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Role of the Federal Reserve in the payment system
Before the Subcommittee on Domestic and International Monetary Policy of the
Committee on Banking and Financial Services, U.S. House of Representatives
September 16, 1997
I welcome this opportunity to discuss the payments system and the Federal Reserve's role in
it. A convenient, safe, reliable means of making payments is extremely important to all of us
in our daily economic lives, but most of us do not think about it very often. We pay our bills
by cash, check, credit or debit card; we have our pay deposited directly in our bank
accounts and transfer funds by computer or telephone. We assume the money will get where
it is supposed to go quickly and without complications. We do not spend time thinking about
how that happens.
Similarly, ensuring the efficiency, reliability and integrity of the nation's payments system is
a big part of the responsibility the congress has given to the Federal Reserve, but neither the
Congress nor the public usually devotes attention to the Federal Reserve's role in the
payments system. The Federal Reserve's monetary policy role tends to dominate the
headlines and the hearings.
As this Subcommittee is acutely aware, enormous changes are occurring in the U.S. financial
services industry. Breathtaking developments are taking place in computing and
communications technology. Consolidation and interstate banking are changing the structure
of the banking industry, and lines are blurring between banking and other types of financial
services. Because these changes could profoundly affect payments mechanisms in the
future, it is a timely moment to reexamine the part the Federal Reserve plays in payments
and whether that role ought to be altered. With this in mind, last fall, Chairman Greenspan
asked me to chair a Committee on the Federal Reserve in the Payments Mechanism. Besides
myself, the Committee members are Governor Edward W. Kelley and Federal Reserve Bank
Presidents William McDonough of New York and Thomas Melzer of St. Louis. Our mandate
is to examine how the payments system is evolving and what part the Federal Reserve might
play in the future. The process is ongoing, but I welcome the opportunity to share with you
some of what we have learned and some preliminary conclusions.
My testimony is in two parts. The first presents some background on the payments system
and the evolution of the Federal Reserve's role in it (a more detailed description of noncash
payment instruments and their processing is given in Appendix 1). The second part of the
testimony discusses the work of our committee, especially the scenarios we developed and
the reactions we received from participants in a series of forums on the payments system.
In addition, Appendix 2 provides a description of a small part of the Federal Reserve's check
processing operation, the Interdistrict Transportation Service (ITS), in which some members
have expressed interest, as well as our views on H.R. 2119.
Part I

The Federal Reserve's Role in an Evolving Payments System
A large and vibrant economy requires a staggering number of payments. In the United
States, hundreds of millions of payments with a combined value of about $1.7 trillion are
made every day. Although a majority of transactions are made in currency or coin, cash
actually accounts for only a tiny fraction -- less than one percent -- of the value of
Non-cash payments can be roughly divided into two categories: (1) wholesale or large dollar
transactions made primarily by banks, businesses, and governments; (2) retail or smaller
dollar payments made by individuals, businesses and other participants in the economy.
Wholesale payments, which have been growing rapidly in recent years, move over two
systems: the Fedwire electronic funds transfer system operated by the Federal Reserve and
Clearing House Interbank Payments System (CHIPS) operated by the New York Clearing
House. CHIPS is used primarily to make international interbank payments. The Federal
Reserve also operates the Fedwire book-entry securities service, which is used to transfer
U.S. Treasury, Federal agency and mortgage-backed securities.
The security and reliability of these large-value systems is crucial to the functioning and
stability of the financial system, both national and international, but the role of the Federal
Reserve, as the nation's central bank, in providing for wholesale payments and final
settlement is not controversial. Hence, this testimony, like the work of our committee,
focuses entirely on retail payments.
Retail payments: Check and ACH
The most common non-cash payment instrument in the United States is the paper check,
used much more widely here than in other industrial economies. Americans love checks. We
wrote 64 billion of them in 1996 with a total value of about $75 trillion dollars. Pundits have
been predicting the replacement of checks by electronic payments for several decades, and,
indeed, electronic transactions have been increasing much faster in recent years than checks.
Nevertheless, the volume of checks has continued to increase about 2 percent annually over
the last five years. Growing use of credit and debit cards has slowed the increase in check
volume, but so far has not reversed it. On-line home banking still accounts for a tiny fraction
of payments. Moreover, the customer's bill paying instruction from a home computer often
simply results in the bank cutting a check to pay the customer's bill, because many payees
are not equipped to receive funds electronically. Hence, while the volume of checks is likely
to plateau and eventually decline as electronic payments become increasingly convenient
and familiar, checks are likely to remain a significant part of the payments system for some
years to come.
A rapidly growing number of retail payments are made by electronic funds transfers over an
automated clearinghouse (ACH) network. ACH is typically used for recurring payments,
such as direct deposit of payroll and social security or direct payment of recurring bills, such
as mortgage, insurance and utility bills. Almost every depository institution in the United
States is equipped to receive ACH payments for its customers, although not all are equipped
to send them. Although the number of ACH transactions is small compared to the number of
checks (four billion in 1996, compared to 64 billion checks) that number has been increasing
much faster (about 15 percent annually for the last decade) and the average value of ACH
transactions is higher than that of checks.
How the Federal Reserve became involved
Although most people now take a reliable payments system for granted, this was not always

so. The severe financial crises that swept the nation periodically in the 19th and early 20th
centuries typically disrupted the payments system. During the financial panic of 1907,
payments were largely suspended throughout the country because many banks and
clearinghouses refused to clear checks drawn on certain banks. The refusals led to the failure
of otherwise solvent banks and greatly exacerbated the impact of the crisis on businesses
and individuals.
The Congress' desire to avoid another 1907-type failure of the national payments system was
one of the important reasons for creating the Federal Reserve System in 1913. The Federal
Reserve Act directed the Federal Reserve to provide an elastic currency--that is, to supply
currency in the quantities demanded by the public--and also gave it the authority to establish
a nationwide check clearing system. Congress was also concerned that some banks refused
to pay the full amount of the check (nonpar collection) and that some charged certain
collecting banks fees to pay checks (presentment fees). In 1917, it amended the Federal
Reserve Act to prohibit banks from charging the Federal Reserve Banks presentment fees.
Congress modified the Federal Reserve's role in the payments system through the Monetary
Control Act of 1980 (MCA). A primary purpose of the MCA was to promote an efficient
nationwide payments system by encouraging competition between the Federal Reserve and
private-sector providers of payment services. The MCA requires the Federal Reserve Banks
to charge fees for their payment services, which must, over the long run, be set to recover all
direct and indirect costs of providing the services. In addition, the MCA requires the Federal
Reserve Banks to recover imputed costs, such as taxes and the cost of capital, that would
have been paid and imputed profits that would have been earned if the services were
provided by a private firm. The MCA also subjected all banks, not just member banks, to
reserve requirements and granted them equal access to the Federal Reserve Banks' payment
Congress further expanded the role of the Federal Reserve in the payments system in 1987
when it enacted the Expedited Funds Availability Act. For the first time, this Act gave the
Federal Reserve the authority to regulate check payments that were not processed by the
Federal Reserve Banks. Thus, the EFAA significantly broadened the Federal Reserve's
ability to ensure that the nation's check collection system is efficient and that all depository
institutions have equitable access to the system. The Act also limited the time that a bank
may hold funds before making them available to customers for withdrawal and directed the
Federal Reserve to speed the process of returning unpaid checks to banks of first deposit to
reduce the risk that banks face when making funds available to their depositors.
Thus, by a series of legislative actions, the Congress has clearly placed responsibility on the
Federal Reserve to ensure:
the integrity of the payments system -- its safety and reliability;
the accessibility of the payments system -- that it is available to all depository
institutions so that they can provide for the payments needs of their customers; and
the efficiency of the system -- that the cost of making payments is reduced as much as
To accomplish these goals, the Congress has given the Federal Reserve regulatory authority,
as well as directed it to encourage efficiency by competing fairly with private-sector
suppliers of payment services. Thus, its payments system missions are a complex and
challenging part of the Federal Reserve's responsibilities.

The Federal Reserve's role in check clearing
Of the roughly 64 billion checks written annually, about a third are "on-us" checks (the
payor and payee have accounts at the same bank), but the rest must be cleared and settled in
the interbank check collection market. Most checks are physically transported and presented
to the paying bank for payment, although the use of electronic check presentment (ECP) is
growing. Under ECP, the information contained on the check is transmitted to the paying
bank, with the actual check often following by slower means.
Some checks are presented directly by one bank to another. About a quarter are presented in
clearinghouse arrangements under which a group of banks agree on rules for presenting
checks to each other simultaneously. Another quarter of interbank checks are collected by
correspondent banks on behalf of other banks. The Federal Reserve serves as an
intermediary for the collection of about a third of interbank checks. Small banks, especially
those in remote locations depend more heavily on the Federal Reserve for check collection
than do big banks in larger cities.
Over the years, competition among providers of check services and advances in technology
have made the check collection process much speedier and less costly. Many of us can
remember when it took quite a few days--often more than a week--for a check to clear,
especially if drawn on a bank in a remote location. Now the Federal Reserve is able to
collect over 90 percent of the value of all checks deposited with it within one day after they
are deposited in the collecting bank.
The Federal Reserve has used both its regulatory powers and its market presence to
encourage technological advance and efficiency in the check market. Since the early 1980s,
Reserve Banks have been able to provide check presentment information to paying banks
electronically, which enables their corporate customers to manage the funds in their
accounts more effectively. The Reserve Banks have recently been working with many of
their customers to increase the use of ECP. The Federal Reserve has also invested in this
development of new techniques for using digital images in check processing. The Federal
Reserve Banks are implementing an image-enhanced check service for the U.S. Treasury
and are offering this service to banks as well.
The Federal Reserve in the ACH market
While electronic technology offers some scope to make check presentment more efficient,
fully electronic payments are both faster and cheaper. The ACH service, which the Federal
Reserve began providing in 1972 at the request of local ACH associations, is now a fully
electronic system reaching nearly every depository institution in the United States. There are
currently four ACH operators that process and transmit ACH transactions between
depository institutions -- the Federal Reserve and three commercial providers. The Federal
Reserve is by far the largest provider, processing about 80 percent of commercial ACH
transactions in 1996 and all of the government ones. As with check collection, depository
institutions rely on the Federal Reserve to deliver ACH transactions to small and remote
banks. The commercial ACH providers serve a limited set of institutions and rely on the
Federal Reserve to deliver ACH transactions to banks not served by their networks. In 1996,
the Reserve Banks implemented a new consolidated ACH operating system, which enables
transactions to be processed on a flow basis and which operates twenty-four hours a day.
This new operating system has increased the efficiency of ACH processing and reduced
operating costs significantly. These lower costs have been passed along to customers in
lower fees.

Prices and costs
In passing the Monetary Control Act, the Congress intended to promote the efficiency of the
payments system by encouraging competition between the Federal Reserve and privatesector providers, and, indeed, private-sector providers have competed vigorously with the
Federal Reserve. Opening access to Federal Reserve payment services to all banks has also
contributed to a more equitable payments system and has played a role in spurring
competition. As a result, on average, the cost of payment services has declined and the
quality of payment services has increased.
Over the last ten years, the Federal Reserve has fully recovered the total costs of its priced
services, including imputed costs as required by the Monetary Control Act. In 1996, the
Federal Reserve recovered 103.4 percent of the total costs of its priced services. Moreover,
because fees are set to recover not only all actual costs but also imputed costs and a profit
margin, the revenues from the Federal Reserve's priced services have exceeded operating
costs by almost $1 billion over the last decade. These net revenues contribute to the amount
the Federal Reserve transfers to the Treasury to the benefit of the American taxpayers.
Shortly after the MCA was enacted, the Board of Governors adopted pricing principles that
are more stringent than the requirements of the MCA and that require the Federal Reserve
Banks to recover priced service costs, not just in the aggregate, but for each major service
category. Our check service, for example, has fully recovered its costs over the last ten
In setting fees, the Federal Reserve's staff applies the principles of economic theory and
considers the practices of private-sector providers of payment services. For instance, in most
cases, the Reserve Banks have implemented fee structures that resemble the cost structure
of each priced service. Because the costs associated with payment services tend to be
dominated by fixed costs, the Federal Reserve typically uses a combination of fixed and
variable fees to price its services. Thus, the fee schedule for the check service includes fixed
fees, called cash letter fees, for each bundle of checks deposited with a Federal Reserve
office and per-check or per-item fees. In addition, all transaction fees are set to recover at
least the marginal or incremental cost of each transaction, which precludes the Reserve
Banks from engaging in predatory pricing and promotes competition.
Allocating costs for the shared parts of the Federal Reserve's operations is a complex and
difficult matter, especially when large fixed costs have to be allocated among several
activities. There is no perfect solution to this problem, but the Federal Reserve's
methodology has been scrutinized by the GAO and other experts and has been declared
"reasonable". We stand ready to discuss our cost and pricing methodology with the
Committee or with outside experts if the Committee would like more detailed information.1
Part II
The Committee's Study on the Federal Reserve in the Payments System
As discussed earlier, Chairman Greenspan created a committee to examine the Fed's role in
the payments system. The Committee believed that the rapid changes occurring in financial
services called for a fundamental review of the role of the Federal Reserve in the payments
system and a thorough discussion of how alternative roles might enhance or undermine the
integrity, efficiency, and accessibility of the system. We decided to focus on retail payments
because they affect so many people and businesses directly and because the case for a
continuing role of the central bank in retail payments is more controversial than the case for

a role in wholesale payments.
The Committee did not regard the retail payments system as "broken" or in any kind of
crisis. Almost all users and participants think it functions just fine. Nevertheless, one
anomaly is striking: why does the nation with the most advanced computers in the world rely
so heavily on paper to make payments? Why do Americans write 64 billion paper checks a
year -- checks that have to be trucked and flown to their destinations -- when these
payments could be made cheaper and faster by electronic means? How might different roles
of the Federal Reserve accelerate or retard movement to electronic payments?
To spark discussion and analysis of these and other payments system issues, the Committee
developed five hypothetical scenarios for the future role of the Federal Reserve in retail
payments ranging from exiting check and ACH services altogether to becoming a more
vigorous competitor and industry leader. These scenarios were not designed to be actual
policy options, but were intended to serve as catalysts for debate both within the Federal
Reserve and among payments system participants.
One scenario under which the Federal Reserve would withdraw from the check and ACH
services was called the Liquidation scenario. In this scenario, the Federal Reserve would
announce its intention to withdraw from the provision of check and ACH services as of a
specified date. During the wind-down period, the Federal Reserve would take steps to
provide for a smooth transition. It would assist its customers in finding alternative privatesector suppliers of payment services and would help potential private-sector providers
evaluate the profitability of serving various markets by providing market data to them.
A second withdrawal scenario envisioned the Federal Reserve's privatizing its check and
ACH services. In the Privatization scenario, the Federal Reserve would first transfer its
check and ACH operations to a newly chartered, special purpose "Clearing Bank." The
Clearing Bank would eventually be sold to a private-sector entity with no privileged ties to
the Federal Reserve nor any restrictions on the type of payment services that it could
Three scenarios under which the Federal Reserve would continue to provide retail payment
services to banks varied from the Federal Reserve's adopting a passive role in providing
check and ACH services to an active role in promoting the conversion of payments to
electronic forms. In the scenario called Continuity and Access, the Federal Reserve would
merely ensure that all depository institutions had access to its retail payment services. For
the most part, the Federal Reserve would allow initiatives by private-sector providers to
determine the future course of the retail payments system and competition among those
providers of payment services would provide the primary catalyst for innovation. Because
the Federal Reserve would not be an aggressive competitor in the retail payments market,
adopting this scenario would likely lead to the Federal Reserve's slowly exiting the retail
payment services over the long run.
In the scenario called Promoting Efficiency, the Federal Reserve would use its operational
presence, pricing strategies, and influence to enhance the efficiency of the interbank retail
payments system. Under this scenario, the Federal Reserve would also take steps to foster
innovation by private-sector providers. In the final scenario, called Leading Toward
Electronic Payments, the Federal Reserve would expedite the movement to an electronic
retail payments system. In this case, the Federal Reserve would fund research and
development and make additional capital investments in payments system improvements;

develop an expanded national payments infrastructure; provide access to the Federal
Reserve's secure interbank communications network to depository institutions at incremental
cost; and work with providers and vendors to develop more flexible, convenient, and
effective software and systems to facilitate electronic transactions.
We asked experts at the Federal Reserve to analyze the impact of each scenario on the
price, availability and structure of payments services, and then sought input and reactions
from a wide range of payments system participants.
We discussed the scenarios during ten national forums that were held in May and June 1997.
The national forums were moderated by an independent facilitator, and attended by
Committee members. Nearly 100 organizations participated in these forums, including
representatives of banks, thrifts, and credit unions of all asset sizes; third-party service
providers; clearing associations; trade associations representing banks, thrifts, and credit
unions, consumers, and retailers; and academics and consultants, among others. The
discussion at these forums was focussed on how the various scenarios would affect the price
and availability of retail payment services and how they would affect market and
technological innovation, and public confidence in the payments system.
In addition, each Federal Reserve Bank held a series of regional forums as well as a number
of one-on-one meetings. Altogether, fifty-two regional forums, which were moderated by
senior Reserve Bank staff, were held. As in the case of the national meetings, a wide range
of payments system participants attended the regional forums, representing over 350
The discussions were varied and lively, but consistent themes emerged across the country.
First, although a few participants favored Federal Reserve withdrawal from the check or
ACH markets (or both), a large majority, including representatives from all size classes of
depository institutions opposed the Federal Reserve's exiting these markets.
Smaller banks and those located in remote areas were concerned that they would have
difficulty obtaining retail payment services, that the prices for those services would rise
significantly, and that they might not be able to access new payment services developed in
the private sector. Many participants raised concerns about how they would obtain retail
payment services if there were a financial crisis. For example, how would smaller institutions
collect checks if their correspondent bank were to fail and how would they obtain services if
their financial condition were deteriorating?
Some large banks and clearinghouses expressed an interest in picking up new customers as a
result of Federal Reserve withdrawal. Other large banks, however, had withdrawn from the
correspondent role and were reluctant to resume what they regarded as a low-profit
business. Some participants expressed fears that the Federal Reserve's withdrawal would
mean heavier regulation of the check and ACH markets as Congress sought to protect the
access of small institutions to these services.
Most participants believed that, in the long run, there would be sufficient capacity in both
the check and ACH markets to absorb the transaction volumes processed by the Federal
Reserve Banks.
A number of participants, however, were concerned that, if the Federal Reserve withdrew
from check and ACH services, there would be short-term service disruptions with few
long-term benefits.

Some participants supported the withdrawal scenarios because they believed that privatesector providers of retail payment services were more efficient than the Federal Reserve and
that the Federal Reserve's withdrawal would enhance the efficiency of the payments system
over time. Some participants argued that the likely increases in the price of collecting checks
that would follow the Federal Reserve's withdrawal might lead to a greater use of electronic
payment services, particularly in remote locations. A few expressed concern about the
conflicts of interest that could arise between the Federal Reserve's role as a payment service
provider and its role as regulator of the payments system. A few of these participants stated
that these perceived conflicts of interest had caused delays in addressing the disparity
between check presentment times for the Federal Reserve Banks and private depository
institutions. Some thought the Federal Reserve might have taken steps sooner to improve its
net settlement service if it did not provide payment services.
At the same time, many participants believed that private-sector providers might be reluctant
to expand their check collection services significantly because of their desire to invest in
new technologies, rather than legacy systems that are perceived to have marginal
profitability and limited growth potential. Some of these participants indicated that they
were currently faced with many competing priorities, including dealing with mergers and
acquisitions, addressing the operational issues raised by the federal government's electronic
payments initiative, and ensuring that they were century date change compliant.
Almost all participants believed that check payments would continue to play an important
role in the U.S. payments system for the foreseeable future and that the Federal Reserve and
other industry participants should focus on achieving additional efficiencies in the check
collection system through the use of electronic check presentment and truncation.
With respect to the ACH, participants cited shortcomings in the current system, which may
be limiting its use. Participants noted that the ACH was a good vehicle for recurring
payments but that its use for purchases at the point of sale was limited. Moreover,
consumers are not generally familiar with how to make ACH payments. Participants also
discussed the problems that businesses receiving ACH payments frequently experience in
receiving the information explaining the amount and purpose of payments from their banks.
This issue, of course, is one of the issues facing the banking industry as the federal
government implements its all electronic payments initiative and is a critical issue facing the
ACH service. At the same time, a number of participants believed that a properly funded
public education and marketing effort aimed at consumers and businesses could lead to
greater acceptance and use of the ACH.
There was strong support among a wide variety of participants for more "leadership" from
the Federal Reserve, especially in moving beyond current payment instruments to more
advanced electronic systems of the future. Not all participants, however, had the same
concept of what "leadership" implied. Community bankers generally supported a more
active, innovative Federal Reserve. Some indicated that the Federal Reserve's investment in
technology-driven products enables them to take advantage of electronic services without
large, up-front investments that they cannot easily afford. Participants representing larger
banks, however, questioned whether the Federal Reserve, as a provider of payment services,
could spur the conversion of payments to electronic forms as well as the private service
providers could.
Nevertheless, the majority of participants agreed that the Federal Reserve should play a

stronger leadership role in improving the efficiency of the check collection system and in
bringing diverse players in retail payment services together in a collaborative way to identify
and to address the impediments preventing a conversion to more economically efficient
retail payment services. Many participants urged the Federal Reserve to work with the
payments industry to establish standards for electronic payments, including standards for the
authentication of payment instructions, standards for privacy and security of payment
information, and standards addressing liability and risks in emerging payment services. In
addition, participants suggested that the Federal Reserve could play an important role in
sponsoring public education aimed at encouraging the use of end-to-end electronic payment
The Committee is still weighing what it has learned from the national and regional forums,
analytical studies and other sources. It has not yet brought specific policy options to the
Board of Governors or the Conference of Reserve Bank Presidents. Two general
conclusions, however, have emerged from our deliberations. First, for the next few years at
least, the Federal Reserve can best meet the expectations of Congress for a safe and reliable
payments system by continuing to provide check and ACH services as efficiently as
possible. Given the concerns expressed to us about the disruptions that would likely occur if
the Federal Reserve were to withdraw from the retail payment services, plus the many
changes that the banking industry must grapple with over the next several years, it seems
prudent not to impose additional disruptions on it that the industry itself is not certain would
lead to long-run benefits.
Second, the Federal Reserve needs to work more closely and collaboratively with the
participants and users of the payments system, both to enhance the efficiency of current
payment instruments (check and ACH) and to evolve strategies for moving to the next
generation of payment methodologies. We look forward to working closely with the
Congress as these strategies begin to unfold, with a continuing focus on ensuring the
integrity, efficiency and accessibility of the payments system.
1 Appendix 2 discusses the Interdistrict Transportation System (ITS) and how its costs and
fees are set. It also discusses the implications of H.R. 2119, "The Efficient Check Clearing
Act of 1997," for the Federal Reserve's check service.
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