accounting literature, but I believe that under Generally Accepted Accounting Principles, an overdrawn bank account would be treated as a receivable or loan asset. (I did not see a line item for overdrafts in the U.S. Flow of Funds, in any event.) However, the issue here is not how accountants deal with overdrafts, but rather within economic models.
In principle, we could treat the overdrawn account as being a negative deposit. This negative deposit would cancel out a positive deposit somewhere, and the net effect would be to reduce the "money supply." It should be noted that this would work if we just recast existing accounting statements to the new convention.
However, it does not work from a behavioural perspective, and so we cannot this in realistic economic models.
- From the perspective of a bank, an overdraft cannot be immediately called, while a deposit can walk out the door at any time. In a system with bank reserves, or liquidity requirements, the bank needs to hold liquid assets/bank reserves against the positive balances, and gets no relief for the negative deposit balances. Therefore, if we tried to cancel out the negative balances, bank reserve calculations within the model would appear incorrect.
- We cannot view transactions as being a transfer of a negative deposit balance. (For example, a seller giving the buyer a good plus a negative deposit balance.) We can transfer claims on a third party that are in the form of a negotiable instrument, but we cannot transfer claims against ourselves. If we wanted to transfer a debt we owe to a third party, we need to get the permission of the lender, as the third party might be a greater credit risk than we are.
It should be noted that we do not have the right to transfer all debts owed to us to others, only negotiable instruments. A corporation that is required to share proprietary financial information to its bank will not allow that bank to transfer that loan (along with its covenants that give it access to information) to a commercial rival.
Nick Rowe suggested that overdrafts (and other loans) could be a form of negative money; normal (positive) money is "green," and negative money is "red."
He discusses this idea in two articles:
His framework will function -- in the world of a (neo-) classical economic model.
The key to those models is that entities do not default. (If the private sector in your model consists of only one representative household, who exactly is that household going to default to?) As he notes, in his framework, future generations have to inherit the debt ("red money") of their parents. However, this mechanism does not cover corporate defaults nor what happens when those without heirs pass on.
In the absence of default risk, my second objection to treating overdrafts as negative money disappears; the only remaining objection revolves around reserve requirements (which are typically not imposed in models).
Of course, in the real world, people and corporations default all the time. Thus any model that captures that reality cannot rely on "negative money." (Admittedly, defaults are complex to model, and do not appear in most post-Keynesian macro models.)
And then some New Keynesian macroeconomists said that money didn't exist in the new combined world. They said there was no "cash", only "credit".One may note an interesting symmetry here. I am attempting to abolish money from economic models (replacing it with credit), while Nick Rowe is attempting to abolish credit and replace it with money.
(c) Brian Romanchuk 2016