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Federal Reserve Bank of Philadelphia

JANUARY-FEBRUARY 1984

Federal Reserve Bank o f Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106
JANUARY/FEBRUARY

1984

PRIVATE CLEARINGHOUSES
AND THE ORIGINS OF CENTRAL BANKING

Gary Gorton ............................................................................................................................. 3
Before the Federal Reserve System was established in 1914, the U.S. had developed effective
private institutions for regulating the banking industry, and for mitigating some o f the shocks o f
the business cycle. These institutions were clearinghouses. They began simply to facilitate the
exchange o f checks; as they grew to assume the task o f maintaining public confidence in the
banking system, they also grew in power and structure, and eventually provided the design— and
much o f the detail— o f our nation’s central bank.
FED PRICING AND THE CHECK COLLECTION BUSINESS:
THE PRIVATE SECTOR RESPONSE

Joanna H. Frodin ............................................................................................................. .

A look at the market for check collection services since the advent o f Fed pricing in 1981 reveals
how vastly its landscape is changing: Market suppliers are breaking new ground in re-pricing, re
designing, and re-packaging their services: clearinghouses are reviving or springing up anew; and
the old geographical boundaries are crumbling.

The BUSINESS REVIEW is published by the
Department o f Research every other month. It is
edited by Judith Farnbach. Artwork is directed by
Ronald B. Williams, with the assistance o f Dianne
Hallowed. The views expressed herein are not
necessarily those o f this Bank or o f the Federal
Reserve System. The Review is available without
charge.
Please send subscription orders and changes of
address to the Department o f Research at the
above address or telephone (215) 574-6428. Edi
torial communications also should be sent to the
Department o f Research or telephone (215) 5743805. Requests for additional copies should be
sent to the Department o f Public Services.
The Federal Reserve Bank o f Philadelphia is part
o f the Federal Reserve System— a System which

includes twelve regional banks located around the
nation as well as the Board o f Governors in Wash
ington. The Federal Reserve System was established
by Congress in 1913 primarily to manage the nation’s
monetary affairs. Supporting functions include
clearing checks, providing coin and currency to
the banking system, acting as banker for the Federal
government, supervising commercial banks, and
enforcing consumer credit protection laws. In
keeping with the Federal Reserve Act, the System is
an agency o f the Congress, independent adminis
tratively o f the Executive Branch, and insulated
from partisan political pressures. The Federal
Reserve is self-supporting and regularly makes
payments to the United States Treasury from its
operating surpluses.

The Monetary Control Act o f 1980 has been a catalyst for prodigious change in the financial
environment in the United States. Amid the many developments, a little-known institution, the
clearinghouse, has shown several interesting forms o f reaction. To students o f financial history,
the adaptive response by clearinghouses to challenging environmental change comes as no
surprise. This issue o f the Business Review touches on the past and present behavior o f this unique
form o f financial organization. — Donald J. Mullineaux, Senior Vice President and Chief
Economist, Federal Reserve Bank o f Philadelphia.

Private Clearinghouses and the
Origins of Central Banking
Gary Gorton
Today it is hard to imagine the business o f
banking without the presence o f a very large,
occasionally recalcitrant, market participant,
namely, the Fed. As the nation’s central bank, the
Federal Reserve System acts as a “ lender o f last
resort,” lends money to banks by discounting,
supervises and regulates banks, and facilitates the
payments mechanism. These functions o f the
Federal Reserve System are common to most o f the
world’s central banks. One might claim a central
bank is what a central bank does, so that identi
fying these functions amounts to defining a central
bank. Yet these functions are not unique to central
banks; indeed, they accurately describe the role o f
private bank clearinghouses in the United States
in the nineteenth century.

‘Gary Gorton, an Economist in the Philadelphia Fed's Depart
ment o f Research, specializes in monetary theory and policy.

The history o f the development o f clearing
houses is marked by banking panics which shook
the financial system, and by the steps clearing
houses took to survive those panics. As one step
follow ed another, U.S. clearinghouses evolved
functions and powers similar or identical to those
which eventually became the province o f a new
institution, the Federal Reserve System, established
in 1914.1 In fact, recurring banking panics were
often cited as justification for a central bank in the
United States.

1Banks were supervised by state authorities or by the Comp
troller of the Currency under the laws of the National Bank Act
(passed during the Civil War). Also, the U.S. Treasury performed
some central banking functions. See Esther R. Taus, Central
Banking Functions o f the United States Treasury. 1789-1941
(New York: Columbia University Press, 1943), and David Kinley,
The Independent Treasury o f the United States (Washington: Govern
ment Printing Office, 1910).

BUSINESS REVIEW

The Federal Reserve System was modelled after
private clearinghouses because these organiza
tions successfully developed a method to restore
confidence in the banking industry during a
banking panic. They invented the clearinghouse
loan certificate, which allowed banks to transform
their illiquid portfolios into money. During the
latter part o f the nineteenth century, clearing
houses had gone so far as to create their own
money during panics— money which was accept
able to bank depositors and used in exchange. The
historical development o f the loan certificate
process is the story o f how the banking industry
was able to cope with panics without the presence
o f a central bank.

JANUARY/FEBRUARY 1 9 8 4

daily exchange could not be made within working
hours.
The New York banks then agreed to continue
exchanging checks daily, but to settle accounts on
Friday mornings. On Fridays bedlam reigned. J. S.
Gibbons, an observer, described the scene:
A Porters’ Exchange was held on the steps o f one
o f the W a ll Street banks, at which [the porters]
accounted to each other for what had been done
during the day. Thomas had left a bag o f specie at
John’s bank to settle a balance, which was due
from W illiam ’s bank to Robert’s; but Robert’s
bank owed twice as much to John’s. W h at had
becom e o f that'. Then Alexander owed Robert also,
and W illiam was indebted to Alexander. Peter
then said that he had paid Robert by a draft from

THE FIRST U.S. CLEARINGHOUSE
During the latter part o f the Free Banking Era,
1837-1860, the use o f checks drawn against bank
deposits grew rapidly, so much so that deposits
became the predominant means o f exchange. The
use o f checks grew fastest in large centers o f
business where most banks were located, and
where the sheer number o f transactions made
cash payments inconvenient. Sizable transactions
began to be conducted by check. For large bor
rowers at banks it became convenient to have their
checking accounts credited rather than to take the
loans in cash. Businessmen no longer needed
more bank notes and coin than was necessary for
retail transactions; the rest could be deposited,
and yet remain easily accessible.
Before 1850, banks cleared checks with a daily
exchange and settlement— each bank sent a porter
to make the rounds o f all the other banks. The
porter carried a ledger book, checks drawn on
other banks, and bags o f gold. At each stop, the
porter turned over checks drawn on that bank and
picked up checks drawn on his bank. If the value
o f the checks he presented exceeded the value o f
those he picked up, he collected the difference in
gold. If the balance netted out against his bank, he
paid in gold. Porters crossed and recrossed each
other’s tracks, lugging bags o f gold, hoping to
reach each o f the other banks by the end o f the
day. The system had the simplicity o f Indian
camps in which each tepee had a path leading to
every other tepee. But as the number o f banks
grew, these paths became a tangled web. By 1850
the fifty banks in New York City found that the
4

James, which he, James, had received from Alfred
on Alexander’s account. That, however, had settled
only half the debt. A quarter o f the remainder was
cancelled by a bag o f coin, which Samuel had
handed over to Joseph, and he had transferred to
David. It is entirely safe to say that the Presidents
and Cashiers o f the banks could not have un
tangled this medley. (Gibbons, p. 294)

In response to this chaos, New York City banks
established a clearinghouse in 1853, officially
adopting a constitution in 1854. The basic princi
ple o f a clearinghouse is simple. Each bank settles
its balances with one institution, the clearing
house, rather than with each bank individually.
The St. Nicholas Bank, for example, delivers to the
clearinghouse all the claims it holds against other
banks. The clearinghouse receives the debit items
and credits the St. Nicholas Bank with that
amount. The clearinghouse then delivers all the
claims that the other banks hold against the St.
Nicholas Bank and debits its account by that
amount. The outcome is the net balance o f each
bank at the clearinghouse. By meeting in a single
place at a specified time and exchanging with only
one other party— the clearinghouse— check
clearing was dramatically simplified.
Once the New York Clearinghouse had been
established, bank porters no longer had to criss
cross each other’s tracks to settle accounts, but
balances at the clearinghouse still had to be settled
in gold. To improve the process o f exchange fur
ther the clearinghouse issued specie certificates
to replace gold in clearing balances at the clearing
house. Each bank deposited gold with a designated
FEDERAL RESERVE BANK OF PHILADELPHIA

Clearinghouses and Central Banking

clearinghouse member bank, and received specie
certificates to use in settling at the clearinghouse.
The certificates were issued in large denomina
tions and were used exclusively to replace gold
coins in clearinghouse settlements. Gold was still
used in clearinghouse settlement, but the certi
ficates reduced the amount needed. In 1857 the
specie certificates amounted to $6.5 million, and
the daily exchanges to $20 million.
The clearinghouse system at this stage reduced
the use o f cash, removed the risk o f transporting
large amounts o f gold through the streets, and
minimized the costs o f runners, porters, messen
gers, and bookkeepers. Clearings through the New
York City Clearinghouse grew by leaps and bounds.
Impressed with the success o f the clearinghouse
in New York City, Boston established one in 1856,
follow ed by Philadelphia and Baltimore in 1858.
The first clearinghouse in the Midwest was estab
lished in Chicago in 1865. By the 1880s clearing
houses dotted the American banking landscape.
The clearinghouse was originated to facilitate
the exchange o f checks, but by 1859, J. S. Gibbons
could write: “ It has already added to this many
other uses which were not contemplated, and
more are suggested.” Indeed, the advent o f clearing
houses set the stage for banks to act together in
response to crises. The New York Clearinghouse
could not prevent the Panic o f 1857, but the
experience o f the panic proved to be a stimulus for
the development o f central banking functions by
clearinghouses.

PANICS A ND THE CLEARINGHOUSE
LOAN CERTIFICATE
Between 1800 and 1915 twelve banking panics
erupted in the United States, almost always just
after business cycle peaks. In the face of worsening
econom ic conditions, depositors feared that there
would be bank failures, resulting in losses on
deposits. Losses meant that for each dollar in a
checking account, the bank would repay less than
a dollar in gold or government currency to the
depositors. Actually, only a small number o f banks
declared bankruptcy during these recessions, but
at the outset o f each recession, depositors did not
know which banks were really in trouble. Since
depositors lacked good information about the
condition o f individual banks, the failure o f a
single large bank or a few small banks could cause

Gary Gorton

people to expect other banks to fail. Checks from
all banks were then viewed as being very risky, and
depositors rushed en masse to demand their cur
rency (redeem deposits) from all banks. Since even
solvent banks held only a fraction o f their deposits
in cash reserves, no bank could meet the demands of
large numbers o f depositors trying to withdraw
funds at one time. Nor could the banking system.
The banking system was illiquid; it could not
readily convert enough assets to cash to satisfy
depositor demands. The loss o f confidence in
bank money spread rapidly across all financial
institutions.
In response to panics, clearinghouses evolved
ways to restore confidence in bank deposits. If a
needy member bank could be prevented from
going bankrupt, all the clearinghouse members
would benefit. Had the needy banks failed, de
positors might expect other banks to fail, putting
the solvency o f these otherwise healthy banks in
jeopardy by creating liquidity problems. Clearing
houses discovered a way to satisfy depositor
demands for currency, at least partially. By pro
viding liquidity to needy member banks, the
clearinghouse prevented the further erosion o f
confidence in the banking system.
The first crisis to occur after the founding of
clearinghouses in the United States was the Panic
o f 1857. As the panic swept the nation, banks tried
to meet the demands for gold from their deposi
tors, but their gold reserves were insufficient. The
New York City banks first reacted by suspending
convertibility; that is, the banks would not convert
checks into currency for the public. This merely
postponed the day o f reckoning. Then to meet
depositor demands, the specie certificates, which
clearinghouse members had already been using to
settle their daily balances at the clearinghouse,
were transformed into a new financial instrument,
called loan certificates. The loan certificates
became the equivalent o f specie in settling
balances at the clearinghouse.
Loan certificates were issued against the assets
o f clearinghouse member banks. The loan certi
ficates were backed by member banks’ portfolios,
parts o f which were submitted as collateral. An
individual clearinghouse member bank which
needed currency to satisfy its depositors’ demands
applied to the clearinghouse loan committee,
submitting some o f its loans and bonds for ex
5

JANUARY/FEBRUARY 1 9 8 4

BUSINESS REVIEW

amination as collateral. Upon accepting the col
lateral, the clearinghouse issued certificates
amounting to a percentage o f the value o f the
collateral, and the needy bank agreed to pay 6
percent interest. The certificates could then be
used to replace currency in the clearinghouse
settlements. Clearinghouse loan certificates, as
they came to be called, were issued for specific
lengths o f time, typically three months.
With depositors on all sides demanding gold,
the clearinghouse reduced its own use o f gold by
issuing loan certificates against the assets o f the
member banks. The loan certificates could be used
instead o f gold in settling at the clearinghouses.
Therefore, the gold that had been used in settle
ment transactions was now available to be paid out
to depositors. Unlike the specie certificates, which
the clearinghouse used for convenience to replace
gold in settlements, the loan certificates were not
backed by gold. Yet banks accepted the certifi
cates instead o f gold in exchange at the clearing
house.
W hy would the clearinghouse member banks
accept the new certificates? There are two reasons.
First, though the new certificates were not backed
by gold, they were backed by securities. Member
banks submitted assets to the clearinghouse
against which the loan certificates were issued.
Moreover, the submitted assets were discounted;
that is, loan certificates were issued, usually at 75
percent o f the market value o f the submitted
assets. During a panic, however, there was the risk
that a member bank would fail and that the value
o f the assets submitted as collateral for loan
certificates was less than the value o f outstanding
loan certificates. Thus, the second reason that the
loan certificates were acceptable or credible was
that this risk was spread among the clearinghouse
members. Loan certificates were the joint liability
o f the clearinghouse member banks. If it turned
out that a member bank failed and that the col
lateral was worth less than the member’s loan
certificates, the loss was borne by the clearing
house members in proportion to each member’s
capital relative to the total capitals o f all the
members.
In Boston, the risk-sharing idea was boldly
articulated in the plan adopted:
The Associated Banks o f the Clearinghouse

severally agree each with the other, that the Bills
received instead o f specie, at the Clearinghouse,
from the Debtor Banks, and paid instead o f specie
for balances to the Creditor Banks, shall be sent in
with the next day’s settlement at the Clearing
house; that such Bills so received shall in the mean
time. be and remain at the jo in t risk o f a ll the Assoc
iated Banks, in proportion to the am ount o f their
Capitals respectively.
And it is further agreed, as above, that the
Clearinghouse Committee may at any moment
call upon any bank for satisfactory collateral
security, for any balance thus paid in bills instead
o f specie; and each Bank hereby agrees with the
Clearinghouse committee, and with all and each
o f the other Banks to furnish immediately such
security

when

demanded.

(Emphasis

added.

Quoted in Redlich, p. 159)

The Boston plan was to become the model for
issuing certificates in subsequent panics.2
Needy banks could temporarily sell parts o f
their portfolios to the other member banks and
receive loan certificates which were as good as
gold in clearinghouse settlements. The risk
associated with the certificates was shared (or
pooled) among the member banks by allocating
the liability for them according to each bank’s
capital as a percentage o f the total capitals o f the
members. In this way an individual bank could try
to protect itself from inability to meet its deposi
tors’ demands for currency. Other clearinghouse
banks benefited because the prevention o f member
failures would insure that they were not adversely
affected through confidence further deteriorating.
When another crisis broke out in November,
1860, the New York City Clearinghouse Associ
ation was decisive in response.3 The Association
2During the Panic of 1857 the New York Clearinghouse
Association also devised a way to share risk, but with a slight
difference: it issued loan certificates against the bank notes of
country banks, not the assets of member banks. Country bank
notes, during the Free Banking Era, were backed by securities
deposited as collateral with state authorities. Hence, in New
York, the loan certificates were indirectly backed by the
securities deposited with state authorities.
3The November 1860 episode has been described by some
authors as a quasi-panic since its cause seems related to the
impending Civil War, the Treat Affair, and certain actions o f the
U.S. Treasury. See DonC. Barrett, The Greenbacks and Resumption
o f Specie Payments. 1862-1879 (Cambridge, Mass: Harvard Univer
sity Press, 1931).

FEDERAL RESERVE BANK OF PHILADELPHIA

Gary Gorton

Clearinghouses and Central Banking

appointed a committee to receive securities from
banks needing aid and to issue certificates based
on this collateral. The value o f the certificates
issued was limited to a maximum o f 75 percent o f
the value o f the collateral securities, and the
borrowing bank agreed to pay 6 percent interest
per year. Suspension o f convertibility o f checks
into currency, which seemed imminent in the fall
o f 1860, was successfully avoided.4 In 1860 the
plan was restricted to New York City. A year later
Boston and Philadelphia adopted the idea o f the
clearinghouse loan certificate. During the Panic o f
1873, clearinghouse loan certificates were issued
in New York, Boston, Philadelphia, Baltimore,
Cincinnati, St. Louis, and New Orleans.
The loan certificate process allowed clearing
house member banks to respond to panics by
increasing the amount o f currency available to
satisfy depositors’ demands. All banks benefited:
confidence was not allowed to deteriorate further,
and could be restored, as banks did not fail solely
due to illiquidity. The loan certificate process,
however, had its limits. The maximum amount of
currency which could be made available to the
depositors was the amount used in interbank
settlements. If this amount was not enough to
meet depositor demands, it was considerably
harder to restore confidence, and the banking
system then had to rely on suspension o f con
vertibility.

ISSUING CLEARINGHOUSE MONEY TO
THE PUBLIC
The Panic o f 1873 provoked a further innova
tion by clearinghouses which involved the deposi
tors directly in the loan certificate program. With
the loan certificate process confined to replacing
gold in interbank transactions, only a limited
amount o f additional gold could be made available
to meet depositor demands. But if the loan certi
ficates could be issued directly to the depositors,
and if the depositors would accept them, then the
clearinghouse would overcome these limits im
posed by the earlier method. The clearinghouse
would be issuing its own money to depositors!

During the Panic o f 1873 the New York City
Clearinghouse Association centralized and regu
lated member banks’ distribution o f currency to
the public by issuing a quasi-currency directly to
depositors. When depositors arrived at banks
demanding currency, banks were authorized to
stamp depositors’ checks as “ Payable through the
Clearinghouse.” 5 The checks o f depositors were
literally stamped by bank tellers at the banks
where the depositors had accounts. The quantities
o f checks that could be certified by a member bank
depended on the amount o f loan certificates it had
obtained. The certified checks became a claim on
the clearinghouse, not the individual bank, and
could be redeemed for currency. By determining
the amount o f checks that could be certified by
member banks, the clearinghouse rationed the
limited amount o f currency available to pay out to
depositors.
During the panics o f 1893 and 1907 clearing
houses took the further step o f printing their own
money which substituted for government currency.
The clearinghouse money could not be redeemed
for currency during the period o f suspension, so
the amount issued was not limited by the currency
reserves o f the clearinghouse members. The
Chicago Clearinghouse Association resolution
passed on November 6, 1907 explains how the
process o f issuing clearinghouse money during
suspension worked:
First, any bank being a member o f the Chicago
Clearinghouse

Association

may

at any time

surrender to the clearinghouse committee any
loan certificate held by it... and receive in lieu,
checks to the am ount o f the principal thereof, in
the denominations o f $2, $5, and $10...
Second,... the clearinghouse association shall
have the benefit and protection pro rata o f the
securities deposited... to the same extent as the
certificates... issued...
Third, at any time any bank on which [the]
checks are drawn may present [them] to the
clearinghouse

committee

and

receive

credit

against the principal o f the loan certificates in
place o f which the [checks] were issued. Any

S u s p e n sio n o f convertibility, however, did occur in 1861.
See, A. Barton Hepburn, A History o f Currency in the United States
(N ew York; 1924); Cannon, Clearinghouses (Washington:
Government Printing Office, 1910), Chapter X.

■See O. M. W. Sprague, History o f Crises Under the National
’
Banking System (Washington: Government Printing Office,
1910).

BUSINESS REVIEW

interest w hich may accrue on [the] loan certi
ficates... shall accrue... to the Chicago Clearing
house Association. (Quoted in Cannon, p. 121-

122)

Issuing clearinghouse money directly to the
public was a straightforward extension o f the loan
certificate process. Once a bank had submitted
acceptable assets as collateral and had received
loan certificates, the certificates could then be
exchanged for clearinghouse currency in small
denominations and given out to the public instead
o f gold coin or government currency.6 The
clearinghouse currency was really the loan certi
ficates denominated in a manner convenient for
the public— as low as 25C. The total amount o f
clearinghouse hand-to-hand money issued during
the panic o f 1893 has been estimated at $100
million (about 2-1/2 percent o f the money stock),
and during the Panic o f 1907, at $500 million
(about 4-1/2 percent o f the money stock).
The same reasons which explain why loan certi
ficates were acceptable to banks in settling clear
ings explain why depositors were confident that
clearinghouse money had value, and hence, was
acceptable. Since the money issued by the clearing
houses was the joint liability o f all the member
banks, individual depositors were insured against
individual bank failures. The risk that a single
bank would be unable to return a dollar o f gold
currency for a dollar in its checking accounts was
reduced since the loan certificate was a claim on
all the banks in the clearinghouse. Moreover, the
clearinghouse money was backed by the securities
that member banks had deposited as collateral. If
the value o f the collateral was insufficient to cover
the clearinghouse money issued, then the differ
ence would be made up by the other member
banks. Since there was always a chance that other
member banks would be unable to make up the
difference, clearinghouse money was not a perfect
substitute for government currency. [See THE
CREDIBILITY OF CLEARINGHOUSE MONEY.]
The certificates issued to the public almost
always affirmed, in print on the money, that “ this

6The National Bank Act, passed during the Civil War, effec
tively outlawed private bank notes. After the Act was passed the
national government issued all currency, including the famous
"greenbacks.”

JANUARY/FEBRUARY 1 9 8 4

certificate is secured by the deposit o f approved
securities.” In Portland, Oregon in 1907, the certi
ficates stated that banks had deposited “notes,
bills o f exchange, and other negotiable instru
ments secured by wheat grain, canned fish, lumber
actually sold, and other marketable products, and
bonds approved by the committee.” In Charleston,
South Carolina the certificates stated that they
were backed by “ securities o f double the value o f
this certificate, or bonds o f the United States or o f
the State o f South Carolina, or o f the City o f
Charleston, or o f the City o f Columbia, 10 percent
in excess thereof.” Certificates issued in Danville,
Virginia were said to be “ secured by the combined
capital o f these banks, also by collateral worth
one-third more than all o f the certificates issued.”
Issuing loan certificates in convenient denom
inations directly to the public was a process o f
money creation limited only by the percentage
applied to the collateral submitted by banks. In
principle, banks could submit their entire port
folios. Since gold currency was not being replaced,
but instead bank portfolios were monetized directly,
much more money could be created to satisfy
depositor demands than could be created by
replacing currency in interbank transactions.
By temporarily joining together during panics
through the clearinghouse loan certificate pro
cess, private banks almost literally became one
bank. The associated banks reached the point
where, instead o f economizing on currency, they
were creating their own money and issuing it to the
public. By exchanging checks for clearinghouse
money, banks were able to satisfy depositor
demands and, hence, avoid failure due to their
illiquid portfolios. Clearinghouse money was
acceptable to depositors because it was a claim on
the association o f banks, not on just a single bank,
insuring them against individual bank failure.

DEVELOPING THE REGULATORY
FUNCTIONS OF CLEARINGHOUSES
Clearinghouse activity during panics was
motivated by the recognition that, in the banking
industry, the performance o f individual banks had
effects on other banks. If a bank failed during a
panic or recession, depositors perceived other
banks as possibly insolvent, and a run on banks
could be sparked or exacerbated. Understanding
that the fates o f separate banks were thus linked
FEDERAL RESERVE BANK OF PHILADELPHIA

Gary Gorton

Clearinghouses and Central Banking

THE CREDIBILITY OF CLEARINGHOUSE MONEY
Even though loan certificates issued to the public were backed by discounted collateral and liability for
them was shared, they were discounted against government currency during a period o f suspension when the
public exchanged with them. In other words, ten dollars o f currency (gold coins or greenbacks) bought more
than ten dollars o f clearinghouse money. The figure belo w shows the behavior o f this currency premium
during the suspension associated with the Panic o f 1907. The behavior o f the currency premium over certified
checks during the Panic o f 1907 is similar to its behavior during the Panic o f 1893 and the Panic o f 1873. In
general, the currency premium declines continuously until it reaches zero; at that point the exchange rate o f
o n e-for-on e is reestablished and the suspension is lifted. This behavior o f the currency premium reflects the
process o f restoring confidence in bank money.

THE CURRENCY PREMIUM DURING THE PANIC OF 1907
Premium (%)

5
Oct. 31, 1907

resulted in clearinghouses developing the func
tion o f lender o f last resort and money creation.
These, indeed, were central banking functions,
and, in the United States, they became functions
o f the Federal Reserve System.
Clearinghouse central banking functions were
not undertaken only during panics. Clearing
houses were involved in ongoing regulation o f
banks because unsound member banks could
create problems for other member banks. Since
check clearing was an indispensable part of
banking, the clearinghouses were able to enforce
regulatory functions by using the power to admit
or expel members.
During a panic the unsound member banks
could not be expelled from the clearinghouses

Days

because o f the consequences for public confi
dence in bank money. Yet such members would
jeopardize the clearinghouse’s response to panics.
Member banks, then, had to be constantly
monitored and regulated so that the loan certi
ficates would work to reestablish confidence during
panics. To achieve this, clearinghouses introduced
supervision o f members and established uniform
policies on banking matters.

Requiring Information to be Made
Public. After the passage o f the National Bank act
in 1863 a “dual banking system” existed in the
United States. There were national banks, chartered
by the federal government and subject to the
regulations o f the National Banking Act. There
were also state banks, chartered and, to varying
9

BUSINESS REVIEW

degrees, regulated by the individual state govern
ments. Often clearinghouse policy imposed the
stricter o f the two regulatory standards on its
member banks. Banks were willing to bear the
regulatory burden in order to get access to
clearinghouse services.
In New York, before the clearinghouse was
established, a state law required each state bank to
publish, every Tuesday, a sworn statement o f the
“ average amount o f loans and discounts, specie,
deposits, and circulation” outstanding during the
preceding week. The process o f exchanging at the
clearinghouse revealed the reserve position at
each bank and, according to Gibbons (1859),
resulted in a "restriction o f loans by the necessity
o f maintaining a certain average o f coin from
resources within the bank.” In effect, by the con
ditions o f membership, the clearinghouse enforced
what it had been the intention o f the law to require,
and applied these standards to national banks as
well. Similarly, in 1864 the Boston Clearinghouse
Association adopted a rule requiring national
banks to publish weekly reports showing their
capital, loans, coin reserves, legal tender notes,
deposits, and bank balances. Under Massachusetts
state law state banks were already required to
furnish that information.
Requiring Reserves, in general, minimum
reserves were required by law, either state or
federal, depending upon whether the bank was a
state bank or a national bank. Where such legis
lative requirements were viewed as inadequate,
clearinghouses adopted reserve requirements for
their members. Thus, in the 1850s the New York
Clearinghouse recommended that the banks “ keep
at all times an amount o f coin equivalent to no less
than 20 percent o f net deposits o f any kind.”
Similar action was taken in Philadelphia. The
Chicago Clearinghouse would admit no state bank
to membership unless it agreed to adhere to the
reserve requirements o f the National Bank Act, the
stricter o f the two requirements.

Auditing M em ber Banks, clearinghouses
frequently audited member banks, as a condition
o f membership in the clearinghouse, and as a
response to rumors about the condition o f indi
vidual member banks. Oftentimes the audits were
made public. Audits were conducted by committees
composed o f bankers from member banks or by
outside auditing firms hired by the clearinghouse.
10

JANUARY/FEBRUARY 1 9 8 4

In 1906 the Chicago Clearinghouse Association
became the first to hire a staff o f its own exam
iners.
The Chicago Clearinghouse Association was
also the first association to implement and enforce
a standardized system o f reporting forms. Beginning
in 1887 the Chicago Clearinghouse Association
required the forms to be submitted four times a
year. The Chicago system made for accurate and
comparable statements, forcing better accounting
methods on some banks. National banks already
reported to the Comptroller o f the Currency five
times a year, but state banks did not. Clearing
houses recognized that the national bank exam
inations were unsatisfactory.7 As a result, better
examination methods were adopted independently
o f the bank regulatory authorities and applied to
state, as well as national, banks.

CLEARINGHOUSES AND CENTRAL BANKS
Many people think o f central banks like the
Federal Reserve System as unique creations o f
government bodies. But by the first decade o f this
century clearinghouses were behaving very much
like today’s central banks. Clearinghouses admitted
and expelled member banks, audited members
with their own examiners, enforced strict accounting
and reserve standards, and created money during
times o f crisis. When the Federal Reserve System
was established in 1914 it was designed to
accomplish exactly these functions. For example,
the discount window at the Fed performed the
same function as the clearinghouse loan certificate.
Needy banks could borrow money from the Fed by
submitting assets as collateral and paying
interest.
However imperfect the clearinghouse mecha
nisms were in preventing panics, they were suc
cessful in shortening the duration o f panics by
restoring confidence in the banking system. Indeed,
a rather significant historical episode— the Great
Depression— showed that central banks were not
capable o f preventing financial panics. It took still
another innovation, deposit insurance, to put a
halt to bank panics. There hasn’t been a banking

C om p troller o f the Currency audit reports were generally
viewed by bankers as inadequate. As one Comptroller of the
Currency put it: ’’bank examinations [were then] illogical and
unscientific ...” Quoted in Redlich, p. 286.

FEDERAL RESERVE BANK OF PHILADELPHIA

Clearinghouses and Central Banking

Gary Gorton

panic in the U.S. since the Federal Deposit In
surance Corporation was formed in 1933.
What, then, makes central banks different from
clearinghouses? A distinction which seems obvious
today is that the Fed conducts a national monetary
policy geared to produce adequate economic
growth and low inflation. No clearinghouse
assumed such a role. But neither did the Fed when it
was first formed in 1914. The Fed’s monetary
policy role was an evolutionary one, much as the

clearinghouses extended their range o f activities
as they developed and grew. In fact, just prior to
the founding o f the Fed, clearinghouses them
selves had proposed linking together in a national
clearinghouse association. W e will never know
whether this step would have led to a national
clearinghouse monetary policy, but it is clear that
the private bank clearinghouse gave rise to the
public institution o f a central bank.

THE FIRST CLEARINGHOUSE
Historians are unsure whether the idea for the first clearinghouse came from an Arabian
coffee bean or from a mug o f beer. Prior to 1770, in London, clearing checks required each bank
to send a clerk every day to all o f the other banks to exchange checks and settle balances— to
“clear” the transactions o f the previous day. These runners had to cover considerable ground,
becom ing exhausted and footsore. It w as natural, then, that they w ould drop into a coffee house
or pub for some refreshment.
Tradition has it that one day runners from two different banks happened to be drinking at the
same place, and started to discuss the day’s work. They discovered that they had checks drawn
for the same amount on each other’s bank so they proceeded to exchange them. To the runners,
meeting at one place to exchange checks over beer or coffee and avoiding the endless treks
around the city was a clearly preferable method o f exchange. It was not long before other
runners were initiated into the secret and the meetings becam e more frequent, eventually
becom ing daily.
Bank managers, upon learning what their runners were doing, were o f two minds. Some
m anagers denounced their runners as lazy and shiftless. Other managers realized the value o f
the idea, taking exception only to the coffee or beer. In 1775 the London banks agreed upon a
com m on room on Lom bard Street for the location o f the first London clearinghouse. Beer and
coffee were not served.

REFERENCES AND FURTHER READING
11

JANUARY/FEBRUARY 1 9 8 4

BU SIN ESS REVIEW

REFERENCES AN D FURTHER READING

Andrew, A. Piatt, “Substitutes for Cash in the Panic o f 1907,” Quarterly
Journal o f Economics, (August, 1908).
Bolles, Albert, Practical Banking (New York: Homans Publishing Co.,
1892).
Cannon, James G., Clearing Houses U.S. National Monetary Commission,
61st Congress, 2d Session, Doc. No. 491 (Washington: Government
Printing Office, 1910).
Gibbons, J. S., The Banks o f New York, Their Dealers, The Clearinghouse, and
the Panic o f 1857 (Greenwood Press, 1968; reprint of 1859 original).
Hepburn, Barton, A History o f Currency in the United States (New York,
1924).
Myer, Margaret, The New York Money Market (New York: Columbia
University Press, 1931).
Redlich, Fritz, The M olding o f American Banking (New York: Hafner
Publishing Co., 1951).
Sprague, O.M.W., History o f Crises Under the National Banking System,
National Monetary Commission, 61st Congress, 2d Session, Doc. No.
538 (Washington: Government Printing Office, 1910).
Timberlake, Richard H., The Origins o f Central Banking in the United States
(Cambridge, Mass: Harvard University Press, 1978).

FEDERAL RESERVE BANK OF PHILADELPHIA

Fed Pricing and
the Check Collection Business:
The Private Sector Response
Joanna H. Frodin*
In March 1980, Congress passed the Depository
Institutions Deregulation and Monetary Control
Act (MCA) and dramatically “ changed the rules” in
the check clearing business. The law directed the
Federal Reserve to offer its check collection ser
vices to all depository institutions, for instance,
not just to its member banks. Furthermore, it
required the Fed to price those services to cover
costs, rather than providing them free. One im
portant aim o f Congress in imposing pricing was to
promote competition and efficiency in the market
for check collection services by removing the
subsidy extended to some banks through free Fed
services.
Pricing has changed the structure o f economic
incentives facing both the suppliers and demanders

•Joanna H. Frodin is a Senior Economist in the Banking Section
of the Philadelphia Fed’s Research Department.

o f check clearing services. How have the major
suppliers in this market, namely, the Federal
Reserve, correspondent banks, and clearinghouses,
been affected? Has the Fed lost business to the
private sector, as econom ic theory would predict?
And how has the private sector responded? Have
clearinghouses become more important? Is the
market more competitive? Are the changes super
ficial, one-time responses to pricing, or are they
more fundamental ones?

A PRIMER ON CHECK COLLECTION
A check takes several steps on its journey from
the bank where it is first deposited to its bank o f
issue (see Figure 1). Once someone deposits a
check into an account, the transaction information
on the check is encoded. Since most checks are
printed with codes for the bank o f issue, the
customer’s account number, and routing infor13

BUSINESS REVIEW

mation, it is the dollar amount which is added at
this point, in the lower right com er o f the check in
magnetic ink. Machines which “read” the infor
mation do the next step— sorting according to a
check’s destination (bank o f issue). The combi
nation o f encoding and sorting checks is known as
“processing.” Next, a check must be cleared, at
which point settlement o f accounts o f the banks
involved takes place. Settlement means the
crediting and debiting o f funds to and from banks’
accounts. After clearing, the check returns to the
issuing bank which debits the customer’s ac
counts.
There is no set formula for a check to follow in
the collection process. Since several alternatives
exist at each step, a check could take a myriad o f
different routes (see Figure 2). An institution might
handle the whole task itself, for instance, by
processing the checks in-house and sending them
directly to the bank o f issue for clearing. These
institutions typically are either small banks, which
exchange and clear checks directly with another
local bank, or institutions which are large enough
to process large numbers o f checks by machine
and use private courier services to send checks
directly to banks for collection. By contrast, a bank
might use one or several agents: a local service
bureau to encode, a correspondent bank to sort,
and a Federal Reserve facility to clear the check.
Both correspondent banks and the Fed clear checks
14

JANUARY/FEBRUARY 1 9 8 4

FIGURE 2

FEDERAL RESERVE BANK OF PHILADELPHIA

Fed Pricing and Check Collection

and settle banks’ accounts. A major reason a bank
uses these agents is to clear checks with banks at
some distance. For clearing local checks, a bank
has a third option— a local clearinghouse, which
holds daily exchanges o f checks among its
members.
Clearinghouses vary in structure and size. A
clearinghouse may be an informal organization
with as few as three banks, or it may have formal
rules and as many as 100 banks. Most clearing
houses settle their members’ accounts through a
so-called net settlement account at one o f 48
Federal Reserve facilities. Each Fed facility parti
cipates at local clearinghouses where it receives
settlement information, presents checks from
non-clearinghouse banks, and picks up checks to
be sent elsewhere.
The choices banks make at each stage o f the
check collection process depend on many factors.
Two econom ic factors loom large— the cost o f the
service and its quality. Costs include those o f
encoding, sorting, transporting, and clearing
checks. The quality o f service depends primarily
on availability o f funds, that is, how promptly a
bank receives credit on checks it presents for
collection. Promptness, in turn, depends on
deposit, transportation, and availability schedules
offered by various agents. The later in the day an
agent is willing to wait to accept checks for clearing
and the more quickly it credits funds to the banks
o f first deposit, the more attractive its service.
Early availability matters particularly for high
dollar value checks. Other factors affect quality
also: timely account information, the handling of
items returned because o f insufficient funds,
charges for overdrafts (a debit in a bank’s clearing
account), and computer downtime. Noneconomic
factors might also affect choices. In particular,
some institutions may have a strong preference for
using private sector services, while others may
have a preference for using the Fed.
A 1979 Federal Reserve study provides an idea
o f the numbers o f checks involved in collection
and o f the relative importance o f the various
agents in the check collection process.1 In 1979,
1Federal Reserve Bank of Atlanta, A Quantitative Description o f
the Chech Collection System. (Copyright by: American Bankers
Association and Bank Administration Institute, 1982). The data
that follow in the remainder o f this section are derived from this
publication.

Joanna H. Frodin

the number o f commercial bank checks written
was about 32 billion. As each check journeyed
through the process, an average o f 2.4 institutions
(banks, Fed, clearinghouses) handled it so that the
total number o f processed checks was 76.7
billion.
The Federal Reserve system processed and
cleared directly about one-fifth o f this total. While
commercial banks individually have smaller corre
spondent banking networks than the Fed, they
processed the remaining four-fifths o f the checks.
Banks, in turn, relied on several institutions for
clearing services. They sent 22 percent o f the total
they handled to Fed facilities, about 16 percent to
correspondent banks, and about 11 percent to
local clearinghouses. They cleared the remaining
half in their own banks as “on-us” checks.
The relative use o f the different clearing agents
varied with bank size. The smallest banks relied
heavily on larger correspondents and used local
clearinghouses, which generally do not process
checks, and the Fed to a relatively small degree.
The largest banks used local clearinghouses to the
greatest degree, reflecting more exchange volume
with other clearinghouse member banks. For
interdistrict checks (ones which cross Federal
Reserve District lines), these banks made relatively
small use o f the Fed, turning instead to private
transportation to exchange directly with banks in
other money centers.

FED PRICING A N D ITS IMPACT
Pricing o f the Federal Reserve’s check services
went into effect in August 1981 and changed the
incentive structure in the check-collection market
overnight. Each o f the twelve Reserve Banks insti
tuted prices for its district, including its branches
and Regional Check Processing Centers (RCPCs).2
*
Pricing changed all the relative costs a bank faced
at each stage o f the check collection process, and,
other things equal, would have made all private
alternatives relatively less expensive for Fed
members than they were before pricing. For pre2In the early 1970s, the Fed set up 12 RCPCs in areas with
relatively large check volumes outside Reserve Bank cities to
speed up check collection. The sites o f the RCPCs are: W indsor
Locks, Conn.; Lewiston, Maine: Jericho, N.Y.; Cranford, N.J.;
Utica, N.Y.; Columbus, Ohio; Baltimore, MD.; Columbus, S.C.;
Charleston, S.C.; Indianapolis, Ind.; Milwaukee, Wise.; Des
Moines, Iowa.

JANUARY/FEBRUARY 1 9 8 4

BUSINESS REVIEW

vious nonmembers, the availability o f Fed services
opened up by the MCA presented these institu
tions with a new option rather than with new
relative prices.
Economic theory suggests that, prior to pricing,
free Fed services induced banks to use more Fed
and less private sector services. Therefore, where
pricing resulted in higher prices for Fed services
relative to private services, there should have been
some reallocation o f resources toward the private
sector. Specifically, Fed pricing should have led to
decreased use o f Fed processing and clearing and
to the increased use o f private sector alternatives.
That is exactly what happened.
In August 1981, pricing brought about an abrupt
drop in the use o f Fed processing, transportation,
and clearing services. The substantial lead time in
announcement o f Fed changes allowed the banking
community ample opportunity to make alternative
arrangements, which explains the prompt adapta
tion to change. In the first month o f pricing, the
Fed lost 19.7 percent o f the volume which it both
processed and cleared. The average monthly
volume for the period August 1981 to April 1983
was about 22.4 percent lower than that o f July
1981.3
The Fed lost less total clearing volume than
processing volume, however. Most Fed facilities
offered a service called “ package sort” which
banks can use to clear already processed checks.
In this program, banks send packages o f checks,
with clearing information, to a Fed facility (via Fed
or private transportation) for clearing and distribu
tion to various end points (banks o f issue or their
correspondents). Package sort grew after the Fed
priced its services because many banks found the
per item price— for private processing plus Fed
clearing— more economical than either all-Fed or
all-private routes.
Figure 3 shows processed volume, package sort
volume, and total clearing volume. W hile pro
cessing volume has remained more or less stagnant
total clearing volume has recouped some o f its
initial losses, thanks to gains in package sort
clearing. W hile the net loss in clearing during the
first six months o f pricing was 10.8 percent (com
pared to 21.4 percent in processing), it narrowed to
3Data based on monthly volumes reported to the Board of
Governors.

FIGURE 3

AVERAGE
MONTHLY CHECK VOLUME
Federal Reserve System
L J
I

Package Sort
Processing

V olum e (Millions)

7.6 percent by the February-April 1983 period
(compared to 21.1 percent in processing).4 These
later figures reflect not only bankers’ immediate
adjustments to non-zero Fed prices, but also sub
sequent reactions to ongoing changes in quality o f
service, and to further price changes made by the
various suppliers o f services. The environment did
not remain static.
Although the Fed as a whole lost clearing volume
after pricing, not all 48 Fed facilities did so.
Because each facility faced different costs and
different markets, and because some did not offer
package sort, the effect o f pricing on clearing
volumes varied considerably. For instance, by
February-April 1983, one Fed facility suffered a
loss o f 39 percent in clearing volume while another
experienced an increase o f 33 percent.5

W HO HAS GAINED CLEARING BUSINESS?
The loss o f Fed clearing volume is mirrored in
the private sector by gains for private clearing
4Ibid.
^Ibid.

FEDERAL RESERVE BANK OF PHILADELPHIA

Fed Pricing and Check Collection

alternatives— direct exchange, correspondent
banks, and clearinghouses. W hile it is difficult to
know how the private sector has carved up its
increased market share, it is possible to make
qualitative judgments about gainers and losers.
The findings reported are based on a survey the
author conducted o f changes in private sector
clearing arrangements in the areas served by each
o f the 48 Fed facilities.6

Direct Exchange Picks Up. After Fed pricing,
many banks, which previously had used the Fed to
clear checks, resorted to direct exchange with
banks o f issue. This method o f collection does not
rely on other agents for clearing. Thus, some o f the
private sector gain in clearing is happening at
banks themselves, not at correspondent banks or
clearinghouses.
The simplest direct exchange involves banks
walking checks across the street and handing
them to each other. In local areas with no clearing
house, banks customarily have exchanged directly if
the volume o f checks on each other warranted it.
When the Fed instituted RCPCs in the early 1970s,
however, the use o f direct exchange declined in
those 12 zones. Banks using direct exchange were
usually competitors and, once RCPCs provided a
free convenient alternative, many banks chose not
to deal directly and to use the Fed. Fed pricing has
altered these relative costs and has led to a resur
gence o f direct exchange.
Growth is occurring not only in local exchanges
but also in the use o f direct sends to distant banks.
These items previously were sent through the Fed
or correspondent banks as clearing agents. Typi
cally, banks use private courier services for direct
sends. One o f the primary motivating factors for
longer distance direct exchange is better availa
bility o f funds; that is, banks’ accounts (in this case
with each other) are credited faster than they
would be using an agent. For all Fed zones, the
survey yielded new examples not only o f direct
exchanges within local areas, but also o f direct
sends between cities, states, and Reserve Dis
tricts.
Correspondent Banks Change. Prior to
pricing, correspondent banks usually priced their

6Joanna H. Frodin. "Changes in Check Collection After Fed
Pricing”, Spring 1983, (unpublished).

Joanna H. Frodin

check collection services indirectly. In particular,
they required their bank customers to maintain a
certain balance with them as compensation for
collecting checks. With Fed pricing, correspondent
banks faced new costs in providing certain services,
such as some interdistrict transfers using the Fed
as clearing agent. These new costs served as a
catalyst for correspondent banks to reevaluate
their costs, their menus o f services, and their
prices. As a result many correspondents unbundled
their services, revamped them, and priced them
explicitly.
It is hard to say whether correspondent banks,
as a group, have gained or lost clearing volume.
Some correspondents have lost business, in some
cases to clearinghouses, and in other cases to the
Fed; some have gained business. Many corres
pondent banks have attracted new business
through expanded direct send services which they
sell to customer banks. Banks can use a corres
pondent bank as a transportation agent to direct
send checks to the issuing bank rather than con
tracting courier services themselves. Many corres
pondent banks have increased significantly the
number o f end points to which they direct send for
customer banks and have lowered the dollar value
cut-off, that is, the minimum dollar amount
necessary for a direct send program. These changes
made their services more competitive with the
Fed’s transportation system.
One example points out the importance o f rela
tive costs. A major correspondent bank in Indiana
started an in-state direct send program after its
district Fed raised its package sort price. The
program initially included one third o f the end
points serviced by the Fed, with a view toward
expansion. Another example illustrates how banks
promote direct send programs by emphasizing
availability o f funds. First Tennessee Bank in
Nashville based a direct send service, First Express,
on the airline network o f Federal Express whose
hub is in Nashville. This correspondent bank’s
objective was to offer customers better availability,
via First Express, than the Fed could offer. The
private sector could make considerable additional
gains in transportation and clearing if expansions
o f direct send programs prove to be economical in
the longer run.

New Clearinghouse Activity. One o f the
primary findings in the survey was evidence of
17

BUSINESS REVIEW

considerable new clearinghouse activity since Fed
pricing. Clearinghouses have expanded both in
numbers and in their roles, which suggests that
they have gained a significant share o f the clearing
volume lost by the Fed. Clearinghouses also appear
to have attracted business at the expense o f
correspondent banks. For many banks, using new

JANUARY/FEBRUARY 1 9 8 4

clearinghouses appears to provide the most eco
nomical route for certain types o f clearing in the
post-pricing environment.

The Number o f Clearinghouses Grows. The
survey revealed that 95 additional clearinghouses
have been established since Fed pricing. Seventy-

Joanna H Frodin

Fed Pricing and Check Collection

eight o f these are new while 17 are renewed.
Renewed clearinghouses are generally ones which
were active prior to the institution o f Fed RCPCs in
the early 1970s, then disappeared as RCPCs
attracted business, and have been reactivated.
Figure 4 shows the location o f these additional
clearinghouses as well as Federal Reserve districts

and facilities. The map indicates that additional
clearinghouses are not evenly distributed around
the country. Rather, there is considerable
grouping.
It is difficult to say what accounts for this
grouping. It is probable that a state’s bank struc
ture is relevant, since it influences the pattern of

FIGURE 4

FEDERAL
RESERVE
D IS T R IC T S
N e w or R en ew ed
C le a r in g h o u s e s

•
—

New or renewed clearinghouses
Boundaries o f Federal Reserve Dis
tricts

•

Federal Reserve Bank Cities

▲

Federal Reserve Branch Cities

•

Regional Check Processing Centers

Note: Alaska and Hawaii are in the Twelfth
District

Prepared by Joanna H. Frodin with the re
search assistance o f Diane Mayer.

FEDERAL RESERVE BANK OF PHILADELPHIA

BUSINESS REVIEW

check collection. A state’s bank structure is defined
in terms o f branch banking (statewide or limited)
or unit banking. W ith branch banking, a larger
proportion o f checks becomes “ on-us” and is
cleared internally by banks than is the case with
unit banking. Therefore, clearinghouses are more
likely to form in unit banking states.
California, with extensive branching by a few
large banks, seems to be a case where banking
structure has affected clearinghouse formation
since pricing. There have been no new clearing
houses. By contrast, eleven new clearinghouses
appeared in the unit banking state o f Texas. While
the experience in certain states seems closely
related to structure, there does not appear to be a
strong correlation between structure and clearing
house formation nationwide. It is likely that other
factors, such as variation in population density,
geography, and some noneconomic considerations
also influence clearinghouse formation. Further
study is needed to attribute the grouping o f clearing
houses more specifically.

Clearinghouses Expand Their Activities.
Clearinghouses not only have increased in num
bers, but also many have expanded in scope—
functionally and geographically. Indeed, these
changes may indicate important trends in private
sector clearing in the future. For instance, many
clearinghouses have expanded their activities by
exchanging more types o f checks than before. The
common practice in the past was for clearing
house members to exchange mainly so-called
“ city” items drawn on each other. Other types o f
checks (that is, from RCPC areas or Country areas)
coming to the clearinghouse would have been sent
to the Fed or to a correspondent bank to clear.
Expansion o f exchange beyond city items has
come from three sources. First, many correspon
dent banks, which process checks for client banks,
now ’’intercept” these items for “swap,” or exchange,
at the clearinghouse. This practice avoids the new
cost o f sending these checks to the Fed to clear.
Second, some banks are performing swaps in
clearinghouses for affiliates o f their parent bank
holding company— an expanded, if not an entirely
new, activity. Third, one Texas clearinghouse has
persuaded banks which are not members o f the
clearinghouse to send certain non-city items to
the clearinghouse rather than to the Fed. These

JANUARY/FEBRUARY 1 9 8 4

examples o f new, or greatly expanded, activities o f
clearinghouses imply that, in the future, clearing
houses can extend their role by clearing different
types o f checks and by enlarging the mix o f insti
tutions they serve.
An even broader avenue o f expansion— via
intra-regional and then inter-regional exchange—
seems likely. The survey revealed that many new
clearinghouses, as well as expanding old ones, are
znfra-regional in scope, that is, their members
come from a larger geographic area than the city
wide area that was typical in the past. For example,
a clearinghouse which served one city on Long
Island has expanded to become the Long Island
Clearing House. Banks in both Southern Michigan
and Northern Indiana are now served by the
Michiana Clearing House.
Some moves to inter-regional exchange are also
taking place. One type involves a bank in one
region and a clearinghouse in another. Banks in
Birmingham, Alabama are presenting checks to
members o f the clearinghouse in Atlanta, Georgia,
through banks which are both their affiliates and
also members o f the clearinghouse. Another
example involves some large correspondent banks
in West Texas cities which are presenting checks
directly at local clearinghouses in other cities
rather than sending them to the Fed.
The survey also uncovered another type o f
expansion into inter-regional exchange— via
inter-clearinghouse exchange. One case involves
clearinghouses in Jacksonville, Florida and Atlanta,
Georgia. A representative bank in the Jacksonville
clearinghouse sends checks drawn on any member
o f the Atlanta clearinghouse to its representative
bank for exchange, and vice versa. Another case o f
inter-clearinghouse exchange exists between Baton
Rouge, Louisiana and Jackson, Mississippi. For
these interchanges to occur, there must be suffi
ciently large dollar values o f on-others checks
among these two groups o f banks to make it
worthwhile. The survey revealed that clearing
houses all over the country are talking about such
interchanges.
Although the potential for a network o f inter
clearinghouse exchanges among business centers
is apparent and discussion is ongoing, it is unclear
how extensive or how formal such arrangements
will become, since interchange is not necessarily
mutually advantageous. Also unclear is whether or
FEDERAL RESERVE BANK OF PHILADELPHIA

Fed Pricing and Check Collection

Joanna H. Frodin

not a national clearinghouse system will develop.
Although 33 clearinghouses met in 1982 to explore
this question, nothing concrete has emerged.
Regardless o f whether the ultimate result in this
post-Fed pricing environment is a national clearing
house, there is considerable potential for further
development in private clearing through clearing
houses. They may provide a relatively inexpensive
clearing alternative for many banks, not only in
traditional exchange o f city items among members,
but for other types o f checks issued by a greater
variety o f institutions from a larger geographical
area. The last phase o f Fed pricing, the pricing o f
float,7 which is currently being instituted, should
provide an additional incentive for banks to use
clearinghouses. Float pricing will make it more
costly to clear through both the Fed and corres
pondent banks. This development particularly
may encourage additional inter-clearinghouse
exchange.

CONCLUSION
Federal Reserve pricing o f check collection
services, as mandated by the MCA, has wrought
considerable change in the market for those
services. The immediate effects o f the August 1981
change in relative prices were more bank direct
exchanges, the formation o f additional clearing
houses, and restructuring o f correspondent banks’
prices. Gains in the volume o f checks cleared by
the private sector came at the expense o f Fed
volume losses. This finding bore out theory’s
n

'Federal Reserve float, a net addition o f reserves to the
banking system, is created when the depositing bank’s account
at the Fed is credited before the issuing bank’s account is
debited. Until now, banks have not had to pay interest on what
amounts to a loan of reserves.

prediction that, if the Fed were a high cost pro
vider, then full cost pricing would lead to changes
in consumption away from the Fed and toward
private sector alternatives.
However, subsequent developments indicate
that more fundamental changes are occurring in
this market. W hile price is still an important factor
in the competition among suppliers, the relative
quality o f service has increased in importance.
One key factor in quality is the availability of
funds. Recently, the Fed has improved its services,
particularly through reorganizing its transportation
services; correspondent banks likewise have
improved theirs through better transportation,
scheduling, and more attention to customers’
needs. Individual banks have cut down clearing
times by exchanging directly with distant banks.
Local clearinghouses, which first expanded in
numbers, have expanded their functional role in
many other ways: greater geographical area, ex
change o f more types o f checks, exchange for
more institutions than previously, exchange with
non-member institutions in other cities or states,
and inter-clearinghouse exchange.
In sum, the legislative innovation o f the MCA
has spawned a great deal o f market innovation and
increased competition. The check collection
market is now characterized by more efficient
allocation o f resources than existed two years ago.
W ill the process continue along the same lines in
the future? W hile additional change is likely in the
directions found to date, the market for collection
o f funds will become more complex. New com
petitors using relatively low-cost, electronic funds
transfer and clearing techniques will enter to
challenge the more traditional paper-based
suppliers.

REFERENCES AND FURTHER READING
21

JANUARY/FEBRUARY 1 9 8 4

BU SIN ESS REVIEW

REFERENCES AND FURTHER READING
Carreker, J.D., “Fed Pricing Triggers Changes in Check-Clearing Ser
vices,” American Banker, (November 16,1981).
Eickhoff, Gerald E., “Pricing of Check Services Stimulates Competi
tion,” BAI Check Processing Conference, American Banker, (March 24,
1982).
Frodin, Joanna H., “The Tax/Subsidy Relationship between Member
Banks and the Federal Reserve System,” Journal o f Monetary Economics,
(January 1980).
Helyar, John, “Fed Irritates Big Banks by Fighting to Regain Share of
Check Clearing,” W all Street Journal, (Oct. 26, 1982).
Little wood-Shain & Co., Guide to M ajor Check Clearing Houses (Wayne,
Pennsylvania, 1982).
Mayer, Martin, “The Fed Goes into Business,” Fortune, (April 4, 1983).
Rawlings, Brown R. “Historical Perspective on Fed’s Check Clearing Role,”
ABA Banking Journal, (October 1982).
Trigaux, Robert, “Fed Pricing One Year Later: Banks Wary of New Rival,”
American Banker, (June 17, 1982).
Trigaux, Robert, “Is Fed Favoring Its Clearing System?” American Banker,
(July 26, 1982).
White, George C., “Implications of Federal Reserve Pricing on Check
Clearing Arrangements,” in The Future o f the Financial Services Industry,
(Federal Reserve Bank of Atlanta, June 3-4, 1981).
Zimmerman, Gary C., “The Pricing of Federal Reserve Services under
MCA,” Federal Reserve Bank of San Francisco, Economic Review, (Winter,
1981).

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