Full text of Economic Review (Federal Reserve Bank of San Francisco) : Winter 1981 : Money and the Monetary Control Act

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FEDERAL RESERVE BANK
OF SAN FRANCISCO
ECONOMIC REVIE\M

MONEY AND THE
MONETARY CONTROL ACT
I\MINTER 19811

The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the
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Money and the
Monetary Control Act
I.

II.

Introduction and Summary

4

Monetary-Control Implications of the
Monetary Control Act

6

Michael A. Klein
In an environment of deregulation, the definitions of the monetary
aggregates should be more meaningful economically, and thus more
useful for monetary policy.

III.

The Pricing of Federal Reserve Services under MCA
Gary C. Zimmerman
. . . The post-MCA world will be both more competitive and efficient, as a

result of the partial or complete elimination of Federal Reserve subsidies
to depository institutions.
Editorial committee for this issue:
Charles Pigott, Herbert Runyon, and Adrian Throop

22

Congressman Reuss called it the most significant piece of financial legislation since the
1930's, and Senator Proxmire went even
further and called it the most important piece
of legislation since the Federal Reserve Act of
1913. But that disagreement aside, few observers would deny that the Depository Institutions Deregulation and Monetary Control Act
of 1980 - the MCA - will strongly influence
the direction of banking and financial activity
in coming decades.
Through the MCA, Congress promoted
greater competition in financial markets, primarily by providing for the phase-out of deposit interest-rate ceilings and a broadening of
asset and payment powers of banks and thrift
institutions. Congress also promoted greater
equity and improved monetary control by
extending reserve requirements (following a
phase-in period) to all depository institutions
with transaction (check-type) accounts and
nonpersonal time deposits. This step helped to
solve the problem of declining Federal
Reserve membership, by reducing the cost of
reserve requirements for member banks and
imposing similar reserve requirements on all
insured depository institutions. Moreover,
Congress promoted greater efficiency in correspondent-banking markets, by providing
access to Federal Reserve services, at explicit
prices, for all depository institutions subject to
reserve requirements. To highlight the importance of the legislation, this issue of the Review
considers its implications in two major areas monetary policy and pricing of Federal
Reserve services.
On the monetary control issue, Michael A.
Klein analyzes several sweeping changes arising from the MCA - including those sections
that don't directly address that specific issue.
First, he discusses the role of reserve requirements in facilitating money-stock control

when the Federal Reserve uses an aggregatereserves measure as its control instrument, as
it has done for the past year and a half. (In
October 1979, the Fed changed its openmarket operating procedures to place more
emphasis on the control of bank reserves and
less emphasis on tightly pegging the cost of
bank reserves, the Federal-funds rate.) He
presents criteria for evaluating reserverequirement systems, and develops an argument for uniform required reserves on all accounts included in the monetary aggregate
targeted by the authorities, within the context
of a simple deposit-multiplier model that
includes both member and nonmember banks.
Klein shows that such a regime serves to
reduce the number of disturbances that
impinge on the money stock, and thereby
facilitates monetary control. In other words,
the imposition of uniform required reserves
reduces the extent of multiplier uncertainty.
His analysis also indicates, however, that two
provisions of the legislation - a sharply higher
reserve requirement on transaction accounts
exceeding $25 million than on smaller
amounts, and the imposition of required
reserves on nonpersonal time deposits - are
inconsistent with the logic of a regime of
uniform required reserves when the
authorities' aim is to control a transactions
aggregate.
Klein next examines the effects of the new
law on the monetary-control problems caused
by the process of financial innovation. Two
forms of bank regulation - differential
reserve-requirements on alternative deposit
accounts, and deposit interest-rate ceilings have induced a number of innovations in
recent decades. Klein's analysis supports other
criticisms of interest-rate ceilings, by showing
that such ceilings tend to induce shifts offunds
among different deposit liabilities in response

4

to interest-rate fluctuations. But the same
analysis shows that deregulation will significantly improve monetary control by reducing
the degree of multiplier uncertainty caused by
such shifts of funds.
More importantly, deregulation will significantly retard regulation-induced financial
innovation, by allowing depository institutions
to compete for funds by paying market-determined interest rates. However, the differential
between transaction-account and time-account
reserve requirements will continue to
encourage innovation, although less so than in
the past.
Klein argues that the new types of transaction accounts developed in recent years clearly
exemplify the innovations generated by
regulations. "Such innovations have considerably complicated the task of monetary
control by altering the relation between the
(old) targeted monetary aggregates and
nominal GNP and inflation. Thus in an
environment of deregulation, the definitions
of the aggregates should be more meaningful
economically and, therefore, should be more
useful for the conduct of monetary policy."
Turning to the pricing issue, Gary Zimmerman examines the impact of MCA pricing and
access provisions on the market for correspondent-banking services. In the pre-MCA
environment, Federal Reserve Banks provided
correspondent services to member banks free
of charge. But nonmember banks, being
denied direct access to these services, had to
produce them internally or rely on (member)
private correspondents.
The passage of the MCA was a major
breakthrough in the rationalization of the correspondent-banking system. As Zimmerman
argues, it opens the door to equal treatment of
all institutions with respect to pricing of (and
access to) Federal Reserve services.
Zimmerman argues that, in the pre-MCA
environment, free Federal Reserve services
represented a major source of inefficiency in
the correspondent-banking system. "First,
this situation led to overconsumption of Fed
services by member banks. Also, by causing

the overproduction of publicly produced correspondent services, this pricing policy
resulted in an inefficient allocation of
resources. "
He thus raises the questions: to what extent
will MCA provisions enhance competition and
improve market efficiency? Also, after the
implementation of MCA, will Federal Reserve
Banks be able to compete with private banks
offering these services? He presents evidence
suggesting that Federal Reserve Banks do not
have a natural monopoly in providing any correspondent services (except possibly automated clearinghouse services) - and that in
many cases, Reserve Banks produce higherthan-optimal levels of such services.
In Zimmerman's view, " 'Full cost' pricing
as implemented under the MCA will not eliminate all of the subsidies to institutions using
Fed services. However, it will provide Reserve
Bank customers with market signals concerning the true cost of the services they consume,
providing strong incentives for more efficient
use of the services produced."
Zimmerman argues that the post-MCA
world will be more competitive and efficient as
a result of the partial or complete elimination
of Federal Reserve subsidies to depository
institutions. He notes that removal of checkprocessing subsidies will allow private producers to compete on a more equal footing
with Reserve Banks. On the other hand, he
points out that cash-handling services will continue to be subsidized, but will be available to
all depository institutions rather than just
member banks.
Zimmerman notes, however, the special
nature of automated clearinghouse services.
The Federal Reserve's published pricing
schedule indicates a short-run willingness to
continue subsidies, so that the market grows
sufficiently for Reserve Banks to take advantage of their economies of scale in this area.
"This would permit lower ACH transfer costs,
making them more competitive with checkclearing costs, and thereby helping to reduce
the burden on the nation's check-payments
system."

5

Michael A. Klein*
These are sweeping changes indeed. The
new legislation extends the reach of Federal
Reserve requirements from member banks to a
number of other institutions, including both
nonmember banks and nonbank depository
institutions (a term that includes mutual savings banks, credit unions, and savings-andloan associations). The definition of transaction accounts is similarly broad, encompassing conventional demand deposits, negotiable
order of withdrawal (NOW) accounts, savings
deposits subject to automatic transfers, and
share-draft accounts. More generally, a transaction account is defined as any account on
which the account holder may make withdrawals by a transferable instrument for the
purpose of making payments to third parties.
Moreover, should the process of financial
innovation introduce close substitutes for
existing transaction accounts, the Federal
Reserve Board of Governors has the power
under the legislation to classify such accounts
as transaction accounts for reserve-requirement purposes.
In Section I, we discuss the role of reserve
requirements in facilitating money-stock control when the Federal Reserve uses an aggregate-reserves measure as its control instrument
- as it has done since October 6, 1979. At that
time, the Fed changed its open-market operating procedures to place more emphasis on the
direct control of reserves [Board of Governors,
2]. In this section, we present criteria for
evaluating reserve-requirement systems, and
develop the fundamental rationale for uniform
required reserves (URR), within the context
of a simple deposit-multiplier model that
includes both member and nonmember banks.
We show that a URR regime serves to

The Depository Institutions Deregulation
and Monetary Control Act of 1980 was signed
into law by President Carter on March 31,
1980. Referred to by Senator Proxmire as "the
most significant banking legislation before the
Congress since the passage of the Federal
Reserve Act of 1913," the bill (Public Law 96221) deals with a large and diverse set of
monetary-control and financial-regulatory
issues. Because of the importance of the
monetary-control issue, we concentrate here
on that particular aspect of the legislation.
It should be understood that the monetarycontrol implications of the legislation are not
coextensive with its monetary-control provisions. Only Title I - designated the Monetary
Control Act of 1980 - specifically addresses
the question of control, by providing for a
system of uniform required reserves (URR)
on depository-institution transaction accounts
and nonpersonal time deposits. In addition,
Title I provides those institutions with access
to various Federal Reserve services, and
instructs the Fed to develop and implement a
schedule of explicit prices for those services.
Title I thus directly addresses the monetarycontrol issue, but the following two titles also
have important implications for that question.
Title n provides for the phaseout and ultimate
elimination of regulatory ceilings on deposit
interest rates, while Title III gives depository
institutions permanent authorization to offer
certain interest-paying accounts (automatictransfer accounts, share drafts, and NOW
accounts) .
'Professor of Economics, Indiana University,
Bloomington, Indiana; Visiting Scholar, Federal Reserve
Bank of San Francisco, Summer 1980.

6

reduce the number of disturbances that
impinge on the money stock and, as a direct
result, facilitates monetary control. Put
differently, within the framework of a depositmultiplier model, the imposition of URR
reduces the extent of multiplier uncertainty.
The analysis also indicates, however, that two
provisions of Title I - a sharply higher reserve
requirement on transaction accounts exceeding $25 million than on smaller amounts, and
the imposition of required reserves on nonpersonal time deposits - are inconsistent with
the logic of a URR regime.
In Section II, we examine the effects of
the new law on the monetary-control problems
caused by the process of financial innovation.
Innovations have been directly induced by two
forms of bank regulation: reserve-requirement
differentials and deposit interest-rate ceilings.
Our analysis supports earlier criticisms of the
reserve-requirement differential on transaction accounts. That same analysis, however,

shows that deregulation will significantly
improve monetary control.
First, deregulation will further reduce the
degree of multiplier uncertainty by lessening
the extent of funds shifts across different depositliabilities. Second, and more importantly,
deregulation will significantly retard regulation-induced financial innovation by allowing
depository institutions to compete for funds by
paying market-determined interest rates. The
new types of transaction accounts dealt with in
the Act's Title III clearly exemplify the
innovations generated by regulations - primarily limitations on deposit interest rates.
Such innovations have considerably complicated the task of monetary control by altering
the relation between the (old) targeted aggregates and nominal GNP and inflation. Thus in
an environment of deregulation, the definitions of the monetary aggregates should be
more meaningful economically and, therefore,
should be more useful for the conduct of
monetary policy.!

I. Title I and Monetary Control:
Rationale for Uniform Required Reserves
Clearly, the new legislation reduces the level
of reserve requirements for virtually all member banks, while simplifying the overall structure of reserve requirements (Table 1). At the
same time, the new reserve requirements on
nonmember banks and other depository
institutions partly offset the reduction in
required base-money holdings of member
banks - as is seen from a Federal Reserve
staff study which compares projected basemoney reserve holdings under P.L. 96-221
with those that would have been held in the
absence of the legislation (Table 2). The estimates cover the 1981-85 period, to reflect the
phase-in of reserve requirements stipulated by
the law. 3
The URR concept is, of course, not a new
one. For more than three decades, beginning
in 1948, the Board of Governors had requested
legislation to subject all insured banks to
System reserve requirements. The Commission on Money and Credit in the early 1960's,

To gain some perspective regarding the
extent of the changes mandated by Title I, we
can compare the preexisting reserve-requirement schedule with the provisions of P.L. 96221 (Table 1). After complete implementation
of those provisions,2 the reserve requirement
will be fixed by statute at 3 percent on each
institution's transaction accounts of $25 million or less. However, at the end of each year
(beginning December 31, 1981), the Federal
Reserve will increase or decrease that $25-million figure by 80 percent of the preceding
year's (June 30-June 30) percentage change in
total transaction accounts of all depository
institutions. Although the Act initially sets the
reserve requirement at 12 percent for accounts
in excess of the base level, the Board of Governors may vary the requirement within the
range of 8 to 14 percent. Similarly, the initial
requirement of 3 percent on nonpersonal time
deposits can be varied, at the Board's discretion, within a range of zero to 9 percent.

7

banking system changes its reserve holdings in
excess of those required, because this alters
the actual ratio of reserves to deposit liabilities.
Similarly, unpredictable changes may occur in
the allocation of the public's asset portfolio
between currency and demand deposits, •between deposit liabilities of depository institutions with different reserve requirements, and
between deposit liabilities and open-market
investments. Changes in any of these will alter
the ratios on which the multiplier depends. In
addition, the setting of the reservesinstrument itself will generally require the Federal
Reserve to undertake defensive open-market
operations, in response to unanticipated
changes in such factors as float and Treasury or
foreign deposits at the Federal Reserve.
These considerations may be expressed in
the following equation:

and the President's Commission on Financial
Structure and Regulation in 1971, both supported that same principle. But the acceleration of membership attrition during the 1970's
intensified interest in the development of
alternative approaches to structural banking
reform, and eventually provided the required
catalyst for the emergence of the present legislation. 4
To understand the fundamental rationale for
the implementation of a URR regime, we must
first develop some general criteria for evaluating reserve-requirement systems. Such a
system can have important implications for
monetary control when the Federal Reserve
attempts to control the money stock with a
reserves aggregate instrument. With that
instrument set, the joint behavior of the public
and the banking system then determines the
level of the targeted money stock.
The relationship between the level of
reserves and the size of some particular monetary aggregate - the muitiplier - is not,
however, a constant one. Rather, it is subject
to the influence of a wide range of disturbances
- disturbances that can originate in anyone
sector or in all sectors simultaneously. For
example, the multiplier may change when the

(1)

Since the Federal Reserve may target more
than one monetary aggregate, M i simply represents one specific money-stock measure. We
assume that the Federal Reserve targets M i by
setting the level of the monetary baseS - the
sum of bank reserves and currency - at B.

Table 1
Comparison of Reserve Requirement Ratios
A. Applicable Reserve Requirements Under P.L. 96-221
Category

Reserve Requirement

3% fixed by statute
8% - 14%

3%

Nonpersonal Time Deposits

Permissible Range

3%
12%

Net Transaction Accounts
$0 - 25 million
Over $25 million

0% - 9%

B. Reserve Requirement Ratios in Effect Prior to September 1, 1980
Category

Reserve Requirement

Net Demand Deposits
0
2
$ 10
$100
Over
$
$

7%
9'!2'Yo
11%%
12%%
16'/.%

-

2 million
10 million
100 million
- 400 million
$400 million

Savings Deposits

3%

Time Deposits

Varies by maturity
and denomination

8

The remaining terms (the e j ) represent potential disturbances to the system - disturbances
that can change the money stock independently of a change in the monetary base.
Within this framework, the reserve-requirement system affects monetary control in two
ways. First, that system influences the number
of potential disturbances that affect the money
stock. Second, the setting of reserve requirements affects the response of the monetary
aggregate to any given disturbance. The
system that minimizes the number of disturbances and/or the sensitivity of the money
stock to those disturbances is, ceteris paribus,
to be preferred from a monetary-control
perspective. The rationale for imposing
uniform required reserves on all depository
institutions is this system's ability to reduce
significantly the number of disturbances that
can affect the money stock independently of
the monetary base.

the targeted money stock but are not subject to
Federal Reserve reserve requirements. The
public holds three assets: currency (C),
demand deposits and other transaction
accounts (D), and time deposits and all other
nontransaction-account liabilities (T). A
superscript denotes the sector for which a particular financial instrument is an asset; a
subscript the sector for which the instrument is
a liability. The Federal Reserve is assumed to
control the money stock by the use of a basemoney instrument (B) .
The model assumes that the public holds
demand and time deposits with both member
and nonmember banks (equations El and E3),
its holdings with members being a constant
fraction of total demand deposits (given by
equations E2 and E4). Thus, the variable (k)
designates the proportion of publicly held
demand deposits at member banks. The public's demands for time deposits and currency,
respectively, are constant fractions of their
total demand deposits (t and c in E5 and E6).
The required reserves of member banks are
determined by the reserve-requirement ratios
imposed on demand and time deposits (qd and
qt) respectively (E7). The demand-deposit
liabilities of member banks (equation ES) are
held by the public (D ~) and by nonmember
m
banks (D: ). Member banks are assumed to
provide correspondent services to nonmembers
which, in turn, hold demand balances with

Theoretical Framework
We can examine the implications of a URR
regime by developing a slightly extended version of the standard deposit-multiplier model. 6
The formal model (Exhibit I) describes the
behavior of four sectors: the nonbank public
(p), the Federal Reserve (D, member banks
(m), and nonmember banks (nm). "Nonmember banks" here include all depository
institutions whose liabilities are included in

Table 2
Comparison of Base Money Reserve Holdings
(in millions of dollars)
1981

1982

1983

1984

1985

Reserves at Fed:
Old Structure

27,196

27,078

27,165

27,369

27,742

Member Bank Reserves at Fed:
New Structure

21,492

17 ,964

14,483

12,664

12,724

1,031

1,702

2,315

2,888

3,523

22,524

19,672

16,749

15,552

16,252

4,672

7,407

10,366

11,817

11,490

Other Institutions' Reserves
at Fed: New Structure
Total Reserves at Fed:
New Structure
Reserves Released

Source: Federal Reserve Memorandum on "Five- Year Cost Projections for Monetary Improvement Legislation."

9

reserves of members - with its level fixed by
the central bank (8).
The narrow money stock (M -0 is defined as
the sum of publicly held currency and demand
deposits: 7

member banks. The crucial point to note is
that member banks' required reserves must be
held in the form of Federal Reserve base
money only (E7).
In contrast, nonmember banks must satisfy
demand-and time-deposit reserve requirements as specified in equation (E9), with these
reserves held either as balances with corresm
pondents (D: ) or as vault cash (V~m). Nonmember reserve holdings are distributed between correspondent balances and Federal
Reserve base money (V~m) in the proportions
(l - a) and (a) respectively. Thus, base
money is divided among currency held by the
public, vault cash of nonmembers, and the

With a given level of the monetary base, we
can derive a behavioral specification for M-I
by substituting equations El-Ell intoequation E12, and then setting the total uses of the
base so derived equal to B. The resulting
expression for M-I is

Exhibit I
Deposit Multiplier Model with Nonmember Bank Sector
I. Model Equations

(EO

D = D~ + D~m

Total Public Demand Deposits

(E2)

n P

Member-Nonmember Demand-Deposit Mix

P

kD

Lim

P

P

T = T~ + T~m

(E3)

P

(E4)

T m= kT

(ES)

T P = tD
P

Total Public Time Deposits

P

Member-Nonmember Tircc ,-

P

:mand Function

P

(E6)

C r = cD

(E7)

RR~ = qctDm + q(T m
m
D m= D~+ D:

(E8)

Mix

Public Demand for Currency
Member-Bank Required Reserves!
Demand Deposits at Member Banks
Nonmember-Bank Required Reserves

(EIO)

RR om = ActO ~m + AJ~m
RR om = D:m+ V ~m

(Ell)

V~m

Nonmember Demand for Base Money

(EI2)

B = RR~+ V~m+

(El3)

B=B

(E9)

Reserve Eligible Assets for Nonmembers

= aRR om

ci

Uses of Base Money
Exogenous Supply of Base Money

II. Coefficient Definitions
k
t

c =
qd' q(

Ad' At
a

proportion of deposits held by member banks.
ratio of time to demand deposits.
ratio of currency to demand deposits.
member-bank required-reserve ratios on demand and time deposits.
nonmember-bank required-reserve ratios on demand and time deposits.
proportion of nonmember-bank reserves held as Federal Reserve base money.

1. Member-bank required reserves, RRf", include their vault cash.

10

Ml

=

[r! ~ ~ ] 13 -

mr13

money reserve requirement increases by $4
(20 percent of $20). Altogether, $16 of base
money is released, and if not offset by the
Federal Reserve, this leads to an increase in
the money stock. Random deposit flows between member and nonmember banks,
therefore, can affect the value of the multiplier
and exacerbate the problem of monetary control. However, the imposition of a URR
regime can significantly reduce multiplier
uncertainty, as we shall next see.

(2)

where
r*

=

+ V nm
D~ + D~m
qd[k + (l - a) (l - k)(Ad + Alt)]
+ qltk + a(l - k) (>I.d + Alt)
RR m

-c-.;;.;f'--_ _

(3)

The parameters are defined in Exhibit I.
Equation (2), which expresses the monetary
aggregate as the product of the monetary base
(B) and a money multiplier (mr), represents a
specific example of the general equation M; =
M; (13, e l , e2, ... , en)' The value of the money
multiplier can change as a result of shifts in any
of the reserve ratios or fractions dividing the
public's wealth among alternative assets and such shifts will affect the money stock if
not offset by appropriate changes in the base.
Although the Federal Reserve sets memberbank required-reserve ratios (qd and ql), it
exercises no direct control over the remaining
coefficients of the multiplier. We should note
in particular the multiplier's dependence on
the ratios applying to the nonbank sector. This
raises the question of how the presence of nonmember banks might increase uncertainty
with respect to the size of the multiplier.
This point can be illustrated by following a
random flow of $1 00 of demand-deposit funds
from member to nonmember banks - a shift
in (k) . Assume that member and nonmember
reserve ratios are 20 percent (qd = Ad = .2);
assume also that nonmember banks hold all
their reserves as correspondent balances
(equivalent to a = 0). The funds transfer produces no initial change in M-1, since both
member and nonmember deposits are
included in the definition of M-l. However,
base-money reserves are released by this
transfer. Member banks release $20 (their loss
in deposits multiplied by qd)' Although nonmembers must now hold $20 of additional
reserves, these reserves do not take the form
of base money, but are instead deposited with
a correspondent bank (assumed to be a member bank). In turn, the correspondent's base-

Imposition of Uniform Reserve
Requirements
Two basic steps are involved in the imposition of a URR regime. First, the assets eligible
to satisfy reserve requirements must be identical for all banks. Second, the ratio of bank
liabilities held in the form of reserve-eligible
assets must be uniform across banks. These
changes can be examined with reference to the
preceding model.
The most fundamental change is in the
definition of the reserve-eligible assets of nonmembers (ElO). Under URR, such assets are
restricted to the components of Federal
Reserve base money (i.e., deposits with the
Fed and vault cash).

Correspondingly, the uses of base money
(E12) now include nonmember reserve deposits, unlike previously.

Within the model, this is equivalent to assuming that nonmember reserves held with correspondents are zero (a = I). As can be seen
from equation (El I), this means that nonmember-bank reserves must consist of Federal
Reserve base money only.H
The second step requires that the reserverequirement ratios imposed on nonmember
banks be identical to those on member banks.
With the necessary changes, and with the
revised uses of the base set equal to 13, the
solu tion for M-I is

11

(4)

Evaluation of URR Provisions
The
of Tilie i, however, do not
completely conform to the principles stated
above. In the first place, the Act subjects all depository institutions to identical, but not
uniform, reserve requirements on transaction
accounts. Specifically, the first $25 million of a
bank's deposits is subject to a statutory 3-percent requirement whereas the amount in
excess of that is subject initially to a 12-percent
requirement, within a possible range of 8 to 14
percent (see Table 1). This increase in the
reserve requirement at the $25-million level is
almost as large as the previously existing
increase in graduated reserve requirements
over the entire range of bank size categories.
Since, with indexing, the base level changes by
only 80 percent of the change in total transaction balances during a given year, an increasing proportion of transaction accounts thus will
be subject to higher reserve requirements in
the future.
It can, of course, be argued that this provision costs very little in terms of increased
multiplier uncertainty. If the distribution of
transaction accounts across size classifications
is relatively predictable, or if the Federal
Reserve can obtain reasonably complete and
timely information on that distribution, it can
offset induced movements in the money
multiplier by appropriate adjustment of its
operating instrument. However, the basic
rationale of a URR regime is that it simplifies
and thus strengthens monetary control.
Differentiation between size classes of deposits thus is inconsistent with this objective,
and must be defended on other grounds, such
as equity for smaller institutions.
Questions also arise about the Act's treatment of time and savings deposits. First, the
reserve requirement against savings deposits
has been eliminated, which is consistent with
improved control over a narrow aggregate such
as M-lB. Simultaneously, however, a 3 percent reserve requirement on nonpersonal time
deposits has been imposed, with the Federal
Reserve given discretion to vary the ratio anywhere between zero and 9 percent. Since time
deposits are excluded from the narrow aggre-

where
(5)

and, once again, the symbol (r) designates the
ratio of base-money reserves to demand deposits.
This structural change has several advantages. The money stock is no longer affected
by shifts of funds between member and nonmember banks, by alterations in the composition of nonmember-bank reserve holdings,
or by differentials in interstate nonmemberbank reserve requirements. Monetary control
is therefore improved, according to our first
criterion for evaluating reserve-requirement
systems. This improvement, in turn, follows
directly from a fundamental principle: the
imposition of identical base-money reserve
requirements on all deposit liabilities included
within a given monetary aggregate insulates
that aggregate from shifts of funds between
those liabilities.
Nonmember-bank demand deposits are
included in all monetary-aggregate definitions,
and so should be subject to the same reserve
requirements as member-bank deposits.
Moreover, the newly defined transaction
aggregate, M -1 B, includes NOW and ATS
accounts at banks and thrift institutions as well
as credit-union share drafts and mutual-savings banks' demand deposits. Thus, our basic
principle applies equally to these institutions
under the new URR regime.
If identical reserve requirements on the
liabilities included within the targeted money
stock are desirable, zero reserve requirements
on liabilities excluded from the target are also
desirable. This would insulate the targeted
money stock from shifts of funds between
included and excluded liabilities, as shown in
(4) and (5). With a positive reserve requirement against time deposits (q, > 0), the transaction aggregate M-l is affected by deposit
flows between demand and time liabilities
(shifts in t). By setting q, = 0, an additional
source of disturbance is thereby eliminated.
12

reserve requirements among different types of
deposits will inevitably stimulate depository
institutions to engage in a process of financial
innovation, in order to substitute lowreserve-requirement time liabilities for highreserve-requirement transaction accounts.
(This process is examined further in Section
II). Such financial innovations can complicate
the monetary-control task by altering the relation between targeted aggregates and the
authorities' ultimate objective of non-inflationary growth. Admittedly, the URR provisions have reduced the incentive for such
innovations, by lowering average and marginal
reserve requirements against transaction balances - but substantial incentives still remain.
This problem illustrates the difficulty of setting reserve requirements to promote monetary control. Because the rationale of URR
requires zero reserves against non-targeted
liabilities, the reserve ratio required for
targeted liabilities must be fairly low to discourage financial innovation. However, a low
reserve ratio - which is tantamount to a high
multiplier - implies a much larger impact
upon the money stock of any remaining disturbances. Thus a trade-off exists between the
need to reduce incentives for financial innovation and the concern to reduce the money
stock's response to disturbances.
To summarize, from a monetary-control
perspective, a strong a priori case can be made
for imposing a URR regime. Such a system
reduces the number of random variables that
affect any definition of the money stock. In
particular, shifts of funds across depositoryinstitution liabilities included in the target
aggregate no longer affect monetary control.
However, the benefits ofURR may be reduced
if reserve requirements are based on bank-size
classifications, and/or if base-money reserve
requirements are imposed on liabilities that
are not part of the targeted money stoCk. 12
Furthermore, the variation in levels of reserve
requirements among different deposit categories continues to encourage financial innovations that may further complicate the monetary authorities' task.

gates, this provision is detrimental to monetary control. By contrast, if the target aggregate
is broadened to include all time deposits at depository institutions, then the zero reserve
requirement on the savings deposits included
in that aggregate would be nonoptimal.
Imposing required reserves on nonpersonal
time deposits can significantly increase the
degree of multiplier uncertainty because such
deposits are highly volatile. When the Federal
Reserve sets an objective for money-supply
growth, it must determine a set of reserve
paths that are, in its judgment, consistent with
the achievement of the money-growth objective. An important element of this process is
predicting the growth rate of nonlargeted
liabilities that are subject to reserve requirements. If these grow faster than expected, a
given reserves path will support a slower than
anticipated growth rate in the target aggregate.
The last quarter of 1979 provides an example of this type of problem. 9 At its October 6
meeting, the Federal Open Market Committee
agreed to a 4.5 -percent annual growth-rate
target for M-l and a 7.5-percent growth-rate
target for M-2. Total reserves actually grew
during that quarter at a 13.8-percent annual
rate, and the resulting growth rates in M-l and
M-2 were 3.1 percent and 6.8 percent, respectively - both substantially below their
targeted growth rates. 1O Of the 13.8 percent
growth in total reserves, less than half (5.6
percent) was absorbed by growth in the
targeted aggregates. The remaining factors
causing reserve absorption included large
negotiable CD's 0.6 percent), interbank
demand deposits (2.7 percent), and excess
reserves (2.0 percent). The setting of reserve
requirements on nontargeted liabilities thus
accounted for roughly half of the growth in
reserves during this period, creating unnecessary complications for monetary policy. In
other words, the Federal Reserve had to predict and then attempt to compensate for disturbances that affected the monetary aggregate
only because reserve requirements had been
imposed on nontargeted liabilities. J J
Perhaps more importantly, the variation in

13

U.

Regulation-lnducedFinanciallnnovstion

Only Title I of the Monetary Control Act
specifically addresses the question of monetary
control, but Title II and Title III may have
even more far-reaching implications in that
regard. Title II - The Depository Institutions
Deregulation Act of 1980 - establishes a
Deregulation Committee to provide for the
orderly phaseout and ultimate elimination of
deposit interest-rate ceilings. The ultimate
goal is the payment of market - rather than
regulatory - rates of interest on deposit
accounts. The Committee has wide latitude for
determining the speed of deregulation, but it
must move to full implementation within six
years from the Act's passage. Title III - the
Consumer Checking Account Equity Act of
1980 - gives permanent authority to different
depository institutions to provide certain
financial services - specifically, interest-paying transaction accounts such as automatictransfer-from-savings (ATS) accounts, creditunion share drafts, and negotiable-order-ofwithdrawal (NOW) accounts.
These sections of the Act jointly reflect a
radically transformed financial environment a transformation brought about primarily by
the impact of high and rising inflation rates on
market rates of interest, and by the increasing
divergence of market rates from regulationcontrolled deposit rates. Financial innovation
has been dramatically exemplified by the
development of new transaction accounts,
such as share drafts and NOW accounts. In
turn, financial innovation has had important
implications for monetary control. It affects
the central bank's ability to control any given
aggregate and, more profoundly, it significantly affects the appropriateness of existing
definitions of the monetary aggregates. For
example, the old distinction between M-I and
M-2 rested on the notion that passbook and
time accounts could not serve as a medium of
exchange, but that distinction has been rendered meaningless by the development of
NOW and ATS accounts. The recent redefinition of the monetary aggregates represents an
attempt by the Federal Reserve [13] to

develop new aggregates more nearly consistent
with the innovation-caused transformation of
the financial environment.
In this section, we examine innovation in
response to two forms of bank regulation:
reserve requirements and deposit interest-rate
ceilings. First we modify the previous model to
inGorporate innovation in response to reserverequirement changes. Following this, we
examine the impact of deposit-rate regulation
- and, by implication, of deregulation as well.
This consideration of behavioral responses to
financial regulation significantly broadens the
implications of the preceding analysis.
Reserve-Requirement-Induced Innovation
The analysis of reserve-requirementinduced financial innovation begins with an
examination of the behavior of the individual
banking firm. Assume that the bank issues two
types of deposits - demand and time deposits
- through the payment of explicit rates of
interest, rdand r" with no regulations governing those interest rates. Let
(6)

(7)

represent the functions determining the
amount of demand and time deposits the public will hold. In (6) and (7), the symbol (r g ) is
used to represent the open-market rate of
interest. It provides a measure of the opportunity cost of holding the liabilities of depository institutions. It is assumed that
D 1 == 8D/8r d > 0,
D 2 == 8D/8r, < 0,
D 3 == 8D/8r g <

°

T I == 8T/8rd < 0,
T 2 8T/8r, > 0,
T 3 - 8T/8r g <

=

°

These conditions simply assert that an increase
in the demand-deposit interest rate raises the

14

desired level of demand deposits held by the
public, whereas increases in the rates of
interest on time deposits and/or open-market
assets reduce desired demand-deposit holdings. We may make corresponding assumptions with respect to the time-deposit function.
The initial reserve requirements on demand
and time deposits are qd and zero, respectively.
This means that, of each additional dollar of
demand deposits, the bank can invest the fraction (1 - qd). For simplicity, assume that,
after satisfying reserve requirements, the bank
acquires a single earning asset - one that pays
a constant marginal and average rate of return,
r g' The profit function for the individual bank
then is:

In terms of our deposit-multiplier model, a
rise in qd leads to an increase in the value of the
coefficient (t), in the following fashion. The
increase in reserve requirements reduces the
marginal revenue from demand deposits.
Profit maximization requires the bank to respond by lowering its offering rate on those deposits. At its new profit-maximizing position,
the bank suffers a loss of both total deposit
funds and. profits.
I£.this were the end of the story, such considerations could easily be integrated into the
preceding deposit-multiplier model. Through a
process of financial innovation, however, the
bank may succeed in offsetting at least part of
its profits loss. For example, the bank could
permit its time-deposit account holders to use
their balances to cover overdrafts in their
checking accounts. Although this may induce
switching of funds from lower-rate demand
accounts to higher-rate time accounts, the
innovation should be beneficia! to both the
bank and its depositors. The bank could
recoup some or all of its lost funds and,
simultaneously, switch those funds from
higher-reserve-requirement liabilities to
lower-reserve-requirement liabilities. The
bank's depositors meanwhile could obtain
higher yields on their deposits, reflecting the
lower reserve requirement on time deposits.
Would monetary control be improved by an
increase in reserve requirements on demand
deposits? The answer is yes, according to the
conventional analysis [Cacy, 3; Kaminow, 6],
which ignores the existence of financial
innovation. Given a narrow target aggregate, a
rise in qd reduces the size of the money multiplier and, therefore, moderates the impact of
exogenous shocks on the money supply. But
that conclusion, although technically correct,
is also very misleading. Given the financial
innovation described here, some transaction
balances would now be labeled time deposits,
with zero reserve requirements. If transaction
balances are the economically relevant object
of policy, monetary control could actually be
eroded, because of the reduction in the
average and marginal reserve requirement on

The bank must choose the deposit interest
rates, rdand r t , which will maximize its profits.
The profit-maximization conditions are:

Equations (9) and (10) implicitly determine
the bank's offering rates, r d and r t, on its deposit liabilities. These rates are chosen so that
the marginal revenue the bank receives from
lending the funds acquired from each deposit
category just equals the marginal costs of such
deposits. Reserve requirements affect the
marginal revenue from deposits - shown by
the presence of qd in (9) and (0) - and thus
influence the bank's offering rates on deposits,
as seen in the following example.
We can measure the direct impact of a rise in
demand-deposit reserve requirements by
differentiating (9) and (10) totally with respect
to qd' Such a rise in reserve requirements produces a fall in the demand-deposit interest rate
and, therefore, causes a shift in the public's
desired deposit mix in favor of time deposits. 13

15

the transaction aggregate. The effective
average reserve requirement on transaction
balances would equal a weighted average of the
qd requirement on demand deposits and the
zero requirement on the transaction component of time deposits. If reserve-requirementinduced substitution is sufficiently large, this
weighted aggregate could be reduced - resulting in a higher money multiplier and increased
sensitivity of the money stock to exogenous
shocks. Professors Stuart Greenbaum and
George Kanatas [4J have advanced an argument of this type, despite a substantial
difference in approach from ours.
We do not contend that reserve-requirement increases invariably affect monetary control in ways opposite to those normally
expected. Rather, we argue only that financial
innovation is a predictable response to such
increases and that any analysis of the impact
of reserve-requirement changes would be
suspect if it failed to consider such induced
innovation.
This discussion further illustrates the
difficulties created by the variation between
the 12-percent reserve requirement on transaction balances and the zero reserve requirement against time-and-savings deposits mandated by URR principles. As argued above,
this sharp difference provides a strong incentive for financial innovation, stimulating
institutions to develop new accounts which
serve the same economic function as traditional transaction accounts, but which can be
classified either as time deposits or other
liabilities subject to lower (or zero) reserve
requirements. Such innovations can substantially complicate the task of the monetary
authorities in reducing and controlling inflation, as recent experience indicates.
Incentives for financial innovation could be
significantly reduced by narrowing the spread
between reserve requirements on different deposit categories. As suggested above, a reduction in the requirement against deposits officially classified as transaction accounts might
not lower the effective reserve requirement
nearly as much against all deposits serving the
function of such balances, because the incen-

tive to disguise lower reserve-requirement balanceS would also be reduced. Admittedly, the
Federal Reserve can determine what is, and
what is not, a transaction account for reserve
purposes - and hence, in principle, can compensateeventually for the impact of reserverequirement-induced financial innovations by
altering its regulations. Clearly, however, such
innovations can present substantial problems
and medium-term future. Hence a
regulatory environment that minimizes
artificial incentives for innovation is inherently
superior, all other factors the same, to one that
relies on ex-post regulatory proceedings.

Rate-Regulation-Induced Innovation
Traditionally, the monetary authorities have
imposed the highest reserve requirements on
demand deposits. Simultaneously, however,
Congress has prohibited the payment of
interest on such accounts. Consequently, the
normal interest-rate differentials that would
have been produced by the demand-deposit
reserve requirement have been exacerbated by
the imposition of interest-rate controls.
Against this background, we should examine
the deregulation provisions of Title II.
Interest-rate controls on the liabilities of depository institutions are a conspicuous feature
of the U.S. financial system. The Banking Act
of 1933 prohibited the payment of interest on
demand deposits and empowered the Federal
Reserve Board of Governors to impose ceiling
rates on member-bank time-and-savings deposits. Two years later, the Banking Act of
1935 provided the Federal Deposit Insurance
Corporation (FDIC) with similar powers with
respect to state nonmember banks. Congress
later (1966) extended this network of interestrate regulations with the passage of the
Interest Rate Adjustment Act. Under its provisions, mutual savings banks became subject to
FDIC rate regulation, while savings-and-Ioan
associations became subject to rate ceilings
administered by the Federal Home Loan Bank
Board.
Economists have vigorously criticized these
regulations on the grounds that they have led
to repeated and disruptive periods of financial

16

disintermediation [Treasury Dept., 15]; to a
substitution of implicit for explicit interest
payments [Klein, 8J; and to consistent discrimination against the small saver [Kane, 7].
We confine our analysis to an examination of
the monetary control implications of such
regulations - and of the benefits flowing from
deregulation.
During periods of rising inflation rates,
nominal interest rates increase to reflect the
anticipated depreciation in the purchasing
power of money over the period during which
the money is loaned out. This increase in the
nominal yield of earning assets acquired by depository institutions would, in the absence of
rate regulation, lead them to offer higher
yields to their depositors. This can be seen by
differentiating (9) and 00) again, this time
with respect to r g' As would be expected, 14 a
rise in the rate of return available on bank
earning assets leads to an increase in the rates
of interest offered on time and demand deposits.
This sympathetic movement of deposit rates
in response to changing market rates assures a
degree of stability in the public's demand for
depository-institution liabilities. Because deposit rates are flexible, there is less need for
quantity adjustment. In this case, the effect of
the rise in open-market rates on the demand
for deposit liabilities is cushioned by the sympathetic movement in deposit interest rates. In
contrast, if deposit rates are fixed so that dr d =
dr, = 0, the flow offunds to depository institutions varies substantially. This is, of course,
the well-known phenomenon of disintermediation.
Weare concerned here with the implications
of this phenomenon for control of a given
money aggregate. We can see this most easily
by assuming that r d is completely inflexible,
whereas r, is at least partly free to respond to
open-market rates of interest. Despite the legal
constraints on time-deposit interest rates,
regulators frequently have modified such constraints in response to changed open-market
rates. Under these conditions, an increase in
the open-market rate will induce a substitution
between bank liabilities and open-market

investments - and in addition, the changed
structure of bank deposit rates will cause depositors to shift funds between various liability
categories. In the preceding section, we treated
shifts in the coefficient (t) as purely random,
whereas such shifts in fact have a strong
systematic component. Changes in relative
interest rates on deposits - and changes between deposit rates and open-market rates induce changes in the behavioral coefficients
of the deposit-multiplier model. Rate regulation inevitably magnifies the size of those
changes and is, therefore, inconsistent with
effective monetary control.
The problems that rate regulation poses for
monetary control are significantly compounded by financial innovation in response to
those regulations. Innovation here takes two
forms. First, in a manner analogous to the case
of an increased reserve requirement on
demand deposits, banks and their depositors
both have a strong incentive to evade the
regulations - at least in part, through a form
of innovation that enables what are, essentially, transaction balances to be transferred to
liability classifications that are less constrained
by the rate restrictions. Since those liability
types generally have different reserve requirements than demand deposits, monetary control is inevitably weakened.
Perhaps more importantly, institutions that
are not subject to deposit rate ceilings could
respond by offering liabilities similar to those
of the constrained institutions - offering an
interest rate on their liabilities which is, at
least, closer to the market rate than the offering rates of the constrained institutions. In the
mid-70's, for example, thrift institutions
developed NOW accounts and share drafts,
and in more recent years, the mutual-funds
industry developed the fast-growing moneymarket funds. Given the sharp difference in
reserve requirements between rate-constrained institutions and those unconstrained
institutions, monetary control once again is
significantly weakened.
The process of financial innovation is, of
course, an ongoing one. It is neither necessary
nor desirable for innovation to be suppressed,
17

or deplored for its effects on monetary-control
procedures. It is, however, desirable - and it
maybe necessary - that policymakers formulate control procedures so that the procedures
themselves do not induce further financial
innovation.
In this respect, Titles II and III together
should unambiguously improve monetary
control. First, the legislation provides for gradual relaxation of interest-rate constraints on
time deposits, and thereby reduces the
variability of the differential between openmarket and time-deposit rates of interest. Second, the legislation provides permanent
authorization for demand-deposit substitutes
(such as NOW accounts) and for rate deregulation on such accounts - even though it does

III.

not expressly repeal the 1933 prohibition of
interest on demand deposits. The legislation
thus reduces the variability of the rate
differential between at least some components
of the transaction aggregate, M-1 B, and time
deposits. Congress thus has reduced the likelihood of "nontraditional" institutions developing successful transaction-account substitutes,
through its decision to permit banks and other
depository institutions to compete for funds by
offering explicit, competitively determined
interest rates. As a consequence, the monetary
aggregates should retain a more consistent
economic interpretation, and therefore,
should be more meaningful for the conduct of
monetary policy.

Summary and Conclusions

The Depository Institutions Deregulation
and Monetary Control Act of 1980 should
have profound implications for the nation's
financial structure, for competition among
banking institutions - and above all, for
monetary control. The reserve-requirement
and deregulation provisions examined in this
paper are only two of the elements affecting
the Federal Reserve's ability to control the
monetary aggregates and, through this
control, to reduce inflation and promote stable economic growth. Indeed, monetary control is a complex process about which significant disagreements still exist. But on the
whole, the Act is likely to aid the Federal
Reserve in its task of monetary control,
despite the impediments created by several
provisions of the Act.
Certainly, the benefits of deregulation are
unambiguous. Deregulation will improve
equity by allowing all savers equal access to
investment opportunities, will promote efficiency by removing artificial barriers to competition - and will enhance monetary control
by reducing most of the incentives for financial innovations that alter the economic significance of targeted monetary aggregates. All
these considerations strongly support the
wisdom of Title II of the legislation.

The reserve-requirement provisions are
more problematical. Theoretically, monetary
control is best promoted when reserve requirements are imposed on targeted liabilities, but
not on untargeted liabilities. Thus the
appropriate setting of reserve requirements
depends upon the precise definition of the
aggregate to be targeted. Despite the lack of
consensus on this point, at least a preliminary
case can be made for targeting a broad transaction aggregate, such as M-IB. This aggregate
can at least be given a consistent interpretation
in terms of a medium-of-exchange concept of
money [Berkman, 1].
Generally, but with some important exceptions, the reserve-requirement provisions are
consistent with the objective of controlling a
broad transaction aggregate. In contrast to the
previous situation, most transaction balances
(but not untargeted liabilities) will be subject
to uniform reserve requirements. The law also
gives the Federal Reserve considerable flexibility in adapting to the changing financial
environment by providing it with the authority
to establish uniform reserve requirements on
all accounts which serve the function of transaction balances.
In other respects, however, the Act's provisions do not go far enough in the direction
18

needed for optimal monetary control. First,
the differential between the reserve requirement on the first $25 million of transaction
balances and the requirement on larger balances clearly violates the basic principle of
uniform reserve requirements. Even though
the fraction of deposits subject to the lower
requirement is likely to decline over time
(because of the partial indexing of the cutom,
the basic logic and intent of the Act argue for
the abolition of this differential.
More importantly, the Act continues to
impose reserve requirements on nonpersonal
time deposits, which is inconsistent with the
URR principle under any plausible choice of
targeted aggregates. Given the objective of
controlling M-IB, shifts between transaction
and nonpersonal time accounts will continue
to lead to unwanted changes in the multiplier.
But optimal control of a broader aggregate
(including time and savings accounts) requires
equal ratios for transaction and nonpersonal
time balances. In either case, the present
reserve requirements against nonpersonal
time deposits should be changed to reflect the
URR principle. Given the M-IB control objective, this can be accomplished at the Federal
Reserve's discretion simply by reducing
reserve requirements on nonpersonal time deposits to zero.

Finally, the process of financial innovation
strongly affects the use of reserve requirements for promoting monetary control. In the
absence of such innovations, monetary control
considerations alone might argue for a fairly
high reserve ratio (low multiplier), because
this approach would provide the best means of
insulating the targeted aggregate from any
remaining disturbances to the base. In an
environment favorable to financial innovations, however, even moderate reserve
requirements against transaction balances can
create problems. The higher the reserve ratio
- assuming URR requirements are met - the
greater the incentive of financial institutions to
modify non-reservable accounts so that they
can be used for transaction purposes. Such a
process considerably complicates the authorties' money-control task, since it forces them
to adjust their targets for the officially defined
aggregates continually to reflect the innovations. Such adjustments are necessarily
imprecise and uncertain in the short run. On
this basis, the present 12-percent reserve
requirement against transaction balances may
be too high for purposes of monetary control.
Our argument suggests that the ratio should be
lowered to the present statutory minimum of 8
percent - and perhaps even this lower limit
should be reconsidered as well.

19

FOOTNOTES
1. Michael Keran has suggested the term "measurement uncertainty" to describe the control problems
caused by regulation-induced financial innovation.
Thus, Section I of this article deals with the implications of P.L. 96-221 for multiplier uncertainty,
whereas Section II examines its implications for
measurement uncertainty.

of the model. From (E1 0) and (E11), a = 1 implies that
D~m "" 0; interbank deposits are eliminated. This
specification implies (incorrectly) the demise of the
correspondent-banking system - the imposition Of
URRwil1 affect the correspondent network, but not
dramaticallY. Estimates are provided in Horvitz [!;i],
9. The following data are taken from the Congressional testimony of Federal Reserve Chairman
Volcker [16].

2. The new law stipulates a gradual phase-in of
reserve-requirement provisions. On September 4,
1980, reserve requirements of Federal Reserve memberbanks •• were reduced by 25 percent of the
difference in the required reserves under the new and
old systems. Subsequent phasedowns will occur
annually until September 1, 1983. Reserve requirements for other institutions are being phased in over
an eight-year period, with complete implementation
scheduled for September 3, 1987. We have limited
our analysis to the case of full implementation.

10.. The testimony indicates that thei'lctual gro...... th
rates, although slower than targeted, were not below
what the FOMC found "acceptable". See 116, p. 16].
11.lni'l 1972 study of money-supply control, Poole
and Lieberman [111 examined the sourCeS .of
variability in the ratio of total member-bank required
reserves to member-bank demand deposits, using
weekly data over a 53-week period. The three largest
sources of variability were due to time deposits,
Treasury deposits, and interbank deposits, in order of
importance.

The Act also provides for the imposition of a supplemental (interest bearing) reserve requirement of
up to 4 percent on transaction accounts. This
requirement could be imposed only if existing
reserves were deemed inadequate for monetary-control purposes. The term "inadequate" is not defined in
the legislation.

12. Variability in the coefficient (t) could have been
responsible for the results of the influential study of
the impact of nonmember banks conducted by Dennis
Starleaf [14]. For the period 1962-73, he found less
variability in the ratio of aggregate reserves to
demand deposits than in the ratio of member-bank
reserves to deposits. He concluded that nonmember
banks were not a monetary-control problem.

3. The member-bank estimates provided in this table
are adjusted for the estimated attrition of member
banks in the absence of legislation designed to halt
the exodus.

The beneficial impact of nonmember banks may
have been due to the fact that Federal Reserve
reserve requirements set qt > 0 during the period of
study. Since the base-money reserve requirements
against time deposits were smaller for nonmembers
than for members, the presence of nonmembers
could have insulated the narrow money stock from
variability in (t).

4. A brief history of URR proposals is provided in
Robert Knight [9].
5. Alternative specifications of central-bank
behavior are clearly possible. The Federal Reserve
could, for example, set the level of bank reserves either total reserves or nonborrowed reserves rather than the monetary base. A general treatment of
these alternatives is provided by Kaminow [6J and
Cacy [3].

13. Denote by H the matrix of second-order partial
derivatives of the profit function. By the second-order
condition, the determinant of H (det H) must be positive. Differentiating (9) and (10) with respect to qd and
assuming that D and T are linear in their respective
arguments, we derive

6. The model is similar to that of Kenneth J. Kopecky
[101. Kopecky's analysis, however, ignores liabilities
other than demand deposits. Note that for the purposes of the present model, "non-member banks"
include institutions (such as credit unions) that issue
transaction balances but which are not normally
denoted as banks.

drd/dqd= [(T1

7. We use the old definitions of the monetary aggregates to illustrate the reserve-requirement principles.
During the 1970's, the Board of Governors undertook
a major research effort on the process of financial
innovation, focusing on the appropriate definitions of
the monetary aggregates in a changed financial
environment. The original Board proposal is given in
Simpson [131. A critical review of the new aggregates
is provided by Berkman [1]. An example of the
research methodology is given in Porter, Simpson,
and Mauskopf [12]. Subsequent sections of the present article discuss the relevance of P.L. 96-221 to
the newly defined transactions aggregate M-1 B.
8. Setting a

=

+ D2)02rg- 2T 2D1rgl/detH

and
dr t Idqd = [(D 2 + T 1)D 1r 9 - 20 102r 9 IIdet H
To simplify the analysis, assume the cross-rate
effects are approximately zero. That is, 02 = T 1 = O.
Thus
drd/dqd<O
drt/dqd= 0
14. If we assume, once again, that T 1 =
drd/drg=2T2[(1
and
dr1/dr g = 20 1[T 2- T 311detH > 0

1 provides an additional simplification

20

°

2 = 0,

qd)01-03J/detH >0

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Berkman, Neil G. "The New Monetary Aggregates: A
Critical Appraisal," Journal of Money, Credit,
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Analysis of the Case for Uniform Reserve
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Reserve Bank of Kansas City (May 1974), pp.
3-16.

Board of Governors of the Federal Reserve System,
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Kopecky, Kenneth J. "Nonmember Banks and Empirical Measures of the Variability of Reserves and
Money: A Theoretical Appraisal," Journal of
Finance (March 1978), pp. 311-318.

Cacy, J.A. "Res.erveRequirements and Monetary
Control," Monthly Review, Federal Reserve
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Poole, W., and C. Lieberman. "Improving Monetary
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Greenbaum, S., and G. Kanatas. "Bank Reserve
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Porter, R., T. Simpson, and E. Mauskopf. "Financial
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Horvitz, Paul. The Federal FleserveMembership
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American Bankers Association, 1979.

Simpson, T. "A Proposal for Redefining the Monetary
Aggregates:' Federal Reserve Bulletin (January
1979), pp. 13-43.

Kaminow, Ira. "Required Reserve Ratios, Policy
Instruments, and Money Stock Control," Journal
of Monetary Economics (October 1977), pp.
389-407.

Starleaf, D. "Nonmember Banks and Monetary Control," Journal of Finance (September 1975), pp.
955-975.

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1978), pp. 3-12.

Volcker, Paul. Statement on Federal Reserve
Requirements before the Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, 96th
Congress, 2nd Session, pp. 16-17.

Knight, Robert. "Reserve Requirements Part II: An

21

Gary C. Zimmerman*
The pricing and access provisions of the Depository Institutions Deregulation and Monetary Control Act of 1980 (MCA) require
Federal Reserve Banks to begin imposing
explicit charges for the correspondent-banking
services they ofTer. The Act also provides for
access by all depository institutions to major
Fed services: check clearing and collection,
automated clearinghouse transfers, wire transfers, coin and currency, settlement, and
securities safekeeping. Previously, these services had been restricted largely to member
banks. Implementation of the Act's pricing
and access provisions during the 1981-82
period thus will bring about a major restructuring of correspondent-banking markets. Still,
after implementation, Federal Reserve Banks
will probably maintain their position as primary suppliers of major correspondent-banking services.
The MCA's pricing and access provisions
are aimed at improving the markets for correspondent-banking services in two major ways.
First, the Act seeks to promote increased competition by requiring Federal Reserve Banks to
charge all users of Fed services an amount
equal to their cost. This would change the
Fed's former service policy - supplying services free-of-charge to member banks while
denying access to non-members - which
tended to restrict and distort competition from
the private sector. Second, the Act seeks to
correct inefficiencies in the production and
distribution of correspondent-banking services
fostered by the Fed's former policy practice of
providing free services to members. This prac-

tice often led Reserve Banks to produce at
higher marginal costs than their private competitors, which raised the total cost of correspondent services to society and stimulated
overconsumption of such services.
This paper examines the impact of MCA
pricing and access provisions on the market for
correspondent-banking services. It raises the
question: to what extent will these provisions
enhance competition and improve market efficiency? Also, after the implementation of
MCA, will Federal Reserve Banks be able to
compete with private banks providing these
services?
We begin with a description of the market
for correspondent-banking services (Section
n. Next we explain MCA's pricing and access
provisions (Section II), and analyze how these
may improve competition and efficiency in
these markets (Section III). However, the final
results will depend critically upon the Reserve
Banks' ability to produce services comparable
to those provided by the private sector, at
competitive costs. Estimates of the cost functions facing Reserve Banks (Section IV) suggest that the System will be quite competitive
in providing check-clearing services - and
that it may dominate the market for automated-clearinghouse transfers because of substantial economies of scale. Taken as a whole,
the evidence suggests that the MCA will significantly alter existing patterns of use of correspondent and Reserve Bank services. The
potential benefits in terms of increased competition and enhanced efficiency appear to be
substantial, despite the continued existence of
several features of the pre-MeA environment.

"Economist, Federal Reserve Bank of San Francisco.
Patrick Weber provided research assistance on this
paper.

22

I. Features of the Correspondent Banking System
The actions of several types of institutions
define the correspondent-banking system's
role in the nation's payments mechanism and
financial structure. The nation's central bank,
the Federal Reserve, plays a prominent role as
a supplier of certain correspondent-banking
services, such as check-clearing and coin-andcurrency services. Many large member banks,
called correspondent banks, supply these and
other banking services to smaller banks, called
respondents - in addition to providing for
their own operations. In some situations correspondents provide these services internally,
while in others they rely on other correspondents or on Federal Reserve Banks for services. Smaller banks have often contracted services out, because of the greater cost of providing services internally, in relation to using
"free" Federal Reserve services or purchasing
services from correspondent banks.
Both private correspondent banks and the
Federal Reserve System have long supplied
certain correspondent-banking services funds transfers, check clearing and settlement,
and provision of coin and currency. In some
cases the services are complementary, as in
automated clearinghouse (ACH) operations,
where correspondent banks handle the preparation of tapes necessary for the electronic
transfers, while the transfers themselves are
usually cleared and settled through the network of ACH facilities operated by the Federal
Reserve. In most cases, however, the services
offered by both the private sector and the
Reserve Banks are close substitutes.
In the pre-MCA environment, Federal
Reserve Banks provided correspondent services to member banks free of charge. But
non-member banks, being denied direct access
to these services, had to produce them internally or rely on (member) private correspondents.! This policy was designed to induce
member banks to remain in the system. In
effect, the free provision of services partially
compensated member banks for the burden
on their earnings represented by the requirement that their reserves be held as vault cash

or as non-interest-bearing deposits with
Federal Reserve Banks.
Yet despite the availability of subsidized Fed
services, many member banks (particularly
smaller ones) relied heavily on the more costly
services provided by private correspondents.
Several factors affected each bank's decision to
use public or private correspondent services,
including:
1. Relative prices charged by various public
and private suppliers;
2. Perceived differences in the quality of
comparable services, such as faster service, earlier availability of funds, later
deadlines, etc.;
3. Relative costs incurred by respondents.
For example, costs associated with
encoding or sorting checks to meet
Reserve Bank specifications and/or
higher reserve-balance adjustment costs
related to use of Reserve Bank services
may be more expensive than sorting or
reserve-adjustment costs associated with
using correspondent services.
These three factors will continue to influence bank decisions under the MCA, but
the Act itself will influence the choices made,
primarily by altering relative price relations.
Prior to the implementation of MCA, many
small member banks purchased services from
correspondents despite the availability of free
Federal Reserve services, because the benefits
of free services failed to offset quality and/or
preparation-cost differentials. In fact, several
studies suggest that the Federal Reserve was
relatively unsuccessful in competing for the
business of small banks; for example, from
one-half to one~third of small member banks
relied on correspondents for all their checkclearing services. 2 The ability of private correspondents to offer tailored services, designed to
meet the needs of selected customers, may
account for some of their success, as it provided them with a niche in the market not
covered by "standard" Federal Reserve services.

23

Automated-clearinghouse (ACH) facilities
transfer funds electronically. In this system, a
central computer accepts and executes the
electronic messages (generally provided from
computer tape) that are necessary for a
"paperless" transfer of funds. At present the
Federal Reserve System provides the only
nationwide ACH network, clearing nearly all
ACH transfers outside of New York City. The
Federal Reserve System has actively promoted
ACH's, hoping to increase the efficiency of
the
mechanism by reducing its
reliance on the traditional paper check.
However, most ACH transfers - over 80 percent of the total - continue to be Government-related payments. s
In an initial stage, correspondents generally
prepare tapes containing the debit, credit and
account information necessary to transfer
funds through an ACH. Then Reserve Banks,
using the tapes provided by commercial banks,
provide further processing and then clear and
settle the electronic transfers among local
ACH members. Thus, Reserve Bank costs
reflect primarily clearing and settlement costs,
while correspondent fees cover handling and
preparation costs. Because the services are
complementary rather than competing, direct
per unit fees for correspondents' ACH services
are not comparable with Reserve Bank costs.
Another major service involves the provision and receipt of coin and/or currency to and
from banks. Here again, Reserve Bank services partly complement, and partly substitute
for, those provided by correspondent banks.
Both Reserve Banks and correspondents provide central cash vaults for safekeeping, as well
as handling, verification, and packaging services. However, the Federal Reserve also provides services, such as the replacement and
destruction of coin and currency, that reflect
its role as the nation's central bank. Furthermore, as with check services, some correspondents rely on Reserve Banks to fill their coin
and currency orders. Hence, the cost of such
correspondent services can also be expected to
increase once the Federal Reserve begins
charging for its own services.
Correspondent banks in the past had trouble

Services Available
Comparisons of Reserve Bank services with
those provided by correspondents should help
determine the direction ofpost-MCA markets.
In a broad sense, most private services are
comparable to services supplied by Reserve
Banks, yet differences exist among correspondent services, and also between correspondent
and Reserve Bank services. These differences
reflect variations in marketing procedures, service standards, and pricing practices. Price
comparisons can be inexact because of the
existence of different pricing practices among
correspondents - and because of the
widespread correspondent practice of reselling
Federal Reserve services. This practice may
dramatically alter correspondent fee structures
once Reserve Banks begin pricing their services. 3
Check clearing and settlement refer to the
entire process for transferring checking and
NOW account funds between economic
agents. This process is essential for the swift
and reliable transfer of funds. It encompasses a
number of steps, including the encoding of
transaction information on checks, presorting
by type and by destination, microfilming for
records purposes, transportation, sorting by
bank for payment and settlement, and the
actual clearing among banks or clearing-house
members.
Checks may take several routes in the clearing process, but roughly 45 percent of the total
are cleared through the Federal Reserve
System's check-processing facilities. 4 Prior to
the implementation of the MCA, most (but
not all) member banks presented at least some
checks at their local Reserve Banks for clearing
and settlement. Non-member banks - lacking
access to Reserve Bank clearing services --and many small member banks meanwhile
relied on the check-processing services provided by correspondent banks. Many of these
correspondents also used Reserve Bank
facilities to clear both their own and their respondents' checks. Hence, correspondent
check-clearing costs can be expected to
increase once MCA pricing provisions are
implemented.

24

competing with the Federal Reserve, which
provided a subsidy to member banks in the
form of "free" correspondent services. Segmentation of the market into two groups of

banks, some with access and some without
access to "free" Reserve Bank services, meant
that nonmembers had to rely on correspondents for their correspondent-banking services.

II. New Direction for Correspondent Banking
The pricing and access provisions of the
Monetary Control Act established the direction of future development in the markets for
correspondent-banking services. The Act
required the Federal Reserve to publish a set
of pricing principles and a proposed schedule
of fees by September 1980. At set times during
1981 and early 1982, the Reserve Banks are
beginning to price individual services, using
fee schedules based on the pricing principles
announced in 1980.
The passage of the MCA was a major
breakthrough in the rationalization of the correspondent-banking system. The reserverequirement changes it mandates should substantially equalize the burden of holding
reserves among all depository institutions (see
the article by Michael Klein in this Review). In
addition, it opens the door to equal treatment
of all institutions with respect to pricing and
access of Federal Reserve services.
The Act requires pricing for a number of
correspondent services (including Federal
Reserve float) formerly provided for free or at
a nominal cost by Reserve Banks. The four
major services considered here - check clearing and collection, automated clearinghouse
transfers, coin services, and currency services
- account for nearly 80 percent of all Federal
Reserve System costs of providing correspondent-banking services (Table 1).
In the words of the Monetary Control Act: 6

schedule applicable to member banks, except
that nonmembers shall be subject to any
other terms, including a requirement of balances sufficient for clearing purposes, that
the Board may determine are applicable to
member banks.
(3) Over the long run, fees shall be established on the basis of all direct and indirect
costs actually incurred in providing the
Federal Reserve services priced, including
interest on items credited prior to actual collection, overhead, and an allocation of
imputed costs which takes into account the
taxes that would have been paid and the
return on capital that would have been provided had the services been furnished by a
private business firm, except that the pricing
principles shall give due regard to competitive factors and the provision of an adequate
level of such services nationwide.
(4) Interest on items credited prior to collection shall be charged at the current rate
applicable in the market for Federal funds.

Pricing will eliminate the major subsidy the
Federal Reserve formerly provided to institutions using its services. Prices are to be set so
that all long-run costs incurred by a private
competitor will be included in the costs that
Reserve Banks must cover. This means that
Reserve Bank prices, in principle, shall take
into account all: 7
- Direct costs
- Indirect costs
-Overhead
- ImlJlutt~d taxes
- Imputed return to capital
Covering all of these costs eliminates the
major competitive advantage formerly held by
Reserve Banks in providing free services to
member banks.
Under the MCA, Federal Reserve prices
may be set at several levels of operations, the
only constraint being that revenues generated

The schedule of fees prescribed pursuant to
this section shall be based on the following
principles:
(l) All Federal Reserve bank services
covered by the fee schedule shall be priced
explicitly.
(2) All Federal Reserve bank services
covered by the fee schedule shall be available
to nonmember depository institutions and
such services shall be priced at the same fee

25

national market exists, a single price will
suffice for all local ACH transfers.
The MCA was designed, through a restructuring of the system, to improve the competitive position of private banks selling correspondent-banking services. Obviously, in the
pre-MCA world these correspondents were at
a severe disadvantage when competing for the
business of member banks, since the latter
already had access to free Federal Reserve services. Pricing Reserve Bank services at "cost"
thus will allow a significant increase in competition from correspondents, who will be able
to compete on price as well as the quality of
services.
Competition also should be encouraged by
the provision authorizing access to Reserve
Bank services for nonmember banks and other
nonbank depository institutions. Competition
from Reserve Banks for such customers opens
this segment of the market to competition; formerly, this market was served only by correspondents.

from each service cover the full cost of providing the service. Thus, prices may be set at a
national level (such as the proposed prices for
ACH transfers), or at a District level (such as
prices for check, coin and currency services in
certain areas), or at the zone or office level. 8
Variations at the district or office level would
allow price schedules to reflect regional
differences in costs of providing services. Correspondent banks as well as Reserve Banks
may encounter such differences because of
regional variations in wages and salaries, as
well as transportation expenses.
Federal Reserve guidelines also require
Reserve Banks to treat differentiated services
within a product line as separate services for
pricing purposes. For example, checks will be
separated into several categories, depending
upon the cost of processing and transporting
various types of checks. This treatment is
necessary if Reserve Banks hope to be competitive in the check-clearing area. For ACH
operations, however, where a standardized

Table 1
1979 Expenditure
(in millions)

Federal Reserve Expenditures
Check Clearing and Collection Services
Currency Services, Totalt
Coin Services, Totalt
ACH Services'

$ 245.0
63.0
25.9

Total for four services examined
Other Correspondent Services
to Financial Institutions and the Public
Other Expenses

346.4

Total Federal Reserve Expenses (gross)

$ 762.8

--.!1.1
88.7
327.7

'Includes ACH expenditures, and estimated overhead for Electronic Funds Transfers that should be allocated to ACH
operations.
tNon-governmental expenses.
Source: 1979 PACS Annual Detail Expense Report; and J 979 PACS Summary Expense Report, Board of Governors of
the Federal Reserve System, 1980.

26

III. Pricing and Efficient Allocation of Services
situation, member banks naturally increased
their demand for "free" Federal Reserve services while reducing their demand for other
privately-supplied services. Reserve Banks
therefore produced relatively more services,
and correspondents relatively fewer services,
than they would if Reserve Banks had based
their prices on actual costs. Thus, as suggested
below, Reserve banks often produced at
higher marginal costs than their private competitors. To the extent this was true, resources
could have been saved by reallocating production from Reserve Banks to lower-cost private
producers.
Production of correspondent services may
also have been misallocated among Reserve
Bank facilities. Efficient production of services
requires that the difference between marginal
costs be no greater than the cost of transportation between competing facilities. Otherwise,
the costs of producing and delivering a given
service could be reduced by shifting production among facilities. Even with efficient production, local or regional factors could lead to
variations in marginal production costs without necessarily implying inefficiency in the
production of a particular service. (These
regional factors include state branch-banking
laws, regional cost-of-living factors, and other
geographic considerations.) In the pre-MCA
environment, however, Reserve Bank
facilities had an incentive to produce up to the
quantity demanded at the zero price, but no
incentive to equalize marginal costs (less
transportation expenses) across facilities. As a
result, production at some Reserve Bank
facilities probably could have been more efficiently produced at other (or new) facilities.
This may indeed have been the case, as we can
see from the following discussion of estimated
long-run average cost curves for various correspondent services.
MeA implementation will promote efficiency by instituting full-cost pricing, but the
Act will not eliminate all of the inefficiencies
associated with the present system. Prices
under the MCA will be determined by current

Free Federal Reserve services represented a
major source of inefficiency in the correspondent-banking system prior to implementation
of the MCA's pricing and access provisions.
First, this situation led to overconsumption of
Fed services by member banks. Also, by causing the overproduction of publicly produced
correspondent services, this pricing policy
resulted in an inefficient allocation of
resources.
What are the necessary conditions for efficient production and consumption? First, efficient production requires that the cost of the
last unit produced (i.e. the marginal cost of production) be equal for all suppliers. Otherwise,
the total industry output obtained from a given
amount of resources could be increased by
shifting production from high-cost to low-cost
producers. Second, efficient consumption
requires that each user of a service pay a price
equal to the marginal cost of producing it. If,
for example, the price charged were set below
the marginal cost, individuals would be led to
over-consume the service, in the sense that its
worth to them would fall short of its
(marginal) cost to society as a whole. Hence,
efficient production and consumption requires
that all firms incur the same marginal costs and
that all users pay the same price for a given service. Neither of these conditions held true in
the pre-MCA environment.
The Federal Reserve's practice of charging
less than marginal cost led to overconsumption of its services. That is, respondent and
correspondent banks in the aggregate used far
more "free" Federal Reserve services than
they would if they had had to pay full cost for
them. This represented a waste of resources,
because the worth of the services to users was
then less than their actual cost to society.
Overconsumption resulted from the gap between the Reserve Bank's marginal cost of
production (some positive number) and the
fee it charged for use of those services
(typically zero).
For similar reasons, production inefficiencies also occurred in the pre-MCA era. In this

27

average (rather than marginal) costs of production. Pricing at marginal cost would eliminate the gap between the price private institutions pay for services and the production costs
incurred by Reserve Bank facilities in producing the last unit of service. Long-run averagecost pricing will significantly reduce the gap
between the price correspondents pay and the
cost of producing these services. But this
approach, unlike marginal-cost pricing, will
not completely close the gap unless the services are produced at constant costs - which
(as noted below) does not appear to be the
case.
Continued inefficiencies also will arise from
the proposed pricing procedure for ACH and
coin-and-currency services. Reserve Banks
will price only coin-and-currency transportation and coin-wrapping services. (They will
continue to provide administrative and handling functions for free, however, since these
functions may be considered a governmental
responsibility, although correspondents also
provide these services in many cases.) The
Fed proposes to set ACH fees at an estimated
long-run average-cost level that is considerably below the present level of costs. As the
volume of ACH transfers rises over time, sig-

nificant economics of scale could lead to a substantial reduction in the cost per ACH transfer.
The Federal Reserve thus has set its proposed
price to approximate long-run average cost at a
mature output level.
Other factors - market size, geographic
location of facilities, competitive factors, and
economies of scale - may all affect the efficiency of Reserve Bank facilities under the
MCA's pricing and access provisions. Scale
economies, or diseconomies in particular, may
profoundly affect a Reserve Bank's market
share. For example, some offices are currently
operating either off of the estimated long-run
average-cost curve, or at a volume considerably above or below that at which average cost is
minimized. In the long-run, MCA pricing creates incentives for those facilities to move
toward a more efficient scale of operations. For
example, large-volume producers operating in
the region of decreasing returns to scale will
incur higher average costs, and this will lead to
higher prices, making these facilities less competitive vis-a-vis correspondents. Higher relative prices will cause Reserve Banks to lose
customers, and this process will tend to return
these facilities to a level of output that minimizes minimum average cost.

IV. Estimating long-Run Average Cost and Average Prices
The future of the correspondent-banking
industry largely depends upon the state of
competition between private producers and
the largest single seller of correspondent services, the Federal Reserve System. The
Reserve Banks' ability to compete and their
ultimate share of the market will hinge· on
answers to three related questions. First, do
economies of scale allow the high-volume
facilities operated by the Federal Reserve
System to produce services more efficiently
than private competitors? Second, in the preMCA environment, how did the average cost
of Fed services compare with the fees set by
private correspondents? The answer will be
critical in determining how Reserve Banks will
fare in the short run. Finally, how do the

average costs of facilities compare with the
estimated minimum average cost? This comparison will provide an indication of the
Federal Reserve's ability to compete in the
long-run.
Scale Economies
These questions can be analyzed in terms of
the long-run average-cost relationship - the
relationship between the average cost of production for each Federal Reserve facility and
the level of production at that facility. The
typical long-run average-cost curve is Ushaped, with each of the curve's three regions
exhibiting a different relationship between
average cost and output (Figure 1).
In the first region, the curve is downward

28

sloping, with the long-run average cost per
unit of output falling as the volume of output
increases. Economies of scale exist in this
region, related to increased efficiency from
larger-scale operations and/or the ability to
spread fixed overhead over a larger number of
units of output. In the second region, the
curve is horizontal, with changes in output
having no impact on the average cost per unit.
Average costs are at a minimum in this constant-cost portion of the curve, so that a firm
will seek to have each of its facilities operate in
this region. The third region is upward sloping,
with diseconomies of scale. In this range of
output, further increases in volume lead to
increases in the average cost per unit. This
may occur for a number of reasons, including
the difficulty of managing and operating largescale facilities. In the case of publicly produced
and subsidized services, inappropriate pricing
policies may lead to overuse and overproduction of services, driving average costs above
the minimum level.
Superficially, production of Federal Reserve
services appears to fit the mold of a decreasingcost activity. The Federal Reserve is the
largest single producer, nearly monopolizing
production of many correspondent services, as
its offices provide the major links in the
nation's payments mechanism. Indeed, most
Reserve banks, branches and offices operate at
a relatively high volume of output, and many
observers thus point to economies of scale as
the explanation for the level of Federal

Reserve involvement in correspondent banking. 9
Economies of scale, to the extent they exist,
could help determine the future distribution of
production between the Federal Reserve and
the private sector. Increasing returns to scale
could indeed give Reserve Banks a competitive advantage. If technology is relatively consistent across Reserve Bank facilities, increasing returns to scale would allow offices to
increase output more than proportionately
each time inputs are
increasing returns to scale can often lead to the
establishment of a natural monopoly - a
single firm that accounts for all or nearly all of
an industry's output. (Public utilities, with
their large fixed capital investment, typically
fall into this category.) This raises the question
whether the Federal Reserve System's large
volume of services makes it a lower-cost producer than correspondent banks, and thus
justifies the System's disproportionate share of
the production of correspondent services.
These propositions can be tested by estimating the long-run average-cost function - the
long-run relation between a facility's average
cost per unit of service supplied and its total
costs for that service. 10 We estimated this function from Federal Reserve actual cost and output data for each facility, derived largely from
the System's Planning and Control System of
accounting (PACS). The data provide several
alternative measures of average cost, depending on whether transportation and overhead
costs are included. ll The measures used here
for check and ACH operations include both
transportation and estimated overhead
expenses. For coin and currency services, the
average-cost measure includes estimated overhead expenses but excludes transportation
similar
expenses. For all services,
results were found with alternative measures
of average cost.
The general functional form of the estimated average-cost relation can be written as:

Figure 1
Standard Long-Run Average Cost Curve
Average Cost
Per Unit
of Output
($)

I
Units of Output
(#!

,
Increasing
Returns to
Scale

i\

,
Constant
Returns to
Scale

AC

,
Decreasing
Returns to
Scale

=

ao

+ ajV + a2V2 + a3PM

+ a~AL + asREG
29

(1)

where
AC = average cost
service produced
V = volume
V2 = volume squared

PM=

cost and output)
or type

SAL=

mc:ufl:ed for any given volume of activity. In
other words, facilities located in regions with
higher salary levels, all other factors equal, will
incur higher average costs than facilities in
low-salary areas. For this reason, we included a
variable measuring the relative level of salary
rates for each facility (relative to the
average) .12
Finally, branch-banking restrictions, an
important regulatory constraint, could also inaverage cost by facility. Branching
restri,;t1c)fiS alter the structure of the bal1lklrlg
market in a way that could result in increased
utilization of Reserve Bank services. In states
that restrict banks to a single operating unit,
average costs per unit may be higher because
Federal Reserve offices must provide services
to a large number of small, geographically dispersed institutions. In states where branch
banking is authorized, the large branch
systems must provide many correspondent
services for their branch offices directly,
because
cannot
on Reserve Banks to
intrabank operations. In this manner,
branch banks may internalize many highcost correspondent-banking operations.
Branch banking, by reducing the proportion of
num-co:st services provided by Reserve Banks,
thus could reduce the average costs of affected
Reserve
in relation to those incurred
Fed facilities in unit-banking states.
However, the branching variables (tested in
dummy variable form) were not statistically
significant, and so were dropped from the reported equations. 13
For each service, we selected a best equation
from the possible combination of independent
variables listed in the general equation. The
simplified equations included measures of
volume, as well as other factors (where suitato
ble
were
that
the explanatory power of the equation (see
Table
Long-run Average Cost Curves
If
of scale actually exist for
Reserve Bank facilities, then we would expect
to find a downward-sloping long-run average
cost curve - rather than the traditional Ushaped curve - for check-clearing and check-

a nonaverage
per-

Federal Reserve

REG =

and
market characteristics
This
was
with cross-section
data on average cost, volume, and
variables for Reserve Bank facilities for 1977. (An
alternative log-linear version of this function
was also estimated, but gave very similar
lurlctlon, essentially a quadratic relation between average cost and volume, is
"shifted" by certain regional conditions such
as
mix
or
rates (SAL).
This
thus allows
the
average costs
decrease
increase with
and allows also
ste,adlJly decI'ea:sing average costs.
exact
curve, and the
average

the
We
terms to account
for the
factors on variations
in average costs for given levels of output.
example, check-clearing operations generally
sense that some
involve a mix of services in
types of checks cost considerably more to process than others.
offices
a
relatively
should, all other factors
average costs than offices

since
account for a major
<:Pf'V;"P<:
costs of
should
the average costs
30

collection operations. In actuality, we found
the reverse. The t-value of both volume
measures, and the product-mix factor measuring the proportion of low-cost checks processed, were statistically significant (Table 2).
Thus, 1977 cost and output data do not support the argument that check clearing is a
decreasing-cost activity for Reserve Bank
facilities. Furthermore, all of the largest
Reserve Bank operations were found along the
upward-sloping portion of the V-shaped curve
(see Chart 1). The estimated curve retained its
V-shape even after exclusion of Chicago and
New York, the two largest check-processing
centers. The shape of the curve, as well as the
location of many facilities, suggests that some
smaller operations still operated in the region
of increasing returns to scale. However, most
of the larger facilities operated at too large a
scale of operations, and thus produced checkclearing services inefficiently. Humphrey
(1980) using a more sophisticated model,
::UC'" JHIHlar evidence regarding diseconomies
of scale. 14
For automated-clearinghouse operations, in
contrast, the estimated long-run average-cost
curve appears to be downward sloping and

Chart 1
Check Clearing Services
Average Cost
per Check
Processed
(in cents)

2.4

Eslimated Long Run Average Cost Curve
for Reserve Bank Facilities'

,

"
600

700

800

900

Millions of Checks Processed

'Long-run average cost for check operations
includes all production costs and estimated overhead
costs. The 16-percent mark-up is not included.

linear (Chart 2). This indicates that average
cost will decline as output rises,as found in
Humphrey's 1980 ACH study. is
evidence
of economies of scale in ACH •. services which at present are almost entirely provided
by the Federal Reserve System - is consistent
with what might be expected in a developing

Table 2
Federal Reserve Processing Costs
Mean·
lndependeo t
Variables

PMLC

Constant

SAL

WRAP

r

2

Obser·

vat ions

Standard
Error

Average

Cost

Cost Per

2.214
Check
Processed (¢) 05.93)

-.20iO x IO- s
(-2.96)

9.768
ACHlmage
Processed (¢) (1237)

-.7388 x 10- 3
(-2.90)

Strap of
-i3.41
Currency +
Processed (¢) (-92)

(-127)

+.2872 x 10- 7
(255)

+45.49
(284)

Thousand
Pieces of
Coin+ (¢)

-.1874 x 10- 4
(-2.79)

+.2744 x 10- 11
(208)

+46.77
(I.26)

-.2219
(-.OJ)

-.i526 x 10- 2

+.2733xlO- 11
(3.40)

-.6656 x 10- 2
(-269)

.343

.163

39t

3.124

7.997

.226

+t7.46
(356)

48

37

5.962

24.67

.354

37

2578

14.10

* Does not include 16-percent markup.
+ Excluding transportation and shipping costs, which may vary significantly wilh the geographic area covered by each facility.
tExciudes Denver because of data problems.
V = Output or units of service produced
V2 = V x V

PMLC = Product-mix variable. For check clearing, it refers to the proportion of low-cost checks processed by
SAL = Salary-adjustment factor.
WRAP = Facilities providing coin wrapping services (I3 of 371. Dummy Variable.

31

1.609

33.60

(Chart 3). However, diseconomies of scale
were evident only at the Federal Reserve Bank
of New York, the System's largest producer,
which provides nearly three times the volume
of the next largest facility. If the New York
operation is excluded, then the shape of the
curve changes considerably, and some other
large facilities also find themselves operating
with diseconomies of scale.
The estimated long-run average cost curve
for Reserve Bank coin-processing operations is
also V -shaped (Chart 4). Some facilities operate in each of the three ranges of production falling, relatively constant, or increasing
average costs. Initially, average cost falls rather
sharply as output rises, and indeed most
Reserve Banks and their offices fall into this
range. However, the medium-volume offices
generally exhibit minimum average costs,
while the highest-volume offices exhibit
increasing average costs as volume rises.
Reserve Banks thus appear to operate with
significant economies of scale throughout the
present range of production for ACH services,
but not for other services. Some check, and
some coin and currency, operations operate at
or near the estimated minimum average cost
associated with the long-run average cost
curve, while most smaller facilities could
benefit from increasing returns to scale by
expanding their output. In contrast, the largest

Chart 2
Automated Clearinghouse Services

Estimated Long Run Average Cost Curve
for Reserve Bank Facililies'

6
4

0'(

!

02356

Millions of Images Transferred

"Long-run average cost for ACH operations includes
all production costs and estimated overhead costs.
The 16-percent mark-up is not included.

industry. It also provides empiricaljustification
for the Federal Reserve's decision to price
ACH services at an estimated average cost
based on a mature volume of services, rather
than on costs at the present output level.
The cost data used in the regressions for
coin and currency operations include the costs
of receiving, verifying, and shipping preparation, but exclude the actual costs of shipping.
These costs are most comparable to the reported fees charged by private correspondents,
which also typically exclude transportation
costs. But in a pricing environment, we should
remember, the Federal Reserve will continue
to provide non-transportation services without
charge. Accordingly, the estimates presented
here mainly indicate how well the Federal
Reserve would compete with the private sector
if it charged users for all costs incurred, as in
the case of other services.
The estimated long-run average cost curves
for both currency and coin operations included
both volume measures, which were
statistically significant in all cases. The relative
(SAL) was also included.. In
addition, for coin services we included. a
dummy variable indicating whether a facility
offered wrapped coin or only bagged coin. The
estimates in Table 2 indicated higher average
costs for any given volume at facilities that
provided wrapping services.
The estimated long-run average cost curve
derived for currency sevices is V-shaped

Chart 3
Currency Services
Cost

30

Estimated Long Run Average Cost Curve
for Reserve Bank Facilities'

25
20
15

....

0"

I

I

I

I

!

!

!

!

o

5

m

~

~

~

~

~

~

Millions of Straps of Currency Processed

'Long-run average cost for currency services
excludes shipping and transportation expenses,
which may vary significantly between districts. All
other production costs and estimated overhead are
included in long-run average cost. The 16-percent
mark-up is not included.

32

facilities all exhibit average costs above the
minimum in coin, currency and check-processing operations. In addition, as their
volume increases, so does their average cost.
These findings refute the contention that
Reserve Banks have a natural monopoly position by virtue of economies of scale in the production of their correspondent-banking services. Clearly, average cost does not continue
to fall as output rises for check, coin, and currency services. Since Reserve Banks do not
have natural monopolies, therefore, they can
expect to encounter substantial competition
from private suppliers even after the adjustment to pricing is made - a subject to which
we shall now turn.
Price Comparisons
In the competitive atmosphere created by
the MCA, the relative prices charged by
Reserve Banks and private suppliers will be
crucial in determining whether banks will
purchase publicly- or privately-produced services. Short-run cost figures provide an indication of how much the volume of Reserve
Bank services will rise or fall, relative to
others, in the immediate wake of pricing.
Long-run cost estimates give an indication of
the competitiveness of Reserve Bank services
following the initial adjustment to pricing and
open access.
The evidence suggests that Reserve Banks
are presently capable of producing check-

clearing services at a cost comparable to, if
not below, the fees set by private-sector producers. However, the data also suggest that the
costs of providing coin and currency services
are substantially higher for Reserve Banks
than for their private competitors. This implies
that Reserve Banks would have difficulty in
competing, at least initially, if they tried to
cover their full costs for these services although of course they plan to charge only for
transportation services. We do not attempt to
compare
and
ACH services
because of the complementary, rather than
competitive, nature of Reserve Bank and correspondent-bank services of this type.
We derived Reserve Bank "prices" for 1977
by summing aU direct and indirect production
costs, estimated overhead costs, and a 16-percent markup to cover imputed taxes and the
return on capital. (The 16-percent figure is the
markup used by the Board in its most recent
pricing proposals.) We then compared these
"prices" with correspondent-bank prices
available from the 1977 Account Analysis
Survey of the Federal Reserve Bank of Kansas
City.16 The survey provides estimates, by
Federal Reserve District, on prices and/or
compensating-balance requirements of 149
large correspondent banks. Our comparison
(Table 3) indicates that Reserve Banks may
find significant competition from the private
sector after MCA implementation.
Check Pricing
The average (and modal) correspondent fee
for a "typical" check amounted to 2.0 cents
per item in 1977, compared to 1.87 cents per
check for the Federal Reserve's average cost,
overhead and markup (Table 3).
Despite considerable regional differences in
both Reserve Bank and correspondent prices,
the Reserve Banks' derived average-cost
prices were lower than average correspondent
fees in seven of twelve Federal Reserve Districts. On a national basis, Reserve Banks thus
showed a slight advantage
1977, and
preliminary evaluation of 1979 data suggests
that the advantage has been maintained.
Clearing of correspondents' checks through
Federal Reserve facilities will become much

Chart 4
Coin Services
Average Cost
Per Thousand

Coins Processed
(in cents)

50

Estimated Long Run Average Cost Curve
for Reserve Bank Facilities'

40
30
20

01' _...&-_"""-........1 1 - - - - 1 . _ - " ' - _....
...
o

1000

2000

3000

4000

5000

6000

Millions of Coins Processed

"Long-run average cost for coin services excludes
shipping and transportation expenses, which may
vary significantly between districts. All other production costs and estimated overhead are included in
iong-run average cost. The i6-percent mark-up is not
included.

33

more expensive once Reserve Banks begin
pricing check services. The increase in costs to
correspondents is likely to be passed along to
their customers. This factor of itself .will
increase the competitive advantage of Reserve
Banks.
On the other hand, the largest Reserve Bank
facilities suffer from operating in the region of
diseconomies of scale. Humphrey (Journal of
Bank Research, 1980) suggests that Reserve
Banks would be unable to expand into the
region of declining
operated in a
competitive environmentY If prices are set at
the District or office level, they would be disadvantaged to the extent their average costs
exceeded those of private suppliers. Over
time, however, competition should reduce the
scale of facilities operating above minimum
average costs, thus reducing their average
costs to a more competitive level.
Coin and Currency
Our average-cost measures for coin and currency services are not the same as those that
the Federal Reserve intends to use for pricing.
Rather, they represent the average cost of handling cash, Le., handling and preparing it for
shipment, and handling and storing it after
receipt. The handling function is distinct from
the transportation function. After implementation of the MCA, in contrast, Reserve Banks

will begin pncmg two types of services transportation and shipping services, and coinwrapping services.
Handling costs nonetheless help provide
information on Reserve Banks' ability to provide non-transportation cash services on a
competitive basis with the private sector. On
the basis of a comparison which excluded shipping charges, we found that Reserve Bank
costs were approximately one and a half times
correspondent fees for coin-and-currency
handling services (Table 3).
These higher costs reflected the Federal
Reserve's governmental role. As the nation's
central bank, the Fed has a responsibility for
maintaining the quality of the nation's coin
and currency. Reserve Banks all require
storage and handling facilities for the new coin
and currency that they distribute. They also
have the task of filtering out unfit currency and
coins, not to mention counterfeits, and removing them from circulation. Consequently, we
cannot easily distinguish between the portion
of handling costs which is strictly related to
transferring cash between depository institutions, and the portion which is strictly governmental. This makes it difficult to determine
whether Reserve Banks would be able to compete with private suppliers if they were to
charge for the former type of services.

Table 3
Reserve Bank Costs and Correspondent Fees
(Based on 1911 data, in cents)
Reserve Bank

Cost per
encoded check

1.87

Minimum Long-Run
Cost 2

Correspondent
Average Fee 3

1.69

Cost 1

2.00

Handling costs
Per roll of coin
Per strap of currency

3.85
31.8

n.a.
21.6

2.5
20.0

Transportation costs
Per roll of coin
Per strap of currency

1.0
12.5

n.a.
n.a.

n.a.
n.a.

1. Long-run average costs are from 1977 Federal Reserve PACS Reports. Includes estimated overhead costs and the 16percent markup.
2. Estimated minimum long-run average costs for cheek and currency services are from the equations reported on
Table 2. The 16-percent mark-up is added to the minimum-cost estimate.
3. Correspondent prices are from the 1977 Account Analysis Survey. Federal Reserve Bank of Kansas City.

34

V. Correspondent Banking in the 1980's
The correspondent-banking environment of
the 1980's, in the aftermath of the Monetary
Control Act, should be increasingly competitive and more efficient. Competition may lead
to some contraction in the amount ofcorrespondent services provided by Reserve Banks
to member banks, as pricing eliminates the
former element of subsidy. On the other
Reserve Banks will be able to compete for the
insltitutiOtlS that nrf~v!(msjlv
access to their services. Over time, production
of these services should become more efficient
as purchasers shift to lower-priced suppliers,
regardless of whether those suppliers are private correspondents or Reserve Banks.
Despite the increases in competition and
most
of corresponefficiency, prices
dent services will rise in the short-run. Respondent banks will experience higher costs
because of the elimination of subsidized
Reserve Bank services. Obviously, respondent
banks that formerly used free services will
have to reevaluate the relative costs of providing services internally, or of purchasing them
from correspondents and/or Reserve Banks.
Correspondent banks that formerly used
Federal· Reserve services for their own and
their respondents' benefit also will have to
reexamine their production of correspondentbanking services in light of the new Reserve
Bank charges. Thus, the MCA pricing scenario
implies higher costs of using most services,
whether provided directly by Reserve Banks,
or indirectly by correspondents using Reserve
Bank facilities.
the long-run,
Federal
ability to operate like a private cornpe~tit<)r
depend on its ability to adapt to market conditions,on
costs
to
costs
and prices set by private competitors, and on
its future costs as affected by economies or diseconomies of scale. Reserve Banks" pricing
MCA; but
decisions
constrained by
within those limits, they must develop market
strategies and internal pricing and accounting
systems. Their ability to compete also
on their ability to produce services in a man-

ner, and at a level
that maintains competitiveness in individual markets.
the
Fed will be pressed to take advantage of
economies
to
facilities operBltirtg at or near minimum longrun average cost. That means
their
scale
where
to reduce
costs.
In the
the MCA
ment may
some
Banks at a comnptiti,,'p disadvantage Vls,-a-VIS cOITe1;pondl~nts,
as they learn to operate their cOlTe:spcmdentbanking
, firms.
Unlike
Reserve
Banks have little or no eXlper'lerlce in this area
and "",""",'''_
the MCA in
to do
essentially it mandates
Federal Reserve
System to provide services as if it were a private
To maintain long-run competitiveness,
Reserve Banks will have to overcome disadvantages associated with pricing - including
the use of average cost pricing, which leads to a
single price for each type of customer. While
the price to all users in a specific region or
group must be the same, the cost
services to all those users will not be the same.
Costs can vary among customers depending
upon
customer's location, volume, or
other factors. For example, although checks
will be broken down into
types for
purposes, pricing at a
derived
for each type will mean overchfug:ing of low-cost users and undercl1,arjging
tre,ltment manrespondent,
SUl)plying services

dents may be able to take low-cost customers
from Reserve
As
the average cost of Reserve Bank-produced

35

services will rise, and Reserve Banks thus
could find it difficult to price services competitively.
A second problem related to MCA implementation arises from the "postal service" or
"cream skimming" dilemma. According to
the "adequate level of service nationwide"
provision in the legislation, Reserve Banks
to provide correspondent sermay be
vices to some customers whose location or
volume might not interest private producers.
these
could boost
Reserve Banks costs substantially. They must
deal with the same type of problem faced by
the U.S. Postal Service, in providing a nationwide level of services at prices that ignore substantial differences in the cost of providing
similar services to different customers.
Correspondent banks could benefit signififrom the pricing of Reserve Bank services. In this situation, correspondents will no
longer have to compete against "free" Federal
Reserve services - and they will also have
more flexibility in their operations than
Reserve Banks, which must operate under
MCA guidelines. Also, as in the past, correspondents will offer a broader package of services than Reserve Banks, such as loan partici..
pations, cash management, and Federal funds.

able to compete with correspondents on fairly
equal terms.
With their overall price advantage on check
services, Federal Reserve facilities should
maintain a strong competitive position in the
paper-check transfer market. The advantage is
rather slight, however, so that the Fed cannot
simply offer the service and let the market respond. Because their market is no longer
assured, Reserve Banks must remain cognizant of the types of services provided by correspondents, and how those services are
priced.
In the long-run, despite restrictions imposed
by the MCA, Reserve Banks should continue
to playa central role in the nation's payments
system. And in the short-run, despite the
impact of output changes on prices for checkclearing services, most Reserve Banks should
be able to weather the shift to a pricing
environment. For facilities operating in the
range of relatively constant costs, even large
changes in volume will not result in dramatic
shifts in average costs, and hence in prices.
Thus, Reserve Banks generally should survive
the pricing-adjustment period successfully.
Future of ACH Services
The Federal Reserve faces a dilemma with
respect to the pricing of ACH services - that
is, the difficulty of setting an appropriate
"long-run" price for this service that exhibits
falling long-run average costs. In addition,
despite the tendency for per unit average costs
to fall in line with rising output, in 1977 the
average cost per image (7.3 cents) far
exceeded the average cost per check cleared
0.87 cents). That large gap still exists today.
This differential could influence users to shift
back to paper checks, unless other processin&
costs for ACH transfers remain well below
comparable check costs.
The Federal Reserve, in its August 1980
proposals, thus based its proposed ACH prices
on estimated long-run average costs at a much
higher volume of output. As a result, the price
per ACH transfer fell below the price per
check. But despite the evidence from our 1977
study, significant economies of scale for ACH

Future of Check Clearing
In the check-clearing area, large Reserve
Bank facilities appear to be operating with
average costs well above the estimated
minimum average cost. This finding is not
surprising, given the expected overuse of free
check-clearing services provided by Reserve
Banks. The largest check-processing facilities
of diseconomies of scale, or
into the
increasing average cost - which suggests that
subject to market. pressures
expanded beyond the region of constant
returns to scale. In the post-MCA environment, these offices will have to reduce their
opl~ratlOns, or open
facilities to take
advantage of lower average production costs
associated with medium-scale operations.. But
Reserve Banks and Branches operating in the
near minimum average cost should be
36

operations may not continue indefinitely. So
the future of this market could hinge on the
prices set by the Federal Reserve. Too high a
price could hamper the growth of the developing market for private ACH transfers, which
now account for only one-fifth of the market.
(Government transfers, which now account
for the vast bulk of all transfers, will not be
priced explicitly,) Too Iowa price, on the other
hand, could create a large subsidy for the users
of the Fed system, and again could retard
development of a competitive private system.

volumes for most services, it may actually
increase the amount of coin and currency
activity. The Federal Reserve's pricing proposals cover only transportation expenses nearly one-third of the total for both coin and
currency - so that Reserve Banks will continue to have an advantage over correspondents on the "price" for cash handling. With
the opening of Reserve Banks' services to nonmember banks and other depository institutions, the Fed may actually experience an
increase in volume in this activity. But while
handling more currency and coin, Reserve
Banks probably will provide fewer transportation services, since pricing eliminates the subsidy in this area.

Future of Cash Services
While pricing could lower Reserve Bank

VI. Summary and Conclusions
the market between member banks and other
institutions. After implementation, all institutions will have access to Reserve Bank services, but of course at a price.
The post-MCA world will be both more
competitive and efficient as a result of the partial or complete elimination of Federal
Reserve subsidies to depository institutions.
Removal of the check-processing and cashtransportation subsidies will allow private producers to compete on a more equal footing
with Reserve Banks. For that matter, increased
competition is also indicated by the evident
lack of a natural Federal Reserve monopoly in
check-processing or cash-handling services. In
addition, historical data indicate that the
charges Reserve Banks •must set for their
check services are comparable to the fees correspondents charged for similar services. In
the long-run, competition from the private
sector will probably .erode the Federal
Reserve's market share, butthat competition
should also spur Reserve Banks to produce at a
more efficient scale of operations, leading to
lower prices and higher quality of services.
In the ACH area, the Federal Reserve's
published pricing schedule indicates a shortrun willingness to continue subsidies, so that
the· market grows sufficiently for Reserve
Banks to take advantage of their economies of

The inefficiencies and competitive barriers
previously associated with the provision of
correspondent-banking services helped bring
about the enactment of the Depository Institutions Deregulation and Monetary Control Act.
The pricing and access provisions of the Act
were designed to rectify the major inefficiency
in the nation's correspondent-banking market
- the provision of free Federal Reserve services to member banks. Simultaneously, the
Act attempted to strengthen competition
among the suppliers of these services. The
implementation of the Act over the next year
will strongly influence the future of the correspondent-banking industry.
The overconsumption of free Reserve Bank
services by member banks has led to overproduction by the public sector in general,and by
some Reserve Bank facilities in particular.
"Full cost" pricing as implemented under the
MCAwiHnot eliminate all of the subsidies to
institutions using Fed services. However,· it
will provide Reserve Bank customers with
markefsignals concerningthe true cost of the
resources they consume, providing strong
incentives for more efficient use of the Services produced.
The MCA was also designed to promote
competition among suppliers of correspondent
services by eliminating the segmentation of

37

Reserve System should continue as a primary
producer, especially of check and ACH services. However, its overall role will be affected
by the economy's increased reliance on the
private sector for correspondent-banking services.

scale in this area. This would permit lower
ACH transfer costs, making them more competitive with check clearing costs, and thereby
helping to reduce the burden on the nation's
check-payments system.
In the 1980's, therefore, the Federal

FOOTNOTES
Reserve Services," Quarterly Review (Federal
Reserve Bank of Minneapolis, Summer 1977), p. 20.

1. Nonmember banks had access to Regional Check
Processing Centers (RCPC's); access to Automated
Clearinghouse (ACH) was open to all institutions.
2. The subject is covered in the following studies:

10. A preliminary evaluation of 1979 data indicates
that similar long-run average cost curves continue to
be the norm for each of the Reserve Bank services.
11. The following measures were estimated: average
cost, which included all production and transportation
costs, plus estimated overhead expenses; average
cost less transportation expenses; average production costs (excludes overhead); and average production costs less transportation expenses. Overhead
cost for each service and for each facility were estimated in direct relation to the proportion of production costs for each service at each Reserve District.
This is the primary method of allocating overhead
under the PACS accounting system.

R. Alton Gilbert, "Utilization of Federal Reserve Bank
Services by Member Banks: Implications for the
Costs and Benefits of Membership," Review (Federal
Reserve Bank of St. Louis, August 1977).
Susan R. Hume and Katherine S. Russell, "A Study of
the Relative Usage of Federal Reserve Services by
Member Banks in the Second Federal Reserve District," unpublished article (Federal Reserve Bank of
New York, January 1978).
Bruce J. Summers, "Required Reserves, Correspondent Balances and Cash Asset Positions of Member
and Nonmember Banks: Evidence from the Fifth
Federal Reserve District," Working Paper 78-3
(Federal Reserve Bank of Richmond, April 1978).

12. Salary adjustment factors were taken from the
Fourth Quarter, 1977, Federal Reserve Evaluation
Program: Quantitative Performance Measures, Conference of First Vice Presidents, PI'. 66-68. Since
these measurements were not statistically significant, and bore the wrong sign for both check and ACH
operations, they were not included in the final check
and ACH equations presented in Table 2.

3. A preliminary analysis of 1979 PACS data and
correspondent-bank account analysis data indicates
little change in the relationship between correspondent prices and average costs.
4. Federal Reserve Bank of San Francisco, "Federal
Reserve Services," 1978, p. 3.
5. Board of Governors of the Federal Reserve
System, 1917 PACS Expense Report, Annual Detail
Reports, (Washington D.C.: Federal Reserve Board,
1978), PI'. 83-165; and 1917 PACS Expense Report,
Annual Summary Report, (Washington, D.C.: Federal
Reserve Board, 1978).

13. Branching variables were estimated in both
dummy and interactive forms relating branching
status and volume of services. Neither method produced significant results.
14. David B. Humphrey, "Economies to Scale in
Federal Reserve Check Processing Operations,"
Journal of Econometrics, January 1981, PI'. 168169.

6. U.S. Congress, Public Law 96-221, Depository
Institutions Deregulation and Monetary Control Act
of 1980 (96th Congress, March 31, 1980), SectiOn
11 A, Pricing of Services.

15. David B. Humphrey, "Scale Economies at Automated Clearinghouses," Research Papers In Banking
and Financial Economics (Washington, D.C.: Federal
Reserve Board, Revised March 1980), p. 2.

7. These two items, imputed taxes and the imputed
return to capital, are estimated by the· Federal
Reserve Board of Governors to be 16 percent of total
costs. This provides the private-sector adjustment
factor.

16. Robert E. Knight, 1977 Account Analysis Survey
(Kansas City: Federal Reserve Bank of Kansas City,
Research Department, 1978), PI'. 1-24.
17. David B. Humphrey, "Are There Economies of
Scale in Check Processing at the Federal Reserve?"
Journal of Ba.nk Research (Park Ridge, Illinois: Bank
Administration Institute, Spring 1980), p. 17

8. Federal Reserve Press Release, "Proposals for
Pricing Federal Reserve Services" (Washington D.C.:
Board of Governors of the Federal Reserve System,
August 28, 1980), 1'.4.
9. Wall Street Journal, "Fed's Plan to End Free
'Float' May Save Taxpayers' Money, Boost Costs to
Banks," Thursday, August 21, 1980, p. 12; and
Preston J. Miller, "The Right Way to Price Federal

38

REFERENCES
Bank Administration Institute, 1977 Survey of the
Check Collection System, Park Ridge: Bank Administration Institute, 1978.

Federal Reserve System Conference of First Vice
Presidents. Federal Reserve Evaluation Program: Quantitative Performance Measures.
Washington, D.C.: Federal Reserve Board, Fourth
Quarter 1977.

Bell, Fredrick W., and Murphy, Neil B. "Economies of
Scale in Commercial Banking, Part I: The
Measurement and Impact:' New England Business Review, Federal Reserve Bank of Boston,
March 1967, pp. 2-11.

Gambs, Carl M. "Automated Clearinghouses Current
Status and Prospects." Economic Review,
Federal Reserve Bank of Kansas City, May 1978,
pp.3-16.

_ _. "Economies of Scale in Commercial Banking,
Part II: Specialization and Technology." New
England Business Review, Federal Reserve
Bank of Boston, April 1967, pp. 2-10.

Gilbert, R. Alton. "Utilization of Federal Reserve Bank
Services by Member Banks: Implications for the
Costs and Benefits of Membership." Review,
Federal Reserve Bank of St. Louis, August 1977,
pp.2-15.

Board of Governors of the Federal Reserve System.
1977 PACS Expense Report, Annual Detail Reports. Washington, D.C.: Federal Reserve Board,
1978.

Hume, Susan R., and Russell, Katherine S. "A Study
of the Relative Usage of Federal Reserve Service
by Member Banks in the Second Federal
Reserve District." Mimeo, Federal Reserve Bank
of New York, January 1978.

_ _. 1977 PACS Expense Report, Annual &ummary Reports. Washington, D.C.: Federal
Reserve Board, 1978.

Humphrey, David B. "Are There Economies of Scale in
Check Processing at the Federal Reserve?"
Journal of Bank Research, Spring 1980, pp. 819.

_ _. 1979 PACS Expense Report, Annual Detail
Reports. Washington, D.C.: Federal Reserve
Board, 1980.
_ _. 1979 PACS Expense Report, Annual Summary Reports. Washington, D.C.: Federal
Reserve Board, 1980.

_ _. "Economies to Scale in Federal Reserve
Check Processing Operations." Journal of
Econometrics, January 1981, pp. 155-173.

_ _. Press Release on Pricing and Access Proposals. Federal Reserve Board, August 28, 1980.

_ _. "Scale Economies at Automated Clearinghouses." Research Papers in Banking and
Financial Economics, Board of Governors of the
Federal Reserve System, December 1979,
Revised March 1980.

Brundy, James M., Humphrey, David B., and Kwast,
Myron L. "Check Processing at Federal Reserve
Offices." Federal Reserve Bulletin, February
1979, pp. 97 -103.

Knight, Robert E. 1978 Account Analysis Survey.
Federal Reserve Bank of Kansas City, Research
Department, 1977.

Budd, George. "The Role of the Federal Reserve in
the Provision of Banking Services." Mimeo,
Federal Reserve Bank of Atlanta, August 1978.

_ _. 1977 Account Analysis Survey. Federal
Reserve Bank of Kansas City, Research Department, 1978.

"Correspondent Banking:' Monthly Review, Federal
Reserve Bank of Kansas City, March-April 1965,
pp.9-16.

_ _. "Correspondent Banking, Part I: Balances and
Services." Monthly Review, Federal Reserve
Bank of Kansas City, November 1970, pp. 3-14.

Cox, Edwin. The Outlook for the Nation's Check
Payments System - A Report to the American
Bankers Association. Cambridge, Mass.,: Arthur
D. Little, Inc., December 1970.

_ _. "Correspondent Banking, Part II: Loan Participation and Fund Flows." Monthly Review,
Federal Reserve Bank of Kansas City, December
1971, pp. 12-24.

_ _. The Pricing of Check Collection Services by
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