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The Dichotomy Becomes Reality: Ten Years of the Federal Reserve as Regulator and Com petitor Federal Reserve Bank of Minneapolis 1991 Annual Report Federal Reserve Bank of Minneapolis 1991 Annual Report The Dichotomy Becomes Reality: Ten Years of the Federal Reserve as Regulator and Com petitor By Leonard W. Fernelius, Senior Vice President of Federal Reserve Financial Services and David Fettig, Public Affairs Editor The views expressed in this a n n u a l report are solely those o f the authors; they are n o t intended to represent a fo rm a l position o f the Federal Reserve System. Presidents Message The Depository Institutions Deregulation and Monetary the Fed’s early years, when the nation’s payments system was Control Act of 1980 required, among other things, that Federal fraught with inefficiency. In this essay, a historical review shows Reserve district banks price their payments services, such as that the Fed’s current role mirrors, in large part, Fed efforts ot check and electronic transfer, and offer them to all financial nearly 80 years ago. institutions, rather than providing them at no charge to member As for the future, one thing is certain: The Fed’s role as banks only. Thus began a new era in modern financial services: regulator and competitor will continue to shape its place in the A federal regulator was authorized to compete with those it payments system. Advances in technology and the prospect ot regulated. national interstate banking will put even greater pressure on the The Fed’s role as regulator and competitor raises two compel Fed to compete efficiently, while these same phenomena— ling questions: first, can a federal regulator viably compete with billions of dollars transferred electronically every day among a the private sector; and second, can a competitor regulate in a fair growing array of large institutions— will underscore the im por manner? Fed pricing began in 1981, and now, after 10 years of tance of sound regulation. Fed competition, it is appropriate to review the record and seek I hope this essay helps illuminate the Fed’s unique role in the answers to those questions, which Leonard Fernelius and David nation’s payments system, while at the same time casting light Fettig have done in this 1991 Annual Report essay. on the significance of an often overlooked part of our financial The circumstances that led to a federal regulator’s entrance sendees industry. into a competitive market reflect the uniqueness of America’s financial services industry. The Fed’s history as a competitor and regulator doesn’t begin with the passage of a law in 1980; rather, the Fed’s current place in the payments system has its roots in Gary H. Stern President The Dichotomy Becomes Reality: Ten Years of the Federal Reserve as Regulator and Com petitor A revolutionary endeavor in government regulation and been both derided and praised, criticized and defended. Ten enterprise was launched in 1980 with the passage of the Deposi years ago, critics said a quasi-governmental agency could not tory Institutions Deregulation and Monetary Control Act. compete effectively with the private sector and they predicted Known as the Monetary Control Act (MCA), the law, among that the Fed would soon fail and drop out of the market; some other things, authorized the Federal Reserve System (Fed) to also said that forcing private companies to compete with their compete for business with the same financial institutions that it regulator was unfair— akin to playing a football game against a also regulates— a dual role that is unique in America’s economy. team whose star quarterback doubled as the game’s referee. Specifically, the Fed was ordered to begin pricing its financial While it may be a relatively arcane law Today, the criticism has ebbed. Not only has the Fed’s payments services, such as check collection and electronic funds payments function survived, but it has also operated beyond transfer, and to offer those services to all financial institutions in expectation. After initially losing check volume during the first direct competition with the private sector— the same private years of the MCA, the Fed eventually recovered and now in the annals of contemporary legislative sector that m ust abide by Fed regulation. O n one hand, the Fed maintains a steady presence in the market. In addition, the action, the M C A did much to change was authorized to enhance efficiency through competitive private sector— for the most part— has come to realize that the the nature of America’s financial services business practices; on the other, the Fed had a responsibility to purpose of payments system regulation is not to give the Fed a regulate its competitors to ensure the safety and soundness of the competitive advantage; rather, it is to help improve the overall payments system. The MCA included other significant reforms efficiency and security of the system. system. that are noted later, but the focus of this report is the MCA’s But all is not rosy for the Fed. The second decade of the MCA creation of the seemingly dichotomous role of the Fed in the brings new challenges. Reductions in check volume for the Fed payments system. will likely occur, putting pressure on the district banks to While it may be a relatively arcane law in the annals of manage costs of production accordingly. Still, with its willing contemporary legislative action, the MCA did much to change ness and drive to innovate, the Fed expects to be an im portant the nature of America’s financial services system. Likewise, it has part of the second decade of the MCA. Also, just as in the 1980s, the dual role of the Fed as regulator and competitor will con Determined to avoid such charges, the Wisconsin bank likely tinue to shape the Fed’s position in the payments system. This took the time to find other banks that had a no-fee relationship continuing role is evidenced in the Expedited Funds Availability with the Minnesota bank. The Wisconsin bank would then Act (EFAA) of 1987. EFAA sets strict guidelines on the time a circulate checks through those banks, and eventually the checks financial institution may hold a check before making the funds would find their way to the Minnesota bank. available to a depositor, and it requires the Fed to enforce those In some cases, checks would circulate through a dozen guidelines— a role that further extends the Fed’s regulator/ different banks before finally reaching the bank on which they competitor position. were drawn. Given the vagaries of transportation at the time, these delayed funds (or float, as the funds came to be termed) were measured in weeks and sometimes months. In an infamous The Fed’s History Shapes its Future example, a Birmingham bank once sent a check on a cross country trip to avoid charges from a North Birmingham bank. At the turn of the century, if a Minnesota shopper wrote a check The check was first sent to Jacksonville, Fla., then to Philadelphia to a business in Wisconsin, that check would likely have taken and finally to North Birmingham; but the check was written on inordinately long to be cleared back at the shopper’s Minnesota insufficient funds and was sent back to Birmingham via Phila bank. There were two reasons for this delay: the practice of delphia and Jacksonville. All told, the check traveled 4,500 miles charging a presentment fee on checks sent to banks for payment, in about two weeks, and the two Birmingham-area banks were and the practice of intentionally slowing payment. just four miles apart. Presentment fees (which existed in some parts of the country Ten years ago, critics said a quasigovemmental agency could not compete The second reason funds were delayed was from deliberate effectively with the private sector and until 1968) were most often charged by rural banks on checks actions by some banks to slow payment to the out-of-town mailed to them for payment from out of town. In our example, bank. They did this, of course, in order to keep funds as long as they predicted that the Ted would soon the Wisconsin merchant deposits the Minnesota check (for possible. Rather than promptly transferring funds on checks fa il and drop out o f the market. $1,000, for example) into his Wisconsin bank. The Wisconsin presented by an out-of-town bank, a bank may have intention bank credits its customer’s account for $1,000 and then mails the ally held the funds to its own advantage and to the detriment of check to the Minnesota bank for collection. But the Minnesota the out-of-town bank. (Funds availability continued to be a bank imposes a charge of, say, $1, and only sends back $999 to major concern of the country’s payments system and many years Wisconsin. later, in 1987 with the passage of EFAA, the issue of funds While it may seem wise for the Minnesota bank to charge for availability was addressed by congressional action.) Clearly, as its check services (although many at the time argued that such these cases of circuitous routing and slowed payment show, the fees were excessive), the result wasn’t always as intended. nation’s payments system was inefficient. 4 In an attempt to address those inefficiencies, Congress ment-fee banks in 1965.) Presentment-fee banking declined included authorization in the 1913 Federal Reserve Act to allow most rapidly in those states that allowed branch banking (when the Fed to clear checks at no charge for member banks, as well as banks had branches located throughout the state they were not to perform other duties relating to clearinghouse operations. subject to out-of-town charges from other banks), and in those Flowever, member bank participation was voluntary, and states that eliminated the practice through legislative action. exchange charges and slowed payment remained the norm. Public opposition swelled against presentment-fee banking This continuing inefficient payments system was contrary to throughout the 1960s and by 1972 the legislatures of the remain the intent of the Federal Reserve Act, the Fed maintained, and in ing states had all abolished the fees. (Minnesota’s Legislature 1916 it issued a regulation requiring member banks to eliminate passed a law eliminating the fees in 1968.) presentment fees and unnecessary routing and to use their As for RCPCs, when the Fed created the regional centers in district Fed bank as a clearinghouse. In addition, the Fed charged 1972, the program addressed check clearing issues that had been for its check services. The Fed believed that banks would be discussed for years. (In 1954, following a surge in check writing eager to use its services in order to shorten check clearing times after W orld W ar II, a joint report by the Fed and the private and to make funds available sooner. But contrary to the Fed’s sector suggested that the Fed establish regional clearing arrange hopes, most banks didn’t care to join the Fed in its attempt to ments and consider establishing branches in financial centers streamline the nation’s payments system because there was too throughout the country. However, because participation in the conundrum— o f the Fed’s responsibilities: m uch to lose by such efficiencies. Many banks earned significant plan was voluntary, the 1954 proposals fizzled in the short run.) to help ensure the efficient viability o f a income from presentment fees and benefited from slowed It wasn’t until the creation of RCPCs that real improvement in complex and important payments system payments. By 1918, just two years after the regulation’s authori the payments system was realized. Under the 1972 plan, checks zation, the Fed rescinded its enforced attempt at check clearing drawn on RCPC-zone banks and deposited at an RCPC by efficiency and went back to providing free check services to its midnight were given final credit the next day. The num ber of member banks. days needed to collect a check dropped from 2.5 days in 1967 to the safety and soundness of the nation’s 1.9 days in 1979 because of the RCPC program. However, financial backbone. While there were many events that helped shape the growing payments system between 1918 and 1980, the two most signifi because the Fed at that time did not price its services but offered cant events in the effort to improve efficiency were the elimina them free to members, many of the privately operated clearing tion of presentment-fee banking by 1972 and the Fed’s develop houses were unable to compete with the new Fed service and ment of Regional Check Processing Centers (RCPCs), also in were forced to close. (Some of those private clearinghouses were 1972. Although from 1942 to 1965, the num ber of presentment- eventually revived in 1981 at the onset of Fed pricing.) fee banks decreased by 940, there were still 1,492 such banks in 15 states. (Minnesota was the largest bastion, with 401 present 6 Therein lies the crux— and the seeming through competitive business practices, and to regulate its competitors to guarantee The Depository Institutions Deregulation and Monetary Control Act ot 1980 clearing were the primary payment services offered by the Fed. The same principles that drove the Fed to price its services in complexity of the financial payments system. For example, in 1916 were largely the reasons that brought the Fed back to the addition to check sendees, the Fed also offers electronic funds market in 1980. But unlike 1916, when the Fed’s first attempt at transfer and automated clearinghouse senices. [See accompany pricing was thwarted by the inefficiencies ot presentment-lee ing glossary of Federal Reserve senices at right.] Every day banking, presentment fees were not an issue. Thus, two histori billions of dollars are transferred electronically throughout the cal obstacles to a more efficient payments system that existed at world as governments and corporations make decisions that are the turn of the century— the lack ot a national clearing system im portant to all sectors of a nation’s economy. W ithout an (addressed by the Fed’s presence) and presentment-fee bank efficient— and safe— payments system, these economic changes ing— had been resolved. By requiring the Fed to price its could not reliably occur. payments services, Congress hoped to clear the final obstacle; for Today, there are a variety of sendees that reflect the growing For most Americans, the nation’s payments system is a as long as the Fed did not price its services, those services would mundane matter. The fact that the check they write at the likely be overused and the entire system would be less efficient grocery store will eventually be debited from their account, or than possible. The framers of the 1980 law hoped to foster the fact that their payroll check will be automatically credited to competition among all providers and thereby increase the their account via electronic transfer is rarely cause for concern. choices available to the public. In that respect the payments system becomes a sort of utility, or Another difference between 1916 and 1980 was the issue of another form of infrastructure— it’s im portant but it’s also taken Fed membership. In 1916, membership in the Fed was voluntary for granted. However, unlike a broken gas main or downed and only Fed members could use Fed services. But the MCA power line that affects a relatively small area, a failure in the required that all financial institutions— banks, savings and loans, payments system can have devastating consequences that could and credit unions— keep reserves at a Fed district bank, thus ripple through the nation’s economy and even to other coun making Fed services available to all financial institutions. (Other tries. MCA provisions include: allowing access to Federal Reserve problems become obvious, and serious problems involving one member depository institutions, the elimination of deposit or more financial institution’s inability to meet its payment interest rate ceilings and the allowance of greater powers to obligations would have major repercussions throughout the savings and loans. ) financial senices industry. Not only is it imperative to have the 1980 and 1916. In the Fed’s early years, check collection and Check Processing Services: The Federal Reserve Bank of Minneapolis clears about 2.9 m illion checks per day, making it the second largest single check processing shop in the Federal Reserve System. Automated Clearinghouse (ACH): ACH is an electronic means for exchanging paperless debit and credit entries between financial institutions for customer accounts like Social Security checks, commercial payrolls, mortgage payments, insurance premiums and utility bills. The Minneapolis Fed processed about 138 m illion commercial ACH transactions and 35 m illion government transactions in 1991. Funds Transfer Service: The Fed’s nationwide backbone telecommunications network allows financial institutions to transfer funds with the assurance that all funds received are final payment in “same day” funds. The Ninth District originated about $2.5 trillion in funds transfers in 1991 and received about $1.9 trillion. Cash Services: The Fed’s priced services for currency and coin primarily involve shipping to financial institutions and cash terminals throughout the district. The Ninth District shipped about $5.3 billion in currency and $148 m illion in coins in 1991, and received about $5.2 billion in currency and $143 m illion in coin. The payments system is one of the first places where financial discount and borrowing privileges and other services to non There was also an im portant technological difference between Federal Reserve Services most efficient possible payments system, but it’s also crucial that the payments system be safe and sound. Therein lies the crux Securities Services: The Fed maintains the securities accounts (such as Treasury bills and bonds) of financial institutions and their customers (including municipal and corporate securities, certificates of deposit and stocks) and also electronically transfers funds for those accounts. and the seeming conundrum — of the Fed’s responsibilities: to help ensure the efficient viability of a complex and im portant payments system through competitive business practices, and to regulate its competitors to guarantee the safety and soundness of As Prices R ise, Fed Unit Costs R em ain S teady Priced Services: R evenues as a P ercentage of Costs 1 9 8 2 -1 9 9 1 1983 Service 1982 1984 1986 1988 1990 1991 Cash 87.9% 102.0% 101.0% 102.6% 102.9% 103.4% Funds 88.7% 111.4% 104.2% 99.8% 106.7% 99.7% ACH 60.4% 96.6% 103.9% 101.1% 100.2% 101.3% Check 82.0% 108.6% 105.1% 98.6% 101.2% 101.1% All Services* 84.3% 104.1% 105.5% 100.9% 103.7% 100.7% = 100 the nation’s financial backbone. The Challenge: Fed as Regulator and Competitor Consumer Price Index Payment Services Unit Costs Can the Fed compete? A ll services = Cash, Funds, ACH, Check, B ook-Entry, D efinitive, Non-cash. 100 The obvious answer to the question of the Fed’s competitive fitness lies in its track record. As expected when the Fed first It’s possible to quantify this efficiency claim by tracking output introduced its prices for check services in August 1981, it lost along with the real, or inflation-adjusted, costs of production for volume. Specifically, the Fed lost 19.7 percent of its check Fed payments system operations. As the graph on this page volume during the first m onth of pricing. From August 1981 to attests, while inflation rose steadily from 1983 to 1991 (from April 1983, the average monthly volume was about 22.4 percent base-year 100 to 136.75 in 1991), the Fed’s average unit costs for lower than that of July 1981. Also, during those transition years payments system operations actually declined (from 100 to the Fed was unable to recoup its costs through priced service 99.39). Likewise, since the Fed had stable costs, it follows that the revenues. Fed also had stable prices. At the same time that real costs were But the Fed bounced back, and since 1984 has recovered its declining, the Fed’s output was increasing: Total checks pro 90 1983 84 85 86 87 88 89 90 91 While changes in presentment times have improved the Fed’s performance and costs for check processing, cash and funds services. [Other cessed were about 12.9 billion for the entire Fed System in 1983, significantly reduced the amount offloat, services matched cost and revenues in later years, see table on and in 1991 the total reached about 15.6 billion. [See graph on those changes gave rise to criticism that this page.] Today, just as it did before the enactment of the page 10.] the Fed unfairly manipulated regulations banks and offices— processes about one-third of the nation’s Can a competitor regulate in a fair manner? to improve its own performance. check volume. The Fed’s ability to compete, however, masks the regulatory MCA, the Fed— including its 12 district banks and 25 branch Not only has the Fed proven its ability to compete, but it has controversy that has embroiled it during the past decade. For also met one of the congressional intents of the MCA, namely, to example, while the Fed has recovered its costs since 1984, there is improve the overall efficiency of the nation’s payments system. debate surrounding the Fed’s method of computing its costs and 8 / / , Commercial Checks Processed 1972-1991 prices. And, while changes in presentment times have improved the Fed’s performance and significantly reduced the am ount of float, those changes gave rise to criticism that the Fed unfairly about the adequacy of the Fed’s internal accounting system, along with suggestions that the Fed has an unfair competitive Ninth District Fed advantage as a federal regulator. Specifically, the charges relating (in m illio n s) manipulated regulations to improve its own performance. W hen the MCA was debated, it was acknowledged that the hearings produced additional complaints from the private sector 1000 --------------------------------------------------------------------- to the Fed’s regulatory status concerned the Fed’s exemption from presentment fees (fees charged by some financial institu Fed would have an unfair price advantage since— as a federal regulator— it was not subject to tax and capitalization costs that affected the private sector. To address this inequality, a private 800 - tions for presentments later than established deadlines) and the Fed’s unlimited ability to operate its check business across state 600 - lines, an option not available to financial institutions. Some sector adjustment factor (PSAF) was created for the Fed to account for “the taxes that would have been paid and the return critics also suggested that all Fed payments operations should be 400 - placed in an autonomous corporation, leaving the Fed with only on capital that would have been provided had the services been furnished by a private business firm.” [See description of the 200 its role as regulator of the payments system. - But the House Committee on Banking found no evidence of PSAF on the following page.] But the PSAF didn’t settle the wrongdoing by the Fed and reiterated the intention of Congress controversy and soon after the MCA’s implementation, some 1972 competitors began calling on Congress to investigate the Fed’s 74 76 78 80 82 84 86 88 90 that the Fed should continue to serve its dual role as a regulator and competitor. However, the committee also found that the pricing policies. The U.S. General Accounting Office (GAO) and congres Federal Reserve System (in b illion s) sional committees have investigated whether the Fed has Fed had not been giving proper weight to the objective of fair competition in its pricing and other operational decisions. operated its payments services in a fair manner. In 1982 the 1 6 --------------------------------------------------------------------------------- Accordingly, the Fed agreed to consider the impact of its GAO released a report that criticized the Fed for its slowness in 14 - business decisions in light of industry competition, a com m it adjusting its fees to a level that was adequate to recover its full 12 ment that still exists today. Currently, all major operating costs— as m andated by the MCA. The GAO estimated that by 10 supposedly underpricing its services the Fed had, in effect, - changes proposed by the Fed undergo a rigorous process of research and analysis, including public comment, to determine 8 - 6 - the competitive impact of its decisions. reduced its income potential and thus held back over $100 million from the U.S. Treasury (and hence American taxpayers) in both 1982 and 1983. The GAO report was followed by joint hearings of the Commerce, Consumer and Monetary Affairs Subcommittee 4 - 2_ _ J __ 1__ I__J__ I__ I__ I__ I__ I__ 1__ I__ I__ I__ 1__ I__ I__ I__ I__ L 1972 74 76 78 80 82 84 86 88 90 Aside from the processes and the procedures that are in place to ensure that the Fed operates in a fair and competitive manner, the Fed has adopted its own unwritten code of fair play that has been labeled a “Chinese Wall.” The reference to the Great W'all and the Domestic Monetary Policy Subcommittee of the House of China is used to describe the separation of the Fed’s payments Committee on Banking, Finance and Urban Affairs. The function from the regulatory activities of the bank. This Chinese 10 The Private Sector Adjustment Factor Because of its federal status, the Federal Reserve does not corporations vary greatly from almost all equity to heavily have the tax and capital costs associated with the opera debt financed, there is no established method to determine tion of a private institution. To bring competitive balance the appropriate mix for the PSAF. between the Fed and its private competitors, the Monetary Control Act of 1980 requires that the Federal Reserve’s 3. The costs of short-term and long-term debt capital. This refers to the interest rates that would have to be paid fees for priced services must include an allowance for the on outstanding bonds, notes or other forms of borrowing. taxes and return on capital costs that would affect a The issue here is whether the costs of long-term debt private firm. This allowance is called the private sector should be measured strictly by the current market rate of adjustment factor (PSAF). interest on corporate debt or by the average coupon rate While in theory it may seem simple to adjust the Fed’s prices to reflect the added costs of private firms, the practical applications of the PSAF are complicated and of interest on a mix of old and new debt on a typical corporate balance sheet. 4. The after-tax rate of return on equity capital. This have been a source of contention over the past 10 years. element is ripe for controversy for three reasons: There is For example, “ capital,” in reference to the PSAF does not no established way to determine an appropriate rate of refer to physical capital like buildings and machinery, but return on equity for a private firm, there is disagreement rather to financial capital, or debt and equity. Federal over whether equity should be viewed from an accounting Reserve banks, however, do not maintain formal balance viewpoint or a market valuation viewpoint, and observed sheets applicable to their priced services operations, but rates of return on both accounting equity and market value rely on estimates, thereby making debt and equity difficult of equity vary widely among U.S. corporations. to discern. These following five elements used in the computation of the PSAF reveal the difficulty in determining such a figure: 1. The dollar amount of capital. Not only does the Fed have to estimate the amount of capital because it keeps no 5. The income tax rate. Through use of standard tax accounting, this is more easily determined. Briefly, the Fed arrives at its prices by taking a before tax return on equity and combining it with the costs of debt and the capital structure proportions to obtain a weighted average cost per dollar of capital. This average cost is then formal balance sheets for priced services, but some of that multiplied by the dollar amount of capital to calculate the capital is used for other Fed operations. Consequently, dollar amount of surplus or net revenue that must be there arises the question of how much of that capital that obtained to cover the imputed cost of capital (including is shared with other operations should be assumed to income taxes). The Fed’s prices for its services must then apply to priced services. 2. The proportions of debt and equity in the capital structure, and the mix of short- and long-term debt. U.S. be set at levels sufficient to generate this amount of surplus revenue in the aggregate, which the Fed does by applying a uniform percentage markup to all prices. 11 Wall is more than just a colorful phrase, it’s a serious com m it It is also important to remember that the Fed is not immune ment. The Minneapolis Fed, for instance, is insistent that its to the demands of regulation— payments system changes account managers never talk about regulatory or loan activity mandated by the regulatory arm of the Fed also apply to the with financial institutions. This policy extends to staff and Fed’s operational arm. This leads to a final point about the Fed’s officers at every level of the bank. Financial institutions that hope dual role as regulator and competitor: Far from being a burden for a price break on services because they may have borrowed to its regulatory responsibility, the Fed’s operational involve funds from the Fed, for example, are disappointed. There is no m ent makes it a better regulator. The Fed’s operational role linkage between the Fed’s payments services and its regulatory or provides valuable insight to senior management that would lender roles. otherwise not be available to the Fed, and this “hands on” Amid all the considerations of competitive fairness, it’s exposure to payments services makes the Fed a better-informed important to remember that the Fed’s motivation for its business regulator. This is not a breach of the Chinese Wall. While the actions does not stem from bureaucratic hubris or to earn Fed’s payments services operations are performed at the district exorbitant profits. The purpose of including the Fed as an active, level, it is the Federal Reserve Board in Washington, D.C., that competitive player in the payments system is to improve the approves pricing structures for the banks, and it is the Board that efficiency of that system for the public good. proposes regulation and seeks comment from the private sector. On the issue of competitive advantage, it should be noted that The Fed’s district bank examiners work under the direct the same element that is reputed to give the Fed its advantage— supervision of the Board. For example, there are about 70 its federal regulator status— is also a competitive albatross. The examiners at the Minneapolis Fed and its Helena branch Fed, unlike its private counterparts, must offer its services to all responsible for the examination of 93 state-chartered banks and financial institutions and cannot pick and choose with whom it 737 holding companies in the Ninth District. These examiners wants to do business; the Fed also cannot greatly vary the terms have no working relationship with the operational arm of the of its business relationships; it has little pricing flexibility; it Minneapolis Fed and Helena, and the same is true at other Fed emphasis on technological innovation to cannot provide the full range of services offered by the private district banks. It is only at the senior management level of the spur increased efficiencies. sector; and, perhaps most importantly, every change in price and district banks and at the Board where the regulatory and every consideration for improvements in service m ust bear the operational experience comes together to provide deeper insight scrutiny of thousands of financial institutions and their respec into the nation’s financial system. This insight proves especially tive trade associations, as well as a highly structured approval valuable during times of financial crisis when the Fed— along process. Any change in operational policy must be publicly with other agencies and the private sector— is relied upon to posted in advance, giving the private sector a unique opportu make timely and informed decisions, some of which may have nity to preview the planned moves of one of its competitors. major implications for the country’s payments system. 12 Perhaps the most important development contributing to the Fed’s eventual success in the payments system field was the Some Welcome the Fed of the Federal Reserve Board of Governors, bluntly recalled the It should be noted that many financial institutions, especially first years of Fed pricing: those of a relatively small size, have welcomed the Fed as a priced “We thought we were an efficient, low-cost provider of service provider. Small financial institutions, of course, are not services, but we learned that we had to do better. We thought direct competitors of the Fed; rather, they are potential buyers of our services were high quality, and that they met the needs of Fed services and as such view the Fed as another choice. depository institutions. W hat we found was considerable Safety and soundness issues are also im portant to small dissatisfaction with the types and quality of services we offered financial institutions, which rely on the financial strength of that forced us to improve. We thought that our internal m an others to ensure their own viability. In his 1984 testimony on agement systems and information flows were adequate to the behalf of the Independent Bankers Association of America task of running the Federal Reserve’s ‘business enterprise.’ In before the House Committee on Banking, Housing and Urban fact, they needed substantial modification. We thought that the Affairs, O.J. Tomson, president of Citizens National Bank in transition period required for the Federal Reserve to adapt to a Charles City, Iowa, stated this concern: “If I send out a cash world of explicit pricing for services might take a year or two. In letter [a document delivered with such items as checks and fact, while the early blizzard of Federal Reserve price and service postal money orders that lists, among other things, dollar level changes is now behind us, we find the world around us amount, num ber of items and the depository financial institu changing so rapidly that we dare not relax and rest on our tions] , that is equal to 50 percent of the value of the capital laurels.” structure of the small bank I am involved in, I want to make sure As most district banks experienced decreases in check volume In the area o f electronics, the Fed I am sending it to a sound financial institution that can properly following the initiation of pricing in August 1981, they had to developed a network that offers computer clear it and that those funds will be safe. We don’t lie awake at reduce their costs in order to be able to compete effectively. For to computer links with financial night worrying about the Federal Reserve System. We know that many district banks that meant reductions in staff and longer it is going to be there.” workdays. Other changes were less drastic and were more The 1980s: A Call for Innovation focused on long-term goals. For example, the entire Federal 1990, the number of institutions Reserve System began to work more cohesively through the connected with the Feds electronic network appointm ent of System product directors who worked directly increasedfrom 2,000 to 8,000. with Reserve banks to restructure and unify services. This The initial prospect of entering the competitive fray of the emphasis on System unity was beneficial in that it helped create a payments system was met with confidence by the Fed district more effective network of Fed resources, but perhaps the most banks, but the transformation proved to be more of a challenge important development contributing to the Fed’s eventual than expected. In a 1985 speech, Lyle E. Gramley, then member success in the payments system field was the emphasis on 14 institutions of a ll sizes. From 1981 to Payments System Innovation 16 While the Fed’s history in the payments system the MICR checks and eventually the Fed would still in place today and serves as the inspiration has been marked by a general wariness on the only accept MICR encoded checks—thus for the Fed’s efforts to introduce truncation to part of the private sector, there have been completing one of the most important transfor the rest of the financial services industry. The many times when the Fed and private institu mations in check processing history. Fed introduced its own truncation test program tions have worked together to improve the Another important transformation— but one in 1986 involving the Reserve banks of Atlanta, system. Two good examples of that coopera that is still years away from total acceptance— Kansas City, Minneapolis, Philadelphia and tion involve innovations in check processing: is check truncation. First implemented by the Richmond. Other Reserve banks have since the introduction of magnetic ink characters on National Association of Check Safekeeping joined the Fed’s effort, which has been a checks (MICR encoding) and the process of (NACS) in 1981, truncation is mainly the consistent priority of the Minneapolis Fed and check truncation. process of stopping the flow of checks. For its branch in Helena, Mont. Of the 154 institu In the early 1950s the American Bankers example, instead of sending a check on a tions currently using truncation, 56 are located Association (ABA) developed the idea of using typical route—from the check writer to the in the Ninth Federal Reserve District. MICR encoding, a process by which banks add payee, to the bank of deposit, to a Reserve to checks a line of magnetic ink characters that bank, to the paying bank and back to the payments system that have been influenced by can be read by electronic machines. MICR consumer—truncation stops the paper check the Fed, like the payment in immediate funds encoding meant that laborious manual tasks— at the Reserve bank and sends electronic on the day of presentment in 1974, improve such as sorting items and posting payments to information in its place. ments related to the handling of checks with accounts—could be done by machines. But the ABA didn’t have the resources or Consumers don’t receive their checks with There have been other innovations in the insufficient funds as mandated by the Expe their monthly statement with truncation; rather, dited Funds Availability Act of 1987, and other the nationwide network to implement MICR if they need a copy of a particular check they electronic innovations that offer increased technology, and in 1956 the Fed joined the can receive a microfilm image from their efficiencies. effort. Following established industry stan financial institution. The benefits of the dards for MICR encoding, the Fed began truncation process are clear: Reduced paper experimenting with various high-speed sorting flow means a more efficient payments system, machines at different Reserve banks. By 1961 which means lower costs for financial institu the successful machines had been determined tions and their customers. and some Reserve banks began accepting The NACS truncation effort, which includes checks that were both MICR and amount a group of large banks that truncate corporate encoded. Unit collection costs plunged with dividend checks at the bank of first deposit, is technological innovation to spur increased efficiencies. This initiative was driven by three factors: the overall aim of adaptation— prior to MCA— of magnetic ink character recogni tion (MICR) to speed check processing, and the more recent the Fed to improve the payments system, the need to be com proposals to reduce the flow of paper checks, known as trunca petitive with the private sector in order to survive as a business, tion. [See accompanying story on preceding page for more on and a growing sense of competition among the 12 district banks. MICR and truncation.] If one district bank developed a new technique to improve In the area of electronics, the Fed developed a network that business, other district banks were not only compelled to at least offers computer to computer links with financial institutions of consider adopting the new technique, but, where possible, to all sizes. From 1981 to 1990, the num ber of institutions con improve on the work done by the other bank. Likewise, a unique nected with the Fed’s electronic network increased from 2,000 to dynamic developed within the System: Individual district banks 8,000; by 1994 that num ber is expected to exceed 10,000. It is were not only competing against the private sector but were reasonable to anticipate that someday all financial institutions competing among themselves to see who could do the best job. using Fed services will be linked to a network where all financial Congress probably did not bargain on getting such an abun transactions— from check images, to securities and ACH— can dance of competitive forces when it enacted the MCA, but the occur via a com m on personal computer. effects of the district banks’ efforts are obvious: By competing internally for new efficiencies— much like private competitors do— the Fed raised the level of efficiency for the entire payments The Fed’s Current and Future Role system. The controversy and change that was so much a part of the Fed innovation initial years following the MCA has given way to an era of By initiating its interterritory check transportation system, relative stability. Calls for the Fed’s removal from the payments offering later deadlines for receipt of checks and presenting system that were prevalent in banking trade magazines 10 years checks to paying banks at later times in the day, the Fed was able ago have given way to articles that now include the Fed as an to collect large numbers of checks faster and thereby reduced the accepted player in the field. Private institutions that compete daily average float by about $6 billion to $7 billion during the with the Fed, many of which have developed good relationships first years of the MCA. The Fed also initiated product enhance with Fed district banks, now concentrate their attention on the ments that have improved the efficiency of the system, such as Federal Reserve Board’s regulatory intentions. Vocal concern new check sorting techniques and transportation arrangements. from the private sector seems to ebb and flow according to the In many cases, cooperation between the Fed and the private issuance of new regulations. Bankers associations find them sector has resulted in important innovations, such as the selves dealing less and less with matters involving the Fed’s 17 payments function; indeed, one industry official has said that payments system market. Even with the prospect of decreased banks and other financial institutions have had so many other volume in the coming years, the Fed— through cost control and critical issues on their minds during the late 1980s and early the introduction of more efficient products and technologies— 1990s that the Fed’s payments services role has paled in com should be able to obtain a match in revenue and costs for most parison. From a purely bottom-line perspective, the Fed has met its years. And beyond the bottom-line considerations, it will still be important for the Fed to be involved in the payments system to objectives in the payments system field over the past 10 years. help ensure the overall safety and soundness of the financial Beyond mere survival, the Fed has maintained about the same services industry. percent of market share in check services that it had before the MCA, while check volume itself has steadily grown. After struggling initially, the Fed also began in 1984 to recover its costs through priced service revenues, a record it maintains to the present. Another measure of success is that the Fed has re sponded to Congress’ call to improve the efficiency of the payments system: Real costs of Fed production have decreased while output has increased. Efficiency has also improved through innovations in electronic transfer and in the Fed’s effort Even with the prospect of decreased volume in the coming years, the Fed to shorten the paper trail of checks— an effort made even more — through cost control and the introduction of more efficient products and technologies— should be able to obtain a match in revenue and costsfor most years. urgent by the aforementioned Expedited Funds Availability Act (EFAA). EFAA grants even more power to the Fed than that granted by the MCA in terms of changing the way checks are handled by financial institutions. Despite past successes, however, the future of the Federal Reserve in payments services is not certain. W ith banking industry consolidation and the trend toward nationwide This annual report may be reprinted if the banking, along with the emerging use of electronic check Federal Reserve Bank of Minneapolis is exchanges among big banks and other such developments, the credited and the Public Affairs Department Fed may very well see a reduction in the total volume of pay is provided with copies of the reprints. ments services during the second decade of the MCA. But this doesn’t portend the withdrawal of the Federal Reserve from the 19 Designer: Phil Swenson Associate Designers: Barbara Birr, Beth Grorud Illustrator: David Suter Photographer: Marc Norberg 20 Federal Reserve Bank of Minneapolis Statement of Condition Earnings and Expenses Directors Officers 21 S tatem ent of Condition (in thousands) Federal Reserve Bank of Minneapolis Digitized 22 for FRASER Assets Dec. 31, 1991 Dec. 31, 1990 $ 171,000 172,000 13,688 0 $ 203,000 172,000 13,228 5,495 78,144 3,445,178 101,300 3,755,330 544,358 364,686 44,161 781,816 64,696 2,640,173 44,079 978,960 96,005 (188,629) $7,955,214 $5,545,454 $6,690,635 $3,928,662 653,413 4,245 37,620 1,027,895 4,500 6,207 Total Deposits 695,278 1,038,602 Deferred Credit Items Other Liabilities 398,577 31,072 395,132 46,036 7,815,562 5,408,432 69.826 69.826 68.511 68.511 139,652 137,022 $7,955,214 $5,545,454 Gold Certificate Account Special Drawing Rights Coin Loans to Depository Institutions Securities: Federal Agency Obligations U.S. Government Securities Cash Items in Process of Collection Bank Premises and Equipment Less Depreciation of $34,525 and $33,493 Foreign Currencies Other Assets Interdistrict Settlement Fund Total Assets Liabilities Federal Reserve Notes1 Deposits: Depository Institutions Foreign, Official Accounts Other Deposits Total Liabilities Capital Accounts Capital Paid In Surplus Total Capital Accounts Total Liabilities and Capital Accounts 'A m o u n t is net o f notes held by the B ank o f $1,427 m illion in 1991 and $769 m illion in 1990. Earnings and Expenses (in thousands) For the Year Ended December 31, Current Earnings Interest on U.S. Government Securities and Federal Agency Obligations Interest on Foreign Currency Investments Interest on Loans to Depository Institutions Revenue from Priced Services All Other Earnings Total Current Earnings Current Expenses 1990 $266,252 71,102 3,395 39,930 426 $322,275 78,441 5,596 40,886 451 381,105 447,649 35,230 8,188 2,009 5,880 492 1,787 2,189 32,901 7,567 1,643 5,576 429 2,041 2,328 Salaries and Other Personnel Expenses Retirement and Other Benefits Travel Postage and Shipping Communications Software Materials and Supplies Building Expenses: Real Estate Taxes Depreciation— Bank Premises Utilities Rent and Other Building Expenses Furniture and Operating Equipment: Rentals Depreciation and Miscellaneous Purchases Repairs and Maintenance Cost of Earnings Credits Net Costs Distributed/Received from Other FR Banks Other Operating Expenses Total Current Expenses 1,113 5,828 2,773 5,165 2,014 1,305 78,557 567 4,573 2,660 6,426 2,103 1,689 72,953 Reimbursed Expenses2 (1,798) (811) Net Expenses Current Net Earnings Net Additions3 Less: Assessment by Board of Governors: Board Expenditures Federal Reserve Currency Costs Dividends Paid Payments to U.S. Treasury Transferred to Surplus Surplus Account 1991 Surplus, January 1 Transferred to Surplus— as above Surplus, December 31 l ,004 1,298 886 1,396 ( 512)1 1,071 862 1,029 76,759 72,142 304,346 375,507 13,769 65,190 2,963 3,836 4,146 305,855 3 ,0 9 4 1,315 3,311 4,061 4 2 9 ,1 0 2 1>129_ 68,511 1,315 67382 $ 69,826 $ 68,511 1,129 'Reflects a $1,424 refu n d o f 1989 taxes an d a reduction in 1990 taxes. R e im b u rse m e n ts due from the U.S. T reasury and o th er Federal agencies; $3,993 was u n reim b u rsed in 1991 a nd $3,893 in 1990. 3This item consists m ainly o f unrealized net gains related to revaluation o f assets d e n o m in a ted in foreign currencies to m arket rates. 23 D irectors Fielena Branch Federal Reserve Bank of M inneapolis D elbert W . Joh n so n C h a irm a n an d Federal Reserve A gent G erald A. R au en h o rst D eputy C h airm an Class A Elected by M em ber Banks R odney W . F ouberg C h airm an F arm ers & M erch an ts B ank & T ru st Co. A berdeen, S o u th D akota Jam es IT H earo n , III F o rm er C h airm an a n d C h ie f Executive O fficer N atio n al C ity Bank M inneapolis, M innesota C harles I,. Seam an I^resident an d C hief Executive O fficer First State B ank o f W arn e r W arn er, S o u th D akota Class B Elected by M em ber Banks Class C A p p o in te d by the Board o f Governors Jam es E. Jenks C h airm an Bruce C. A dam s P a rtn e r T rip le A dam s Farm s M in o t, N o rth D ak o ta D elb ert W . Jo h n so n P resid en t a n d C h ie f Executive O fficer P io n eer M etal F inishing M in n eap o lis, M in n eso ta J. F rank G ard n er Vice C h airm an D u an e E. D in g m a n n Presicient T ru b ilt A u to Body, Inc. Eau C laire, W isco n sin Jean D. Kinsey P rofessor o f C o n su m p tio n and C o n su m e r E conom ics U niversity o f M in n e so ta St. Paul, M in n e so ta Earl R. St. John, Jr. P resid en t St. John Forest P ro d u cts, Inc. S palding, M ichigan G erald A. R au e n h o rst C h a irm a n a n d C h ie f Executive O fficer O p u s C o rp o ra tio n M inn eap o lis, M in n e so ta Federal A dvisory C ouncil M em ber Lloyd P. Jo h n so n C h a irm a n a n d C h ie f Executive O fficer N o rw est C o rp o ra tio n M in n eap o lis, M in n e so ta A ppointed by the Board o f Governors }. F rank G ard n er P resident M o n ta n a R esources, Inc. B utte, M o n tan a Jam es E. Jenks H ogeland, M o n tan a A p pointed by the Board o f Directors Federal Reserve B ank o f M inneapolis R o b ert T. G erh ard t C h airm an , P resid en t and C h ief Executive O fficer First In terstate Bank o f M o n tan a, N.A. Kalispell, M o n tan a Beverly D. Flarris P resident E m pire Federal Savings a n d L oan A ssociation Livingston, M o n tan a N ancy M cL eod S tephenson Executive D irector N e ig h b o rh o o d H o u sin g Sendees G reat Falls, M o n ta n a D ecember 31, 1991 24 O fficers Helena Branch Federal Reserve Bank of Minneapolis G ary H. Stern P resident T h o m as E. G ain o r First Vice P resident M elvin L. B urstein S enior Vice P residen t an d G eneral C ounsel L eonard W . Eernelius S enior Vice P residen t R onald L. Kaatz S enior Vice P resident A rth u r J. R olnick Senior Vice P residen t an d D irecto r o f Research C olleen K. S trand S enior Vice P resid en t an d C h ie f Financial O fficer S heldon L. A zine V ice P resid en t and D ep u ty G eneral C ou n sel K athleen J. B alkm an Vice P resid en t John H. Boyd S enior R esearch O fficer V arad arajan V. C h ari S enior R esearch O fficer T h eo d o re E. U m h o efer, Jr. Vice P resid en t W illiam B. H olm A ssistant Vice P resident John D. Johnson Vice P resid en t and B ranch M anager W arre n E. W eb er S enior R esearch O fficer R onald O. H o stad A ssistant Vice P resid en t Sam uel H . G ane A ssistant Vice P resid en t S. Rao Aiyagari R esearch O fficer K ent C. A u stin son S upervision O fficer Phil C. G erb er Vice P resid en t R o b ert C. B ran d t A ssistant V ice P resid en t C aryl W . H ayw ard Vice P resid en t M arilyn L. B row n A ssistant G eneral A u d ito r Bruce H. Jo h n so n V ice P resid en t R ichard I,. K uxhausen V ice P resid en t Law rence J. C h ristian o R esearch O fficer Scott H. D ake A ssistant V ice P resid en t D avid Levy Vice P resid en t a n d D ire cto r o f P ublic Affairs Jam es T. D e u sterh o ff A ssistant Vice P resid en t Jam es M. Lyon Vice P resid en t R ich ard K. E inan A ssistant V ice P resid en t an d C o m m u n ity Affairs O fficer Susan J. M an ch ester Vice P resid en t Jean C. G arrick A ssistant Vice P resid en t P resto n J. M iller Vice P resid en t an d D ep u ty D irecto r o f R esearch P eter J. G avin A ssistant V ice P resid en t C harles J,. S h ro m o ff G eneral A u d ito r K aren L. G ra n d stra n d A ssistant V ice P resid en t Jam es H . H am m ill A ssistant V ice P resid en t T h o m a s E. K leinschm it A ssistant V ice P resid en t M arvin I,. K noff Supervision O fficer R ichard W . P u ttin A ssistant V ice P resid en t S usan K. R ossbach A ssistant G eneral C ounsel T h o m a s M . Supel A ssistant V ice P resident C lau d ia S. Sw endseid A ssistant V ice P resid en t R o b ert E. T eetsh o rn Supervision O fficer K en n eth C. T heisen A ssistant V ice P resid en t T h o m as H. T u rn e r A ssistant V ice P resid en t C aro ly n A. V erret A ssistant V ice P resident M ild red E. W illiam s A ssistant Vice P resid en t W illiam G. W u rster A ssistant V ice P resid en t December 31, 1991 Federal Reserve Bank of M inneapolis 250 M arquette Avenue M inneapolis, M N 55401-2171 The cover and text paper used in this report are recycled
@FedFRASER