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bank depositing a check for collection with a
Federal Reserve Bank receives credit for the
check in the form of an increase in its re-

serve is currently
considering
plementing the law.5

serve account.
The length of time between the payee
bank depositing
a check and the Federal
Reserve Bank increasing its reserve account
is determined
largely by the geographical
location of the payor bank. The payee bank
has an "availability
schedule,"
constructed

Pricing Float and Efficiency

by the Federal Reserve Bank, that gives the
approximate
time it has taken the Federal
Reserve Bank to collect checks from the
payor bank in question. After this scheduled
time has elasped, the Federal Reserve Bank
will automatically
increase
the
reserve
account of the payee bank; the payor bank's
reserve account,
on the other hand, is not
decreased
until the check is actually collected. For a variety of reasons, the check
may not be collected in the scheduled time,
and for a period of time both banks will
have credit for the reserves represented
by
the amount
of the check. The float generated by this "double counting" constitutes
one source of total bank reserves supplied by
the Federal Reserve System.4
Payor banks benefit from float, since
they can invest these funds in interestbearing assets. Congress reasoned that float
constituted
an "interest-free"
loan to the
banking industry, because the same amount
of total bank reserves could be supplied to
the banking system if float were reduced and
Federal Reserve holdings of U.S. government
securities
increased by equivalent
amounts.
The government
would then receive interest
on the additional
holdings
of securities
through the annual transfer of Federal Reserve surplus revenues to the Treasury. Reflecting this reasoning, the Depository
Institutions
Deregulation
and Monetary Control Act requires that the Federal Reserve
charge banks for float. Regardless of the
merits of this reasoning,
the Federal Re-

4.

For the month of August 1980, float averaged
$5,098
million and accounted
for approximately 11 percent of the total reserves supplied
to the banking system by the Federal Reserve.

means

of im-

The
Federal
Reserve
could
avoid
charging for float by eliminating
it, either
by lengthening
its availability
schedule
and/or
increasing
the speed at which it
collects
checks.6
Lengthening
the availability schedule would induce payee banks
to shift to private-sector
collection
services
that are willing to use real resources
to
speed collection;
increasing
the speed at
which the Federal Reserve processes checks
would increase its own costs. Either alternative would
increase the social cost of
processing
checks
and result in an efficiency loss to the economy.
Could the Federal Reserve increase the
efficiency
of payment
by check through a
policy of charging for float? One means of
reducing costs imposed by negative externalities is to tax any private gain associated
with the externality.
Private interests, recognizing that any gain is to be taxed, would
not incur costs to capture the private benefit
of the external ity. Because there are no economic costs associated with producing float,
charging for float and remitting the revenues
to the Treasury would allow the general tax
burden to be decreased by the amount of
the float revenues." Thus, charging for float
represents a tax on the time value of reserves
that, properly instituted,
could increase the
efficiency of the payments mechanism.
Such a "float tax" would have to be designed in a manner that would reduce or
eliminate private incentives to incur costs in
an effort to capture the time value of re5. See Benjamin Wolkowitz and Peter R. LloydDavies, "Reducing
Federal
Reserve
Float,"
Federal Reserve Bulletin, December 1979.
6. The Federal Reserve has proposed to adopt a
combination
of these alternatives.
See Board
of Governors
of the Federal Reserve System,
"Federal
Reserve Bank Services Proposed Fee
Schedules and Pricing Principles,"
Docket No.
R-0324, August 28, 1980 (processed).
7. See Wolkowitz
and Lloyd-Davies,
Federal Reserve Float."

"Reducing

serves. An effective way to do this would be
to grant immediate availability for all checks
deposited
with the Federal Reserve for collection, but to charge payor banks for the
resultant
float. Granting
immediate
availability
would eliminate
the incentive
of
payee banks to speed check collection,
and
charging payor banks for float would impose
a private cost on delaying collection.
Payor
banks could not avoid the float tax by shifting to private sector collection services, because the choice of collection
services is at
the discretion of payee banks, and, all other
things equal, payee banks would choose the
system that grants the fastest availabil ity
of reserves.
Payors and their banks would bear the
float tax, which would encourage
both to
seek relatively cheaper means of payment.
For example, payors and their banks would
find it profitable
to encourage
payees to
accept payment
by the electronic
transfer
of funds among banks-a
service provided
by automated
clearinghouses.
In addition,
remote
disbursement
and
other
costly
practices
adopted
to increase float would
become
unprofitable,
thus reducing
their
use and improving
the allocational
efficiency of the payments mechanism.
Charging payors for float and payees
for the actual cost of collection would preserve competition
between public and private collection
services. However, the Federal Reserve could promote economic efficiency by reducing the incentive to use resources in response to the time value of
money.
Assuming
the
Federal
Reserve
could process
a given number
of checks
at the same cost as the private sector, the
Federal Reserve could lower its collection
costs and, therefore,
prices by reducing the
speed at which it collects checks. Private
collection
services, for competitive
reasons,
would respond by clearing checks at a comparable speed, thus reducing their costs and
prices. Price competition
between the Federal Reserve and the private sector would
assure that the efficiency gains of the float
tax were transmitted
to the private sector.
Although the float tax would have de-

sirable consequences
on the efficiency
payments
mechanism,
these gains

December 15, 1980

of the
would

have to be weighed against the cost of collecting the tax. The Federal Reserve would
incur additional
accounting
costs associated
with collecting charges on float. In addition
to these administrative
costs, the imposition
of the above scheme might interfere with the
conduct of monetary policy. Under a policy
of targeting the growth rates of the monetary aggregates, the Federal Reserve attempts
to supply an amount of nonborrowed
reserves consistent with these targets. Granting
immediate
availability
and collecting
at a
slow speed might supply an amount of reserves, in the form of float, that would exceed the reserves consistent with the rnonetary targets. The above design for a float
tax seems unlikely
to hit this constraint,
since the float tax would encourage payors
and the banking industry to minimize float.
Even so, if the absolute amount of float is
larger on average, it may make it more difficult to forecast
the amount
of reserves
that will be supplied by float and thus make
the short-run
control of the monetary
aggregates less exact. If this turns out to be
the case, the Federal Reserve could, to offset the adverse effects on monetary pol icy,
increase the float tax, further encouraging
the banking industry to reduce the amount
of float. Another
alternative
would be to
increase its collection
speed and count the
resulting inefficiency
in the payments mechanism as a cost of effective monetary policy.

ECONOMIC
COMMENTARY
ISSN 0428-1276

The Pricing of Float and
an Efficient Payments Mechanism

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address correction

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

requested

Conclusion
The

Federal

Reserve

System

is under-

standably
reluctant
to accept the price and
market
share
consequences
of charging
payee banks for float.
However,
a welldesigned payor float tax, subject to monetary policy constraints,
would have desirable
consequences
on the efficiency of the payments mechanism. The problems, difficulties,
and costs involved
in charging
for float
should
be weighed against the efficiency
gains that would occur in the payments
mechanism as a result of such a policy.

Address Change

o Correct

o Remove

as shown
from mailing list

Please send mailing label to the Research Department,
Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,

OH 44101.

From a bank's

point

of view, the trans-

sumption (for example, hand guns), the market tends to yield an inefficient allocation of
resources. Although there are no discernible
externalities
associated with the production
or consumption
of payment by check, there
is an externality
associated with the speed
of check collection.
The social benefit of increasing collection speed is the reduced risk of loss associated with accepting a bad check. This reduction of risk enhances the general acceptabil-

The Pricing of Float and
an Efficient Payments Mechanism
by Jim Winner

Most checks are deposited
in a bank
other
than the one on which they are
drawn. In such instances, the bank in which
the check is deposited
(the payee bank)
must collect the funds from the bank on
which the check is drawn (the payor bank).

sidized by the Federal
Reserve System's
free check collection
services. As a result,
the extent
to which checks and similar
paper instruments
(and resources employed
in processing these paper instruments)
are
used is widely
recognized
as being inef-

In the United States, check collection
services are provided by both private and public
institutions.
The
private
sector
collects
checks via local clearinghouses,
bank service corporations,
and an extensive
network of correspondent
banks; the public
sector
is represented
by the Federal
Re-

ficient.1
To increase the efficiency
of the
payments
mechanism,
the Depository
In-

serve System,
which, until this year, provided
check
collection
services,
free of
charge, to its member banks.
Because the collection
of checks requires the use of real resources
(for example, personnel, transportation,
and computers),
the question
arises as to whether
the extent to which these resources are employed in collecting
checks constitutes
an
efficient use of the nation's scarce resources.
The quantity
of resources
employed
in
clearing checks depends both on the number of checks written and the speed with
which the checks are collected.
In addition
to being underpriced
because of interest
rate ceilings on demand
deposits and encouraged
by the pricing practices
of the
banking
industry,
the use of checks and
similar
paper
instruments
has been sub-

Jim Winner is an economic analyst, Federal ReserveBank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of
Governors of the Federal ReserveSystem.

stitutions
Deregulation
and Monetary Control Act of 1980 requires the Federal Reserve System to charge for its check collection services and for float.2 This Eco-

nomic Commentary
float

examines the pricing of
and the related issue of the efficiency

of the payments

mechanism.

Economic Efficiency
and Check Collection
Economic
efficiency
in allocating
the
nation's scarce resources requires that an additional unit of a good be produced only if
the additional social benefit (marginal social
benefit) of the unit is greater than or equal
to the additional social cost (marginal social
cost) associated with its production.
As long
as private benefits and social benefits do not
diverge, that is, there are no "externalities,"
the interaction of private producers and consumers in competitive
markets will assure an
efficient allocation of resources. However, if
there are externalities
in the production
of a
good (for example,
pollution)
or its con-

1.

For a full
Stevens,
for

the

Transfer,"
Reserve
2.

See Title

discussion
"Repricing
Development

Economic
Bank

sents an increase in the payee bank's cash reserves and an equivalent
decrease
in the
payor bank's cash reserves. Reserves, because
they are the basis on which banks expand
their earning assets, possess time value for
banks. Thus, when checks are deposited
in
banks, the incentive to waste society'S resources in altering the rate at which checks
clear is passed from payees and payors to

ity of checks

the banking

as a means of payment,

bene-

fiting both payees and payors to the extent
that payment by other means, such as currency, is less convenient
or more costly.
However, the amount of a check represents
money, and money has time value-it
can be
invested

in interest-earning

assets. Therefore,

the private benefit associated with collection
speed, which includes
the time value of
money, exceeds the social benefit, and, left
to the market, too many resources will be
devoted to the processing of checks.
If interest
rates
and the
sums of
money
involved
are
sufficiently
large,
payees have an incentive
to speed check
collection
and
payors
have
an equal
incentive to delay collection.
Any interest
income gained by payees through speeding
the collection
of a check is lost in an
equivalent
amount
by payors.
Society,
that
is, payees
and payors
considered
together,
is no better off for playing this
zero-sum game. Therefore,
resources
used
to play this game represent
a net loss to
society.
If payors were simply to transfer
an equivalent
amount
of interest
income to payees, the resources
formerly
used to speed check collection
would be
available
to produce
other
things,
and
everyone's
real income could be increased.
The real cost of the negative externality
associated
with the time value of money
is this foregone income.3

of these issues, see E. J.
Payments
of

and

Incentives

Electronic

Funds

Commentary,

Federal

of Cleveland,

I Public

fer of funds from a payor to a payee repre-

October

Law 96·221,1980.

6, 1980.

Regardless

of

the

rency,

electronic

if

transfer

the

instantaneous,

means
funds

of

payment-cur-

transfer,

money

the time

of
in

or

payment

value of money

impose a negative externality

on society.

checkis not
would

Due to Time Value of Reserves to Payee Banks

Price

industry.

The efficiency
loss to society as a resuit of the time value of reserves to the
payee bank is illustrated
in figure 1. The
vertical axis (price, P) measures the value
of marginal benefits and marginal costs in
terms of price, while the horizontal
axis
measures the collection
speed for a given
number and value of checks. The marginal
social benefit (MSB) curve shows that, as
collection speed increases, the additional social benefit of increasing collection
speed,
positive, decreases. The marginal
of increasing collection speed
consists of two components:
the benefit received from increasing the general acceptability of checks (MSB) r which is valuable
to the payee and society; and the marginal
time value of reserves (MTRI. which is valuable to the payee bank but not to society

Collection

speed

although

private benefit

because it is lost in an equivalent
amount
to the payor bank. For any given speed of
collection,
the total marginal private benefit can be derived by summing the two components and arriving at the curve (MSB +
MTRI. with the marginal time value of reserves represented
by the vertical distance
between MSB and MSB + MTR. The marginal social cost curve (MSC) shows that, as
collection
speed increases,
the additional
costs (and price) associated with increasing
collection speed rise.
The

3.

Figure 1 Inefficiency

economically

efficient

collection

speed occurs at S£, where MSB and MSC
are equal to price PE. However, because market behavior reflects private incentives, payee
banks have an incentive to increase collection

speed up to the point where the marginal

so-

cial cost (and the price they must pay for increased collection speed) is equal to the marginal private benefit. This would occur at
5j, where MSB + MTR and MSC equal p,.
It is clear that at 5j the marginal social cost
P, exceeds the marginal social benefit Po by
an amount equal to the time value of reserves to the payee banks-an
economically
inefficient resu It.
The choice among collection
services
provided by correspondent
banks, bank service corporations,
and the Federal Reserve
System is at the discretion of payee banks.
Because payee banks have an incentive to
speed collection
of checks,
private institutions
offering
check collection
services
compete
by offering
rapid collection
of
checks. If the Federal Reserve must price
its services on the basis of marginal social
costs, it would have to provide collection
service at speed 5j in order to be competitive. If the Federal Reserve cleared checks
at the efficient but slower speed of SE' payee

banks simply would

not use the Federal

Re-

serve's service since they would be losing
some of the time value of reserves. Under
such conditions,
even if the full social costs
of the Federal Reserve's check collecting services were covered by Federal Reserve prices,
checking would remain an inefficient means
of payment. Pricing Federal Reserve check

collection services on the basis of social
costs would simply incorporate the inefficiency of the private sector into the Federal
Reserve's public sector services.
Federal Reserve Float
While the private sector redistributes
a
given amount of reserves among banks, the
Federal Reserve can and does create reserves
in the process of check collection.
The
amount of reserves thus created is known as
Federal Reserve float.
Banks using Federal Reserve check collection services hold their reserve accounts in
Federal
Reserve District
Banks. A payee

From a bank's

point

of view, the trans-

sumption (for example, hand guns), the market tends to yield an inefficient allocation of
resources. Although there are no discernible
externalities
associated with the production
or consumption
of payment by check, there
is an externality
associated with the speed
of check collection.
The social benefit of increasing collection speed is the reduced risk of loss associated with accepting a bad check. This reduction of risk enhances the general acceptabil-

The Pricing of Float and
an Efficient Payments Mechanism
by Jim Winner

Most checks are deposited
in a bank
other
than the one on which they are
drawn. In such instances, the bank in which
the check is deposited
(the payee bank)
must collect the funds from the bank on
which the check is drawn (the payor bank).

sidized by the Federal
Reserve System's
free check collection
services. As a result,
the extent
to which checks and similar
paper instruments
(and resources employed
in processing these paper instruments)
are
used is widely
recognized
as being inef-

In the United States, check collection
services are provided by both private and public
institutions.
The
private
sector
collects
checks via local clearinghouses,
bank service corporations,
and an extensive
network of correspondent
banks; the public
sector
is represented
by the Federal
Re-

ficient.1
To increase the efficiency
of the
payments
mechanism,
the Depository
In-

serve System,
which, until this year, provided
check
collection
services,
free of
charge, to its member banks.
Because the collection
of checks requires the use of real resources
(for example, personnel, transportation,
and computers),
the question
arises as to whether
the extent to which these resources are employed in collecting
checks constitutes
an
efficient use of the nation's scarce resources.
The quantity
of resources
employed
in
clearing checks depends both on the number of checks written and the speed with
which the checks are collected.
In addition
to being underpriced
because of interest
rate ceilings on demand
deposits and encouraged
by the pricing practices
of the
banking
industry,
the use of checks and
similar
paper
instruments
has been sub-

Jim Winner is an economic analyst, Federal ReserveBank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of
Governors of the Federal ReserveSystem.

stitutions
Deregulation
and Monetary Control Act of 1980 requires the Federal Reserve System to charge for its check collection services and for float.2 This Eco-

nomic Commentary
float

examines the pricing of
and the related issue of the efficiency

of the payments

mechanism.

Economic Efficiency
and Check Collection
Economic
efficiency
in allocating
the
nation's scarce resources requires that an additional unit of a good be produced only if
the additional social benefit (marginal social
benefit) of the unit is greater than or equal
to the additional social cost (marginal social
cost) associated with its production.
As long
as private benefits and social benefits do not
diverge, that is, there are no "externalities,"
the interaction of private producers and consumers in competitive
markets will assure an
efficient allocation of resources. However, if
there are externalities
in the production
of a
good (for example,
pollution)
or its con-

1.

For a full
Stevens,
for

the

Transfer,"
Reserve
2.

See Title

discussion
"Repricing
Development

Economic
Bank

sents an increase in the payee bank's cash reserves and an equivalent
decrease
in the
payor bank's cash reserves. Reserves, because
they are the basis on which banks expand
their earning assets, possess time value for
banks. Thus, when checks are deposited
in
banks, the incentive to waste society'S resources in altering the rate at which checks
clear is passed from payees and payors to

ity of checks

the banking

as a means of payment,

bene-

fiting both payees and payors to the extent
that payment by other means, such as currency, is less convenient
or more costly.
However, the amount of a check represents
money, and money has time value-it
can be
invested

in interest-earning

assets. Therefore,

the private benefit associated with collection
speed, which includes
the time value of
money, exceeds the social benefit, and, left
to the market, too many resources will be
devoted to the processing of checks.
If interest
rates
and the
sums of
money
involved
are
sufficiently
large,
payees have an incentive
to speed check
collection
and
payors
have
an equal
incentive to delay collection.
Any interest
income gained by payees through speeding
the collection
of a check is lost in an
equivalent
amount
by payors.
Society,
that
is, payees
and payors
considered
together,
is no better off for playing this
zero-sum game. Therefore,
resources
used
to play this game represent
a net loss to
society.
If payors were simply to transfer
an equivalent
amount
of interest
income to payees, the resources
formerly
used to speed check collection
would be
available
to produce
other
things,
and
everyone's
real income could be increased.
The real cost of the negative externality
associated
with the time value of money
is this foregone income.3

of these issues, see E. J.
Payments
of

and

Incentives

Electronic

Funds

Commentary,

Federal

of Cleveland,

I Public

fer of funds from a payor to a payee repre-

October

Law 96·221,1980.

6, 1980.

Regardless

of

the

rency,

electronic

if

transfer

the

instantaneous,

means
funds

of

payment-cur-

transfer,

money

the time

of
in

or

payment

value of money

impose a negative externality

on society.

checkis not
would

Due to Time Value of Reserves to Payee Banks

Price

industry.

The efficiency
loss to society as a resuit of the time value of reserves to the
payee bank is illustrated
in figure 1. The
vertical axis (price, P) measures the value
of marginal benefits and marginal costs in
terms of price, while the horizontal
axis
measures the collection
speed for a given
number and value of checks. The marginal
social benefit (MSB) curve shows that, as
collection speed increases, the additional social benefit of increasing collection
speed,
positive, decreases. The marginal
of increasing collection speed
consists of two components:
the benefit received from increasing the general acceptability of checks (MSB) r which is valuable
to the payee and society; and the marginal
time value of reserves (MTRI. which is valuable to the payee bank but not to society

Collection

speed

although

private benefit

because it is lost in an equivalent
amount
to the payor bank. For any given speed of
collection,
the total marginal private benefit can be derived by summing the two components and arriving at the curve (MSB +
MTRI. with the marginal time value of reserves represented
by the vertical distance
between MSB and MSB + MTR. The marginal social cost curve (MSC) shows that, as
collection
speed increases,
the additional
costs (and price) associated with increasing
collection speed rise.
The

3.

Figure 1 Inefficiency

economically

efficient

collection

speed occurs at S£, where MSB and MSC
are equal to price PE. However, because market behavior reflects private incentives, payee
banks have an incentive to increase collection

speed up to the point where the marginal

so-

cial cost (and the price they must pay for increased collection speed) is equal to the marginal private benefit. This would occur at
5j, where MSB + MTR and MSC equal p,.
It is clear that at 5j the marginal social cost
P, exceeds the marginal social benefit Po by
an amount equal to the time value of reserves to the payee banks-an
economically
inefficient resu It.
The choice among collection
services
provided by correspondent
banks, bank service corporations,
and the Federal Reserve
System is at the discretion of payee banks.
Because payee banks have an incentive to
speed collection
of checks,
private institutions
offering
check collection
services
compete
by offering
rapid collection
of
checks. If the Federal Reserve must price
its services on the basis of marginal social
costs, it would have to provide collection
service at speed 5j in order to be competitive. If the Federal Reserve cleared checks
at the efficient but slower speed of SE' payee

banks simply would

not use the Federal

Re-

serve's service since they would be losing
some of the time value of reserves. Under
such conditions,
even if the full social costs
of the Federal Reserve's check collecting services were covered by Federal Reserve prices,
checking would remain an inefficient means
of payment. Pricing Federal Reserve check

collection services on the basis of social
costs would simply incorporate the inefficiency of the private sector into the Federal
Reserve's public sector services.
Federal Reserve Float
While the private sector redistributes
a
given amount of reserves among banks, the
Federal Reserve can and does create reserves
in the process of check collection.
The
amount of reserves thus created is known as
Federal Reserve float.
Banks using Federal Reserve check collection services hold their reserve accounts in
Federal
Reserve District
Banks. A payee

From a bank's

point

of view, the trans-

sumption (for example, hand guns), the market tends to yield an inefficient allocation of
resources. Although there are no discernible
externalities
associated with the production
or consumption
of payment by check, there
is an externality
associated with the speed
of check collection.
The social benefit of increasing collection speed is the reduced risk of loss associated with accepting a bad check. This reduction of risk enhances the general acceptabil-

The Pricing of Float and
an Efficient Payments Mechanism
by Jim Winner

Most checks are deposited
in a bank
other
than the one on which they are
drawn. In such instances, the bank in which
the check is deposited
(the payee bank)
must collect the funds from the bank on
which the check is drawn (the payor bank).

sidized by the Federal
Reserve System's
free check collection
services. As a result,
the extent
to which checks and similar
paper instruments
(and resources employed
in processing these paper instruments)
are
used is widely
recognized
as being inef-

In the United States, check collection
services are provided by both private and public
institutions.
The
private
sector
collects
checks via local clearinghouses,
bank service corporations,
and an extensive
network of correspondent
banks; the public
sector
is represented
by the Federal
Re-

ficient.1
To increase the efficiency
of the
payments
mechanism,
the Depository
In-

serve System,
which, until this year, provided
check
collection
services,
free of
charge, to its member banks.
Because the collection
of checks requires the use of real resources
(for example, personnel, transportation,
and computers),
the question
arises as to whether
the extent to which these resources are employed in collecting
checks constitutes
an
efficient use of the nation's scarce resources.
The quantity
of resources
employed
in
clearing checks depends both on the number of checks written and the speed with
which the checks are collected.
In addition
to being underpriced
because of interest
rate ceilings on demand
deposits and encouraged
by the pricing practices
of the
banking
industry,
the use of checks and
similar
paper
instruments
has been sub-

Jim Winner is an economic analyst, Federal ReserveBank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of
Governors of the Federal ReserveSystem.

stitutions
Deregulation
and Monetary Control Act of 1980 requires the Federal Reserve System to charge for its check collection services and for float.2 This Eco-

nomic Commentary
float

examines the pricing of
and the related issue of the efficiency

of the payments

mechanism.

Economic Efficiency
and Check Collection
Economic
efficiency
in allocating
the
nation's scarce resources requires that an additional unit of a good be produced only if
the additional social benefit (marginal social
benefit) of the unit is greater than or equal
to the additional social cost (marginal social
cost) associated with its production.
As long
as private benefits and social benefits do not
diverge, that is, there are no "externalities,"
the interaction of private producers and consumers in competitive
markets will assure an
efficient allocation of resources. However, if
there are externalities
in the production
of a
good (for example,
pollution)
or its con-

1.

For a full
Stevens,
for

the

Transfer,"
Reserve
2.

See Title

discussion
"Repricing
Development

Economic
Bank

sents an increase in the payee bank's cash reserves and an equivalent
decrease
in the
payor bank's cash reserves. Reserves, because
they are the basis on which banks expand
their earning assets, possess time value for
banks. Thus, when checks are deposited
in
banks, the incentive to waste society'S resources in altering the rate at which checks
clear is passed from payees and payors to

ity of checks

the banking

as a means of payment,

bene-

fiting both payees and payors to the extent
that payment by other means, such as currency, is less convenient
or more costly.
However, the amount of a check represents
money, and money has time value-it
can be
invested

in interest-earning

assets. Therefore,

the private benefit associated with collection
speed, which includes
the time value of
money, exceeds the social benefit, and, left
to the market, too many resources will be
devoted to the processing of checks.
If interest
rates
and the
sums of
money
involved
are
sufficiently
large,
payees have an incentive
to speed check
collection
and
payors
have
an equal
incentive to delay collection.
Any interest
income gained by payees through speeding
the collection
of a check is lost in an
equivalent
amount
by payors.
Society,
that
is, payees
and payors
considered
together,
is no better off for playing this
zero-sum game. Therefore,
resources
used
to play this game represent
a net loss to
society.
If payors were simply to transfer
an equivalent
amount
of interest
income to payees, the resources
formerly
used to speed check collection
would be
available
to produce
other
things,
and
everyone's
real income could be increased.
The real cost of the negative externality
associated
with the time value of money
is this foregone income.3

of these issues, see E. J.
Payments
of

and

Incentives

Electronic

Funds

Commentary,

Federal

of Cleveland,

I Public

fer of funds from a payor to a payee repre-

October

Law 96·221,1980.

6, 1980.

Regardless

of

the

rency,

electronic

if

transfer

the

instantaneous,

means
funds

of

payment-cur-

transfer,

money

the time

of
in

or

payment

value of money

impose a negative externality

on society.

checkis not
would

Due to Time Value of Reserves to Payee Banks

Price

industry.

The efficiency
loss to society as a resuit of the time value of reserves to the
payee bank is illustrated
in figure 1. The
vertical axis (price, P) measures the value
of marginal benefits and marginal costs in
terms of price, while the horizontal
axis
measures the collection
speed for a given
number and value of checks. The marginal
social benefit (MSB) curve shows that, as
collection speed increases, the additional social benefit of increasing collection
speed,
positive, decreases. The marginal
of increasing collection speed
consists of two components:
the benefit received from increasing the general acceptability of checks (MSB) r which is valuable
to the payee and society; and the marginal
time value of reserves (MTRI. which is valuable to the payee bank but not to society

Collection

speed

although

private benefit

because it is lost in an equivalent
amount
to the payor bank. For any given speed of
collection,
the total marginal private benefit can be derived by summing the two components and arriving at the curve (MSB +
MTRI. with the marginal time value of reserves represented
by the vertical distance
between MSB and MSB + MTR. The marginal social cost curve (MSC) shows that, as
collection
speed increases,
the additional
costs (and price) associated with increasing
collection speed rise.
The

3.

Figure 1 Inefficiency

economically

efficient

collection

speed occurs at S£, where MSB and MSC
are equal to price PE. However, because market behavior reflects private incentives, payee
banks have an incentive to increase collection

speed up to the point where the marginal

so-

cial cost (and the price they must pay for increased collection speed) is equal to the marginal private benefit. This would occur at
5j, where MSB + MTR and MSC equal p,.
It is clear that at 5j the marginal social cost
P, exceeds the marginal social benefit Po by
an amount equal to the time value of reserves to the payee banks-an
economically
inefficient resu It.
The choice among collection
services
provided by correspondent
banks, bank service corporations,
and the Federal Reserve
System is at the discretion of payee banks.
Because payee banks have an incentive to
speed collection
of checks,
private institutions
offering
check collection
services
compete
by offering
rapid collection
of
checks. If the Federal Reserve must price
its services on the basis of marginal social
costs, it would have to provide collection
service at speed 5j in order to be competitive. If the Federal Reserve cleared checks
at the efficient but slower speed of SE' payee

banks simply would

not use the Federal

Re-

serve's service since they would be losing
some of the time value of reserves. Under
such conditions,
even if the full social costs
of the Federal Reserve's check collecting services were covered by Federal Reserve prices,
checking would remain an inefficient means
of payment. Pricing Federal Reserve check

collection services on the basis of social
costs would simply incorporate the inefficiency of the private sector into the Federal
Reserve's public sector services.
Federal Reserve Float
While the private sector redistributes
a
given amount of reserves among banks, the
Federal Reserve can and does create reserves
in the process of check collection.
The
amount of reserves thus created is known as
Federal Reserve float.
Banks using Federal Reserve check collection services hold their reserve accounts in
Federal
Reserve District
Banks. A payee

bank depositing a check for collection with a
Federal Reserve Bank receives credit for the
check in the form of an increase in its re-

serve is currently
considering
plementing the law.5

serve account.
The length of time between the payee
bank depositing
a check and the Federal
Reserve Bank increasing its reserve account
is determined
largely by the geographical
location of the payor bank. The payee bank
has an "availability
schedule,"
constructed

Pricing Float and Efficiency

by the Federal Reserve Bank, that gives the
approximate
time it has taken the Federal
Reserve Bank to collect checks from the
payor bank in question. After this scheduled
time has elasped, the Federal Reserve Bank
will automatically
increase
the
reserve
account of the payee bank; the payor bank's
reserve account,
on the other hand, is not
decreased
until the check is actually collected. For a variety of reasons, the check
may not be collected in the scheduled time,
and for a period of time both banks will
have credit for the reserves represented
by
the amount
of the check. The float generated by this "double counting" constitutes
one source of total bank reserves supplied by
the Federal Reserve System.4
Payor banks benefit from float, since
they can invest these funds in interestbearing assets. Congress reasoned that float
constituted
an "interest-free"
loan to the
banking industry, because the same amount
of total bank reserves could be supplied to
the banking system if float were reduced and
Federal Reserve holdings of U.S. government
securities
increased by equivalent
amounts.
The government
would then receive interest
on the additional
holdings
of securities
through the annual transfer of Federal Reserve surplus revenues to the Treasury. Reflecting this reasoning, the Depository
Institutions
Deregulation
and Monetary Control Act requires that the Federal Reserve
charge banks for float. Regardless of the
merits of this reasoning,
the Federal Re-

4.

For the month of August 1980, float averaged
$5,098
million and accounted
for approximately 11 percent of the total reserves supplied
to the banking system by the Federal Reserve.

means

of im-

The
Federal
Reserve
could
avoid
charging for float by eliminating
it, either
by lengthening
its availability
schedule
and/or
increasing
the speed at which it
collects
checks.6
Lengthening
the availability schedule would induce payee banks
to shift to private-sector
collection
services
that are willing to use real resources
to
speed collection;
increasing
the speed at
which the Federal Reserve processes checks
would increase its own costs. Either alternative would
increase the social cost of
processing
checks
and result in an efficiency loss to the economy.
Could the Federal Reserve increase the
efficiency
of payment
by check through a
policy of charging for float? One means of
reducing costs imposed by negative externalities is to tax any private gain associated
with the externality.
Private interests, recognizing that any gain is to be taxed, would
not incur costs to capture the private benefit
of the external ity. Because there are no economic costs associated with producing float,
charging for float and remitting the revenues
to the Treasury would allow the general tax
burden to be decreased by the amount of
the float revenues." Thus, charging for float
represents a tax on the time value of reserves
that, properly instituted,
could increase the
efficiency of the payments mechanism.
Such a "float tax" would have to be designed in a manner that would reduce or
eliminate private incentives to incur costs in
an effort to capture the time value of re5. See Benjamin Wolkowitz and Peter R. LloydDavies, "Reducing
Federal
Reserve
Float,"
Federal Reserve Bulletin, December 1979.
6. The Federal Reserve has proposed to adopt a
combination
of these alternatives.
See Board
of Governors
of the Federal Reserve System,
"Federal
Reserve Bank Services Proposed Fee
Schedules and Pricing Principles,"
Docket No.
R-0324, August 28, 1980 (processed).
7. See Wolkowitz
and Lloyd-Davies,
Federal Reserve Float."

"Reducing

serves. An effective way to do this would be
to grant immediate availability for all checks
deposited
with the Federal Reserve for collection, but to charge payor banks for the
resultant
float. Granting
immediate
availability
would eliminate
the incentive
of
payee banks to speed check collection,
and
charging payor banks for float would impose
a private cost on delaying collection.
Payor
banks could not avoid the float tax by shifting to private sector collection services, because the choice of collection
services is at
the discretion of payee banks, and, all other
things equal, payee banks would choose the
system that grants the fastest availabil ity
of reserves.
Payors and their banks would bear the
float tax, which would encourage
both to
seek relatively cheaper means of payment.
For example, payors and their banks would
find it profitable
to encourage
payees to
accept payment
by the electronic
transfer
of funds among banks-a
service provided
by automated
clearinghouses.
In addition,
remote
disbursement
and
other
costly
practices
adopted
to increase float would
become
unprofitable,
thus reducing
their
use and improving
the allocational
efficiency of the payments mechanism.
Charging payors for float and payees
for the actual cost of collection would preserve competition
between public and private collection
services. However, the Federal Reserve could promote economic efficiency by reducing the incentive to use resources in response to the time value of
money.
Assuming
the
Federal
Reserve
could process
a given number
of checks
at the same cost as the private sector, the
Federal Reserve could lower its collection
costs and, therefore,
prices by reducing the
speed at which it collects checks. Private
collection
services, for competitive
reasons,
would respond by clearing checks at a comparable speed, thus reducing their costs and
prices. Price competition
between the Federal Reserve and the private sector would
assure that the efficiency gains of the float
tax were transmitted
to the private sector.
Although the float tax would have de-

sirable consequences
on the efficiency
payments
mechanism,
these gains

December 15, 1980

of the
would

have to be weighed against the cost of collecting the tax. The Federal Reserve would
incur additional
accounting
costs associated
with collecting charges on float. In addition
to these administrative
costs, the imposition
of the above scheme might interfere with the
conduct of monetary policy. Under a policy
of targeting the growth rates of the monetary aggregates, the Federal Reserve attempts
to supply an amount of nonborrowed
reserves consistent with these targets. Granting
immediate
availability
and collecting
at a
slow speed might supply an amount of reserves, in the form of float, that would exceed the reserves consistent with the rnonetary targets. The above design for a float
tax seems unlikely
to hit this constraint,
since the float tax would encourage payors
and the banking industry to minimize float.
Even so, if the absolute amount of float is
larger on average, it may make it more difficult to forecast
the amount
of reserves
that will be supplied by float and thus make
the short-run
control of the monetary
aggregates less exact. If this turns out to be
the case, the Federal Reserve could, to offset the adverse effects on monetary pol icy,
increase the float tax, further encouraging
the banking industry to reduce the amount
of float. Another
alternative
would be to
increase its collection
speed and count the
resulting inefficiency
in the payments mechanism as a cost of effective monetary policy.

ECONOMIC
COMMENTARY
ISSN 0428-1276

The Pricing of Float and
an Efficient Payments Mechanism

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address correction

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

requested

Conclusion
The

Federal

Reserve

System

is under-

standably
reluctant
to accept the price and
market
share
consequences
of charging
payee banks for float.
However,
a welldesigned payor float tax, subject to monetary policy constraints,
would have desirable
consequences
on the efficiency of the payments mechanism. The problems, difficulties,
and costs involved
in charging
for float
should
be weighed against the efficiency
gains that would occur in the payments
mechanism as a result of such a policy.

Address Change

o Correct

o Remove

as shown
from mailing list

Please send mailing label to the Research Department,
Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,

OH 44101.

bank depositing a check for collection with a
Federal Reserve Bank receives credit for the
check in the form of an increase in its re-

serve is currently
considering
plementing the law.5

serve account.
The length of time between the payee
bank depositing
a check and the Federal
Reserve Bank increasing its reserve account
is determined
largely by the geographical
location of the payor bank. The payee bank
has an "availability
schedule,"
constructed

Pricing Float and Efficiency

by the Federal Reserve Bank, that gives the
approximate
time it has taken the Federal
Reserve Bank to collect checks from the
payor bank in question. After this scheduled
time has elasped, the Federal Reserve Bank
will automatically
increase
the
reserve
account of the payee bank; the payor bank's
reserve account,
on the other hand, is not
decreased
until the check is actually collected. For a variety of reasons, the check
may not be collected in the scheduled time,
and for a period of time both banks will
have credit for the reserves represented
by
the amount
of the check. The float generated by this "double counting" constitutes
one source of total bank reserves supplied by
the Federal Reserve System.4
Payor banks benefit from float, since
they can invest these funds in interestbearing assets. Congress reasoned that float
constituted
an "interest-free"
loan to the
banking industry, because the same amount
of total bank reserves could be supplied to
the banking system if float were reduced and
Federal Reserve holdings of U.S. government
securities
increased by equivalent
amounts.
The government
would then receive interest
on the additional
holdings
of securities
through the annual transfer of Federal Reserve surplus revenues to the Treasury. Reflecting this reasoning, the Depository
Institutions
Deregulation
and Monetary Control Act requires that the Federal Reserve
charge banks for float. Regardless of the
merits of this reasoning,
the Federal Re-

4.

For the month of August 1980, float averaged
$5,098
million and accounted
for approximately 11 percent of the total reserves supplied
to the banking system by the Federal Reserve.

means

of im-

The
Federal
Reserve
could
avoid
charging for float by eliminating
it, either
by lengthening
its availability
schedule
and/or
increasing
the speed at which it
collects
checks.6
Lengthening
the availability schedule would induce payee banks
to shift to private-sector
collection
services
that are willing to use real resources
to
speed collection;
increasing
the speed at
which the Federal Reserve processes checks
would increase its own costs. Either alternative would
increase the social cost of
processing
checks
and result in an efficiency loss to the economy.
Could the Federal Reserve increase the
efficiency
of payment
by check through a
policy of charging for float? One means of
reducing costs imposed by negative externalities is to tax any private gain associated
with the externality.
Private interests, recognizing that any gain is to be taxed, would
not incur costs to capture the private benefit
of the external ity. Because there are no economic costs associated with producing float,
charging for float and remitting the revenues
to the Treasury would allow the general tax
burden to be decreased by the amount of
the float revenues." Thus, charging for float
represents a tax on the time value of reserves
that, properly instituted,
could increase the
efficiency of the payments mechanism.
Such a "float tax" would have to be designed in a manner that would reduce or
eliminate private incentives to incur costs in
an effort to capture the time value of re5. See Benjamin Wolkowitz and Peter R. LloydDavies, "Reducing
Federal
Reserve
Float,"
Federal Reserve Bulletin, December 1979.
6. The Federal Reserve has proposed to adopt a
combination
of these alternatives.
See Board
of Governors
of the Federal Reserve System,
"Federal
Reserve Bank Services Proposed Fee
Schedules and Pricing Principles,"
Docket No.
R-0324, August 28, 1980 (processed).
7. See Wolkowitz
and Lloyd-Davies,
Federal Reserve Float."

"Reducing

serves. An effective way to do this would be
to grant immediate availability for all checks
deposited
with the Federal Reserve for collection, but to charge payor banks for the
resultant
float. Granting
immediate
availability
would eliminate
the incentive
of
payee banks to speed check collection,
and
charging payor banks for float would impose
a private cost on delaying collection.
Payor
banks could not avoid the float tax by shifting to private sector collection services, because the choice of collection
services is at
the discretion of payee banks, and, all other
things equal, payee banks would choose the
system that grants the fastest availabil ity
of reserves.
Payors and their banks would bear the
float tax, which would encourage
both to
seek relatively cheaper means of payment.
For example, payors and their banks would
find it profitable
to encourage
payees to
accept payment
by the electronic
transfer
of funds among banks-a
service provided
by automated
clearinghouses.
In addition,
remote
disbursement
and
other
costly
practices
adopted
to increase float would
become
unprofitable,
thus reducing
their
use and improving
the allocational
efficiency of the payments mechanism.
Charging payors for float and payees
for the actual cost of collection would preserve competition
between public and private collection
services. However, the Federal Reserve could promote economic efficiency by reducing the incentive to use resources in response to the time value of
money.
Assuming
the
Federal
Reserve
could process
a given number
of checks
at the same cost as the private sector, the
Federal Reserve could lower its collection
costs and, therefore,
prices by reducing the
speed at which it collects checks. Private
collection
services, for competitive
reasons,
would respond by clearing checks at a comparable speed, thus reducing their costs and
prices. Price competition
between the Federal Reserve and the private sector would
assure that the efficiency gains of the float
tax were transmitted
to the private sector.
Although the float tax would have de-

sirable consequences
on the efficiency
payments
mechanism,
these gains

December 15, 1980

of the
would

have to be weighed against the cost of collecting the tax. The Federal Reserve would
incur additional
accounting
costs associated
with collecting charges on float. In addition
to these administrative
costs, the imposition
of the above scheme might interfere with the
conduct of monetary policy. Under a policy
of targeting the growth rates of the monetary aggregates, the Federal Reserve attempts
to supply an amount of nonborrowed
reserves consistent with these targets. Granting
immediate
availability
and collecting
at a
slow speed might supply an amount of reserves, in the form of float, that would exceed the reserves consistent with the rnonetary targets. The above design for a float
tax seems unlikely
to hit this constraint,
since the float tax would encourage payors
and the banking industry to minimize float.
Even so, if the absolute amount of float is
larger on average, it may make it more difficult to forecast
the amount
of reserves
that will be supplied by float and thus make
the short-run
control of the monetary
aggregates less exact. If this turns out to be
the case, the Federal Reserve could, to offset the adverse effects on monetary pol icy,
increase the float tax, further encouraging
the banking industry to reduce the amount
of float. Another
alternative
would be to
increase its collection
speed and count the
resulting inefficiency
in the payments mechanism as a cost of effective monetary policy.

ECONOMIC
COMMENTARY
ISSN 0428-1276

The Pricing of Float and
an Efficient Payments Mechanism

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address correction

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

requested

Conclusion
The

Federal

Reserve

System

is under-

standably
reluctant
to accept the price and
market
share
consequences
of charging
payee banks for float.
However,
a welldesigned payor float tax, subject to monetary policy constraints,
would have desirable
consequences
on the efficiency of the payments mechanism. The problems, difficulties,
and costs involved
in charging
for float
should
be weighed against the efficiency
gains that would occur in the payments
mechanism as a result of such a policy.

Address Change

o Correct

o Remove

as shown
from mailing list

Please send mailing label to the Research Department,
Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,

OH 44101.