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For Release on D elivery April 14, 1981 10: 30 A. M. E.S.T. Remarks by Lyle E. Gramiey Member, Board of Governors of the Federal Reserve System at the 1981 NACHA SurePay Conference New York, New York April 14, 1981 I am delighted to have this opportunity to address the annual conference of the National Automated Clearing House Association. The bulk of my remarks today will relate to the present and future role of automated clearing houses in our nation's payments mechanism. We in the Federal Reserve share with you a lively interest in this topic. the issues involved, however, I want to consider in the larger context of the effect of the Monetary Control Act of 1980 on the provision and pricing of financial services. It is only infrequently that the Congress, the Federal agencies that regulate financial institutions, and the financial community are able to reach a consensus on major banking and financial issues of a controversial character. The enactment of the Monetary Control Act of 1980 was one such case. Act deals with several problems. the payments system are: The Those that most directly affect (1) the extension nationwide of interest- bearing checking accounts for individuals and some other depositors, (2) the placing of thrift institutions and commercial banks on an equal footing in competing for individuals' checking accounts, and (3) the requirement that the Federal Reserve price all of its financial services. This last requirement may have larger implications for the use of ACH than is generally realized. - 2 - The ACH innovation was a product of joint efforts in the public and private sectors. We in the Federal Reserve take some pride in our role in the innovational process. I want especially to acknowledge the important part played by one of my predecessors on the Board of Governors, George Mitchell. Without his tireless efforts, ACH might never have become a reality. The ACH was originally intended to handle a narrow range of payments transfers, generally low-value recurring payments. The Treasury Department was first to demonstrate the versatility of the ACH by using it to make large-value deposit transfers to State and local governments participating in the Federal Revenue Sharing Program. The banking community has begun to use the ACH to exchange consumer-initiated payments such as ATM items and telephone bill payments. A recent demonstration of the versatility of the ACH is the program that began two weeks ago with the banking industry's selection of the ACH as the mechanism for clearing truncated checks in the ABA's check safekeeping test. - 3 - Over the past decade, the ACH has developed operational procedures that provide a number of significant advantages to banks and their customers for both credit and debit transfers. However, the diversion of check and cash payments to electronic transfers through ACH thus far has been relatively small. ACH volume in 1980 was less than 250 million transfers, only about 1-1/2 percent of the 15.6 billion checks cleared by the Federal Reserve. The Federal Government is still the major user of the ACH, accounting for over 80 percent of total volume. In the fourth quarter of 1980, the ACH credits generated by the Federal Government were equal to 30 percent of its check volume. The number of Federal checks has been declining for some time--in 1980, there were 20 percent fewer than in 1975. Commercial ACH volume has grown much more slowly. True, volume growth very recently has been impressive in relative terms--nearly a 90 percent increase last year. in New York was even larger--more than 150 percent. Growth In many areas of the country, however, volume growth has been modest. During the past five years, increased commercial use of ACH has not been sufficient to stem the tide of a growing volume of commercial checks. At the Federal Reserve, commercial checks rose 38 percent from 1975 to 1980. - 4 - Some countries have been more successful than the United States in promoting the use of ACH. In the United Kingdom, for example, where payments practices rather closely resemble ours, the Bankers Automated Clearing House (BACS) began operations in the early 1970's, at about the same time as the earliest ACH associations in the U.S. handled 384 million transfers, In 1979, BACS equivalent to more than 15 percent of the 2.2 billion checks written in the U.K. Why is it that ACH volume in our country has grown so slov’ly, considering the security, convenience and potential efficiency that ACH transfers provide? A number of reasons have been advanced--such as inertia in the management of depository institutions, the difficulty of altering the public's payments habits, and the lack of electronic capability to initiate or receive transfers at smaller depository institutions. There is some truth to each of those allegations. Nevertheless, the more fundamental reason for slow growth is the lack of appropriate economic incentives. In markets for financial services, prices have not been playing the role they can play in promoting economic efficiency. - 5 - The major reason for this is the fact that, prior to passage of the Monetary Control Act of 1980, the Federal Reserve generally did not charge explicit prices for the financial services it provided to its member banks. Up until now, the Federal Reserve has always given first priority to providing the maximum certainty, reliability and promptness to its clearing and settlement functions. Tight schedules for cut-off hours and delivery times have impaired efforts to utilize equipment and staff more efficiently for processing operations. The lack of explicit prices for payments services has encouraged excessive fine-sorting at Federal Reserve offices and wasteful courier deliveries of small daily volumes. Delivery is a costly service; in 1980, courier, mail and express charges incurred by the Fed for payments services amounted to $40 million. Availability schedules have been provided for checks that make no allowance for transportation or equipment breakdowns or weather delays. Funds have been, and still are, made avail able to depositing banks on the basis of those schedules regardless of the actual collection time. The user of paper checks, moreover, has benefitted greatly from float. has given rise to payments practices, controlled disbursement, such as remote and that waste resources from the stand point of society as a whole. This - 6 - Another reason is that banks typically have not passed on to banking customers the costs of using payments services in the form of explicit prices. This is especially true as regards transfers of funds by individuals. To some degree, the lack of explicit prices for payments services to ultimate users may reflect the absence of pricing by the Federal Reserve. There is, however, no logically necessary connection between the two. Considering the environment that has prevailed in the last decade, it is not surprising that ACH volume has grown slowly. ACH transfers have been competing in a payments system in which originators of payments transfers have strong reasons to continue use of paper checks because they incur few, if any, costs in the process. More importantly perhaps, by doing so they delay the ultimate transfer of funds and thus benefit from float. The Monetary Control Act of 1980 addresses this issue by requiring the Federal Reserve to price its financial services and to open access to those services to all depository institutions. The Act stipulates that the Federal Reserve must charge prices for all of its services, including Federal Reserve float, that cover the full costs of producing them. The Act makes clear that the Federal Reserve must permit--indeed, I would say encourage--competition from the private sector in the provision of financial services. - 7 - We believe that the requirements of the MCA offer a unique opportunity for the Federal Reserve to take steps that will have profound implications for the efficiency with which payments services are provided in this country. The Act puts other requirements on us also--namely, that we ensure an adequate level of payments services nationwide. There is, as I am sure you know, concern within the Federal Reserve about whether the System can discharge these responsibilities effectively if it does not maintain an operational presence in some, if not most, areas of payments services. However, we cannot, and will not, compete in ways that are designed to "protect our turf." Our principal concern must be an efficient and effective operation of the payments mechanism. In this connection, let me comment briefly on the Board's decision to provide temporarily a subsidized price for ACH services. For all services other than ACH, the prices published by the Board are based on fully allocated costs plus a 16 percent private sector adjustment factor. ACH prices, on the other hand, are based on a projection of costs based on volumes that are large enough to realize economies of scale. We elected to price on this basis because we believe that, over the long run, the ACH will prove to be a much more efficient - means of transferring funds. 8 - Financial institutions can offer their customers secure,prompt and relatively economic electronic payment services that are more adaptable to their internal data processing operations than are paper-based transfers. Your industry has understood our purposes and supported the temporary subsidization of ACH. The Federal Reserve does not, however, intend to subsidize ACH items indefinitely. It is not our purpose to drive the paper check out of existence. event. I doubt that we could, or should, in any The paper check will almost certainly have an important role to play in the payments system for the indefinite future. The Board will review ACH prices annually to determine if the subsidy presently granted should be continued or modified. If our assumptions about ACH volume growth or economies of large-scale operations prove to be incorrect, we will not hesitate to modify them and to change our ACH unit prices accordingly. Among the pricing decisions that the Federal Reserve makes, one of the most important for the future of the ACH may well be the way in which Federal Reserve float is handled. That decision is, at the same time, of fundamental importance to the evolution of more efficient payments practices. - 9 - Pricing float in ways that increase efficiency in the payments mechanism is a complex matter. One of the knottiest problems stems from the fact that resources used to collect checks may be wasted from the standpoint of the economy as a whole. Both originators and collectors of checks presently expend substantial amount of resources to increase the avail ability of funds to themselves. Since the result is merely a transfer of money from one economic unit to another, there may be no useful social product created. Timely collection of checks is important to prevent fraud and abuse in the nation's payments mechanism. probability, however, In all the time value of money--especially in an economy with a 10 percent inflation rate--would lead to a greater use of resources to collect checks than could be justified by such considerations. moreover, This would tend to be true, even in an economy in which check collection services were provided entirely by firms in the private sector, operating under competitive conditions, and charging prices that reflect costs. - 10 - It seems to us extremely important, therefore, that we take this problem very carefully into account in handling float. Also, we believe it is important to avoid loading all of the cost of float onto the depositing institution. Efficiency in resource use is unlikely to be enhanced by charging for float unless the paying bank bears the burden and passes the cost on to the user of paper checks. Unfortunately, it is not easy to design effective procedures for shifting more of the burden of reducing float to the paying bank. The first phase of our program for dealing with float has emphasized operational improvements within the Fed with a high benefit-cost ratio. Since these improvements speed up the check-collection process while adding modestly to Federal Reserve expenditures, they put most of the burden of the resulting float reduction on the paying bank. These efforts have met with considerable success. In 1979, the daily average level of total Federal Reserve float was $6.7 billion. As a result of operational improvements, float decreased 37 percent in 1980 to a level of $4.2 billion. More recently, total Federal Reserve float has declined to below $4 billion. - 11 - The costs of the operational improvements under taken to achieve these results were added into the prices for check collection that will go into effect August 1, 1981. By increasing the costs and prices of collecting paper checks, these operational improvements will help modestly to stimulate increased use of ACH. Another program under consideration to reduce Federal Reserve float is the use of the Fed Wire to speed up the collection of large dollar-value checks. The program involves capturing the MICR data from the check and converting it into an electronic item for same-day collection, with subsequent delivery of the paper item for verification. Electronic collection of checks has important advantages over other methods of eliminating float. In effect, it provides immediate availability to the collecting bank and removes the benefit of Federal Reserve float that previously accrued to the paying bank. Because of that, it would significantly reduce payments practices (such as remote and controlled disbursement) that are very costly for the standpoint of society as a whole. - 1 ? .- If electronic collection of large dollar value checks proves viable, it will increase the incentives for a gradual evolution of the payments mechanism toward greater use of electronic payments transfers in all forms. ACH usage will, we believe, be encouraged. For certain types of payments, ACH cannot realistically be expected to displace checks, use of cash, or other electronic forms of money transfers. But it has extraordinary capabilities for making income payments of all kinds to individuals and for bill paying, particularly when the amounts are repetitive. What other steps could be taken to promote greater use of ACH technology? There are at least two that deserve mention. Last year the Federal Reserve's ACH deposit deadlines were moved up five hours by adding a night-time processing cycle. This allows corporations to receive cash payments from any ACH member in the nation on an overnight basis. Despite this improve- ent, the schedule is not as expeditious as it could be since it is still geared to the time required to serve the remote depository institutions by mail or courier. Deposit deadlines could be improved substantially if remote banks had the equip ment needed for electronic delivery. - 13 - Electronic capability to receive and originate payment advices has many advantages even for low transaction volumes. Electronic terminals are better and cheaper than they were when Governor Coldwell stressed the importance of electronic delivery at this Conference two years ago. also have many uses outside the payments mechanism. They Wide spread use of low-cost electronic terminals should be encouraged by the banking industry and the Federal Reserve. Another operational problem that needs resolution is the processing of return items. Almost 90 percent of the flow of payments between the ACHs and depository institutions is by telecommunications or magnetic tape, but all return items are initiated and handled as paper items. This causes delays, errors, and unnecessary costs to users of ACH services. The returns should be automated or, better yet, depository institutions should address and reduce the problem of NSF returns through pricing, minimal balances, or guarantees of payment below certain amounts. Returns for stop payment or fraud, of course, would not be affected. - 14 - Let me conclude by noting that we are at a watershed in th<-> history of our country's payments system. In the next several years, we are likely to see substantial movement towards a system of money transfers that is increasingly efficient. We in the Federal Reserve are confident that ACH will play a larger role in payments transfers in the future than it does today. We look forward to working with you in NACHA toward the development of a more secure and efficient payments mechanism. ###############
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