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The Payments Mechanism System: Emerging Changes and Challenges E. Gerald Corrigan President, Federal Reserve Bank of Minneapolis Presented to The Future of the U.S. Payments System Symposium Sponsored by The Federal Reserve Bank of Atlanta June 24, 1981 My purpose here, as I understand it, is to shed some light on the emerging changes in our payments mechanism system from the vantage point of one senior Federal Reserve official who has had more than a casual interest in this area for many years. I'll cover three broad areas. First, I'll comment brief ly on the status of our payments mechanism system with emphasis on why the rapid advances in the use of electronics so widely forecast a decade or more ago have not occurred. Second, I'll summarize some of the major forces now at work which represent a new and prob ably irreversible impetus for the increased use of electronics banking and finance. in Finally, I will share with you some concerns that I have about our brave new world of electronic banking— con cerns which may not be immediate but which should shape our think ing about this future environment. In looking at the payments mechanism today, we must start with the obvious: the recognition that our current payments system is still a paper-based system. Indeed, if one were to look simply at numbers of transactions, the paper medium is dominant. ample, For ex during 1980, we in the Federal Reserve processed 15.7 bil lion checks and we handled 6.7 billion pieces of currency. By con trast, the number of wire transfers processed was 43.3 million and the number of ACH entries handled was however, such a snapshot view of our 227.4 million. payments based on a transaction rather than a value defect of all snapshots: Obviously, system— which indicator— suffers the image is two-dimensional. is the If, how ever, we look at the value of payments made electronically, quite a - different picture is exposed. 2 - In 1980, for example, the value of payments processed via Fed-wire and ACH alone was $78.9 trillion. Impressive as that value-based number is, we are still nowhere near the checkless, cashless society that many futurists of the mid-sixties envisioned. not captured a larger We're still asking why electronics has piece of the action. In considering this question, we can, I think, lay to rest the argument that technology is the barrier. arrived. It seems clear to me today that the technology has Indeed, I am convinced that the technology for a virtual explosion of electronic payments exists and that in some instances it has existed for some time. The book-entry system for Treasury securities— which is, we all sometimes forget, more than a decade old— makes that case better than words can. If not technology, what then has stood in the way of the more widespread use of electronic payments? Here, I think we can all tick off an impressive list of legal, structural, economic, and attitudinal factors which have worked to slow the momentum of elec tronic payments systems. nificant factor. For example, start-up costs are a sig Right now, the estimated cost of a check payment is less than the cost of an ACH entry. In the past decade, there have been sizable advances made in the technology of paper process ing equipment such as the latest generation of high-speed currency and check processing equipment. At the same time, while electronic systems are evolving rapidly, they suffer some of the diseconomies associated with low volume "infant" However, pediments should industries. the ease with which we can not misdirect our attention all cite from these other im equally 3 - important factors. There - are characteristics of our current pay ments systems— some real and some perhaps illusory— that have con tributed and will continue to contribute to the longevity of paperbased payments. A subtle advantage of a tangible paper-check-based sys tem— one that is often ove rlooked— is that a check can be returned in the event the funds to cover the check are not in the account. That same quality of tangibility— however cumbersome in the aggre g a t e — also seems audit trails, safe. to create a sense records management, With electronic impulses, of this confidence is, of course, man y segments of our society, Another, rent payments and more mec hanism of and confidence control because illusory. are fail many users aren't so sure. Some illusory, but these attitudes, in are deeply entrenched. important, which the that characteristic promotes its society as a of continued the cur vitality is Here, I say perceived whole these benefits are The float game— like any ga m e — cannot be one in which we all winners. whether for users are virtually the perceived benefit associated with float. benefit, for they take In most cases the form of the costs associated with uncertainty about the float— timing and finality of payments or the credit risk associated with float— are indirect and implicit. Even the legislative mandate explicitly price or otherwise eliminate that the Fed its float will have only a limited impact, since the Fed's balance sheet float is only a small part of the total procedures. a "free amount of float associated with current payment In any event, as long as individuals perceive float as good" working to their benefit, that belief will, in it 4 - self, remain a powerful element - reinforcing the continued use of paper checks. All of this may sound as if I were leading up to a judg ment that we will again have to delay predictions that we are on the verge of a major acceleration in the use of electronics in banking and finance. precisely not To the contrary, my own current thinking is moving in the opposite direction. irreversible, I believe there are strong, forces now at work which will produce the anticipated leap forward in the use of electronic payments. briefly comment on some of the more view, important if longLet me forces’ which, in my are serving as a catalyst for change. First, we have a public that is more technically sophi s ticated and better educated than even a decade ago. deed, we are now at the point tion of young people terminals— sometimes about to begin who as to enter in time in which a ge ner a have early the been as exposed to computer grade schools— are in labor the role of heads of households. force the generalized acceptance sign that if obstacles the of benefits to take on to a computer will encountered ATMs and/or For these people, pu re ly attitudinal biases about "talking" not present In also the earlier. represents individual are The now a clear there, these attitudinal barriers will give way. Second, as I have already suggested, it is apparent to me that current and tested "state-of-the-art" both are telecommunications more than adequate and to generalized foster a technology in data processing large expansion of 5 - - electronic pay m en ts — even into the arena of high volume, low value payments. The relative costs favorable in all cases to electronics, a reasonably safe bet to assume may not yet be but I think it is that economics will be working from both sides to further narrow and likely re verse future cost differences. The third reason I expect tronics accelerate are now to see the trend is due to the witnessing in the intense market for toward elec competition we the provision of banking and financial services. The results of this new competitive manifest the energy almost services, kets. daily abound; proliferation and new players The they erosion of of new themselves instruments, in new in previously "protected" m a r geographic restraints on banking and finance— both domestically and internationally— is a case in point. response to healthy, vital, whatever their quickly. Thus These regulation; and service they are, are innovative source, they they can hard and soft dollar cial forces are in also part, going be expected natural symptomatic financial not a of sector. to to help a But, fade away foster the investment in more efficient finan delivery systems— systems that will almost certainly rely on more electronics. Fourth, the more financial services electronics. ed the widespread will, I use of explicit believe, pricing encourage use of of In this connection, I have already ment io n explicit pricing of Fed float but, as you know, 6 - there must is much price - more involved its services. all than just float. Similarly, The NOW Fed accounts, the phase out of Regulation Q, and the gradual lifting of state usury ceilings are other signs of the move to more explicit pricing. These symptoms are also evident in the private sector where we are now seeing many ca ses — rang ing from credit charges, to fees card for service charges, small-balance to savings return-item ac counts— in which explicit pricing at or nearer full cost is becoming more common. These examples are, in my view, symptomatic of an emerging trend toward generalized explicit pricing in banking— a trend that I welcome because explicit pric ing should promote the best allocation of economic re sources . Finally, the inflationary periods and the related pattern of interest rate and exchange rate volatility experienced in recent years both in the United States and around the world also provides momentum for a shift to electronics. Traditional but work direction in the heightened time-value of money. of market changing risk considerations attitudes about Indeed, while the standard unit for the valuation of cash balances remains a 24-hour day, would not character the it surprise m e — particularly given the worldwide of that money ma r k e t s — to see even standard changed so that money on deposit in a particular location for a period of ho u rs — not for that time interval. days— might receive interest In such an environment the abil- - ity to muster and 7 - disburse funds on short notice will carry an even larger premium than it already does. Once these they pressures have begun to take hold, I doubt will be eliminated even as we bring inflation under con trol . While these trends may seem unambiguous, I cannot foresee how far or how fast they will move. The process probably will ac celerate from what we have seen over the past decade, but even if it does, I do not foresee anything like the demise of the check. more importantly in the current context, And, I can foresee some major new challenges and potential problems that we may all have to con front in an era of generalized usage of electronics in banking and finance. While my present unease regarding these potential prob lems may prove to be unfounded, this is one instance when it will be to everyone's advantage to be over- rather than under-prepared. Surely, for example, we can all conjure up a vision of a world in which the computer terminal— perhaps even the hand-held pocket-size computer terminal— is used for everything from trading stocks and bonds to purchasing our week's groceries. But, such a view of the world presupposes, among other things, that there is a mechanism or an institution, or both, that stands in the midst of this massive electronic blur to provide the equivalent of our con temporary clearing and settlement functions. Stated differently, we have to find a mechanism that insures that the funds transferred are "good funds," or I suspect wishes and expectations. the system will not satisfy our - 8 - Having made that observation, I will freely confess that I am not at all sure how we will come to grips with this problem. One possible answer is that all economic agents would have to hold larger— and perhaps significantly larger— average cash balances. Another possible answer is that financial intermediaries would have to assume larger credit risk and exposure. Still another possible answer would be a change in the very essence of the payments system from its current debit instrument orientation to a credit ment orientation. On a large scale, instru any or all of these or other changes, however, entail real problems in their own right and will not come about quickly or cheaply. To put this concern in a clearer perspective, let me com ment briefly on a couple of the elements of the problem that I be lieve should remain in the forefront of our thinking about the future. First, in any payments scheme, including our current one, there are certain risks; the risk of fraud, the risk of mechanical failures— including failures on a large scale such as the blackouts in New York— and there is always the risk of a sudden bankruptcy of a large participant. To date, all of these risks have proven manageable even though certain episodes including bank failures, natural disasters, and political turmoil have from time to time tested our resolve and our creativity. It would be nice to think problems or shocks of this type would not occur in the future, but they surely will. And, to me, clear that it will be more difficult to manage it is them and 9 - - contain them in a world dominated by electronic payments unless we are imaginative and farsighted in designing the future with these potential problems in mind. Second, I think we must recognize that whatever else electronics does, it will create a financial landscape in which the financial large and small, creased. interdependence financial and institutions— non-financial— is in Because of this, the credit judgments— or even mechanical problems— of any one implications chain of of for other electronic ments mechanism. institution have larger institutions impulses that that •make constitutes up that the pay Recent experience with the CHIPS net work in New York provides an example of how credit risks associated with can have major operation of an implications the pants— sensitive electronically for system. to In credit based the this risk payment shape, system design, instance, and partici considerations— have been willing to go through a time-consuming and expensive restructuring of an otherwise very successful electronic payments system primarily because of their collective desire to reduce and better manage credit risk. As I suggested above, I am not altogether sure at this juncture how we will deal with these and other issues in a world of electronic finance and banking. system Yet, it is clear that our payments of the future will need to have the same (or a greater) mea sure of confidence associated with it as is the case with the cur rent system. That will mean that all aspects of the network— from - 10 - the initial implicit and explicit credit judgments, to the security devices on the computer room door— will require our most aggressive thinking and design. best and our It .vill also mean, I suspect, that we will have to more fully come to grips with the whole subject of finality of payment. ment, Indeed, as I ponder this future environ I have to ask myself whether widespread use of electronics attainable without some ambitious goals involving the in banking and finance are in fact further evolution infrastructure of the payment system. of the institutional For example, unless the Fed (or any other entity with vast resources and "clout',•) is prepared to stipulate governing and unequivocally stand behind rules and time frames the finality of at least the core of these electronic payments, our goals may not be attainable. From all of this, I think it should be obvious that I believe the Federal Reserve has a clear, natural, tinuing interest in the evolution of to you and con the payments mechanism. me, at least, that is inherent in our role as a central bank. interest can arise in several ways To That including the obvious— namely, that we are a provider of payments services. However, even if com petitive forces were to fully push us out of these service areas— a result which I, for one, do not expect— that natural interest would remain intact. — I say that for several reasons: First, under any reasonable scenario that I can foresee, I think it is virtually certain that reserve balances will remain the fulcrum for the payments mechanism. In deed, the fact that reserve balances can and do play this role is one of the characteristics of the system that 11 - - permits it to work with the high degree of efficiency we have all grown so accustomed to. Having said that, we must also recognize that the absolute size of those re serve balances relative to the sheer volume and speed of transactions has already shrunk considerably and probably shrink further with more electronics. of events has already created intra-day turnover in some a situation will This turn in which the institutions' reserve ac counts has grown sharply with all that implies for poten tial intra-day and even overnight overdraf-ts accounts. That is why the Federal in reserve Reserve Board has begun to impose some greater discipline on reserve man agement practices, including daylight overdrafts, on the part of individual banks. In a future of increased elec tronics that discipline will be even more important. Another reason part of the Fed for a continued in our natural evolving interest on the payments mechanism re lates to the safety and soundness of the banking system. I have already generalized suggested use of several electronics avenues in which could— and I the emphasize could— result in increased risk to banks and other finan cial intermediaries. it is clear prepared that To the extent this occurs, the to exercise bank regulatory proper agencies surveilance to a recent example of this in must insure the principles of safety and soundness are met. seen I think connection be that We have with the action of the Federal Financial Institutions Examination 12 - Council - in developing examination guidelines and proce dures for CHIPS. Finally, also at monetary stake in For now system. future, policy the considerations future and, evolution I suspect, themselves of for the the are payments foreseeable the objectives of monetary policy are stated in terms of growth rates in the supply of money and credit. Fulfilling these objectives requires, among other things, that one can define and measure money and credit. As you well know, those are not easy tasks*even now, and I sense they future. mental will Perhaps change in only become events will the difficult ultimately apparatus tives of monetary policy. more and force in the a funda intermediate objec In either case, it is apparent that our grand design for the future will have to leave ample room exercise for some the monetary form of authorities discipline and to be restraint able to on our monetary affairs or we could be left with a potentially explosive and unmanageable system. The challenges for those of us in the Federal Reserve and those of you in the private sector are great— but so are the oppor tunities. As we seek to meet the challenges and seize the oppor tunities, we will need to muster the very best we have to offer in terms of innovation, old common sense. intelligence, and a generous dosage of good I am confident that we are up to that task, but I am also confident that we will meet some new and unexpected prob lems and challenges along the way. I hope the kind of thoughtful - 13 - consideration of these challenges that will take place at this con ference will help us all to better anticipate and solve those prob lems .
@FedFRASER