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JuIy 31, 1981 PricingFedServices On August 1, the Federal Reserve begins charging users for clearing and collecting checks, and for transferring funds electronically via automated clearinghouses (ACHs). Pricing of these Reserve Bank services will significantly affect the nation's payments mechanism, because Reserve Banks process nearly half of all paper checks, and also operate most of the cou ntry' s automated cleari ng-. houses. The Federal Reserve System ultimately will price a number of correspondentbanking services under the terms of the Depository Institutions Deregulation and Monetary Control Act of 1980 (MCA). Check processing is the System's major banking service, however, so that charging for check and ACH services-which are close' substitutes-represents a major step in the implementation of the Act's pricing and access provisions. encoding or microfilming services. Also, they typically require all but the smallest institutions to presort checks by predeterm i ned processi ng categories. Check-clearingservices The Fed's ACH services provide financial institutions with the ability to transfer debits and credits automatically between institutions and account holders. A central ACH computer accepts and executes electronic messages necessary to complete a "paperless" transfer of funds. (Governments and financial institutions provide most of these inputs, primarily in the form of magnetic tapes.) The ACH takes the inputs, processes them, sorts debits and credits to the appropriate accounts, and then clears and settles the clearinghouse members' accounts. Reserve Banks clear and collect checks in order to facilitate the paper transfer of funds. Last year, for example, the Fed handled 15.7 billion checks at its 48 check-processing offices. Operation of this network of check facilities cost the System almost $280 million in 1980, or nearly two-thirds of the entire cost of all the correspondent-type banking services it provides. The swift and reliable transfer of funds via a bank-checking account (or thrift-institution N OW or share draft) entails a number of processing stages. The process involves encoding transaction information on each check, microfilming for records purposes, sorti ng by check type and desti nation, transporting the checks, sorting by institution for payment and settlement-and finally, crediting or debiting institutions' or clearinghouse members' accounts. Private banks (correspondents) also sell check-processing services to other financial institutions (respondents). Unlike such correspondents, however, Reserve Banks do not provide Automated clearinghouses ACHs are the computer-age equivalents of-as well as direct competitors with-the check clearinghouses operated by the Federal Reserve and by the private sector. Last year,.38 Reserve Bank facilities handled 227 million ACH transfers, although at a much smaller cost ($18 million) than the cost of its check-handling facilities. Ever since ACHs began operating a decade ago, the Federal Reserve has supported the development of a national ACH network, asa means of utilizing computer technology to reduce the nation's reliance on paper checks for the transfer of funds. Pricing services... Under the MeA, Reserve Banks must set service fees to reflect the "full cost" of producing these services at a mature volume of output. Full-cost prices should include all of the costs that a private competitor wou Id have to cover in the long-run in order to remain in operation. In compliance with the Act, Reserve Banks now add production costs to allocated overhead expenses for each service from available Federal Reserve accounting data, and then add a 16-percent In this nevvsielter do not (efleer the:, of the rnanagement of the Fc-dcral Ri:".'serve r:'ank of San Franci':;'(:(j, or of the of CO\'("frlCHS i)t i hI:" Federal Reserve SYsten1. necf":;s(lrilv - - - - - - - - - - , ---- Reserve Bank check services and fees may vary by type of check and by region. Each check type-generally determined by the type of processing it requires, and the location of the paying'and depositing institution -wi II be priced separately. Th is reflects actual differences in the costs of processing cash letters (bundles of similar checks). While all districts will offer a similar package of services, in some cases Reserve Bank charges will vary because of inter-office differences in services and/or costs. Thus, fees will differ between districts, and in some cases, even between Reserve Bank faci Iities (although not in the San Francisco District). Pricing and open access to Reserve Bank check services, as called for under the M CA, will directly affect the correspondent banks selling check services 'in competition with Reserve Bank services. First, correspondents will no longer be able to rely on "free" Federal Reserve check services to lower their cost of producing services for resale to respondents. Thus, pricing should increase the cost of privately supplied check-processing services, as well as the price correspondents charge respondent institutions purchasing services. Second, the elimination of free check services will allow correspondents to compete with the Fed both on price and service quality, instead of simply on service quality alone. Finally, open access should mean increased competition in the sale of check services to nonmember banks and thrifts-institutions which previously had only limited access to Reserve Bank check services. Reserve Bank fees for check services (see table) compare favorably with previously reported prices charged by large correspondent banks for similar services. For example, the average charge per encoded check in the San Francisco (Twelfth) Federal ReserveDistrict in 1 979 was 2.1 cents, with a range from 1 .4 to 3.0 cents for individual banks-according to the Account Analysis Survey of Charges for Selected Correspondent Banking Services conducted by Robert Knight Associates. These prices of course do not include any increase in costs that correspondents may face because of Reserve Bank pricing, which may boost correspondent prices after the August 1 shift by the Fed. The Federal Reserve has adopted uniform pricing for ACH services-except for New York. Those services are provided on a standardized basis nationwide (except for New York, where Fed-provided ACH services are limited to settlement of clearing balances among institutions). Also, the cost of computer-processing facilities, the major ACH category, essentially is determined in the national market. In addition, advances in ACH technology are likely to lead to a national ACH market linked by on-line computer-communications facilities, which would reduce the locational importance of both clearinghouses and ACH users. Thus, markup to cover imputed taxes and returns to capital. The Fed includes this private-sector markup to offset the fact that Reserve Banks, unlike private suppliers, are neither taxed nor required to earn a market return on capital. . . . for checks . .. andACHs Pricesof Selected CheckServices-San Frandsco District Centsper item Machine readable items deposited locally City checks Regional Check Processing Center (RCPC) Package sort (presorted by paying institution) Mixed items (unsorted items) Other Fed (items payable at other ReserveBank facilities) 0.58 1.71 4.12 Non-machine readable items deposited locally 7.99 2 1.54 1.71 ---_. __ __ ._-----_._-_.. .-_ .... ---_ _ _---------------_. •. .... _ _-_ .., ---------_. _--- dampen the growth of the developi ng market for ACH transfers and increase the bu rden on the nation's check-payments system. Setting fees too low wou Id also create problems, even while promoting faster ACH growth to take advantage of scale economies and alleviate pressure on the check-clearing' system. Low fees could act as a barrier to competition from the private sector and resu It in a long-run ACH subsidy that would run cou nter to the Monetary Control Act's pri ci ng and access provisions. Indeed, intended just the reverse-to improve the efficiency of the payments mechanism by eliminating Reserve Bank subsidies and barriers to competition. the Federal Reserve has set prices for intra-ACH transfers at 1.0 cents per item, except in New York where the charge will be 0.3 cents per item-while transfers between clearinghouses will cost 1.5 cents per item, except in New York where the fee will be 1.2 cents per item. Rapid expansion of ACH volume and the evidence of scale economies in such operations complicate the task of pricing ACH transfers. Both factors i nd icate that ACH facilities have yet to reach a mature volume of services as called for underthe M CA's pricing provisions. ACH volume, for example, has not leveled off -rather, it has more than doubled in'the lastthreeyears-and itcari be expected to continue growing even with the advent of pricing. In addition, Federal Reserve cost and output data indicate the existence of sizable economies of scale in ACH processing. Thus, the continued expansion of ACH facilities should lead to further reductions in "full cost" as output rises. Therefore, the Federal Reserve has set fees for ACH transfers based on an estimate of "full cost" at an estimated mature volume that takes both potential growth and scale economies into consideration. In sum, August 1 represents the dawn of a new era in correspondent banking. Reserve Bank implementation of explicit charges for check and ACH services wi II strongly affect the future markets for these two services. Pricing will increase the cost to institutions using check and ACH services, but it wi II also increase the efficiency of Reserve Bank production and distribution. Uriderthe M CA, Reserve Bank check-clearing faci Iities shou Id be able to compete, both on price and service quality, with the private sector. At the same time, the ACH fee schedule should leave ACH-transfer prices competitive with check fees, while encouraging the continued development and use of ACH faci Iities. Gary C. Zimmerman Advertised ACH fees are below the price of comparable paper-check transfers. Because of possible substitutability, setting the ACH price too high relative to checks could Publication-Monetary PolicyObjectives Copies are now available of the publication, Monetary Policy Objectives for 7987 -Midyear Review. This is a summary of the report made by Federal Reserve Chairman Volcker to Congress on July 21, 1 981. Free copies of this publication can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P. O. Box 7702, San Francisco 941 20. Phone (415) 544-21 84. 3 U01SU!4Sl?M.4l?ln • uoSaJO • l?pl?/\aN • 04l?PI S !!l?Ml?H • l?!UJOJ!ll?:) • l?UOZ!JY • l?>Il?IV CG) <§ \illW2(d ( \illW2 J CG) @!iL\ J(@<§@@ :[t BANKIN G DATA-TWELF TH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) SelectedAssetsand Liabilities large Commercial Banks Loans(gross,adjusted)and investments* Loans (gross,adjusted)- total# Commercial and industrial Realestate Loansto individuals Securitiesloans U.s. Treasurysecurities* Other securities* Demand deposits - total# Demand deposits - adjusted Savingsdeposits - total Time deposits'- total# Individuals, part. & corp. (LargenegotiableCD's) Weekly Averages of Daily Figures Member Bank ReservePosition ExcessReserves + )/Deficiency (- ) ( Borrowings Net free reserves(+)/Net borrowed(- ) Amount Outstanding 7/15/81 150,188 129,084 38,643 53,130 22,939 1,579 6,190 14,914 43,196 29,875 30,327 82,813 74,575 33,825 Weekended 7/15/81 n.a. 72 n.a. Change from 7/8/81 Changefrom year ago Dollar Percent 9.1 239 12,522 11.3 13,120 23 - 254 5,309 15.9 13.0 201 6,132 - 3.8 915 15 60.1 145 593 1.7 8 108 - 3.2 270 486 2.8 1,099 1,262 - 2,328 7.2 363 5.0 346 lA40 33.8 906 20,912 1)75 20,985 39.2 52.9 1,070 llJOl Comparable Weekended year-agoperiod 7/8/81 - n.a. 39 n.a. - 65 47 -112 * Excludestrading account securities. # Includes items not shown separately. Editorial comments may beaddressedto the editor (William Burke) or to the author . ... Freecopiesof this and other FederalReserve publications can beobtained by calling or writing ..he Public Information Section, Federal ReserveBank of SanFrancisco,P.O. Box 7702, SanFrancisco94120. Phone(415) 544-2184. 24I \illW2cgr