INFORMATION TO USERS

This material was produced from a microfilm copy of the original document. While the most advanced technological means to photograph and reproduce this document have been used, the quality is heavily dependent upon the quality of the original submitted.

The following explanation of techniques is provided to help you understand markings or patterns which may appear on this reproduction.

1.The sign or "target" for pages apparently lackingfrom the document photographed is "Missing Page(s)". If it was possible to obtain the missing page(s) or section, they are spliced into the film along with adjacent pages. This may have necessitated cutting thru an image and duplicating adjacent pages to insure you complete continuity.

2. When an image on the film is obliterated with a iBrge round black mark, it is an indication that the photographer suspected that the copy may have moved during exposure and thus cause a blurred image. You will find a good image o f the page in the adjacent frame.

3. When a map, drawing or chart, etc., was part of the material being photographed the photographer followed a definite method in "sectioning" the material. It is customary to begin photoing at the upper left hand corner of a large sheet and to continue photoing from left to right in equal sections with a smalt overlap. If necessary, sectioning is continued again — beginning below the first row and continuing on until complete.

4. The majority of users indicate that the textual content is of greatest value, however, a somewhat higher quality reproduction could be made from "photographs" if essential to the understanding o f the dissertation. Silver prints of "photographs" may be ordered at additional charge by writing the Order Department, giving the catalog number, title, author and specific pages you wish reproduced.

5. PLEASE NOTE: Some pages may have indistinct print. Filmed as received.

Xerox University Microfilms 300 North Zoob Rood Ann Arbor, Michigan 48106 7*4-3271

MORRIS, Russell Dale, 19*41- AN ANALYSIS OF CERTAIN ASPECTS OF THE FEDERAL RESERVE SYSTEM PAYMENTS MECHANISM PROGRAM.

The Ohio State University, Ph.D., 1973 Economics, finance

r University Microfilms, AXEROX Company, Ann Arbor, Michigan

THIS DISSERTATION HAS BEEN MICROFILMED EXACTLY AS RECEIVED. AN ANALYSIS OF CERTAIN ASPECTS OF THE FEDERAL

RESERVE SYSTEM PAYMENTS MECHANISM PROGRAM j

DISSERTATION

Presented in Partial Fulfillment of the Requirements for

the Degree Doctor of Philosophy in the Graduate

School of The Ohio State University

By

Russell Dale Morris, B.Sc., M.B.A.

* * * * *

The Ohio State University

1973

Reading Committee: Approved By

Dr. David W. Cole

Dr. Wilbur A. Rapp

Dr. Ernst Baltensperger

6 j .

Adviser Department of Business Administration ACKNOWLEDGMENTS

I am Indebted to the Wagnall'e Manorial Scholarship

Fund, Lithopolls* Ohloi The Board of Governor* of the

Federal Reserve System* and the U.S. Postal Service* whose financial support have contributed greatly toward my academic progress* and to the latter two Institutions for enlightened personnel policies which made time available for work on thle study.

On the staff of the Federal Reserve Board* Z am particularly grateful for the assistance of Mr. Joseph

Morrissey and Mrs* Ann Hanklnson in the collection* assimilation and processing of data. Messrs* Hubert White and Roy Fauber also contributed significantly in providing orltloal sounding boards for developing ideas*

I wish to express appreciation to Dr. David Cole*

Dr. Wilbur Rapp* and Dr. Ernst Baltensperger for patience and expertise* as well as constructive orltloism In the development of this study. Special thanks go to Professor

Cole for his competent administration of this project from a distance of several hundred miles.

Particular thanks go to my sister* Mrs. Robert Tice* who not only accepted the unpleasant task of typing* but also provided muoh needed editorial advloe.

11 Above all* I am grateful to my wife, Becky, without whose encouragement, patience, understanding, and unselfish support this project would have been impossible.

H i VITA

May 14, 1941 • • • • B o m - Columbus, Ohio

1 9 ^ 3 ...... B.So., The Ohio State University

1 9 6 4 ...... MBA, Tho Ohio State University

1964-1968...... The Huntington National Bank, Columbus, Ohio

1968-1970...... Teaohlng Aeeooiate, Department of Bualneea Adalnletratlon, The Ohio State University

1970-1973...... Analyst, Board of Governors of the Federal Reserve System, Washington, D.C.

1973 ...... Dlreotor of Cash Management, U.S. Postal Service, Washington, D.C.

PUBLICATIONS

"A Note on the Transaotlons Demand for Cash." Quarterly Journal of Boonomlos. UCXXV (August, 1971)» ?4b-347.

"Payments System Progress." Bankers Magazine. CLIV, No. 4 (Autumn, 1971)* 12-16. Co-authored with Hubert D. White*

lv TABLE OF CONTENTS

Page ACKNOWLEDGMENTS...... 11

VITA ...... It LIST OF TABLES...... Til

Chapter

I. DESCRIPTION, PURPOSE AND DATA...... 1

The Federal Reaerre Program Purpose and Objectives Dlreot Coat Effects Correspondent Banking Effeots Structural Implications of the Amendment to Regulation J Data Justification Limitations Outline of the Study

II. SURVEY OF THE LITERATURE...... 30

Operational Studies Correspondent Banking Banking Industry Struoture Summary and Conoluslons

III. DIRECT COST EFFECTS FOR TRANSIT CHECK PROCESSING...... 67

0Terview Selection of Representative Group Cost of Transit Prooesslng at Commercial Banks Tests of Hypotheses Marginal Cost Calculations Net Transit Volume at Respondent Banks Federal Reaerre Costs The Baltimore RCPC Lewiston RCPC Windsor Looks RCPC Cleveland RCPC Interpretation v IV. IMPLICATIONS OP REGIONAL CHECK PROCESSING CENTERS FOR CORRESPONDENT BANKING RELATIONSHIPS 107 Cheok Flow Adjustments Balance Requirement Profitability Impaot Unit Balance Requirements Reserve Requirements Earnings Rates Interpretations

V. EXPECTATIONS FROM REGULATION J ...... 131

Analysis Interpretation Conclusions VI. SUMMARY AND CONCLUSIONS AND RECOMMENDATIONS. . 152

Direct Cost Effeots Indirect Correspondent Banking Effeots Profitability and the Regulation J Amendment Considerations for Further Research Conclusions and Recommendations

APPENDIX

A 165 B 166

SELECTED BIBLIOGRAPHY 167

▼i LIST OF TABLES

Table Page 1. Federal Reaerre Regional Cheolc Processing Centers, Maroh 30, 1973...... 72 2* Distribution of Computed Coaaerolal Bank Marginal Cost of Transit Processing (Functional Cost Banks, 1970)* • ...... 83 3* Computations for 1973 Vn at Baltimore Clearing Center...... 90

*f. Estimated Aggregate Savings for Cheok Processing, Baltimore Center Area, 1973* • • 91 5. Estimated Aggregate Savings for Cheok Processing, Lewiston Center Area, 1973 • • • 93

6. Adjusted Sd , Lewiston Center, 1973 ...... 9**

7* Estimated Aggregate Savings for Cheok Processing, Windsor Looks Center Area, 1973 ...... 96 8. Estimated Aggregate Savings for Cheok Processing, Cleveland Center Area, 1973* • • 98 9* Ratio of Net Looal Volume from Respondents to New RCPC Volume, RCPC Cases ...... 102

10. Distribution of Demand Deposits Between Member and Nonmenber Participating Banks, Selected Areas as of 12-31-71 ...... 116

11. Distribution of Demand Deposits Between Member Bank Respondents, Seleoted Areas as of 1 2 - 3 1 - 7 1 ...... 116 12. Reserve Requirements and Demand Deposit Distribution for Participating Nonaember Banks, Seleoted Areas as of 12-31-71 .... 117

13* Computed Earnings Rates for Member Respondent Banks, Seleoted Areas, bp Demand Deposit S i z e ...... 118 v n 14. Computed Barnlngs Bates for Nonmember Beepondent Banks, Seleoted Areas» by Deaand Deposit S i z e ...... 119

15* Aggregate Belanoe Requirement for Displaced Cheok Colleotion Serrloes, Baltimore Area Banks* 1973Vo l u m e s ...... 120 16, Computations for S9, Baltimore Area Banks, 1973 Volumes ...... 121 17, Computations for sf, Baltimore Area Banks, 1973 Volumes ...... 121 18, Aggregate Balance Hequirement for Displaced Cheok Colleotion Serrloee, Lewiston Area Banks, 1973 Volumes...... 124 19* Computations for sf, Lewiston Area Banks, 1973 Volumes...... 124 20, Computations for sT, Lewiston Area Banks, 1973 Volumes • ...... 124 21, Aggregate Balance Hequirement for Displaced Cheok Colleotion Serrloes, Windsor Looks Area Banks, 1973 Volumes • • • • ...... 125 22, Computations for S?, Windsor Looks Area Banks, 1973 Volutes...... 125 23* Computations for sF, Windsor Looks Area Banks, 1973 Volumes...... 125 24. Aggregate Balanoe Requirement for Dlsplaoed Cheok Colleotion Serrloes, Clereland Area Banks, 1973 Volumes...... 126

25* Computations for S?, Clereland Area Banks, 1973 Volumes . 126

26, Computations for sF, Clereland Area Banks, 1973 Volumes ...... 126 27* Comparison of Value of Compensation and Cost of Cheok Clearing Serrloes, Annual Basis, 1973 Estimated Values...... 129 28, Distribution of Number of Banks by Size, Federal Reserre Membership and Payment Status, as of Deoember 31* 1971...... 133 rill 29- Computations for Batlo Ed/d for Member Banks by Size and Payment Status, as of December 31, 1971. « ...... 138

30. Computations for Liquidity Ba.tlo for Member Banks as of December 31, 1971 . . • • 142

31. Computations for Liquidity Batlo for Nonmember Banks as of December 31. 1971* • • 142

32. Computations for Liquid Investments Batlo for Member Banks as of December 31, 1971 • • 143

33. Computations for Liquid Investments Batlo for Nonmember Banks as of Deoember 31, 1971. * . 143

3*. Computations for Average B e t u m Batlo for Member Banks as of Deoember 31, 1971 * . ■ • 144

35. Computations for Average Betum Batlo for Nonmember Banks as of Deoember 31 • 1971. • • 144

36. Computations for Average Yield Ratio for Member Banks as of Deoember 31* 1971 . • • • 145

37. Computations for Average Yield Ratio for Nonmember Banks as of Deoember 31* 1971. • ■ 1*5 00

• Computations for Profitability Batlo for Member Banks as of Deoember 31f 1971 * • • • 146

39. Computations for Profitability Ratio for Nonmember Banks as of Deoember 31* 1971* • • 146

1*0. Results of Hypothesis Testing Ratio. • . • 147

ix CHAPTER I

DESCRIPTION, PURPOSE AND DATA

In January, 1970, the Federal Reserve System embarked

on a program to substantially alter the process of effecting

payments among commercial banks In the United States. The

program was begun on an experimental basis at the Baltimore

branch of the Federal Reserve Bank of Rlohmondi but by the

end of 1972, it had reaohed national scope, affecting virtu­

ally every bank in the country. The program was two pronged,

involving the establishment of Federal Reserve Regional

Check Processing Centers (RCPC's) throughout the country

and an amendment to Federal Reserve Regulation J, whioh

specifies the conditions under which Federal Reserve banks

colleot checks.

The Federal Reserve Program

On June 17, 1971, the Board of Governors of the

Federal Reserve System issued a statement of polloy on the payments mechanism. In that release the Board stated that

it considered, "Increasing the speed and efficiency with which the rapidly mounting volume of oheoks is handled * • • a matter of urgency." The Board called on Federal Reserve bankB to implement "structural changes in the present oheok 1 clearing system," that would "result In faster, more conven­

ient and more economical banking services to the public,"

The policy statement, further, called for establishing i "regional clearing facilities" to accomplish this purpose.

On February 2, 1972, the Board added operational

substance to the earlier policy statement by releasing a set

of operating guidelines, " . . . to be used by Reserve

banks In establishing Regional Centers for overnight proc­

essing and settlement of checks." The accompanying press

release stated that the Board, "ezpeoted that the new check

clearing system will result In the majority of the 62 million

checks written dally by Amerioans being oleared and paid by

the opening of business the day following deposit of a

oheok."2

An operational description of Regional Check Proc­

essing Centers Is contained In the section of this ohapter

entitled, "Direct Cost Effeots," below. In general, however,

they are Intended to reduce the aggregate cost of check col­

lection by eliminating redundant processing, and reduoe the

time required to collect oheoks through overnight processing.

In a statement accompanying the Board's Guideline

Statement, the Federal Reserve System Steering Committee on

^Statement of Policy on the Payments Mechanism. Board of Governors of the Federal Reserve System, Washington, D.C., June 17, 1971. ^Federal Reserve Press Release, dated February 2, 1972. Improving the Payments Mechanism commented that "the nation's cheok payments system should evolve In a manner that will achieve overall efficiency, taking Into account both public and private costs."^ The RCPC program was described as a step In this evolutionary process.

Between February, 1972, and Maroh, 1973* the Federal

Reserve banks responded to the Board's statements of policy and guidelines by Implementing Regional Check Processing

Centers In twenty-two looations. These were In addition to oenters already in operation In Baltimore, Miami and Denver.

The seoond phase of the Federal Reserve program, the amendment to Regulation J, was Intended to speed the flow of funds from the bank on whloh checks are drawn to the ool- leotlng bank. Prior to this amendment, banks that were neither members of clearinghouses In Federal Reserve offloe oitlejB nor participants In RCPC's were permitted to defer payment for oheoks written by their customers and presented by a Federal Reserve bank for one business day. The

Regulation J Amendment eliminated this deferment privilege.

In announcing Its Intention to amend Regulation J in a press release dated Maroh 27, 1972, the Board of Governors statedi

In considering these proposals, particularly the proposed ohange in the oheok collection prooedure, two things Bhould be kept In mlndi

3gtatement by the System Steering Committee on Improv­ ing the Payments Mechanism. Board of Governors of the Federal Reserve System, Washington, D.C., February 2, 1972. if First, the proposed new oheok collection procedures would eliminate approximately $2 billion In "float" arising out of the present practice which involves country banks paying for checks presented by the Federal Reserve in funds that are not available until the next business day after presentment of the checks.

Second, the proposed revision of oheok colleotion schedules is an Integral step in the movement being fostered by the Federal Reserve, in cooperation with the commercial banking system, to increase the efficiency of the payments system in the face of the rapidly rising volume of checks.

On June 21, 1972, the Board adopted amendments to

Regulations D and J, slightly modified from the March pro­ posal, to become effective September 21, 1972. In the public statement announcing the adoption, the Board reiterated its belief that the amendment to Regulation J would lead to a "more efficient" payments system

Prior to September 21 a group of 3*f California banks sought to enjoin the Federal Reserve System from imple­ menting its Regulation J amendment through a oourt order.

The Federal Reserve System agreed to withhold implementation pending Judicial review. In lieu of a temporary restraining order. The basis for the suit was an assertion that the

Federal Reserve Banks are not authorized to impose their regulations on nonmember banks. In subsequent hearings on motions for temporary and permanent injunctions the oourt found that Federal Reserve

^Federal Reserve Press Release, dated Maroh 27, 1972.

^Federal Reserve Press Release, dated June 21, 1972. 5 banks are impowered to specify the conditions under which

they will collect checks, and that banks which provide

checks to their oustomers containing Federal Reserve

assigned routing symbols implicitly agree to Federal Reserve bank oheok colleotion conditions* Banks have the option of not utilizing Federal Reserve assigned routing symbols* For many years non-par banks have taken this option and the

Federal Reserve Banks do not collect such checks* The delayed Regulation J amendment became effective November 9,

1972. It is clear from these statements that the objective of the Federal Reserve System in its oheok payments meohanlsm program was to reduce the aggregate cost of the oheok col­ lection network* It is also clear that as a matter of policy the Federal Reserve System was not concerned with the distribution of oheok collection costs between the public and private sectors.

At a press conference held March 27, 1972. to announce a proposed amendment to Regulation J , George W« Mltohell, member of the Federal Reserve Board of Governors, stated that with the RCPC program and the amendment to Regulation J, the Federal Reserve has done all that it oan for the oheok

The Regulation J amendment went Into effect November 9, 1972,

^Although this statement was made at the press conference, it was not part of the official press release and did not appear in the accounts of the conference in the financial press* 6

and the BCPC program, begun In January, 1970, was near

completion by Maroh, 1973.

Purpose and Objectives

The purpose of this study is- to evaluate the

Federal Reserve System*s payments mechanism program. If, as Governor Mltohell has stated, the Federal Reserve System has done all that it can for the check, It is appropriate at this time to evaluate what has been done. The evaluation is based on the Federal Reserve System's stated objective of reducing oheok collection costs as well as potential secondary effeots on correspondent banking relationships and the distribution of profits among commercial banks.

In accordance with the overall purpose of evaluating the Federal Reserve program, this study has three specific objectives. First, it is an objective of this study to ascertain whether the Federal Reserve RCPC program is meeting its stated objective of reducing the direct cost of oheok collection. The approach utilized to aohleve this objective Is to analyze in detail the operations of four representative Regional Cheok Processing Centers. The sohema developed for the analysis is desoribed in the section of this chapter entitled, "Dlreot Cost Effeots," belowj and the analysis is desoribed in Chapter III. The second objective of this study is to estimate the impact of the Federal Reserve RCPC program on interbank balanoes and on the distribution of benefits, if any, 7 between correspondent banks as a class and respondent banks

as a class. In attempting to aohleve this objective,

national average earnings and prlolng data are applied to

volume and deposit values of banks In the four RCPC areas

seleoted for analysis of dlreot cost effeots. The analyt­

ical sohema Is desoribed In the section of this chapter

entitled "Correspondent Banking Effeots," below, and the

analysis Is contained In Chapter XV.

The third objective of this study is to estimate

the effect that the November, 1972, amendment to Regulation

J will have on the distribution of profits among commercial

banks. Because requisite data describing the flow of oheok

values among banks are not available, It is necessary to approach this objective by measuring past differences In

profitability between deferred payment and same-day payment banks. The approach used In measuring those differences Is desoribed In the section of this ohapter entitled "Structural

Implications of the Amendment to Regulation J," and the analysis is contained In Chapter V.

Dlreot Cost Effeots

The Regional Cheok Processing Center program is the

Federal Reserve System's approach to reducing the dlreot oost of oheok collection. The concept of an RCPC is to eliminate redundant oheok processing and duplication of effort by establishing near-midnight deposit deadlines for local oheoks and permitting all participating banks to 8 deposit checks directly with the Federal Reserve faoillty.

In the absence of an RCPC, deposit deadlines for local checks are typically JtiOO p.m. and only member banks are permitted to deposit with a Federal Reserve bank*

The actual flow of checks between the bank of first deposit and the paying bank appears to have remained essentially unohanged between 1952 and 1970* Studies of the oheok oolleotion Industry in 1967 by Fenner and in 1970 by

Coz found similar patterns of oheok flow to those desoribed in the industry-wide study by Wurts in 1952.^ The pattern of oheok oolleotion discovered was essentially as follows*

Small banks reoeived oheoks as deposits from customers and* after separating oheoks drawn on accounts in their own bank (home debits or on-us items) forwarded their transit oheoks to a larger* regional correspondent bank for ool­ leotion. The respondent banks typloally did not separate oheoks payable looally from those payable at some dlstanoe.

Correspondent banks whloh typloally were members of olty olearlnghouses and of the Federal Reserve System would separate out home debits and sort the remaining* or transit* items as to oolleotion ohannel* Cheoks payable at other clearinghouse banks would be sorted by paying bank and

^Llnda Penner, The Cheok Colleotion System. A Quantitative Description (chloagot Bank Administration Institute, Edward Cox, The Outlook for the Nation's Cheok Payments Svatemi 1970-1980 (Washington. D.C.i Amerloan Bankers Association, l$7o)i "Study of Cheok Colleotion System," John H* Wurts* ohalrman (unpublished, Federal Reserve Bank of New York* June, 195*0 • exchanged directly In the clearinghouse. Checks payable at

other banks within the sane Federal Reserve territory were

presented directly to the paying bank or deposited with the

local Federal Reserve office for oolleotion.

Checks payable at banks in a remote Federal Reserve

territory were sent to a correspondent bank in that ter­

ritory or deposited with the local Federal Reserve office.

The deolslon criteria for selecting the appropriate channel

of oolleotion were the cost of processing, the cost of

shipping, the length of time required to gain available

funds and the average dollar value of oheoks payable at

various locations. The Federal Reserve RCFC program anticipated reducing

the cost of collecting oheoks deposited and payable within

relatively large areas surrounding regional financial

oenters. Under the February, 1972, guidelines the size of

the area served by an RCPC is to be determined by transpor- O tatlon and processing times.

The anticipated savings were expected to result from

two factors• First, in the absence of a regional oenter many checks that were deposited with a respondent bank were

channelled through a correspondent and on to the Federal

Reserve. In bypassing the correspondent the oenter elimi­ nates a commercial bank handling and reduces the aggregate

oost of collecting the checks.

^Federal Reserve Press Release, dated February 2, 1972. 10

The seoond factor relates to the oheoks that olear

through an RCPC that would not enter the Federal Reserve

System If the oenter did not exist* This "new" volume

consists of three oomponents.

The first component was the volume for which a

noncollecting bank was the bank of first deposit* Without

a oenter these items would have been deposited by the

respondent with a collecting bank correspondent, and subse­

quently presented for payment by the correspondent* For

these items the aggregate cost effeot is the difference in

unit cost of processing between the regional oenter and the

collecting bank multiplied by the volume of such items.

While it is not neoessarlly the case that Federal

Reserve Regional Centers and correspondent banks would have different costs for processing and collecting oheoks, it is not unreasonable to believe that they might. Factors that would contribute to cost differences arei (1) differences

in time patterns for receipt and dlspatoh of oheoks, which affects oapaolty requirementsi (2) differences in sorting patterns for distribution of transit oheoks, which affeotB the efficiency of utilization of computer equipment) and

(3) differences in transportation arrangements for presenting oheoks.

The seoond component of "new" volume was the volume of items deposited in a respondent payable at its correspond­ ent* For these items a oenter adds an additional handling! that is, the oheoks now go through the RCPC rather than 11 directly to the paying bank. Under the assumption that no

significant savings occur in home debit processing because

of a center, the cost to the Federal Reserve of processing

these items tends to increase the aggregate oost of cheok

colleotion.

The third component of "new" oheoks to the Federal

Reserve was the volume of items that would be collected

directly by the bank of first deposit if a regional oenter

did not exist. With the establishment of a center, such

items are routed through the RCPC (exclusive of continuing

local clearings). While there may be limited savings to

commercial banks due to a reduction in the number of end points for sorting, it is clear that a cost increase results from routing these items through the Federal Reserve. The increase amounts approximately to the processing cost to the

Federal Reserve.

For the purpose of evaluation, the anticipated oost savings may be structured in a schema as followst

Define*

* Volume of items of type i first deposited in bank class J

MC^ t= Marginal oost of transit processing for commercial banks

MC? *= Marginal oost of transit processing for Federal Reserve regional centers.

Sd B Total dlreot oost savings 12 supersorlpts on V

r & respondent or noncolleoting bank

o e correspondent or collecting bank

none • total volume of that class

subscripts on V

n e new items to the Federal Reserve System

0 = items payable outside the regional clearing area

a *= items previously handled by the Fed after passing through two banks

ho = home debit at the respondent's correspondent

t s total transit volume

1 *= items payable within the olearlng area

Thus, savings may be defined as (1-1)

Sd ■= vj (MC? - HC?) + Va (MC®) - vj0 (MO?) - V° (MC?)

(It should be noted from the above discussion that

does not contain v£0.) oomblning terms, gives»

Sfl ■ MC?

NnewM volume to the Fed, that 1st

(Vn + Vge + V°) c Vn . (1-3) so, equation (1-2) may be simplified asi

S4 « MC? (Vj + Va ) - MC? (Vn ) (I-lf)

That Is, direct oost savings equal the marginal processing oost to banks times the items that now avoid redundent handling, minus the oost to the Fed of handling new volume. Further, since the volume of items now avoiding double

handling equals total transit volume at respondents minus

"new" Items to the Fed and nonlooal itemsi

(1-5) then, adding V£ to both sides of (1-5) shows that the first

term in parentheses in (I-1*) Is equal to total local transit

volume at respondent banks. tv ; + va) = (V? - v j - vg0) = V[ - Vg0 = (v p * (1-6)

so that a computational formula for total dlreot oost

savings may be stated ast

Sd * MC® (V{)* - Yicl (Vn ) (1-7) where (vf)* = vj - v£0 Chapter III of this study applies this schema to a

sample of existing RCPC's to evaluate the performance of

the Federal Reserve System In meeting Its oost reduction

objective. The analysis consists of estimating values on

the right hand side of (1-7) to solve for an estimate of Sd .

Correspondent Banking Effeots

From the previous section it Is clear that the

suooess of the Federal Reserve System In meeting its oost

reduction objectives Is dependent on the ability of the

RCPC's to attract the dlreot deposits of respondent banks.

In so doing the Federal Reserve Is offering without charge a

service that has traditionally been sold to respondents by 1* correspondent banks. Essentially, the Pederal Reserve is monopolizing a market that has traditionally been supplied

in'the private sector.

Respondent banks pay for correspondent-provided oheok

collection services by maintaining a balance sufficient to permit the correspondent's investment earnings to cover the price of the service. If the respondent is able to acquire check collection services from the Pederal Reserve without charge, it may reduce its balance with the correspondent, or

if it is restricted from doing so by state reserve require­ ments, it may purchase other services of equivalent value.

Assuming respondent banks do shift deposits of local items to the Pederal Reserve RCPC, correspondents lose the earnings from investment of interbank balances, either directly or in the production of other services. The offset to this loss is a reduction in the oost of processing local transit items that would otherwise be deposited.

It is possible to evaluate these two indirect effeots of the establishment of RCPC's in the following framework.

Definei

B t= Collected compensating balance required by correspondent

P *= Unit prloe of cheok processing for respondents

b Earnings rate applied by correspondent to lnveatable balances for determining balance requirement

k 2 s Average before tax earnings rate on lnvestable funds by correspondent 15 K, * Average before tax eamlnge rate In lnveatable D funds by respondent

r« m fieserve requirement applied by correspondent to oolleoted balanoes for determining balance requirement

r» ■ Marginal reserve requirement rate for correspondent

r, «= Marginal reserve requirement rate for respondent j Other symbols as defined in the previous section.

The correspondent states his price for oheok ool- lection services to his respondent banks In terms of a compensating balance. The correspondent's long run require­ ment is that his revenue oover his costs. That is,

K2 (B.r2B ) > 0 or. B ^ k '( & 2) where C is total cost including return to oapltal.

In stating his prioe, however, the correspondent is free to adjust K and r to make them appear more palatable.

Further, oheok processing servloes are typically stated in terms of unit prices, P, which gives the correspondent additional flexibility in stating balance requirements as long as the following condition is met.

„ P*vT w C B * K^l-r^^K 2(l-r2) In competitive markets it would be expected that the

Inequality would beoome an equality.

The respondent does not observe "C" in the market p and must aooept or rejeet Rj (1-fj7 *s the unit balance requirement for oheok collection services. Since it is known that respondents do purchase oheok collection servloes 16 from correspondents, a profit maximizing assumption for respondents Is that they will hold as little as they can get away with In compensating balances. That is, for respondents the objeotlve is ae-—^ KJTT^rJT Because there Is only one point of Intersection between the two objectives( at

B * Ki(T -fi.) ’ (I_8> that Is the expected result. As a practical matter It is not likely that this oondltlon exists every day. but since deficient and exoess balances oan be adjusted over time. It

Is not unreasonable to expect that Equation (1-8) holds on average over time.

The correspondent bank does not reduce Its cost by the entire amount of vj, because It still must process Its own home debit portion, even though those Items are received from a new souroe (the RCPC). The correspondent loses inoome from investing the investable balance at its earnings rate, Kg, not at Its allowed rate, • Thus the correspond­ ent indirect savings from the RCPC may be identified asi

sj - MC® •

sj « K 3 B (l-r3) (1-10)

Chapter IV of this study analyses the net impact of

RCPC1s on the correspondent-respondent relationship by estimating the appropriate values to solve equations (1-9) 17 and (1-10). The analysis is restricted to a representative group of RCPC areas* Selection of the representative group

Is discussed In Chapter III*

Structural Implications of the Amendment to Regulation""?

Prior to the November 9. 1972* amendment to Federal

Reserve Regulation J, banks that did not participate In clearinghouses or regional clearing arrangements In Federal

Reserve office cities deferred payment for checks presented by Federal Reserve banks for one business day* Such banks are known as "country banks.M Clearinghouse banks ("city banks") have for many years paid for oheoks presented by the Federal Reserve on the day of presentment.

The amendment to Regulation J revoked the deferment privilege of country banks by requiring all banks to pay for their checks on the day of presentment. This revocation should be expected to have resulted In a shift of lnvestable funds among groups of banks.

For any Individual Federal Reserve office It Is possible to Identify five classes of checks for collection purposes. It Is useful to describe the five classes In order to describe the effects of the Regulation J amendment on various bank groups. 1. Same zone "city" oheoks are checks drawn on clearinghouse or regional center banks local to the Federal Reserve office In question. Such oheoks were paid for on 18 the day of presentment before the Regulation J amendment and, therefore, were not affected. Deposit deadlines at

Federal Reserve offices for such checks are typically near midnight for regional center oheoks and near 6t00 a.m. for clearinghouse Items.

2. Same zone "country1' checks are the oheoks for which the Federal Reserve office In question Is the last collecting bank, and which held deferred payment status prior to the amendment to Regulation J. The typloal deposit deadline for suoh Items Is 4i00 p.m.

Prior to November 9» 1972, Federal Reserve offices received payment and passed oredlt for same zone country oheoks on the second business day after the day of deposit.

Under the amended regulation, payment and oredlt have been advanced one day.

3. Inter-dlstrlot one day city oheoks are Items payable at "city" banks In other Federal Reserve office oltles that are sufficiently close to the office In question that oheoks can be transported, presented and paid for on the day following deposit at the first Federal Reserve office. The Regulation J amendment did not affect the one day deferment of these Items*

4. Inter-dlstrlot two day city oheoks are Identical to the third olass above, except that the oltles In which the paying banks are looated are too far distant to present 19 the checks on an overnight basis. The Regulation J amend­ ment did not affect the payment or credit date for such items. 5. Inter-district country checks are checks drawn on country banks in other Federal Reserve territories.

Although, prior to the 1972 amendment to Regulation J,

Federal Reserve banks required three days to oollect inter- district oountry checks) since 1952, the Federal Reserve

System as a matter of policy has passed oredlt to depositing member banks for suoh items on the second business day after deposit. The one additional day required for collection generated Federal Reserve float. The amendment to Regulation J reduced collection time for inter-distrlot country checks from three days to two, but the Federal Reserve banks have not altered their defer­ ment schedules for suoh items. The result, therefore, has been to reduce Federal Reserve float, and funds availability to colleoting banks has not been affooted.

From the standpoint of commercial banks, then, the

1972 amendment to Regulation J had the following effoots.

1. All oountry banks pay for oheoks drawn by their customers and presented by the Federal Reserve one business day earlier than before. This faot tends to reduce invest- able funds to oountry banks,

2. All banks receive credit one day earlier for oheoks drawn on oountry banks located in the same Federal 20

Reserve territory and collected through the Federal Reserve

System. Although Federal Reserve Bank records would Indicate the gross loss of funds for each oountry bank due to the

Regulation J amendment, the complexity of check collection arrangements prohibits the computation of net losses and gains. Smaller country banks that deposit their transit items with a correspondent for collection are the ultimate beneflclarleB of much of the earlier availability on same zone country Items, but data are not available to permit segregation of the funds made available earlier by bank of first deposit. The published studies of the oheok collection indus­ try and interviews with commercial bankers indicate a large variance in the ratio of same zone country checks to total transit value among oountry banks. Further, there exists a wide range of accounting practices among correspondent and respondent banks with a resulting wide range of impact and conceptualization of the impact of the Regulation J amend­ ment. Consequently, it is not feasible to measure the shift in available funds due to the Regulation J amendment in a manner that is meaningful for evaluation of the impact on the structure of the industry.

It should be expected that, relative to city banks, banks that are able to pay for their customers' oheoks on a deferred basis would be more profitable, ceteris paribus, for two reasons. First, and most apparent, by deferring 21

payment country banka should have had more funds available

to Invest per dollar of demand deposit than banks that paid

on the day of presentment. Second, deferred payment status allows the paying

bank an additional business day of reaction time for

portfolio adjustments. Thus, it would be expected that

deferred payment banks would hold less liquid, higher

yielding assets as a liquidity reserve so that average

return on earning assets would be higher than for city banks,

other things equal. The first effect was tested in this study by compar­

ing the ratio of earning assets attributable to demand deposits to total demand deposits between city and country banks of like size. The second effect was tested by

comparing a series of income and asset relationships between

city and country banks of like size. The analysis is

contained in Chapter V.

Data

This section desoribes the data utilized in the

study. Methodology for analysis of cost effects, indirect

correspondent balance effects and Regulation J effects are

contained in Chapters III, IV, and V, respectively.

Check volumes

Check volume data are required for estimation of

values for (1-7), (1-8), and (1-9)• The partloular volumes 22 required are v j, the locally payable transit volume depos­

ited in respondent banksv and (V*)*, the V* net of suoh oheoks that are payable at the correspondent of the bank of first deposit, v£0 .

If all respondent banks in an RCPC area were to take advantage of the free servloe being offered by the Federal

Reserve, then the volume of RCPC area oheoks deposited with the RCPC by respondent banks would correspond identically to

V*. To the extent that respondents do not take advantage of the free servloe and continue to deposit local transit items with their correspondent, that volume will show up at the

Federal Reserve as new volume, Vn , or as old volume, Va , or it ' i s . oolleoted outside the RCPC.

In order to utilize a survey of RCPC deposits by respondent banks as an estimate of V*, it is necessary to determine whether measurement errors due to continued correspondent deposits impair the estimate of savings, S^.

First, the RCPC is neutral with respect to items included In continuing correspondent deposits that are oolleoted outside the RCPC, Vjjc and clearinghouse oheoks, so that suoh oheoks would not impair the estimate.

* Second, if suoh items come to the RCPC as they tend to lnorease oheok collection costs and the schema treats in this way, so that measurement would not be impaired. Finally, if suoh oontlnued deposits have historically been redeposlted at the Federal Reserve bank and oontlnue to be so deposited, they are included in Va , 23 and the RCPC is neutral Kith respeet to the cost of

collection. The measurement equation (1-7) is neutral with

respect to Va , It may be concluded, therefore, that continued

correspondent deposits do not violate the adequacy of equation (1-7) to measure direct oost savings. It may also be concluded that a survey of respondent bank deposits of

RCPC area items at the RCPC provides an estimate of V* satisfactory for deriving a solution to equation (1-7)•

Therefore, the estimate of v£ utilized in the study was an annualized value for a one-week survey of local volumes deposited at the four RCPC*s selected as a representative group.

The values for vjj0 came directly, as a percentage of deposits of local respondents, from a 1972 survey of commercial banks in the areas analyzed. The survey form and list of respondents utilized In this study are attached as

Appendixes A and B, respectively.

The values utilized for Vn , new volume at Federal

Reserve offices due to the establishment of an RCPC, came from estimates of suoh volume developed by Federal Reserve bank officers and included in proposals for RCFC's submitted to the Board of Governors. The estimate of Vn for the

Baltimore oenter was based on a projection of the historic growth pattern of volume as described in Chapter III. 2**

Costs

The Federal Reserve cost data utilized in this study

oame from two sources, the proposals submitted by Federal

Reserve banks to the Board of Governors for establishment

of RCPC's, and the Federal Reserve Functional Expense Report, an internal System document*

The commercial bank cost data utilized in this study were from the Federal Reserve Functional Cost Analysis

Program. Despite certain limitations of these data for certain types of studies, they have considerable appeal for this study. First, only the costs of large correspondent banks are considered in this study, so the small bank bias of the

FCA data file is not restrictive. Only the costs of banks with over $50*000,000 in demand deposits are utilized. Second, the Interest of this study is in the direct variable cost of check processing, not fully burdened or total oost. The FCA participating banks identify direct costs by oategory and by funotlon.

Third, FCA participating banks report demand deposit t activity for the same period that they report oosts. This enables the avoidanoe of uncertainty that would result from estimating volumes independent of costs.

The FCA file utilized in this study is the report for the year 1970. Although data for 1971 and 1972 have been oolleoted by the Federal Reserve* they have not been edited, 25 and as suoh they contain duplications and keypunch errors so

as to make them unacceptable for this study.

Correspondent pricing

Under the auspices of the Federal Reserve Bank of

Kansas City the Federal Reserve System In July, 1972,

surveyed the pricing practices of 85 large correspondent banks in all areas of the country except the Sixth and Tenth

Federal Reserve Districts. All 85 banks are Included in the largest 125 banks by size of deposits due to other banks as of December 31t 1971* The results of the survey were reported by Robert Knight of the Federal Reserve Bank of Kansas City In October, 1972.9 The values for P, r^, and K^ were taken directly from Knight's reported survey results.

Additional sources

In addition to the sources described above, Chapter V of this study utilized the Statement of Inoome for the year,

19711 end the Statement of Condition (Call Report) as of

December 31* 1971* These reports are oolleoted on a regular basis from all Insured banks by the FDIC.

^Robert E. Knight, "Innovations and Trends in Bank Aooount Analysis" (remarks presented at the National Correspondent Banking Seminar, New Orleans, Louisiana, October 30 , 1972). 2 6 Justification

The Federal Reserve System Is a self-budgeting

congressional agency with considerable autonomy. The

Congress, through the Federal Reserve Act of 1913 with

subsequent amendments, has delegated to the Federal Reserve

System the constitutional authority for managing the

country's money supply. In addition, the Congress has

assigned numerous other duties to the Board of Governors

and to the System.

The exclusive franchise to manage the money supply

provides the Federal Reserve System with a substantial port­

folio of Interest-bearing U. S. Treasury obligations.

Although the Interest on the Federal Reserve System's port­

folio represents an allocation of tax revenues, It Is also

Income to the Federal Reserve. The Federal Reserve System

returns Its "profits'1 to the Treasury, but the System's

budget Is not subject to pre-expenditure review by the

Congress. Thus, the Federal Reserve System Is In the

position of spending tax receipts without dlreot legislative

allocation.

In the absenoe of either hearings or legislation relating to the Federal Reserve payments meohanism program

It may be assumed that the Congress is In agreement with

the stated objectives. Nevertheless, the Congress has the responsibility and the public has the right to evaluate the performance of the Federal Reserve System in attempting to 27 achieve Its objectives. This study Is designed to fill the

requirement for evaluation of Federal Reserve performance In

the payments area. There are additional areas of public policy to which

this study relates. First, in the Regional Check Processing

Center program, the Federal Reserve System may be absorbing

a larger share of the cost of sorting checks. To the extent

that such a practice may lead in the direction of developing

a controlled public utility or a Federal Reserve monopoly

in the field of payments processing, this issue is of

considerable public concern.

Second, the actions taken by the Federal Reserve during the period studied may significantly affect the distribution of investable funds among classes of banks.

Because of the degree of regulation of commercial banks, a product of state and national legislation, it must be assumed that the existing structure of the industry, that has resulted from the regulation, is desired by the various legislatures. Therefore, actions by the Federal Reserve

System that affect the industry struoture are potentially disruptive of legislative objectives.

This study does not address these questions of publlo policy. The study does, however, provide a basis for evaluating the performance of the Federal Reserve System in light of these and other policy issues. 28

Limitations

This study Is limited by the absence of perfect data#

The limitations are particularly apparent In the routing and

volumes of checks and the cost of processing checks In

commercial banks.

Utilization of Functional Cost Analysis banks for

commercial bank cost data Is problematical because of the

opportunity for Inconsistency In reporting practices among

banks. What some banks may Include as overhead may be

Included as direct costs by others* There Is considerable

leeway In Interpretation,

A second problem for the analysis due to the neces­

sity of depending on FCA data Is the opportunity for Incon­

sistency In reporting volumes. Banks are requested to estimate If volumes are not known. It Is likely, however, that this problem Is minimized by restricting the use of

FCA data to large banks.

A third limitation of FCA data Is Its questionable representativeness. Because oheok processing technology Is widely shared through equipment manufacturers and trade organizations, however, this limitation Is not likely severe.

That is, the cost functions for large banks are expected to be similar,

The absence of detailed volume and routing data for transit oheok collection particularly limits the ability to analyze the effeots of the Regulation J amendment* The 29 value of oheoks paid for earlier because of the amendment could be determined by analysis of Federal Reserve Bank presentments. It Is not possible to determine the distri­ bution of earlier credit among banks• however, because It Is not feasible to Identify the bank of first deposit for checks deposited with the Federal Reserve. It Is neces­ sary, therefore, to estimate the effects of the amendment by comparing past performance ratios.

Outline of the Study

The balance of this paper proceeds as follows.

Chapter II contains a survey of relevant literature with a discussion of the findings that relate to this study and the gaps that this study attempts to fill. Chapters III, IV, and V contain the analyses of direct cost effects, Indirect correspondent banking effects and the Impact of the

Regulation J amendment, respectively.

Each of these chapters contains a conclusions section which Interprets the analysis of that chapter Independent of the other effects. Chapter VI discusses the combined effects and develops overall conclusions regarding the propriety of the Federal Reserve payments mechanism program. CHAPTER II

SURVEY OP THE LITERATURE

The purpose of this ohepter Is to describe previous work related to this study in order to identify gaps in the literature of the banking Industry that this study attempts to fill, and in order to validate oertaln assumptions upon which various facets of the analysis are based, Bsoause this study is concerned with a unique phenomenon, the

Pederal Reserve Payments Meohanlsm Program, there are no previous studies sufficiently similar to provide guidelines for the analysis. There have been, however, numerous studies of the banking Industry related to the general subject matter of each of the three parts of this analysis that provide a basis upon which this study is built.

The balanoe of this chapter is divided into four seotlons. The immediately following section, entitled

"Operational Studies" dlsousses a series of studies that have desorlbed the oheok oolleotion industry, lnoluding the operating oosts of oheok oolleotion.

The immediately following seotlon dlsousses the relevant literature relating to the correspondent banking industry. The literature disoussed relates primarily to 30 31 the role of oheok oolleotion In the oorreepondent banking relationship.

The third eeotlon is titled "Industry Structure."

This eeotlon deeorlbee the development of banking industry structure theory to its ourrent state, and dlsousses the problems involved in developing suoh a theory.

The final section of this ohapter dlsousses the links between this study and the existing literature and the gaps that this study attempts to fill. The eeotlon also dis- ousses the rationale for the analytloal approach taken In this study in comparison with related studies.

Operational Studies

This eeotlon dlsousses five studies of the oheok oolleotion prooess that were undertaken to provide a basis for designing improvements in the flow of payments. The time period covered by those studies is 1952 to 1972.

The initial modem effort to desorlbs the oheok oolleotion network on a national soale was Jointly sponsored by the Amerloan Bankers Assooiatlon, The Assooiatlon of

Beserve City Bankers and The Conferenoe of Presidents of the

Federal Beserve Banks. The study, whloh was based on a

July, 1952 survey of 770 banks representing 52 per oent of all bank deposits as of June 30, 1952, and all Federal

Beserve offloes, had the following objeotlve, " to determine whether fundamental improvements oould be made in ourrent oheok oolleotion methods and praotloes, with a view 32 to increasing the epeed and efficiency of oheok oolleotion

In the Interests of the banking system and the general public,"1

The report of the study oommlttee, whloh is usually referred to as the Vurts Beport after the oommlttee chairman, desorlbed the typical oheok oolleotion and payment proce­ dures for fire sice groups of banks, and distinguished between reserve olty banks and oountry banks. The oommlttee oonoluded that lnefflolenoies and delays resulted from overuse of the correspondent banking system for oheoks payable near the bank of first deposit and underuse of the correspondent system for oheoks payable in other Federal

Beserve dlstrlots.

In the former oase. Instances were olted in whloh the bank of deposit and the paying bank were looated within walking dlstanoe but the oheoks traveled several miles to a correspondent then to the Federal Beserve Bank and baok to the paying bank, while they might have been exohanged directly. In the latter oase many oheoks traveled olroul- tous routes through the Federal Beserve System rather than dlreotly through the correspondent system. For example, a oheok deposited in Columbus, Ohio, payable In Indianapolis might have traveled from Columbus to the Cleveland Federal Reserve

Bank then to the Chloago Federal Beserve Bank and finally to

lMStudy of Cheok Oolleotion System," John H, Hurts, ohalrman (unpubllahed. Federal Beserve Bank of New Xork, June, 195*0* P* 13* 33 the paying bank. If tha oheok were aant directly to the

Indlanapolla bank, two prooaaalng banka and at laaat two day# oould ba eliminated from tha oollaotlon flow.

Tha Wurte committee reoommended that olaarlnghouaaa be expanded In area and partlolpante to lnoluda more banka

In exlatlng olearlng arrangements and that olaarlnghouaaa or dlraot exchange of ohaoka ba Implemented in areaa where they did not previously axlat. Tha aeoond reoommendatlon waa for tha Federal Reserve banka to aooapt deposits dlreotly from nonmambar banka to avoid redundant handling of ohaoka.

Finally, tha oommlttee reoommended that banka utilise correspondents for oolleotlng interdistriot ohaoka to a greater extent. The oommlttee expreaaed the opinion that Implementa­ tion of Its reoommendatlone would not affeot correspondent relationships slgnlfloantly. nor did they believe that resultant faster presentment and payment would alter the relative earnings or the oompetltive position of affeoted banks. These opinions were not based on analysis of the data.

Beoause of disagreement among the sponsoring agenoles on the seoond reoommendatlon. the report was neither widely distributed nor Implemented on a systematic national basis.

The Federal Reserve Regional Cheok Processing Center Program did effectively institute the first two reoommendatlons sixteen years later. By 1966, considerable interest had been generated in

the banking oomaunity in the possibility of replacing oheoks

with eleotronio fund transfers (EFT). George W. Mitohell,

member of the Pederal Reserve Board* spoke on the topio at

the 1965 convention of the Aaerloan Eoonoalos Association,2

and various Federal Beserve and trade publications disoussed

the subject in a rather matter-of-fact manner.3

In light of this thinking the Subcommittee on Improv­

ing the Payments Heohanisa of the Conference of Presidents

of the Federal Beserve Banks commissioned the Stanford

Besearoh Institute to conduct a study of the availability of

oost savings in an EFT system, in early 1966. The SBI study

inoluded a survey of all Federal Beserve offioes and

seventy-three large commercial banks in an effort to

identify the flow of payments and the oost components.

With respect to the flow of oheoks the SBI report**

indicated that the pattern had not changed significantly from that found by the Hurts oommlttee fourteen years

earlier. With respeot to oosts, SBI applied weights to

2George H. Mitohell, "Bffeote of Automation on the Structure and Functions of Banking." AasrloanEoonomlo Review. Vol. LVI, Mo. 2 (May, 1966), pp. l$9-66.

^See, for example, Federal Beserve Bank of Blohmond, "The Giro, the Computer, and Cheokless Banking,” Monthly Bevlew. April, 1966, pp. 2-5t Bobert V. Head, "The Cheokless Sooiefcy,” Datamation. Vol. XII (Hatoh, 1966), pp. 22-27.

**B. Cox, A. W. Dana, and H. M. Zeldler, "A Teohno- Eoonomio Study of Methods of Improving the Payments Mechanism," (unpublished study, Menlo Park, California, Dsoember, 1966)• 35 volumes in a manner similar to tha Federal Reserve Functional Cost Analjsls Prograa in ordar to estimate tha aggregate oost of tha ohaok oollaotion prooass to tha hanking industry* Tha study did not oonsldar dlffaranoas in oost elaaants for dlffarant oatagorias of ohaoks* Tha resulting estimate of $2*3 billion total oost to tha banking syeten equates to approximately thirteen cants par average ohaok on a fully oostad basis* During 1967* tha Bank Administration Institute (BAI) and tha Basaaroh Institute of tha Illinois Institute of

Teohnology (IITHI) jointly oonduoted two surveys of prooasslng steps and ohaok flows in tha ohaok oollaotion network* Tha first survey was of a general nature and

Included eighty-two banks ranging in size from lass than tan million dollars in total deposits to over one billion*

Tha saoond survey oolleoted highly detailed data from six large banks in five oltles.

These surveys lad to tha produotlon of three doou- aenta. Tha first, entitled "Design of a Communications

System for Interbank Information Bxohange,"^ was a 00m- munloations system design dooument for developing a national information exohange network* That dooument is of little Interest to this study beoause of the breadth of the subjeot matter oonsldered*

^Illinois Institute of Teohnology, Researoh Institute, "Design of a Communications System for Interbank Information Bxohange” (unpublished, Chloago, 1968). 3 * The second document, whloh was released In 1969 end entitled An Bleotronlo Network for Interbank Payment

Communications. attempted to refine the results of the first study by defining the oommunloatlon problem to inolude only the exohange of payments data* The 1969 report also contained oost estimates for both oheok and EFT processing*

The third report was released In 1970 and entitled, 7 The Check Collection 8ystemt A Quantitative Description.

This report contained detailed value and volume oheok flow distributions* The flow patterns reported were substan­ tially similar to those that had been reported by SBI and by the Wurts committee* Neither of the earlier studies

Included dollar value distributions*

The oost estimates In bhe 1969 "Bleotronlo Network" report were based on applying standard costs developed by the BAX over a period of time to the processing steps

Identified in the survey. The resulting estimate for dlreot oost of transit oheok processing was $0*0137 per oheok* The oostlng prooess excluded overhead oosts*

During 1969, the Amerloan Bankers Assooiatlon formed a polloy level committee of oommerolal bankers, named the

Monetary and Payments Systems (MAPS) Committee, to

^Bank Administration Institute, An Bleotronlo Network for Interbank Payment Communications (Chicago1 Bank Administration institute, 1909)* ?Llnda Fenner and B* V* Long, The Check Collection System» A Quantitative Description (Chicago1 Bank Administration Institute, 19/Oj. inveatlgate the lmplloatlone of oheokleae banking for tho banking induetry. Tha eoamlttee in turn oraatad four taak foroaa for Operationa Teohnology, Marketing, Eoonoaloa, and

Legel/Leglalatlve mattara,

Tha Oparmtiona Taohnology taak foroa oommiaaionad

Arthur D. Littla (ADL), a nanaganant oonaulting firm, to atudy tha aziating ohaok paymente ayatam, "to datarmina whether tha praaant ayatam ia oapabla of baing auatainad in Q an oparmtionally aound condition until 1980*"

Tha ADL ataff atudiad operating prooaduraa in detail in fifty-two oommarolal banka and fiftaan Federal Beaerve offloaa looatad in alxtaan flnanolal oentere. Additionally, 188 banka in amallar oommunltlaa wara surveyed in a more general manner. Tha aurveye were oonduoted during April and

Kay, 1970, with all participating banka larger than

25 million dollara in total depoaita.

Tha ADL report oontalned dlreot, unburdened oost eatlmatea for varloua ohaok prooeealng funotiona. An approximation of tha ooat of ohaoka may be obtained by auaaing proof and enooding, and tranait prooaaaing to gat

#0.0142 par item. Thia value la dlffloult to oompare dlreotly with tha BAI aatimata above baoauae funotiona are defined aonewhat differently. Tha ADL figure doaa not identify aaparataly ooata for raoaivlng and initial

®Edward Cox, The Outlook for the Nation*a Chaok Pavwanta Svatami 19TO-l4d6 tWaanlnaton. D.C.i Amerioan Bankara Aaaoolatlon, 197*)• P* !• processing, but appears to include the ooete in the proof and enooding function. The relative order of magnitude it, however, similar, and seemingly oomparable. One result oontained in the Arthur D, Little report

that was assumed bj earlier studies but not treated analyti­

cally was the existence of limited soale economies in oheok processing. This result was achieved by plotting reported total oost for all banks reporting against oheok volumes prooessed. The most recent researoh published on oheok pro­ cessing oosts was the result of what has become known as the

Atlanta Payments Project, During 1970, the Federal Beserve

Bank of Atlanta sponsored a massive data gathering and analysis projeot at the Georgia Institute of Teohnology,

The original projeot had the objective of defining the existing payments system in detail, lnoludlng the retail level, for the purpose of designing a replacement EFT system, for the Florida, Georgia two-state area. Support of the projeot has subsequently been taken over by the large

Atlanta banks and the system under design is for the Atlanta area only. The results of the Atlanta studies have been pub­ lished in two multi-volume reports. The first report, released in 1971 and entitled Phase I-II Reporti Researoh on Improvements in the Payments Meohanlsm. oontained flow of payments descriptions and attitude surveys for banks, 39 Individual! and firms .9 Tha flow of ohaoka after dapoait in

a bank waa not found to differ froa the 1952 Wurte results*

Tha "Phase III Report," released in 1972, contained

oost estimates and systea design specifioationa for an

autoaated clearinghouse for tha electronic transfer of funds

aaong banka.10 The Atlanta approaoh to ohaok processing

oost ooaputation waa at variance with tha approaoh taken in

the studies diaouaaed above, and is not consistent with tha approaoh taken in this study.

Tha Atlanta group defined a set of ooat nodules and oonputed tha fully burdened oost of each. The five large

Atlanta banka ware used as a saaple group and adjustments were aade within tha banks to insure uniformity in reporting.

As a result tha report defines two olasaas of transit iteas with different ooats. Transit itens raoeivad froa tha nonbank publio were oaloulated to oost $0.1055 P«r oheok. Transit iteas raoeivad froa another bank for oolleotion ooat $0.0268 per oheok. These oosts ware on a fully allooated basis.

Tha Atlanta projeot teas was able to work In depth with tha five sponsoring banks and as a result it is likely that their results are the aost complete and oonsistent of

?Paul Han, Phase .1-11 Report i Researoh on Improve- ents in the Payments Heohanisa (AtlantaiGeorgia Tsoh gesearoh Institute, Georgia Institute of Teohnology, 1971). 10Alan H. Llpls, Phase III Report» Bsasaroh on Improvements In the Payments Heohanisa I Atlanta i Georgia Teoh Researoh Institute, Georgia Institute of Teohnology, 1972). 40 all processing coat studies. Because their cost modules

included both branch costs and overhead, however, utili­ zation of the Atlanta cost results as estimates of available savings from switching to an alternative payments system requires an assumption that sufficient oheok volume would be avoided to reduce the number of branches and avoid overhead

oosts. This study assumes that the flow of oheoks after first deposit will be altered by Regional Check Processing

Centers, but it does not assume that the need for branohes will diminishi nor is it assumed that volume reductions will be sufficient in large banks to avoid overhead costs.

Therefore, the Atlanta oost results are not considered applicable to the problem at hand.

Correspondent Banking

Correspondent banking relationships have been subjected to considerable analysis within the Federal

Reserve System, especially at the Federal Reserve Bank of

Kansas Cltyi but have received limited aoademlo attention outside that sphere. The Federal Reserve publications treat correspondent banking servloes almost as a distinct product linei whereas others apparently do not distinguish banking servloes on the basis of class of oustomer. The following paragraphs are Intended to lndloate the role of the traditional correspondent banking system in oheok oolleotlon. 41

Of the approximately 21*5 billion oheoks written in the United States in 197011 about 20 per oent or 4*3 billion were payable at the bank of first deposit,*2 and about

6.8 billion were oolleoted by Pederal Reserve banks.*3 Of the remaining 10.4 billion oheoks, about 60 per oent were presented dlreotly to the paying bank either through clearinghouses or informal agreements* The remainder were oolleoted through correspondent banking networks in which a large bank serves as a olearing center for its smaller 1 4 respondents*

This figure, 4*2 billion oheoks for 1970, understates the Importance of correspondent relationships for oheok oolleotlon, however, because many of the oheoks presented through clearinghouses and Pederal Reserve banks were earlier deposited with correspondents by other banks* It has been estimated that, on the average, a oheok presented by a Pederal Reserve bank has passed through 1*3 collecting commercial banks.No oomparable data are available for

^Edward Cox, The Outlook for the Nation*s Cheok Payments System, p* 4*

12Penner, The Cheok Colleotlon System, p. 19*

^Board of Governors of the Pederal Reserve System, "Punotlonal Expense Report" (unpublished, Washington, D.C., 1970), p. 44.

lJfPenner, The Cheok Colleotlon System, p. 19. 15Ibid,, p. 18. 42

clearinghouses* Thus, it must be concluded that corre­

spondent relationships are a very laportant part of the payments process*

The importance of correspondent relationships to individual banks varies considerably* At one extreme is the National Stookyards National Bank of National Stockyards,

Illinois, for whloh balances due to other banks constituted

86*8 per oent of total deposits on September 30, 1970*18

Por large New York banks correspondent balenoea oomprise about 20 per oent of total deposits, but for large banks in other major oltles the percentages range generally between

5 and 10 per cent**? Por all banks in the United States demand balances due to domestic banks on June 30, 1970, were

$22*8 billion or 5*2 per oent of total deposits of $436*7 billion*18

The importance of correspondents for oheok colleotlon also varies, but this apparently varies with bank size* The

BAI found that banks with under $10 million in total deposits oolleot almost 95 P*r oent of their transit oheoks through oorrespondents while the oomparable figure for banks larger than $1 billion is less than 14 per oent*1^ Services

l f t ■“1970 Correspondent Banking Survey," The Aaerloan Banker. Deoember 18, 1970, p. 57•

17Ibid*, pp. 49-60. IQ *°Pederal Deposit Insuranoe Corporation, Annual Report. 1970 (Washington, D*C*i Pederal Deposit Insurance Corporation, 1971)* PP« 192-93*

spanner, The Cheok Colleotlon System, p, 21. 4 3

provided by one bank for another are generally not paid for

on a fee basis. Bather, compensating balances are eaployed

for remuneration. The correepondent bank providing servloes

calculates an "lnvestable balanoe" In the following way.

Proa the respondent's gross balanoe the portion of

uncollected checks la deducted, I.e., the amount of deposits

represented by ltens still In the process of collection.

Prom this "oolleoted balance" the correspondent deduots Its

reserve requirement to determine the amount of funds avail­

able for Investment.

Although banks are not permitted to pay Interest on demand deposits explicitly, an earnings rate Is applied to

the lnvestable balanoe to determine the gross value of the deposit to the correspondent. From the gross earnings figure Is deducted the sum of prloes for servloes performed.

The result Is an estimate of the profit earned on the aooount.

Over a period of time correspondents require that

earnings credits be at least equal to the aooount servioe

charges. Bespondents attempt to maintain their balanoea so that the earned oredlt does not exoeed charges.

Correspondent prlolng policies have been studied In detail at the Pederal Beserve Bank of Kansas City, espe­ cially by Bobert B. Knight. During July, 1971 end July,

1972, Knight surveyed banks from the largest 125 In terms of deposits due to domestlo banks, requesting aooount analysis formulae for correspondent aooounts. The 1971 survey resulted in 86 usable responses, and the 1972 surrey provided 8 5 *

Knight reported the 1971 surrey results In the third part of a three part review of correspondent banking, in

December, 1971.20 The 1972 results were released in a 21 speeoh given in Ootober, 1972.

In his 1971 artiole Knight introduced the oonoept of unit balanoe requirements to avoid the comparison diffi­ culties faoed when banks offer higher or lower earnings rates and adjust prices or reserve requirements to compen­ sate . This technique and Knight's 1972 survey results are utilized in the analysis contained in Chapter IV. Knight's analysis and oonolusions are dlsoussed below.

Katherine Plnney's 1958 book, Interbank Deposits.22 provides an overview of correspondent banking relationships during the period 193*+ to 195*+* Despite the age of the study, in light of more recent findings oomfliming oonstanoy of oheok flows over time, Plnney's work has relevance to this study.

20Robert B. Knight, "Correspondent Banking, Part IIIi Aooount Analysis,* Monthly Review. The Pederal Reserve Bank of Kansas City, December197** PP* 3-17. 21Robert B. Knight, "Innovations and Trends in Bank Aooount Analysis," Remarks at the National Correspondent Banking Seminar, New Orleans, Louisiana, Ootober 30, 1972.

22Katherlne Finney, Interbank Deposits (New Yorki Columbia University Press, 1958) • 45 Although Finney listed and described twenty-three

distinct services provided to respondents( she pointed out

the Wurts study finding that of 14,189 commercial banks in 1952, 10,872 did not send any Items to Federal Reserve

banks.This, she oonoluded, indicated a heavy reliance on

correspondents for oheok colleotlon.

In attempting to determine the geography of interbank relationships, Finney utilized semi-annual oall reports from

1934 to 1954. She plotted balances due from banks at country banks and demand balances due to banka at Reserve olty member banks on the same aoale, and found the pattern of fluctuation to be virtually ldentloal. She then aohleved a similar result comparing plots of balances due from banks at Reserve oity member banks with demand deposits due to banks at oentral Reserve olty member banks.

From these plots Finney oonoluded that smaller oountry banks maintained their aotlve or working balances with oity banks in nearby financial oentera and larger olty banks maintained aotlve balanoes in national flnanolal centers.25

Finney analysed the prooess by whloh member banks adjusted their asset portfolios In response to reserve

23lbld., P* 4. The reference is to Wurts, "Study of Cheok Colleotlon System," p. 33* 2**At the time of Finney's study. New York and Chloago were designated oentral Reserve oltles and were not lnoluded as Reserve oltles in the study. 2^Finney, Interbank Deposits, p. 24. 46 requirement Increases during the period studied. In the earlier years of the period higher reserve requirements were almost totally offset by reduotlons In Interbank balances.

Zn later years, however, additional reserves were supplied by a reduotlon in securities holdings, primarily U. S.

Government obligations.2^ Noting that balanoes due from banks at country banks deollned, relatively, from 30 per oent of demand deposit liabilities in the mid 1 9 3 0 's to

13 per oent in the early 1 9 5 0 's and that Beserve olty banks experienced a similar decline from 30 per oent to

7 per oent, Finney oonoluded that the adjustment to lnoreased reserve requirements is further evidenoe that,

" • . • correspondent balanoes have fallen to a kind of minimum needed for day to day transactions."2?

Finney's findings indioate that smaller respondent banks tended to hold working balanoes with oorrespondents In their own trade area and that these respondents likely maintained their balanoes near the level required to oompen- sate for servloes purohased. These findings are essentially the assumptions upon whioh the analysis of lndlreot cor­ respondent banking effeots In Chapter IV are based.

During the 1960's the number of bank mergers and the 1 acquisitions of bank holding oompanles grew speotaoularly.

This movement toward concentration in banking aroused

26Ibld., p. 9*f. 2?Ibid. 47 considerable Interest In the Committee on Banking and

Currenoy of the United States House of Representatives.

During 1963 that Committee's Subcommittee on Domestlo

Finance authorized two studies of the correspondent banking 28 Industry. The Committee wanted to asoertaln the status of the oorrespondent banking Industry beoause of Its relevance to legislative decisions on suoh matters as merger and acquisition legislation. Portions of eaoh study are relevant to this study.

The House Committee reports provided very little analyslst but Instead, oonoentrated primarily on presenting data oolleoted In the two surveys. The two sections of interest here are entitled, "A Report on the Correspondent

Banking System," and "Correspondent Relations 1 A Survey of

Banker Opinion."

The former section lndloated not only that for smaller respondents the bulk of oheok value was oolleoted through the oorrespondent system, but also that for banks over $10 0 ,000,000 In deposits over forty per oent of value was oolleoted through correspondents.2^* Of the responses to the question1 Why are correspondents preferred to the

Fed? the study's author stated1

2®The two studies were published Jointly, U.S. Congress, House, Committee on Banking and Currenoy, Suboommlttee on Domestlo Flnanoe, Reports on Banking Questionnaires. 88th Cong., 2d sess. (Washington, D.C.i U.S. Government Printing Offloe, 1964).

29lbld., Seotlon 3, p. 14. J*8 Perhaps the most important of the reasons listed above is that Mthe Fed does not perform the sane short haul services.” This suggests that the Fed has oonoentrated on long-haul servloes. This division of labor Is. of course. consistent with the size distribution of preferences • • • • since small banks are most apt to handle local money ~0 transactions and large banks long-haul transactions.*7

It should be clear from Chapter I that It is in the area of ”short haul” servloes that the Federal Reserve RCPC program is expeoted to have Its effeot. The House. "Report on the Correspondent Banking System” implies that if the

Federal Reserve does Improve collection of local items, it should expect to take cheok collection business away from correspondent banks. The Survey of Banker Opinion^* indicated almost universal support for the oheok collecting servloes of oorrespondents. Responses to the opinion questions were categorized asi "replies expressing unqualified approval of the present operation of the oorrespondent banking system.” and "replies in whloh reservations are expressed oonoeming the present operation of the oorrespondent banking system.”

In the seoond oategory of the responses reported, no bank under fifty million expressed dissatisfaction with corre­ spondent oheok oolleotlon services. In general, those banks that did find some fault with oorrespondent relationships praised the clearing servloes provided.

This result indicates that, at least as of 19&3# respondent banks were satisfied with the level of servloe

3°Ibid, p. 20. ^Ibid., Section 1. being provided for oolleotion of oheoks by correspondents,

and were not demanding improved clearing services from the

Pederal Beserve. Thus* it does not appear that the Federal

Reserve RCPC program was motivated by a demand on the part

of respondent banks for improved oheok oolleotion servloes.

The Pederal Reserve Bank of Kansas City published two

studies of oorrespondent banking relationships in its

Monthly Review during 1 9 6 5 * The earlier article, entitled

"Correspondent Banking," analyzed the portion of total

servloes sold by banks of various sizes that were purohased from other banks. The second study, "More on Correspondent

Banking," attempted to estimate the importance of oorre­ spondent balanoes to the profitability of the depository bank.

In the first study two functions were estimated with linear regression analysis, balanoes due from banks as a function of total deposits and operating revenue as a funotlon of total deposits. Estimated operating revenue was taken as a measure of total sales. The level of oorrespond­ ent servloes purohased was approximated by applying a market based earnings rate to the estimated values of balanoes due from banks. Total sales were found to be a constantly rising function of total deposits, but the level of oorrespondent

32Pederal Reserve Bank of Kansas City, "Correspondent Banking," Monthly Review. Maroh-Aprll, 1965* PP« 9-16t and "More on Correspondent Banking," July-August, 1965* pp. lA-2 3 . 50 servloes purohased rose for banks with less than $26 million

in deposits and declined for larger banks* Sales divided by

deposits rose over the range studied (0*5 million to

35 million), but servloes purohased divided by sales and

servloes purohased divided by deposits declined through­

out . 33

The authors did not attempt to determine the types of

services that were purohased by banks of various sizes, but

rather, oonoluded that the results indicated the existence

of economies of soale from specialization by larger banks*

It Is Interesting to note that this finding is oonslstent with a oontentlon of the Arthur D* Little report that banks

smaller than $25 million do very little of their own oheok

sorting but that banks over that size find it economical to do 8 0 * ^

As is pointed out by the authors, the analysis in

"More on Correspondent Banking" was based on precarious assumptions, and It should be noted that the artlole was motivated primarily by a desire to test methodology and spur discussion. Under an assumption that specifio earning assets were dlreotly related to speolflo classes of liabili­

ties, linear regression was utilized to estimate the relationship between net operating earnings and three

33pederal Reserve Bank of Kansas City, "Correspondent Banking," pp. 13-14* ^Edward Cox, The Outlook for the Nation’s Cheok Payments System. 51 liability classes among Tenth Federal Reserve District banks with at least $5 million of due to banks during the period

1962-196*+. The three laibility classes were Interbank

Demand Deposits, All Other Demand Deposits, and Time and

Savings Deposits*

The derived ooeffioients estimated the marginal rate

of return from the three deposit classes* The authors

concluded that, at the margin, Interbank Deposits are

signlfloantly more profitable than the other two deposit classes*^ The conclusion from this result would be that any event that resulted In a substantial reduction in the level of Interbank balanoes would be signlfloantly detri­ mental to the profits of oorrespondent banks.

Neither the assumptions nor the oonoluslons of the

"More on Correspondent Banking" article are convincing.

First, there is no evldenoe that Investment opportunities available to oorrespondent banks are superior to those available to non-correspondents of similar size. Seoond, while it is generally aooepted that the structure of bank asset portfolios is Influenced by the volatility of deposits, it is more likely that it is total deposit vola­ tility rather than that of particular deposit categories that is important. Further, there is no evldenoe that

^ F e d e r a l Reserve Bank of Kansas City, "More on Correspondent Banking,* p. 22* 52 correspondent banks have less varlanoe In total deposits

than non-oorrespondentsi in faot, the reverse is likely.

Third, there is the question of correlation versus

causation. It would not be surprising to find that banks

with a higher proportion of correspondent liabilities offer

a wider range of servloes and, therefore, have higher net

operating earnings.

Because of these considerations, the approach taken

in Chapter IV of this study for assigning earnings rates to

Interbank balanoes is not consistent with the approaoh taken

in "More on Correspondent Banking." Bather, the earnings

rates utilized in the analysis are average returns on

earning assets.

In a study published in 1970, Bobert Lawrence and

Duane Lougee attempted to shed new light on the nature of

oorrespondent relationships.^ They utilized data froa

PDIC Call Beports and Folk's Bank Dlreotorv for banks

looated in Colorado, New Mexico, and Wyoming for the study.

Linear regression was used to analyze the relationship between the nuaber and dollar amount of oorrespondent aooounts and a series of Independent variables.

Bank size was found to be the key variable for

explaining the total nuaber of oorrespondent aooounts, the nuaber of aooounts outside the trade area and the total

^^Bobert S. Lawrence and Duane Lougee, "Determinants of Correspondent Banking Belatlonshlpa," Journal of Money. Credit and Banking. August, 1970* PP» 358-69. 53 balanoe due from banks. Other faotors found to be signifi­

cant were the ratio of demand, deposits to total deposits and the distance of the bank from the major commercial

center.

Lawrence and Lougee also found that virtually every bank had an aooount in the regional financial center

(Denver) but that only banks of over $50 million in deposits were likely to hold balances in other areas. This finding substantiated the conclusions of both Finney^? and the

House of Representatives study.3® This result, while tending to substantiate the other findings is of limited applicability here because no attempt was made to identify the nature of servloes purohased. by location.

Finally, in late 1972, Robert Knight of the Federal

Reserve Bank of Kansas City analyzed correspondent banking transactions in the Tenth Federal Reserve District and in the Baltlmore-Washlngton and Miami RCPC areas to identify in general terms the likely effect of the Federal Reserve RCPC program on interbank balanoesBased on Tenth Distrlot transactions Knight oonoluded that "the maximum decline in

^Finney, Interbank Deposits.

3®U.S. Congress, Reports on Banking Questionnaires.

^Robert E. Knight, "The Impact of Changing Cheok Clearing Arrangements on the Correspondent Banking System," Monthiv Ray1ew. The Federal Reserve Bank of Kansas City, December, 1972, pp. llf-24. 5* principal oorrespondent aooounts of snail banks would

average about 50 per oent for rural banks with deposits under $10 million and over 70 per oent for other banks."

Knight pointed out that the oomputed reductions

related to book balanoes due from banks at the respondent

and not oolleoted balanoes on the books of the oorrespond­

ent. Percentage reductions In oolleoted balanoes would be

substantially lower beoause a substantial portion of

oomputed reductions were the result of expediting oolleotion

time.

Knight also pointed out that his estimates were of maximum reduotlons possible, and he did not consider state reserve requirements as a restriction. He oonoluded that the correspondents faoe a severe ohallenge to offer suf­ ficient servloes to maintain respondent balanoes beoause of the RCPC program.

Banking Industry Struoture

In 1970, the Boonomlos Task Poroe of the Amerloan

Bankers Association MAPS Committee commissioned three faculty members of Northwestern University to analyze the likely lmpaot of payments meohanlsm changes on the struoture of the banking Industry. In their report to the Boonomlos

Task Foroe the authors, Jaoobs, Moag, and Lamer,

**°Ibld., p. 17* Emphasis Is the author's. 55 Interpreted their assignment as describing the banking system at a point in time when oheoks hare been virtually eliminated! end as suoht they did not consider the iii transition path from 1970 to that future date. *

It is interesting to note that, despite the array of servloes offered by oonmerolal banks, the authors oonoluded that payments system considerations alone would dictate that smaller banks will beoome service outlets for larger insti­ tutions either as captives, due to the oost of eleotronlo Lo equipment, or as merged branches. This conclusion was based on an assumption that it would be uneconomical for smaller banks to maintain electronic oommunloatlon equip­ ment. and the expectation that large banks would possess the requisite equipment. It is not d e a r from the paper how these factors differ from the existing situation in whloh respondents purchase payments processing servloes from correspondents but are typically not oaptlves.

In ignoring the transitional period between the existing situation and a remote oheokless world, the Jacobs.

Hoag* and L e m e r paper leaves a gap of substantial propor­ tion. While the authors' oonoluslons may in time be proven valid. It Is likely that the struoture of the banking

^ D . Jaoobs. J. S. Hoag, and S. H. Lemer. "The Impact of the Bleotronlo Transfer Meohanlsm on Bank S Struoture," (unpublished. Amerloan Bankers Association, Washington, D. C., Ootober, 1970).

42Ibid., p. 1*8 . 56 Industry twenty years henos will be the cumulative result of an erolutlonary prooess rather than the result of one change in the prooessing of paynents.

The 1972 Regulation J amendment was billed by the

Pederal Reserve as one step In the evolutionary prooess toward widespread eleotronlo payments.*^ The role of that regulation In bringing about a world suoh as envisioned by

Jacobs, Hoag and Lemer, has been debated in the trade press but has not been subjected to detailed analysis prior to this study* It Is interesting to note that the discrepancy between deferred and immediate payment status has existed for many years without economic oonsideration of its effect on the struoture of banking* Beoause both deferred and immediate payment banks were to be found in size groups up to #400 million in demand deposits, the amendment to Regulation J cannot be considered to be strlotly a small bank-large bank issue* Yet, prior to

November, 1972, deferred payment banks tended to be smaller rural banks and immediate payment banks tended to be large olty banks, and if oountry banks tend to lose earning power while olty banks tend to gain, and If it were demonstrated that natural soale economies existed in banking, it must be oonoluded that the Regulation J amendment moves the banking

Industry toward the Jaoobs, Hoag, and L e m e r description*

^Federal Reserve System Press Release, dated June 21, 1972. 57 The issue of natural eoonomles of soale, however, is not ooapletely dear. It has been demonstrated that, due to the nature of the banking firs, economies of soale should be expected. The expeoted soale eoonoaies relate to spreading risk over a large nuaber of depositors and assets, so eoonoaies should be expeoted to dlalnlsh as the lneuranoe prlnolple diminishes at the margin.

The eaplrloal studies that have been oonoemed specifically with the exlstenoe of eoonoaies of soale have been universally plagued by definitional probless. Beoause of the aultlproduot nature of the banking firm, two problems arise. Plrst, It Is difficult to relate speolflo coats to speolflo outputs beoause of overlapping functions. Second,

It Is difficult to ooapare Institutions beoause they nay differ signlfloantly not only as to uses of funds but also as to souroes.

The early studies ignored these problems and took a straightforward approaoh. Studies by Alhadeff and by

^ T h e Initial article in this vein wasi Franols Y. Edgeworth, "The Mathematical Theory of Banking," Journal of the Boval Statistical Society. LI (Maroh, 1888)• tfke oonoept has been extended reeently, however, by Ernst Baltensperger, "Eoonoaies of Soale, Flra Size and Conoentratlon In Banking," and "Costs of Banking Activities— Interactions Between Bisk and Operating Costs," Journal of Vol. IV, No. 3 (August, 1972)• pp. 467-88 and pp. 595-611, respectively.

^Davld A. Alhadeff, Monopoly and Competition In Banking (Berkeley 1 University o? California Press,195**) • 58 Horvltz*^ essentially plotted total earning! againat total

operating ezpenaea for a range of bank sizes. Effectively

these studies were measuring whether gross operating margins

increase, relatively, with else. Both studies oonoluded

that significant soale economies exist up to 25 to 50 million dollars in total deposits and beyond 200 million dollars In deposits, but that banks aohleved very few

economies between 50 and 200 million dollars. 47 Gramley, studying banks in the Tenth Pederal kg Reserve Distrlot, and Sohwelger and MoGee, studying

Chloago banks, rejeoted the operating margin approaoh of the earlier studies and utilized linear regression analysis to measure the relationship between operating costs and total assets. The results of both studies roughly substantiated earlier conclusions. Gramley*a sample did not oontaln any large banks but both he and Horvltz found significant eoonoaies of scale up to approximately 50 million dollars in total assets* Failure to deal with the multlproduot problem meaningfully however, leaves the oonoluslons of the studies somewhat questionable*

^ P a u l H. Horvltz, "Economies of Soale in Banking," in Private Financial Institutions. Commission on Money and Credit (Englewood Cliffs, N.J.iPrentloe-Hall, Ino., 1963). ^ L y l e E. Gramley, A Study of Soale Economies in Banking (Kansas City, Mo.t Federal Reserve Bank of Kansas City, 1962) • Monograph. 48 Irving Sohwelger and John S. MoGee, "Chloago Banking," Journal of Business. Vol. XXXIV, No. 3 (July, 1961), pp. 203-386. 59 Greenbaun attempted to solve the multlproduot

problem by grouping eaoh type of aeeet into one of sixteen

categories and developing an index of total output by

estimating the yield on eaoh olass through a linear regres­

sion equation* Greenbaum's index of output was the b u b of

yields weighted by the asset categories. The index was

used to explain operating oosts.

Greenbaun, like others* found significant soale

eoonoaies for relatively snail banks but* unlike others,

he found increasing oost per output unit for very large

banks. This U-shaped oost ourve implied an optlaun bank

else.

The U-shaped oost ourve has not been found in other

studies, and Greenbaun has not published his data for

examination by others. Further, Greenbaun apparently

Ignored the faot that any given value for his " index" oould

be aohieved by essentially an infinite number of combin­

ations of yields and asset values.

Benston^0 rejected the idea of a single index of

output and attempted to relate speolflo oosts to a series

of funotions or output classes. The six functions defined

^Stuart j. Greenbaun, "A Study of Bank Costs,11 The National Banking Review. Vol. I, No. 4+ (June, 1 9 6 9 ), PP. 4i5-3*t. See also, "Costs and Produotlon in Commercial Banking." Monthly Review. Federal Reserve Bank of Kansas City, Maroh-Aprll, l?oo, pp. 11-20.

3°George J. Benston, "Economies of Soale and Marginal Costs in Bank Operation,** The National Banking Bevlew. Vol. II, No. k (June, 1965)# PP* 507-5 9 . 60 by Banston included demand deposits, tine deposits and six asset classes* Uniquely Banston used the number of aooounts rather than the size of aooounts as a measure of output*

By utilizing the number of aooounts rather than the dollar size as a measure of output, Benston oonoluded that the oonoluslon of previous authors, that soale eoonomles existed, was somewhat illusory* He found limited soale eoonomles in dlreot oosts* Although Benston's sample did not inolude any banks larger than $55 million in total deposits, Bell and Murphy utilized an identical technique on a larger sample of banks ranging up to over $800 million in deposit size with similar results*^

Benston's Interest in the question of the appropriate measure of eoonomles of soale related to the issue of whether soale eoonomles exist in banking, per set or whether, if they exist they are the result of regulation that, for example, permits larger institutions to make larger loans* In a 1972 review artiole,^2 Benston combined his earlier results with those of Bell and Murphy and oonoluded that the estimated overall elastlolty of operating oosts, with respeot to output of 0*93* does indicate

W. Bell and Nell B* Murphy, Costs In Commercial Banking* A Quantitative Analysis of BankBehavlor and its • O T O :U! a5 T O Lon* Besearoh Beport Ho, ei (Boston* The Federal Boserve Bank of Boston, 1968)*

32Goorge B* Benston, "Boononles of Soale of Flnanolal Institutions," Journal of Money* Credit and Banking* Vol. IV, No* 3 (August, l$7z), pp* 312-W* 61

eoonoaies of soale, per se. These obserred eoonoaies were

not found to exist In all banking functions, nor does

Benston bellere that they are sufficiently large to dlotate

a publio polloy of enoouraglng Increased oonoentratlon In

banking.

It would appear that at this stage of derelopaent of

the theory of the banking firm, general agreement has been

reaohed on the existence of eoonomles of soale In banking up

to the size of $25 to $50 million In total assets. Beyond

that level the Issue remains In question, but Benston's

finding of soale eoonomles in numbers of aooounts and at

least a solid theoretloal expectation of eoonomles In size

of aooounts Indicates that further sophistication In the

field will likely lead to consensus In the direction of

Benston's most reoent statement.

?uTtrftyr Conclusions

The literature discussed in this chapter ranges from

operational orientation to theoretloal. The major findings desorlbed are summarized and discussed In order.

Operations

The operational studies have lndloated that the flow pattern of oheoks remained virtually unchanged from the

early 1950's until at least the Implementation of the

Pederal Reserve Regional Frooesalng Center program. The 62 pattern found was that desorlbed in Chapter I of saall banks depositing transit oheoks with large oorrespondents who oolleoted the oheoks directly or forwarded then to the

Pederal Reserve or still other oorrespondents*

As dlsoussed in Chapter I* Chapter III of this study analyzes the oost Implications of redirecting this oheok flow to bypass the oorrespondent as the bank of second deposit* Under the RCPC program small respondents are induced to deposit directly with the Pederal Reserve facility*

The oost findings of the operational studies indicated that direet marginal oosts in the area of $0*01 to

|0*015 should be expected for oheok processing* The varl- anoe results in definition of dlreot oosts* The Atlanta study33 indicated that oost savings in the order of #0*03 per oheok are available for eliminating oheoks deposited by respondent banks*

The Atlanta oost oaloulatlons were based on fully burdened processing functions and oannot be oonsldered as marginal oosts. It would appear that a substantial relative volume of oheoks would have to be eliminated from a bank in order to aohieve unit oost reduotlons of the order of magnitude oomputed by the Atlanta group*

^Lipis, Phase III Report. Although eoonomles of soale in oheok processing were

assumed in the BAX studies^** they were addressed direotly by

Cox in the operational study group* Cox oonoluded that

liaited soale eoonomles were available in oheok processing

for large volume banks* This issue is also analyzed in

Chapter 1X1*

Correspondent banking

Xt is reasonable to oonolude from the literature of

oorrespondent banking that oheok oolleotion servloes have

traditionally played a very important role in the oorre­

spondent relationship* Knight speculated* quite reasonably,

that oheok oolleotion servloes may have initially been the

basis for the development of the compensating balanoe

approaoh to payment*55

The long term continuation of the praotloe as well

as the House of Representatives study^ indicated a high

degree of satisfaction among bankers with the oorrespondent

oheok oolleotion network* By altering the flow of oheoks

the Pederal Reserve System should expeot to signlfloantly

alter the respondent-oorrespondent relationship in oheok

.oolleotion*

^Penner, The Cheok Colleotlon System.

^Knight, "The Xmpaot of Changing Cheok Clearing Arrangements•M 5^U.S. Congress, Reports on Banking Questionnaires. 6* Structure

With respect to banking struoture it should be

recognized that the possibility exists that expenditures

to meet capital equipment requirements M y In the foresee­

able future lead toward a high degree of oonoentratlon In

the banking Industry* While the question of the existence

of constantly inoreasing eoonomles of soale Is still some­

what In doubt reoent literature Indicates that suoh may well be the oase. It Is conceivable that the type of

eoonomles of soale foreseen by Jaoobs, Hoag* and Lemer have occurred over the last ten years due to the oapltal requirements for oheok prooesslng and other suoh computer­

ized financial servloes.

It Is interesting to note that the differences that have existed in the manner and time of payment between deferred and immediate payment banks have universally been

Ignored In banking struoture studies. It Is reasonable to believe that the results of emplrloal studies, especially those of Alhadeff and Horvltz, were biased by the deferred payment situation, especially beoause of heavy weighting of smaller banks by deferred status and the high lnoldenoe of

Immediate payments among larger banks.

The analysis oontalned In the suooeedlng three chapters Is built upon the body of literature dlsoussed In this chapter. As lndloated in Chapter I, the sohsma utilized for evaluating the oost effectiveness of Regional 65 Cheok Processing Canters assumes an initial oheok oolleotlon

pattern suoh aa that described by Wurta and verified by

Fenner* by Cox* and by Han. Additionally* Chapter III contains prooeasing oost estimates that permit testing the

conclusions of Cox and of Benston relative to the souroe and existence of scale economies in bank demand deposit processing.

Chapter IV nay reasonably be oonstrued as an analytical extension of previous work done by Robert Knight in evaluating the potential effect of Regional Centers on . interbank balanoes. The analysis by Finney and the House of

Representatives surveys permit the oonoluslon that RCFC's were not brought about by an absenoe of* or a dissatis­ faction with* oheok clearing servloes offered by corre­ spondents. Rather* the centers must be required to stand alone on the basis of their ability to reduce oheok olearlng costs.

A continuing question exists as to the desirability of increased concentration in the banking industry* both as a matter of eoonomlo efficiency and as a matter of publlo polloy. Jaoobs* Hoag* and Lemer oonoluded that* from the standpoint of eoonomlo efflolenoy* payments mechanism considerations will lead toward lnoreased oonoentratloni and others have* at the very least* found no refutation for suoh a oonoluslon. 66

Certainly, if the checking eyeten is replaced on a widespread basis, the tine pattern of change will effect the structural oonsequenoes* In attempting to ascertain the profitability implications of the 1972 Regulation J amendment, Chapter 7 provides a basis for previewing that time pattern. CHAPTER III

DIRECT COST EFFECTS FOR TRANSIT

CHECK PROCESSING

Overview

The purpose of this ohapter Is to establish a basis for evaluating the Federal Reserve System's suooess In achieving Its objective of reducing the overall oost of oheok collection through the establishment of Regional Check

Processing Centers (RCPC's). The RCPC program Involves a major Federal Reserve oommlttment and Is the mainstay of the System's efforts to aohleve "faster* more efflolent and more economical banking services to the public."*

The approaoh taken In establishing a basis for evaluation was to analyse individually* and In detail* a representative group of regional oenters In order to draw conclusions relative to the overall program and to identify the characteristics required for the program to aohleve its objective. Individual oenter analysis was preferred to aggregate analysis beoause negative savings at a particular looatlon nay be offset by positive savings at another*

*Board of Governors of The Federal Reserve System* "Statement of Polloy on the Payments Neohanlsa*" June 17* 1971. 67 68

Invalidating net results. Because the differentiating characteristics of regional oenters are few In number It was deolded that a small representative group would satis­ factorily represent the entire program.

Proa the soheaa developed In Chapter I It was determined that diraot cost savings( as defined in equation

(1-7), nay be computed by solving for the values in equation

(1-7)• as follows* Sd - MC® * (v j)* - MC* * Vn (1-7) where

Sd m Total dlreot cost savings from transit oheok processing B MCt ■ Marginal cost of transit processing in large ooaaerolal banks

vF > Transit voluae payable within the defined ECPC x area (local oheoks) and deposited in a smaller, respondent bank

vF m The voluae of vl that is payable at the no correspondent of the bank of first deposit p MCfc > The marginal oost of transit processing in Federal Reserve RCPC's.

Vn > The volume of the class of oheoks that are oolleoted through an RCPC but would not d e a r through the Federal Reserve in the absence of the oenter (i.e., "new" oheoks to the Federal Reserve)•

This ohapter desorlbes the estimation of the values in equation (1-7), 69

Selection of Representatlve Group

In aeleotlon of a representative group of regional centers, the first step was to Identify the oharaoterlstlos that may differentiate the oentere and to Identify whloh of these oharaoterlstlos affeot the values In equation (1-7)•

Next, the list of existing oenters was reviewed to seleot a representative group*

Federal Beserve Regional Chock Prooesslng Centers may be olasslfled according to the following oharaoterlstlosi

1. Volume of oheoks handled*

2. Locationi on-promlee at a Federal Reserve offloe

or at a remote site (off-premise)•

3* Banking struoture of the area served*

if. Operating oharaoterlstlos (l*e*, second or third

generation oomputer equipment)•

5* Area of the oountry. The first Item, volume of operation, olearly relates to the purpose of the analysis of Identifying the oharaoterlstlos of a suooessful RCPC program* It was deemed desirable, therefore, to view the range of else* The seoond characteristic would also be expeoted to differentiate between regional oenters* This Is true beoause of the opportunity to share resources and overhead among departments of an existing offloe, whereas suoh an opportunity does not exist at a specialized oheok prooesslng center* 70

Although* Intuitively, it would teen that the eziet- enoe or prohibition of branohlng would affeot tranait roluaee and, thua, the requirements for regional prooeaaing oentera, earlier reaearoh has Indicated that thla la not the case* In an analyala of faotora influencing variation of tranait voluaea among banka, dumay varlablea repreaentlng both limited and atatewlde branohlng were found to be not 2 algnlfloantly different from zero*

Item number four, operating eharaoteriatloa, la aomewhat questionable as a selection criterion, as it la likely redundant with oheok volume. Although there la a range for decision, the nature of the oheok prooeaaing operation dlotatea, generally, that third generation computers are more efficient for large volume operations and seoond generation systems are more efficient for smaller voluaea* Thla is the oaae because of larger data retrelval requirements for balancing and reoonolliatlon In large volume operations.

The region of the country was not considered to be a significant oharacterlatlo, In view of the other orlterla.

This was the oaae primarily beoause operating teohnology is widely shared throughout the industry, and all Federal

Beserve Banks operate under a uniform set of polioy guide­ lines*

2Buasell D. Norris, "Techniques for Estimating Transit Volume," (unpublished working paper. Board of Governors of the Federal Beaerve System, November 16, 1972) • 71 Table 1 lists the Federal Beserve Regional Check

Prooesslng Centers In operation as of Haroh 30* 1973* with

Indications of the relevant characteristics* The list omits

the oheok processing operation at the Federal Reserve Bank of

Philadelphia which is referred to by that bank as an RCPC, but which Is not consistent with the Board's guidelines*

From this list the following selections were made*

Lewiston, Maine, was selected as representative of a

small RCPC* It was considered as particularly relevant to evaluation of the program beoause, while it is atypical, it represents a olass of center that could easily proliferate*

That is, there are a limited number of large finanolal oenters in the United States, but a substantial number of trade areas, oomparable for the purposes at hand to the state of Maine*

Beyond seleotlon of Lewiston as representative of small RCPC's, It was decided to analyze Windsor Looks,

Connecticut, as representative of larger, off-premise facil­ ities, and Cleveland, Ohio, as representative of larger on­ premise operations. Additionally, it was decided to lnolude

Baltimore, Maryland, in the analysis beoause that RCPC has been in operation since January, 1970, and the results were ezpeoted to serve as a benchmark for evaluating the validity of the findings at the other looatlone* 72 TABLE 1 i FEDERAL RESERVE REGIONAL CHECK PROCESSING CENTERS MARCH 30. 1973

e o % e Sf S ij 2 M t M O £ 0 0 | 0 0 O ^ > 3 3 (0 - CQ Vi Looatlon ^ «K * w g

£ 4*cs *»* 0 0 0 O W W cq

Lewiston, Maine 9-72 200,000 100,000 S off Windsor Looks, Conn. 1-73 1 ,021,000 621,000 S off Long Island, N.Y. 9-72 506,000 275,000 L off Buffalo, N.Y. 10-72 274,000 50,000 L on Cleveland, Ohio 1-73 1 ,600,000 720,000 L on Columbus, Ohio 10-72 580,000 316,000 L off Baltimore, Md. 1-70 1 ,469,000 340,000 S on Atlanta, Ga. 9-72 765,000 314,000 L on Birmingham, Ala. 9-72 276,000 79.000 L on Jacksonville, Fla. 9-72 362,000 249,000 N on Nashville, Tenn. 9-72 117,000 12,000 L on New Orleans, La. 11-72 192,000 65,000 L on Chicago, 111. 4-72 1 ,010,000 120,000 N on Des Moines, Iowa 11-72 586,000 236,000 N off St. Louis, Mo. 9-72 642,000 476,000 N on Little Rook, Ark. 9-72 126,000 27,000 N on Louisville, Ky. 11-72 273,000 134,000 L on Memphis, Tenn. 9-72 297.000 99.000 L on Minneapolis, Minn. 10-72 671,000 305,000 N on Denver, Colo. 5-71 47,000 15.000 N on Oklahoma City, Okla. 5-72 46,000 6,000 N on Omaha, Neb. 5-72 240,000 95.000 N on Dallas, Tex. 8-72 700,000 500,000 N on Houston, Tex. 9-72 400,000 200,000 N on

a"S" Indicates statewide branohlng, MLM lndloates limited branohlng and MNM lndloates no branohlng In the state where the RCPC Is looated. Coat of Tranait Prooeaaing At C(w*roial Banka

The computation of marginal coat of tranait Q prooeaaing (MC£) waa basal on 1970 Punotional Coat Analysis data for banka with demand depoaita greater than $50 million. In order to compute marginal ooat, it waa first neoeaaary to describe a ooat function for oheok prooeaaing, and solve for the partial derivative with respect to tranait volume•

Demand deposit prooeaaing in a commercial bank involves three separate functions that ahare resources.

These are, the prooeaaing of deposits (i.e., the actual oredlt aa opposed to the checks or oaah oontalned in the deposit), the prooeaaing of home debits (oheoks oharged against accounts of the prooeaaing bank's customers) and the prooeaaing of tranait oheoks. Thus, the dlreot variable ooat of oheok prooeaaing waa expected to be a funotlon of tranait volume, home debit volume and the volume of deposits. The ooat funotlon waa tested In the form

°4 - bo • Ttx • vh2 • vd 3 • E (XIX-l) where

C4 m dlreot variable ooat of demand deposit prooeaaing

c volume of tranait oheoka

Vh m volume of home debits

« volume of depoaita 74

E ■ Stoohastlo error term

b^ (1 * 0 , 1 , 2 , 3 ) * ooat parameters*

The parameters (b^) were estimated with least squares

linear regression In the following formi

Log Cd * Log bQ + bj Log V + bg Log Vh + bj

Log Vd + Log E (111-2)

Beoause of the Interrelated nature of the three oheok

prooesslng funotlons and the large capital expenditure

requirements for computerised operation It should be

expected that the unit cost of each funotlon would decline

with volume* at the margin* Thus* the following hypotheses were tested*

1CH0 = o < b x

2CH0 - ° < b 2 30Ho * 0 < b 3

The question of the exlstenoe of economies of soale

in oheok prooesslng has been raised by Cox^ and by others*

This formulation of the oost funotlon raises the additional

question of definition of soale eoonomles*

Por a produotlon funotlon of the Cobb-Douglas form

eoonomles of soale are defined to exist If the funotlon has

less than unitary homogeneity* that Is* If the sum of the

exponents Is less than unity*

^Edward Cox* The Outlook for the Nation*sCheok Payments System 19fro-19ao (Washington. D.d.i Amorloan Bankers Assoolatlon, 1971)* P* 1* 7-5 Suoh a definition of soale eoonomles In this tost

funotlon Implies that average cost per unit processed must

decline as Tolume inoreases( given a constant proportionate

mix of deposits, home debits and transit oheoks. Given this

definition, the question of soale eoonomles may be tested as

a hypothesis In the following formt

iWH0 - bi + b2 + b3 < 1

Three questions arise as to utilization of least

squares linear regression to estimate the parameters in

equation (III-l). The first two questions relate to the

teohnlque itself, and the third relates to the aooeptability

of the results.

The first question oonoems the dlreotion of

oausation. Utilization of linear regression implies that

the dependent variable is caused by the explanatory variable

and that the explanatory variables are independent of "feed­ back" effoots from the dependent variable.

In limiting the analysis to dlreot variable oosts,

this condition appears to be met in this analysis. If fully burdened oosts were used, it might reasonably be argued that advertising expenses or other marketing oosts generate additional volume. With dlreot variable oosts as a measure, however, it is reasonable to assume a single direction of oausation. The seoond question oonoeme the validity of least

squares for estimating the parameters* The Markoff Theorem

states that least-squares estimators of the b*s in equation

(XXI-2 ) are the best linear unbiased estimators if the

following four conditions are met*

1. The expected value of the residual is zero, for

each bank. (Zero expected value of residuals)

2* The expected value of the square of the residual

for eaoh bank is equal to the variance of the estimate*

(Constant variance of residuals)

3* The expeoted value of the product of residuals

for any two banks is zero* (Independence of the observa­

tions)

4* The expeoted value of the product of the residual

times eaoh variable is zero for eaoh variable for eaoh bank.

(Independence of explanatory variables from residuals)

Condition 1 was assumed to be met. In bank oross-

seotlonal studies analysts frequently deflate variables by dividing by total assets to minimize the likelihood of heteroskedastiolty, in fulfilling condition 2. This teohnique is olearly not appropriate for the purpose at hand, however* Condition 2 was assumed to be met and analysis of plots of residuals bore out the assumption*

In order for oondltlon 3 to be violated it would be necessary for the residuals of certain classes of banks to have a higher likelihood of having a particular sign* For 77 the group of banka included In the analysis It nay be safely

assuaed that prooesslng equipment and methodology are

sufficiently homogenlous that condition 3 Is not violated.

If conditions 1, 2, and 3 were met and condition

were violated, It would Imply that some banks oould make up

excessive oosts In one funotlon with more efficient opera­

tions In another. This possibility seems very remote

beoause of the sharing of resources among functions.

k possibility exists for correlation between the

residuals and the Independent variables due to errors In reporting the data. The Pederal Reserve as assimilating agent for the data exerts no oontrol over the oolleotlon method, and bias oould enter from this source. In the absenoe of a means of evaluating or measuring reporting error, It Is assumed to be normally distributed and to not violate condition *t.

Prom the above considerations, It was assumed that the conditions of the Markoff Theorem were met by equation

(III-2) and that the least-squares estimates of the b*s are

the best linear unbiased estimators. The third question

Involving the teohnlque Is, given that the least squares estimators are the best estimators, does oolllnearlty among the Independent variables sufficiently obstruct the ability to measure the ooefflolents so as to Invalidate the results. 78 The correlation semi-matrix of the variables is as follows.

Cd 1.0000 v t 0.603*f 1.0000

Vh 0.8259 0.5599 1.0000

Vd 0.8333 0.5331 0.9506 1.0000

The question of what ie an aooeptable level of correlation among explanatory variables is difficult to answer, a priori. Beoause the analysis is oonosrned solely with the ooefflolent for V^, however, and beoause the results were reasonably olose to oost values oaloulated by other methods, it was assumed that oolllnearlty among explanatory variables did not invalidate the results.

Banks participating in the Federal Reserve Functional

Cost Analysis program allocate direct oosts aooordlng to funotlon. Of the oosts allocated to the demand deposit funotlon. the sum of the following elements is defined as variable dlreot oost (Cd ).

employees' salaries, wages, and fringe benefits, furniture and equipment, oomputer servloe fees, printing, stationery and offloe supplies, postage, freight, and delivery, telephone and telegraph, and data prooesslng expense.

This definition oolnoldes with expense elements defined by the Federal Reserve System aooountlng system as the dlreot variable oost elements of oheok prooesslng, thus Insuring the comparability of oommerolal bank and Federal

Reserve Bank cost results. The definition was also discussed with oommerolal bank officers who concurred in the definition.

The relationship described above was tested on 1970

Functional Cost data for all participating banks with total demand deposits equal to or greater than fifty million dollars. Of 159 suoh banks in the data file, preliminary analysis resulted in the elimination of nine banks beoause of incomplete responses, errors in keypunching of the data or obvious anomalies.

The BMD, P1R multiple linear regression program

(October. 1971* version) was utilized for the analysis.

The results for the log funotlon are as follows1 (Values in parentheses are standard errors.)

F Value bQ * Antilog -0.4998035 » 0.316 bx « 0.1274526 (0.02766942) 21.218

bg « 0.4404892 (0.1115159) 15.603

b3 - 0.4229242 (0.1035890) 16.669

Standard error of the estimate - 0.1313

Multiple R * 0.9264

All coefficients were significantly different from zero at the 99Jf level of confidence. 80

The analysis of variance table la as followsi

Sum of Degrees of Mean F Squares Freedom Square Ratio

Regression 15.25248 3 5 .084161 294.719 Residual 2.518622 146 0.017251

Tests of Hypotheses

Confldenoe Intervals based on the NtN statistic were

oomputed for the parameters estimated by the equation. The

99^ confidence Intervals are as follows 1

bc 1 (0 .2878, 0.3442)

bx 1 (0 .1216, 0.1334)

b2 1 (p.4141, 0,4668)

b3 1 (0,4007. 0.4451)

Based on these results, hypotheses 1CH0 , 2CHQ , and

3CHq were not rejected. That is, the unit oost of eaoh funotlon— deposit prooesslng, home debit prooesslng, and transit oheok prooesslng— was found to decline at the margin for fixed volume in the other two funotlons.

Hypothesis 4CHQ was also tested utilizing the "tM statistic, with the varlanoe of the statlstio, bj + b2 + b^, oomputed from the following formulat ViB (1^) . XVAR (b)A + 2 pi}8 ^ where1 P *. * the correlation ooeffiolent for b4 and bj

■ the standard error of b^ 81

Computation of the variance for the statlstlo b^ + b2 + b^

permitted identification of the following confidence

intervals.

99% confidence interval « (.9*121, 1 .0397)

95J* confidence interval * (.9539* 1 .0279)

Thus, the sum of the exponents of the oost funotlon

was found to be not significantly different from 1.0 at the

99 pur cent or at the 95 per cent level, and hypothesis **CH o was rejeoted. That is, it was found that for constant

proportionate distribution of transit volume, home debit

volume and deposit volume unit oosts do not decline with

Increased workload.

Marginal Cost Calculations

Prom above, total dlreot variable oost has been defined as related to prooesslng voluae, in the functional

fora,

The test of hypothesis *K3HQ indicated that total oost

ohanges at a constant rate if all three types of volume

change proportionately. It is expeoted, however, that with

the implementation of RCPC's, only transit volume will deollne so that Vh and Vd are expeoted to remain constant.

To determine the amount of ohange expeoted in total

oost it was neoessary to estimate the unit oost and multiply by the volume. The approaoh taken in estimating unit oost 82 w a s to compute marginal oost for large correspondent banks and compute an average for the group.

* The marginal oost of transit processing Is defined as the partial derlvltive of the total oost funotlon with respect to transit volume.

From above, the marginal cost of transit oheok prooesslng may be calculated from the following equation) 0.8725W . v0 .44048920.4229242 MC® * 0.040326 * Vt vh This equation was applied to the reported volumes for the 150 Functional Cost banks with demand deposits greater than $50 million. The results are described in Table 2.

Computed mean values are as follows)

all 150 banks 0.0171

73 banks with Demand Deposits greater than $100 million 0.0123

33 banks with Demand Deposits greater than $200 million 0.0127

13 banks with Demand Deposits greater than $1*00 million 0.0128

32 banks identified as regional correspondents 0.0125 Based on these results, a value of 0.0125 was used throughout D the analysis as the estimate of MC^. 83 T A BLE 2

DISTRIBUTION OP COMPUTED COMMERCIAL BANK MARGINAL COST OP TRANSIT PROCESSING (FUNCTIONAL COST BANKS, 1970)

Bank Size (Demand Deposits In Computed Millions of Dollars) Marginal Cost Totals*

50-100 100-200 200-1*00 400+

0-0.0025 0 3 1 0 4 (0 ) 0 .0025-0.0050 5 3 2 2 12 (6 ) 0.0050-0.0075 8 4 2 2 16 (6 ) 0 .0075-0.0100 5 4 7 1 17 (7) 0 .0100-0.0125 6 1 1 0 B (0 ) 0 .0125-0.0150 12 11 2 5 30 (6 ) 0 .0150-0.0175 7 4 2 0 13 (2 ) 0 .0175-0.0200 8 4 2 0 14 (2) 0 .0200-0.0225 9 2 0 2 13 (2) 0 .0225-0.0250 6 1 0 0 7 (0 ) 0.0250-0.0275 2 1 0 l 4 (1 ) 0.0275-0.0300 4 1 0 0 5 (0 ) 0 .0300-0.0325 3 1 °b 0 4 (0) 0.0325+ l 0 2° 0 3 (0 )

Totals 76 40 21 13 150 (32)

•Values in parenthesis Indicate distribution of oaloulated aarginal oosts among thirty-two banks identified by Federal Reserve Bank officers as regional correspondents•

toThe reported values for the two banks in this cell appear to be due to reporting or keypunching errors•

Net Tranait Volume at Respondent Banka

Estimation of looal transit volume deposited at respondent banks was based upon an assumption as to the flow of oheoks after the establishment of a Pederal Reserve

Regional Cheok Processing Center* This assumption was 81* substantiated In Interviews with oommerolal bankers, both respondent and correspondent, participating In the Baltimore

RCPC, and with operations offloers at various Federal Reserve banks.

From above, the value (vj)* Is the net of the volume of oheoks payable locally and first deposited In a respondent bank (V^) minus the volume of suoh Items that are payable at the correspondent of the bank of first deposit

‘vSo>- It was assumed that, with the establishment of an

RCPC, respondent banks begin depositing all looally payable checks with the Federal Reserve facility. Under this assumption the volume of Items reoelved by the RCPC from suoh banks corresponds Identically to vj.

The bases for the assumption were, first, under the

RCPC program Federal Reserve offloes have lifted an historic prohibition to permit non-member participating banks to deposit looally payable items with the Federal Reserve.

Second, beoause the Pederal Reserve does not levy a charge for its services, respondent banks are motivated to deposit directly with the RCPC In order to reduce correspondent balanoes or purchase additional services with existing balances. Further, to the extent that member bank respondents traditionally cleared oheoks through corre­ spondents beoause of later deposit deadlines and earlier credit availability, the overnight credit and midnight dead­ lines at RCFC's should reroute the flow of oheoks* 85 Finally, In establishing regional oenters, Federal

Beserve Banks have begun underwriting the oost of trans­ porting oheoks from the bank of deposit to the BCPC.

Correspondent banks are prohibited from offering similar servloe beoause of the prohibition against payment of

Interest on demand deposit aooountB.

Although the Interviews dlsoussed above Indicate that this assumption Is generally valid. It Is certain that there are exoeptlons. Analysis of the sohema developed In

Chapter 1, however, leads to the oonoluslon that the exoeptlons to the assumption— looal oheoks oontlnulng to flow to correspondents— do not Invalidate the oomputatlonal results beoause the oomputatlonal form aecounts for suoh oheoks In an appropriate manner.

Estimates for vj[ for the four oenters under analysis were derived by annualizing the average dally volume of oheoks reoelved from respondent banks at the four oenters during the five-day business week beginning March 26, 1973*

The letter from Board Member, George W. Mltohell, dated

Maroh 1, 1973* requesting the data from Federal Beserve banks left Identification of nonoorrespondent banks to the dlsoretlon of the Beserve banks. Conversion of the reported volumes to an annual basis was aooompllshed In the following manner. The Federal

Beserve Banks of Boston and Cleveland, and the Baltimore

Branch of the Federal Beserve Bank of Blohmond provided the 86 percentage that eaoh month represented of total annual

voluae during 1971, and the percentage distribution of monthly volume by quarter of the month.

The use of these distributions, therefore, assumes

(1 ) that the 1971 distributions remain validi (2 ) that the flow within eaoh month does not vary slgnlfloantly over timet and (3) that the time pattern for the Federal Reserve Bank

of Boston Is not significantly different than the time pattern for the two, newly created, off-premise facilities

in the Boston District.

The values provided by the Federal Reserve banks permitted computation of a value representing the percentage of annual volume oontalned in an average day's workload during the last week in Maroh. Average dally volumes were determined by summing the reported individual dally volumes and dividing by five.

Values for estimation of vj0 were derived from surveys of oommerolal banks oonduoted by the Federal Reserve

Banks of Boston and Cleveland and the Baltimore Branoh of the Federal Reserve Bank of Riohmond. The survey form requested, among other items, the volume of items reoelved, by souroe, and the fraction from eaoh souroe that was home debit, on a dally average basis for a representative five- day business week. The survey form is attached as Appendix

A. 87 Survey results from banks Identified by officers of the respeotive Federal Beserve banks as being major correspondent banks were utilized for computation of vJQ.

The lists of banks in eaoh area is contained in Appendix B.

In utilizing the survey results, it was assumed that the fraction of items deposited by respondents that is payable at the correspondent remains oonstant over time.

Federal Reserve Costs

The second product on the right hand side of equation

(1-7), MC^ * Vn , was estimated In two ways with both results presented. The first method was to compute the budgeted

1973 P*? item oost and apply the results to projected "new" volumes to derive a product. These values are then compared with actual unit oosts of operation during the fourth quarter of 1972, for validation.

The Baltimore BCPC

The dally average volume deposited with the Baltimore

RCPC by participating banks other than major correspondent banks for the five-day week beginning Monday, Maroh 26,

1973t was 553*100.^ From 1971 results described above, this dally average volume is expeoted to represent 0.00387

^Letter to Mr. Donald G. Barnes, Assistant Director, Board of Governors of the Federal Reserve System, from The Federal Reserve Bank of Rlohmond, dated April 11, 1973. 88 of total annual volume from this source. Therefore,

1973 volume for Vj was estimated as 1^2,919,000 items.

Two major correspondent hanks in the Baltimore RCPC area responded to the survey of disposition of checks by source. From these responses the average percentage of checks received from same zone respondents that are payable at the correspondent was calculated to be 5*65 per cent.

The estimate for v£c for the year, 1973» therefore, was

8.075*000 and the estimate for (V^)* is 13^,8^ , 000.

Utilizing computed average marginal cost for correspondent check processing (MC®) of $0.0125 the estimated value for MC® (Vj)* for 1973 was $1,685,550. This value represents the estimated 1973 operating cost reductions in commercial banks due to the existance of the

Baltimore RCPC.

For the Baltimore RCPC an estimate for the 1973 "new" volume was not as readily available as it was for the other three centers analyzed, because the Baltimore center has been operational since 1970 and the other three began opera­ tions during 1972 or 1973« An estimate for Vn was derived as follows.

The annual growth rate in check volume processed by the Baltimore Branch was calculated for the period 1967 through 1969 and for the period 1970 through 1972. Total volumes before 1970 are not comparable with volumes after

1970 because of the opening of the RCPC on January 1, 1970. From the five observations an average annual growth

rate was oomputed to be 13.81*- per oent. This growth rate

was applied to the 1969 total oheok volume at the Baltimore

Branoh to derive an estimate for the 1972 equivalent of

"old" oheok volume.

The 1972 equivalent was subtracted from 1972 actual

volume at the Baltimore Branoh, including BCFC volume, to

derive an estimate for 1972 new volume, Vn . The ratio of

1972 Vn to total 1972 BCPC volume was oomputed.

The projeoted 1973 dally average volume for the

Baltimore center from Table 1 of 1,4-69,000 includes a

projeoted lnorease In dally average volume of 3^0,000 due to

an expansion of the clearing area which was soheduled to

take plaoe at mid year. Thus, the appropriate value for

applying the 1972 ratio of Vn to total BCFC volume was

1 ,129,000 and the estimated 1973 value for dally average

Vn was 0.62 times 1,129(000. The annual estimate for 1973

Vn was 200,1*00,000.

It was possible to project the analysis to beyond the

1973 expansion by adding the projeoted volume lnorease both

to Vj and Vn for the seoond half of the year. These results are inoluded below. A summary of computations for 1973 Baltimore Vn is contained in Table 3«

During the fourth quarter of 1972 the dlreot variable unit oost of transit oheok prooesslng at the Baltimore 90

TABLE 3

COMPUTATIONS FOB 1973 V- AT BALTIMORE CLEARING CENTER

Total Cheok Volume Growth Rate Year (In Thousands) From Previous Year

1966 89,927 NA 1967 100,595 1968 107,443 1969 126,422 17.7 1970 259,489 NA 1971 317.658 22.4 % 1972 344,833 8.6 Average Growth Rate 13.48*

1972 Actual Volume RCPC 259,136 Other 8 5 ,697 Total 344,833 Lesst 1972 Equivalent of 1969 Volume 184.358 1972 New Volume (Vn ) 160,475

Ratio of 1972 Vn to Total 1972 RCPC Volume 0.62 Estimated 1973 Dally Average Vn 699,980 times 252 Business days Estimated 1973 Vn , Without Expansion 25575557§0§ plus 340,000 Items for 126 days 42.840.000 Estimated total 1973 V,n £43*240:666 91 Regional Center was 0.00828.^ The 1973 budgeted unit oost for the Baltimore center* based on a dally average volume of

1 *129,000 for the first half year and 1,460*000 for the seoond Is 0.00995*^ Table 4 contains the computational results for the Baltimore oenter. The values In parentheses

In Table 4 and subsequent tables In this chapter represent negative values.

TABLE 4

ESTIMATED AGGREGATE SAVINGS FOR CHECK PROCESSING BALTIMORE CENTER AREA, 1973

Case Mjg x (V[)» - Mjg » Vn * jd

1 0.0125 134*844,000 0.00828 200,400,000 26,238 2 0.0125 134,844,000 0.00995 200,400,000 (308,430) 0.0125 177i684,000 0.00828 243,240,000 207*023 I 0.0125 177,684,000 0.00995 243,240,000 (199.188) p V Breakeven value for MC* at Low Volume r 0.00841 I / Breakeven value for Mc£ at High Volume ^0.00913

'’Board of Governors of the Federal Reserve System, "Ponetlonal Expense Report, Fourth Quarter, 1972,* (unpublished,.Washington, D.C., 1973)* ^Federal Reserve Bank of Rlohmond, "Proposed Regional Check Clearing System for the Fifth Federal Reserve Dlstrlot” (unpublished, Rlohmond, Va., August, 1972). 92 Lewiston HCPC

The Lewiston, Maine, clearing oenter analysis also

contained unique properties* Although there are regional

correspondents in the state of Maine, most checks being

processed by the Lewiston oenter were previously oolleoted

through Boston correspondents*

The major difference for the purpose of this analysis

is that the average ratio value of was 6*75 per cent for

Boston banks and 5 P*r cent for Maine banks* The analysis

considered both extremes.

The daily average volume deposited with the Lewiston

BCPC by participating respondent banks during the survey

week was 117*200. ? Based on the 1971 Boston Federal Reserve

volume distribution, this volume represented 0*00375 of

total annual volume from this source. Therefore, 1973

volume for V* was estimated as 31,253*000, The two

estimates for (Vf)* were 29,690,000 based on the assumption

that v£c * 5 per cent, and 29,l*f3,000 if vj0 * 6.75 P«r cent.

Although the Lewiston Center is a new faolllty, not

all of the volume prooessed at the oenter is considered as

MnewM to the Federal Reserve* An estimated 100,000 items,

on a dally average basis, were previously being prooessed by

^Letter to Mr* Donald G. Barnes, Assistant Director, Board of Governors of the Federal Reserve System, from the Federal Reserve Bank of Boston, dated April 16, 1973* 93 the Federal Reserve Bank of Boston. Of the 100.000 prooessed In Boston, 37,000 originated In Maine and were transferred to the oenter. The remaining 63,000 oontinue to be prooessed In Boston and are sent to Lewiston for presen­ tation, (see Table 1) so that the estimated value for Vn at Lewiston Is 25*200,000.

The Federal Reserve Bank of Boston, In proposing to establish the Lewiston RCPC projeoted unit operating oosts p of 0.01128. During the fourth quarter of 1972, the initial quarter of operation for the oenter, direot variable operating oosts were 0.01249 per ltem.^

Table 5 summarizes the results of the analysis of the

Lewiston RCPC.

TABLE 5

ESTIMATED AGGREGATE SAVINGS FOR CHECK PROCESSING LEWISTON CENTER AREA, 1973

Case (v£ )* vn f / d 1 0.0125 29, 690,000 0.01128 25, 200,000 86,869 2 0.0125 29,690,000 0.01249 25,200,000 56,377 3 0.0125 29,143,000 0.01128 25, 200,000 80,031 4 0.0125 29,143,000 0.01249 25, 200,000 49,539

p Federal Reserve Bank of Boston, "A Regional Cheok Processing Center Proposal for the State of Maine" (unpublished, Boston, February 10, 1972). q 'Board of Governors of the Federal Reserve System, "Funotlonal Expense Report, Fourth Quarter, 1972." 9 ^ In the case of an off-premise oenter, suoh as

Lewiston, If there Is a shift In volume from another Federal

Reserve office, and If unit oosts are different for the two

facilities, the net lmpaot on Federal Reserve oosts Is not

totally reflected In the value MC^ ' vn * It Is necessary to

adjust the values of 8d oomputed In Table 5 by the dif­

ference in unit cost for the dally average of 37,000 items

shifted from Boston.

During the fourth quarter of 1972 the unit direct

variable cost of oheok processing at the Federal Reserve

Bank of Boston was 0.00925*^ Thus, the adjustment factors for Sd In oases 1 and 3 are (0.01128 - 0 .00925) times

9,324,000 or $18,927 and the adjustment factors for oases

2 and 4 are (0.01249 - 0.00925) times 9.324,000 or $30,209. The adjustment results are presented In Table 6.

TABLE 6

ADJUSTED Sd , LEWISTON CENTER, 1973

Case Adjustment Adjusted Sd /

1 86,869 18,927 67,942 2 56,377 30,209 26,168 3 80,031 18,927 61,104 4 49,539 30,209 19.330

10n>id. 95 Windsor Looks BCPC

The area served by the Windsor Looks Regional Center is characterized by being geographically relatively small, having statewide branching in' most of the area and containing a few dominant correspondents. Prior to the establishment of the Federal Reserve center in January, 1973* two Hartford correspondent banks offered regional clearing services for local and remote respondents. As an indication of the relative market position of these banks, the average rate of

Vg0 experienced was 33*2 per cent.

The dally average volume deposited with the Windsor

Looks RCPC by participating respondent banks during the survey week was **12,000.** Based on the 1971 Boston distri­ bution, this volume is expected to aooount for 0.00375 of total 1973 Vj. The estimate of 1973 vj at Windsor Looks, therefore, was 109,869,000. Based upon the above 33.2 per oent rate for vjj0, the estimated value for (v£)* is 7^,^92,000.

The Federal Reserve Bank of Boston proposal to establish a Regional Check Processing Center at Windsor

Looks, Conneotiout, anticipated direot variable unit oosts 12 of 0.01153* Beoause the oenter began operation in

^Letter to Nr. Donald G. Barnes, Assistant Director, Board of Governors of the Federal Reserve System, from the Federal Reserve Bank of Boston, dated April 16, 1973* 12 Federal Reserve Bank of Boston, MA Regional Cheok Processing Center Proposal for Southwestern New England" (unpublished, Boston, July 13* 1972). 96

January, 1973* no record of performance has been estab­ lished* Considering the volume of operations at the

Windsor Looks facility, however, it Is not unreasonable to expect that Windsor Looks could achieve operating cost levels equivalent to those of the parent facility at Boston of 0.00925* This possibility was considered In the analysis* Table 1 Indicates that a dally average "new" volume of 621,000 Items was expected at the Windsor Looks facility*

Thus, the estimated value for Vn was 156,492,000. As was the case with Lewiston, It was necessary to adjust the oomputed value of Sd due to a shifting of 400,000 items per day from Boston to Windsor Looks. A summary of the computations Is oontalned in Table 7 *

TABLE 7

ESTIMATED AGGREGATE SAVINGS FOR CHECK PROCESSING, WINDSOR LOCKS CENTER AREA, 1973

Case * v„ / d 1 0.0125 74.492.000 0.01153 156,492,000 (873.202) 2 0.0125 74.492.000 0.00925 156,492,000 (517,436)

Adjustment for Case 1 = $100,800,000 x .00228 « ($229,824) Adjusted Sd (Case 1) = ($1,103,026) 97 Cleveland RCPC

A b Indicated In Table 1, the Federal Reserve Bank of

Cleveland anticipated a substantial growth In volume with

the opening of Its on-premlse oenter In January, 1973* due

to the dissolution of bank clearing arrangements that

existed prior to that time. A substantial portion of the

volume growth, however, oame from the large correspondent banks rather than from the respondents.

The Federal Reserve Bank of Cleveland reported dally average volumes from participating respondent banks of 13 208,440 for the survey week. J Based on 1971 volume distributions, the estimated value of V* for 1973

50,715*000. Four Cleveland correspondent banks reported values for the rate of vjj0 and the average value was

5.75 P©r oent, yielding an estimated value for 1973 (vj)* at Cleveland of 47,800,000.

The Federal Reserve Bank of Cleveland proposal for the Implementation of the Cleveland clearing oenter antlol- l4 pated unit variable oosts of 0.00611. This oompares with actual unit direct variable cost for the Federal Reserve

^Letter to Mr. Donald G. Barnes, Assistant Dlreotor, Board of Governors of the Federal Reserve System, from the Federal Reserve Bank of Cleveland, dated April 16, 1973*

***Federal Reserve Bank of Cleveland, "Proposed RCPC Clearing System for the Fourth Federal Reserve District" (unpublished, Cleveland, October, 1972). 98

Bank of Cleveland during the fourth quarter of 1972, of

0.00710.The summary of Cleveland RCPC computations is

contained in Table 8.

TABLE 8

ESTIMATED AGGREGATE SAVINGS FOR CHECK PROCESSING CLEVELAND CENTER AREA, 1973

Case

Interpretation

In this chapter an estimate was derived for the

average of the marginal oost of transit oheok processing among large correspondent banks. The result was applied to volume and cost data from analysis of four Federal Reserve

Regional Check Processing Centers to estimate the net effect

that those RCPC's have on the total direot oost of processing oheoks.

The functional form of the relationship between direot variable oosts and oheok processing volumes was estimated to bei

°d - bo • Vt1 • VE2 * v4 3

^Board of Governors of the Federal Reserve System, "Functional Expense Report, Fourth Quarter, 1972." 99 with the solution values for the parameters as followsi bQ * 0.316 bj * 0.1274526

b2 * 0.4404892

b^ «= 0.4229242

Utilizing the partial derivative of the cost function with respect to transit volume, a marginal cost value was oomputed for all banks in the data base. The average value of the oomputed marginal oost for 32 data base banks identified as regional correspondents was $0.0125 or I .25 cents per transit item. This value was used as the marginal oost of transit oheok processing in commercial banks.

Although the cost calculations were made only as input to the BCPC evaluation schema» certain of the results are of more general interest. These results have to do with the existence and observation of economies of scale in bank demand deposit processing.

Based on the analysis of this chapter it was oonoluded that the sum. b^ + b2 + b^, is not signlfioantly different from unity. This finding indicates that eoonomles of scale do not exist for oheok processing if the proportionate mix of transit items, home debits and deposits prooessed remains oonstant.

If 1 on the other hand, the ratio of transit volume to total work load (V^/Vt + Vh + Vd ) lnoreased with bank size, the average oost per unit prooessed would deollne because transit items oost less to prooess than do home debits and 10 0

deposits. If correspondent banks have a higher proportion

of transit items to total work load than do banks of similar

size that do not specialize in correspondent services, then measured oost per unit prooessed would be lower for

correspondents even if unit costs per functional item were the same.

Cox observed the oost per item prooessed to decline with increased work load and concluded that economies of soale exist in oheok processing.1^ What appears more likely is that for a given bank, as workload increases the pro­ portion of transit checks in the total work load increases.

Thus, it is not necessarily the oase that larger volumes of transit checks oost less per item than smaller volumes of transit items.

Tables if through 8 contain the computational results of the oost analysis for the four BCPCs studied. Table 4, containing the Baltimore Center results, indicates that the oenter oould expeot to meet its oost reduotlon objectives it if were able to match its 1972 unit processing oost during 1973* If* on the other hand, costs Increase as anticipated, the expectation would be that the total oost of oheok collection will be higher because of the RCPC than they would have been if it did not exist.

l6Cox, The Outlook for the Nation's Check Payments System. 101

Tables 5 and 6 contain the oost calculations for the

Lewiston, Maine RCPC, The Maine oenter Is comparatively

small In terms of check volumes processed, but the calcula­

tions Indicate that It should be expected to reduce the

total cost of oheok collection In the area served.

Unlike the areas served by the other centers In the

sample group, the state of Maine does not contain a major

financial oenter or a group of large banks, by national

standards. As Is discussed below, this area characteristic

appears to be critical In determining the suooess of a regional oenter In meeting Its objective of reducing oheok

collection costs.

The oomputatlonal results for the Windsor Looks, Connecticut, and Cleveland, Ohio, regional centers are

contained In Tables 7 and 8, respectively. Within the limits of the measurement teohnlque and data utilized In

this study, It should be expected that the Implementation of RCPCs In these two areas will result In an Increase In the total direot variable oost of looal oheok collection.

This result Is oontrary to the Federal Reserve's stated objective of reducing total oost.

Further analysis was performed on the values In Tables 7 and 8 to test the sensitivity of the direction of the results to the oost values used in estimating total savings. For Windsor Looks Case 1, the breakeven value for

MC®, given MC^ * 0.01153* 1b 0.02*t2, or almost twice the 1 0 2 p estimated value, and the breakeven value for MC^., given

MC® = 0.0125 Is 0 .059* or less than half the budget estimate. Comparable breakeven values for Cleveland

Case 2 are MC® = 0.0229 and Mc£ «= 0.0032.

The conclusion from this further analysis Is that the findings with respeot to Windsor Looks and Cleveland are valid within the range of error for the oost estimates used. An explanation of the substantially differing results between these two centers on one hand and Baltimore and

Lewiston on the other must, therefore, lie In the volume relationships. In comparing the values contained In Tables 4 through

8, the relationship between Vn and (vj)* stands out as being critical for success. The ratios (V*)*/Vn from the above tables are presented In Table 9*

TABLE 9

RATIO OF NET LOCAL VOLUME FROM RESPONDENTS TO NEW RCPC VOLUME RCPC CASES

Case ^ l ^ n Baltimore! 1, 2 0*67 Baltimore! 3* ^ 0.73 Lewiston1 1, 2 1.18 Lewiston1 3* **■ Windsor Looks 1 1, 2 0.48 Cleveland! 1, 2 0.27 103 The ratio (v£)#/Vn Indicates the maximum of new

volume that could be contributed by respondent banks*

Because the concept of the Regional Center approach is the

reduction of check handlings, it would be expected that the higher the value of the ratio, that is, the higher the likelihood that new volume to the Federal Reserve is bypassing a correspondent bank handling, the more likely the oenter Is to meet its total oost reduction objective.

If Baltimore were considered marginally successful,

Lewiston considered successful and Windsor Looks and

Cleveland considered unsuccessful in meeting cost reduction objectives, Table 9 would indicate that value of the ratio

(v£)*/Vn in the order of seventy per cent is a break even point for success or failure* That Is, among the four centers analyzed, for areas in which large collecting banks contribute in excess of thirty per oent of new volume to the RCPC, the resultant cost Increases from redundant handlings dominate oost savings*

This result was seemingly anticipated by the Board of

Governors which stated in Its press release of February 2,

1972, "The new system will make maximum use, consistent with improved service to the public, of oheok processing centers operated by commercial banks•" It should be surprising,

^Federal Reserve Press Release, dated February 2, 1972. 10** thereforei to find RCPCs located In cities such as

Cleveland, which oontaln large banks with large processing centers of their own.

The Baltimore results are of considerable Interest for two reasons. First, It might be expected that an area containing large nonmember banks, such as Is the oase In the

Baltimore area, would show more positive results than areas

In whloh members predominate. This Is the case because, in the absence of an HCPC, nonmember banks are not permitted to deposit directly with the Federal Reserve, but must pass their checks through a member bank In order to avail themselves of Federal Reserve collection services.

Second, the Baltimore oenter may be considered a mature operation relative to the other three analyzed. A likely result of maturlzation Is that oheok flows shift over time and not overnight, so that smaller respondent banks In the Baltimore RCPC area generally deposit directly with the oenter. In the other centers, it Is likely that many smaller banks continue to deposit with their corre­ spondents out of custom or habiti but will, with time, shift their oheok flow.

From the analysis of this ohapter It must be con­ cluded that, as of March, 1973• the Windsor Looks and

Cleveland RCPCs were not meeting Federal Reserve oost reduction objectives. This result does not appear to be related to a failure to perform operationally, but rather it

Is related to this distribution of check flows. 105 It oannot be determined from available data or from the analysis whether the oomputed oost Increases result from oontlnued correspondent deposits by local respondents that result In redundant handlings, or whether the large new volume to the oenter coming from correspondents originates locally with the correspondent banks. If the former is the case, it could be expected that over time oheok flows will be rerouted with a communsurate reduction in redundant processing and oosts. If, however, the latter is the case, the two centers oannot expect to meet oost reduction objectives.

While It is dangerous to generalize from a small group to the entire population, especially from a non-random sample, it appears that the results of the analysis of the four centers desorlbed in this chapter do have applicability to the Pederal Reserve RCPC Program as a whole. Based on these results, with the Baltimore oenter being pivotal, it appears that the Pederal Reserve System oannot expect to achieve its oost reduction objective in those areas in which large correspondent banks are the local bank of first deposit for checks constituting over thirty per cent of new

Federal Reserve volume.

The data and analysis of this study do not permit testing of the sensitivity of the thirty per cent figure, and that value would be expected to vary locally depending on operating oosts at banks and the Federal Reserve, should not, however, be expected to fluctuate widely because of widespread sharing of check processing methodology. CHAPTER IV

IMPLICATIONS OP REGIONAL CHECK PROCESSING

CENTERS POR CORRESPONDENT

BANKING RELATIONSHIPS

The purpose of this ohapter Is to Identify the

expeoted adjustment in correspondent banking relationships

resulting froa the establishment of Pederal Reserve Regional

Cheok Processing Centers* and to estimate the lmpaot of such

adjustments on the profitability of correspondent and

respondent banks* The approach taken is to apply national

oost and pricing data to regional volumes In order to

estimate the magnitude of the scale of the effeot, The

results, therefore, are not Intended to be preolse estimates for the areas analysed, but rather they are Intended to be representative, generally, of all RCPC situations.

The analysis In this ohapter may reasonably be oonstrued as an extension of Robert Knight*s analysis of correspondent relationships,* The analysis foouses on the

^Robert E, Knight, "Innovations and Trends In Bank Account Analysis" (remarks prssented at the National Correspondent Banking Seminar, New Orleans, Louisiana, Ootober 30, 1972)i and "Correspondent Bankings Account Analysis," Monthly Review. Pederal Reserve Bank of Kansas City, Deoemcer, 1971# PP* 3-17-

107 1 0 8

four regional clearing areas analysed In Chapter III*

Lewiston* Mainei Windsor Looks* Conneotloutt Cleveland,

Ohioi and Baltimore* Maryland.

Cheok Plow Adluataents

As discussed in Chapters I and III* Pederal Reserve

regional oenters are expeoted to affeot the flow of oheoks

between the bank of first deposit and the paying bank* when both banks are looated within the same clearing area*

especially when the bank of first deposit Is a smaller, respondent bank. The assumed routing of oheoks deposited in respondent banks* in the absenoe of an RCPC is through a correspondent looated in the respondent's trade area. With the establishment of a regional oenter* however* the pattern

is assumed to ohange* with all area banks depositing looal

items dlreotly with the Pederal Reserve.

Correspondent banks oharge for oheok oolleotlon servioes by requiring a deposit balanoe sufficiently large to enable investment return to oover the prloe of services.

Beoause pederal Reserve banks do not oharge for oheok oolleotlon servioes* rsspondent banka that reroute their’ transit Items may slthsr reduoe thsir compensating balances or purchase additional servioes with existing balanoes. State obartered nonmember banks may be restricted from reduolng correspondent balanoes by the exlstenoe of state reserve requirements. Competition for balanoes among 109 correspondents, however, should Insure that these banks receive servioes of equivalent value to oheok oolleotlng servioes no longer required*

Balanoe Heaulreaent

Proa the dlsousslon in Chapter I, the compensating balanoe requlrenent for displaced oheok oolleotlon servioes was identified asi

B ■ K'j ( f r t) ^ wherei

B m oolleoted balanoe requirement

P « unit price of oolleotlon servioes

Kj k earnings rate applied to B by correspondent

r* ■ reserve requirement applied to aooount analysis by correspondent

V* b volume of looally payable transit items deposited 1 in respondent banks

The unit balanoe requirement, z corresponds

Identically to Knight's oonstruotlon*2 Knight points out the flexibility of correspondent banks In adjusting P, Kj, and r^, indicating that a particular bank may offset a relatively high earnings allowanoe, Kj, with a high unit prloe, P, or a high value for r^. Thus, Knight has properly

^Knight, "Correspondent Bankingi Aooount Analysis," Pootnote 8, p* 11* u o

Timed the variable ^ ^ ^ j as a single element for

eaoh bank and has not separated the ooaponents for analysis

of ooapensating balanoe requirements.

Pgof jfrgbUlfr .lipgqt

Chapter I also disoussed the profitability effeots on

the two bank groups of the establishment of BCPCs.

Correspondent banks lose either the investment inoone from

oorrespondent balanoes held as compensation for looal oheok olearlng services, or the equivalent in the produotlon of other serrloes. Correspondents are benefltted, however, by a reduotlon in operating oosts from a reduotion in oheok

▼oluae• Respondents, on the other hand, should experience a net gain from acquiring, without oharge, a service that they have traditionally paid for.

These indirect effeots were avaluatadi by estimating values for the right hand side of the following two equations,

sj - HcJ • Kj • B(1 - r3) (1-10) wherei

S® ■ indirect savings to oorrespondent banks

S* m lndlreot savings to respondent banks

K2 * average before tax return on earning assets by oorrespondent banks

Ko m average before tax return on earning assets by respondent banks Ill r2 ■ marginal reaerre requlraaent rata for oorraapondanta

r~ ■ marginal reaerre requirement rata for J raapondanta

othar aynbola ara aa daflnad abore

Batlaatea for tha unit balanoa raqulraaant, p * were baa ad on a aurray oonduotad by tha Fadaral

Raaarra Bank of Kanaaa City In July« 1972* Tha elghty-flre raapondlng banka rapraaant tha major financial oantara of tha Unitad Stataa, exolualra of thoaa In tha Tanth and

Sixth Fadaral Raaarra Dlatrlota, and all aurray raapondanta wara among tha 125 largeat banka by ordar of dapoalta due to doaaatlo banka aa of tha Daoaabar 3 1 , 1971, call report,3

Tha publlahad raaults of tha aurray prorlded tha range, araraga and aedlan annual balanoa raqulraaenta for ltaaa dapoaltad. Tha analyala In thla ohapter oonaldarad tha high, low, and araraga raluea for aaoh area In ordar to

Identify tha aaxlaua, alnlnua, and noat likely lapaot,

Surrey reeulta lndloatad that oorraapondant banka aaaaaa a lower balanoa raqulraaant for ltaaa dapoaltad ' that are aaount anoodad by tha reapondent than for ltaaa

’'T h e raapondlng banka agreed to aupply analyala lnforaatlon on tha undaratending that tha raaponaaa would be treated aa atrlotly confidential, Tha daaorlptlon of tha raapondlng group waa aupplled by Robert Knight of tha Pederal Raaarra Bank of Kanaaa City, 112

that are not encoded. The Yaluea utilised In thla analysis

were baaed on pre-enooded Iteas beoause Federal Beaerre

regional oentera require amount encoding, and thoae

respondents that previously purchased enoodlng services would lose part of the overall benefit through the require­ ment that they now enoode.

The annual balanoe requlreaents per transaction, for enooded items deposited, reported by Knight are as follows

Average $0,1+2

Low 0.13

High 1.14

Median 0.32

Reserve Requirements^

The oorrespondent banks that were ezpeoted to lose oheok oolleotlon business beoause of the establishment of

Federal Reserve regional oentera were assumed to be large member banks. With the exoeptlon of the Lewiston, Maine

k ^Federal Reserve banks require amount enoodlng of depositing banks with a dally average volume In exoess of 300 oheoks. Even for suoh banks, however, early deposit deadlines for unenooded oheoks generally Induce them to deposit enooded oheoks.

^Knight, "Innovations and Trends in Bank Aooount Analysis•"

^Subsequent to the analysis desorlbed In this ohapter but prior to completion of this dissertation, the Board of Governors of the Federal Reserve System raised reserve requirements for all banks with more than $2 million of net demand deposits. Although that ohange would affeot the speolflo results obtained In the analysis, It Is not believed that the oonoluslons would be affeoted. 113 canter, therefore, the marginal reserve requirement rate, r2, was assumed to be 17*5 per oent* The Maine corre­ spondents are somewhat smaller so the value of r2 applied to Maine data was 12 per oent, the marginal rate for banka with net demand deposits between $10 and $100 million.

Estimation of the marginal reserve requirement rate for respondent banks Is somewhat more oomplex. It lsr neoessary to distinguish between member banks and nonaembers, as well as to take into aooount the rate differentials between size oategorles and among states.

The value oomputed for B represents the average balanoe requirement for all respondent banks for looal oheok oolleotlon servioes In eaoh respeotlve area. On the assumption that vj Is distributed among respondents aooordlng to demand deposit size, B was allocated to member and nonmember banks aooordlng to demand deposit size.?

Table 10 oontalns the distribution of demand deposits as of year end, 1971» between member and nonmember respondent banks in the areas served by the four RCPCs under analysis.

k weighted average value of was oomputed for the member bank group by weighting eaoh of the Pederal Reserve

System reserve requirement rates by the proportional distri­ bution in eaoh area of banks with total demand deposits in

?Thls assumption, while Intuitively appealing, is supported by unpublished researoh In Russell D. Morris, "Teohnlques for Estimating Transit Volume,1* working paper. Board of Governors of the Pederal Reserve System, November 16, 1972. 11*1-

the respective categories. Beoause reaerre requirements are

assessed against net deaand deposits* this technique may

tend to overstate the true value of T y but the difference

was not considered to be material. The results are

presented in Table 11.

The value used for for nonmember respondent banks

was the state reserve requirement for banks in eaoh of the

states containing participating banks. The values and

weighted averages are contained in Table 12.

Baralnas Bates

The earnings rates utilised in determining a value for

8® in the four areas under consideration were weighted

averages of earnings rates for all banks In the respective

membership and slae groupings. National data were seleoted

in order to maintain the generality of the results— the

results were Intended to be exemplary rather than definitive— and to maintain the oonfldentlality of earnings

data for those areas with a small number of banks in the

oorrespondent olass.

The ratio of interest* dividends and servloe charges

on securities and loans to total loans and securities was

computed for all Insured ooamerolal banks, based on 1971

earnings and year end* 1971* statements of oondltlon. The banks were grouped aooordlng to slae* Pederal Reserve membership status, and clearing status, i.e.* membership in a clearinghouse association or regional clearing area, and 115 the arithmetic mean was calculated for each group. This prooeas la described in detail In Chapter V, and the reaulta are contained in Tables 36 and 37.

The value for Kg was taken dlreotly from the computed average return ratio for large clearinghouae banks, except in Lewiston, for whioh the average return for the smaller clearing bank group was applied. Ae was the case with reserve requirement computations, the estimation of the value of Kj Is somewhat more complex. Participating banks in eaoh of the four RCFCs under analysis were grouped aooording to demand deposit size and Pederal Reserve member­ ship, corresponding to the groups for whioh the earnings ratio had been oaloulated. A weighted average K^ was computed, based on the distribution of demand deposits among the groupings in eaoh RCPC area.

The earnings rates applied were those of nonolearing banks. While it is the case that not all respondents are nonolearing banks and that during 1971 • all Baltimore RCPC banks were olearing banks, the use of nonolearing bank earnings is more consistent with the purpose of this study.

Because the objective of this seotion is to draw oonolu- sions as to the likely impact on the general olass of oountry banks, it was deoided that the earnings rates for nonolearing banks would be more appropriate to this end.

In the particular case of Baltimore, the results may be viewed as an estimate of what happened in 1970 or what would II6 be expected to happen if the center were opened In 1972 or

1973* The results of the calculations of are presented

in Table 13 and Table !<*•

T A B U 10

DISTRIBUTIOI OF DWtARD DWP03IT8 BKTWKEN MBtBER AHD HOMfBIBSR PARTICIPATIIO BABKS 3KUCIBD AREAS AS OF 12-31-71 (dollar uluei in thouaanda)

% * RCPC Moiber Romoaber Total - M « b e r Vonaaaber

. $_ . . . . $ $

Lewiston 238,321 127,631 360,962 64 86 Windsor Looks 873,761 456,927 1,319,678 66 34 Cleveland 2,134,706 422,731 1,567,437 88 17 Baltimore' 1,100,826 1,644,626 2,646,450 41 59

Souroet Call Report, Tear Wnd, 1971, ROIC.

TABLS 11

DISTRIBUTION OF D M A R D DXPOSITS OF MBIBiSR BARK RBSPORDBITS. 5BLBCTSD ARIAS, AS OF 12-31-71 (dollar valuaa in thouaanda)

0-2 2-10 10-100 100-400 Weighted RCPC Million Million Million Million Total Average

Lewiston $ 6,120$ 68,970 $ 169,223$ -0- $ 233,321 % 2.2 29.6 68.2 -0- 100*0 11*82 Windsor Looks $ 6,727 $117 ,211$ 397,816$ 352,997$ 878,751 % 0.7 18.4 45.4 40.4 100*0 12*11 Cleveland $ 48,189 $ 466, 867 $ 1,294,194 $ 340, 966 $ 2 ,134,706 % 2*0 21.4 60.6 16*0 100*0 11*66 Baltimore $ 14,187 $143,041$ 619,677$ 824,020$ 1,100,826 % 1.8 13.0 66.3 29*4 100*0 12.08 8 10 12 13

Sources Call Report, Tear Bad, 1971, FDIC. 117

TAB XI 12

RBSBE7I REQUIBBIBVT3 AID DBCAID DEPOSIT DISTRIBOTIOI FOR PARTICIPATIVE VOMiaiBBR BASKS SKLBCTKD AREAS, AS OF 12-31-71 (dollar ralnaa In thouaanda)

Demand Raaarra Weighted RCPC Dapoalta* Raqulrananta Average $

Lawiaton 127,631 12.0* Maine 127,631 12.0* Windsor Looka 445,927 11.4 Connaotleut 396,605 12,0 Maaaaohuaotta 47,324 9,0 Claraland 422,731 12.0 Ohio 422,731 12,0 Baltimore 1,544,625 14.0 Diatrlot of Coluabla 118,230 16,6 Maryland 1,109,886 16,0 Virginia 316,610 10,0

*8ouroat- Call Raport, Taar End, 1071, FDIC.

*8onroat A Prof11a of Stata Chartarad Banking. latlonal Aaaoolation of Suparriaora of 6t«te Banka, (WAahlngton, D,C«, 1971), 118

TABU 15

CCHPUT1D U jm iia s BATES FOB UM B E R RESPOIDEIT BANKS SELECTED AREAS, BT DMAHD DEPOSIT 8IZB (dollar values in thousands) ■ 1 ■

lational Wslgjbted Dmsand Percentage Average Average RCPC Deposits* Distribution Earnings" Earnings $

Lewiston 0-2 6,120 2*2 7.9* 2-10 68,978 29*6 6.2 10-100 169,225 68*2 9.5 100-400 ^>- mQm 8.2 Total 255,521 100*0 8.9* Windsor Looks 0-2 6,727 0.7 7.9 2-10 117,211 15*4 8.2 10-100 597,816 46.6 9.5 100-400 562,997 40*4 8.2 Total 875,761 100*0 8*7 Cleveland 0-2 45,189 2*0 7*9 2-10 466,567 21*4 8*2 10-100 1,294,194 60*6 9.5 100-400 540,966 16*0 8.2 Total 2,154,706 100*0 8.7 Baltimore 0-2 14,187 1.5 7.9 2-10 145,041 15.0 8.2 10-100 619,677 66.5 9*5 100-400 524,020 29*4 8.2 Total 1,100,826 100*0 8.8

•Sourcet Call Report, Tear End, 1971, FDIC*

^Sourooi Ratio of interest, dividends and servioo oharges on seourities and loans, from 1971 Statement of Inoaae, FDIC* to total loans and seourities from Call Rsport, Tear End, 1971, FDIC* 119

TABLB 14

CdfPOTB) lARRXMH RATB8 FOR S O H M B B RBSPOIDIVT BilKS 8KUCTSD AJRUL8, BT DIULXD DffOSIT SIZB (dollar u Im i In thousands)

Rational Ralghted Daaand Faroantaga Iraraga Arsraga RCPC Dapwiita* Distribution RarniagaD ■arnings

Lswlston 0-8 8,613 2.8 8.85 9-10 27,809 21.4 9.0 10-100 96,609 76.8 10.9 100-400 ^)- -0- 9.0 Total 127,631 100.0 10.45 Vlndaor Looks 0-2 8,472 0.8 8.8 2-10 94,780 21.2 9.0 10-100 100,687 22.6 10.9 100-400 247,068 66.4 9,0 Total 445,927 100.0 9.4 ClaTaland 0-2 48,282 10.7 8.8 2-10 178,826 42.8 9 JO 10-100 198,678 47.0 10.9 100-400 -0- 9,0 Total 422,781 100.0 9.9 Baltiaoro 0-2 26.221 1.6 8.8 2-10 214,061 18.9 9.0 10-100 269,469 16.8 10.9 100-400 1,046,894 67.6 9,0 Total 1,644,626 100.0 9.8

*Soarost Call Raport, Toar Bad, 1971, PDIC,

^Souroas Ratio of lntaraat, divldands and aarrloa chargsa on saauritlaa and loana, frcat 1971 Btataaant of Inoaaa, FDICj to total loana and aaottrltlaa fraa Call Raport, Toar Rod, 1971, FDIC* 1 2 0

Utilising the 1973 annuel volume for V* as computed

in Chapter III and the unit balance requirement* reported

by Knight ae above, the following values aay be ooaputed for

reduced oonpeneatlng balance requirements due to the

existenoe of the Baltimore clearing oenter.

TABLE 16

A00RB0ATS BA1AMCB REqUXRBIEIT FOR DISPUCBD CHECK COIICCTIOK SERVICES, BALTIMORE AREA BAMKS 1978 VOLUMES

Unit Balanoe Annual Cm * Requirement y ° | « . Aggregate B $

1. Low Talu* 0.15 142,919,000 18,689,470 2. High Talus 1.14 142,919,000 162,927,660 5. Average Talus 0.42 142,919,000 60,025,960

Tablet 16 and 17 ooablne the results of Tables 10 through 15 with volume estlaatee derived in Chapter III for estimation of S® and sf, respectively. Values in paren­ theses are negative. The three oases in eaoh of the tables relate to the low value9 high value, and average value estimates of the oolleoted balanoe requirement, respec­ tively. Cases 1 and 2 indicate the range of possible results, but were not considered representative.

The results, based on average values, lndioate an expectation that Baltlmore-Vashlngton correspondents as a olass would experience reductions in oolleoted balanoes in 121

the order of 60 million dollar* and reduced before-tax

profits of approximately 1*6 million* Respondents as a

olass should hare found the RCPC'a oheok collection serrloss

worth 4*7 million dollars in terms of before-tax profits in

1973.

TABLI 16

CCMPHTATIOIS FOR 8?, BALTIMORE ASEA. BARKS 1978 T0LTKS8

Case c * i > *2 (*"r2) 1 *

1* 0*0126 134,844,000 *066 18,689,470 0*826 678,864 2. 0*0226 184,844,000 •066 162,927,660 0*826 (7,458,111) 8. 0*0126 184,844,000 •066 60,026,980 0*826 (1,582,864)

TABU IT

CCMFUTATI0I8 FOR 8f, BALTIMORE ARIA BARKS 1978nrOLTMKS

Case Distribution B (l-rs) Ij aj I s j $ $

141 saber .41 18,689,470 •8792 •088 669,668 ■omaeber .69 18,689,470 .8600 .098 877,287 1,466,896 2 41 saber •41 162,927,660 •6792 •088 6,168,066 Bomsaber •69 162,927,660 •8600 JO 98 7,688,666 12,866,621 541saber •41 60,026,960 •8792 •08B 1,904,024 Vomeaber •69 60,025,960 •6600 •098 2,882,626 4,786,649 1 2 2

In spite of the faot that the Baltlaore Center was

established in 1970* these results cannot be substantiated

emperloally by analysis of balanoe sheets and lnooae state­

ments. The following is a partial list of impediments to

suoh analysis, derived from conversations with :

bankers• For many of the nonaember banks, compliance with

state reserve requirements resulted in holding balances

sufficient to pay for oheok collection servioes so that a

reduotion in due-from-bank accounts was not observed. For

others, lnoludlng member banks, transaction balanoes and

purchases of additional servioes have held due-from-banks

accounts near previous levels.

Although the correspondents did experience balanoe

reductions from looal respondents, as a olass they were able

to replaoe the lost balanoes by selling looal collection

servioes to out-of-area banks. The deposit deadlines at

the Baltimore center permitted participating banks to

deposit until midnight, or later for preprooessed oheoks,

but restricted out-of-area banks with an afternoon deadline.

Baltimore and Washington correspondent banks were, thus, able to replaoe balanoes lost from looal banks with deposits

of banks In other oltles who were eager to speed oolleotlon of HCPC area oheoks.

With respeot to lnoreased profitability among respondent banks, the advantage was at least partially offset by the requirement that participating banks pay for items presented by the center on the dey of presentment*

The Baltimore oenter wee established prior to the November, 1972, amendment to Regulation J, discussed in Chapter Vi and, thus, the respondent banks as a class experienced an offsetting reduction in investable funds and likely, a reduction in earnings*

Thus, while in every likelihood the relationships between respondent banks and their regional correspondent are significantly affected by the establishment of Federal

Reserve oenters, the effeot is reflected in oheok flows and not neoessarily in balanoe sheets and income statements*

One area correspondent banker oonfided that his bank had lost eighteen million dollars in oolleoted balanoes from looal respondents, yet that loss was not refleoted in year end balanoe sheet comparisons•

Tables 18 through 26 oontain the computations for the Lewiston, Windsor Looks and Cleveland olearing areas respectively. 12k

TABU 18

AOOBBOA1B HAUICB REQUIRBIEIT FOR DISPIACBD CBXCX C0LUCT20B SERVICE8, 1EWI8TOV ARIA BAHK5 1878 VOLWE8

Unit Balanov Annnal Cm * Roqulrwent Yoltaa Aggro^to B

1. Low Valu* 0*18 31,263,000 4,062,890 2. Hlgb Yaluo 1*14 81,268,000 86,628,420 8* Average Vain* 0.42 81,268,000 18,126,260

T A B U 19

CCMFUTATIOIS FOR 8$, 1EWI8TOH AREA BARES 1978 VOLQIX8

6° Cm o xc! (v?)* *2 B (l-r2) . $ l l 1. 0.0126 29,690,000 0.082 4,062,890 0.88 77,947 2. 0.0126 29,690,000 0.082 86,628,420 0.86 (2,199,821) 8. 0.0116 29,690,000 0.082 18,126,260 0.88 (676,066)

T A B U 20

CCMFUTATIOIS FOR flff, UWI8I0M AREA BAJOCS 1978 fOLTXES

% Cm * Distribution B (l-r,) *8 8* x*l $ r

1-Mabir •64 4,062,890 •6868 •089 206,226 Vonatabor •86 4,062,690 .88 •104 188,860 889,086 24f«ibor •64 86,628,420 .6868 •069 1,799,667 Iom«ibor .86 86,628,420 .88 •104 1,178,866 2,978,628 8-Xoabar •64 18,126,260 .8866 •089 668,086 Xonawbar •86 18,126,260 .88 •104 481,478 1,096,608 125 TA B U 21

AGGREGATE RAIASCS REOUZRMEIT POR DISPLACED CHECK COIUCTIOS 8EHYICB, WIIDSOH LOCKS AREA BASKS 1978 VOLTEES

Unit B*l*ne* Annual Cm * R*quirM*nt Tola** A||r*(tte B £_____ 1. Low T*l«* 0.18 109,869,000 14,282,970 2* Hitfi T*ln* 1.14 109,869,000 126,260,660 S. AT*r*g* T*la* 0,42 109,869,000 46,144,980

T A B U 22

C

Cm * M c J (t J)* L B (l-r2) 8? -* , *______f 1. 0.0126 74,492,000 0.066 14,262,970 0.86 101,695 2 . 0.0125 74,492,000 0.066 126,260,660 0.88 (6,848,408) 8. 0.0126 74,492,000 0.066 46,144,980 0.88 (1,748,960)

T A B U 28

ompuiatioes f o r ij, w u d s o r l o c k s a r e a b a s k s 1978 T0LQI2S

% Cm * Distribution B (X-r8) r8 a & £ ______$ 1 4 « b * r .66 14,282,970 •6789 #08T 720,810 Som**b*r •84 14,262,970 .8860 .094 404,444 1,126,264 2

AGGREGATE BALANCE RBQUIRBCENT FOR DISPLACED CHECK COLLECTION SERVICES, CLEVELAND AREA BANES 1973 VOLTMES

Unit Balanoe Annual Cm * Require*#nt Volua# Aggregpt* B

1* Lev Value 0.18 60,716,000 6,692,960 2. High Tali* 1.14 60,716,000 67,616,100 3. Average Value 0.42 60,716,000 21,800,800

T A B U £6

COMPUTATIONS FOR Sf, CLIYEIAND AREA BANKS 1978 VOLQfZS

Cm * MC? (*?)• h B (1-r*) 8° $ a 1

1. 0.0126 47,800,000 0.066 6,692,960 0*86 214,681 2. 0.0126 47,800,000 0.066 67,816,100 0.88 (2,760,401) S. 0.0126 47,800,000 0.066 21,800,800 0.88 (689,621)

TABLE £6

IMPUTATIONS FOR 8*, CIEVBIAND AREA BANKS 1978 VOLOIES

* Cm * Distribution B < ^ r 8> *8 8j $ .. r

1-Maaber •88 6,692,960 •8886 .087 420,818 Nomeaber .17 6,692,960 .88 •099 97,644 618,267 2-Meaber •88 67,815,100 •8886 .087 8,688,460 Nomeaber .17 67,816,100 •88 •099 666,264 4,644,724 5-Me*b*r •83 21,800,800 .8886 •087 1,868,906 Noaaeaber .17 21,800,800 •88 •099 816,466 1,674,871 12? Interpretations

Analysis of the results oontslned In Tables 15 through 26 leads overwhelmingly to the oonoluslon that in

the areas served by Federal Reserve Check Processing Centers

correspondent banks aay be expected to experienoe a signif­

icant loss of inooae and respondents aay be expeoted to

experienoe a significant lnorease. The Pederal Reserve is

absorbing a larger share of the cost of oheok oolleotlon and

Is passing the. private sector cost reductions baok to the

bank of first deposit. In doing so the Federal Reserve is

also effectively passing the correspondents* profit aargln

on sales of oheok oolleotlon servioes baok to the

respondents.

It is expeoted that the aggregate level of Interbank balanoes will be reduced substantially beoause of RCPCs.

The reduotlon will be nltlgated sonewhat by the exlstenoe of

reserve requirements Imposed by the states.

Additionally) it would appear that correspondents

that price their oheok oolleotlon servioes at or near the

lowest point of the range found by Knight either provide

suoh servioes at a loss, or have unique situations with regard to operating oosts. Beoause the average oost values utilised in this analysis are direct variable oosts and do not inolude any overhead allocation, it is reasonable to assume that lowest prloe banks are offering oheok oolleotlon 128

aervloea m a loaa leader, either knowingly or unknowingly,

Por euoh banka the aatabllahaant of an BCPC aay tend to

lnoreaae profitability.

Finally, the data fron Tablaa 15 through 26, along

with roluae data fron Chapter III, parait a oonaldaration of

a peculiarity of the aarket for oorraapondant aervloea that

la a raault of both the regulatory ayataa and the nature of

ooapanaatlon. Thla peculiarity Ilea In the faot that the

value to the aallar of what la reoeived aa payaent la lower

than the value to the buyer of what la paid, in an abaolute

aenae aa oppoaed to a utility aenae.

Under the aaauaptlone of thla and the previoue

ohaptera the groaa value of ooapenaatlon to oorreepondent

banka for looal oheok oolleotlon aervloea la equal tot V* * HO® + 8®.

and the ooat to reapondenta of providing the oorreepondent

with thla ooapenaatlon la equal to 8*. Table 2? liata

theae valuea, baaed on average valuea for 8° and 8*.

Even if eamlnga ratee were equal, due to the

graduated aohedule of reeerve requirement*, oorreapondenta would reoelve leaa than reapondenta pay. fieoauae enaller banka hold lower reaervea agalnat demand depoalta, reapond­

enta aa a olaaa oan earn more on eaoh dollar depoalted than

oan large oorreapondenta aa a olaaa. Thla impllea that under the exlatlng atruoture of reaerve requirement■, 129 respondents would be better off to pay for correspondent

serrloes on a fee basis than on a compensating balanoe

basis.

TABLE 27

CCMFAHI80I OF VALUE OF COUFBMSATIOI AID COST FOB CHICK CUARZVO 8EKVICK, A1KUAL BASIS 1978 K8T3MATSD VALUI8

Ccaponoatlon to Coot to A*** Correspond* nt Respondent Difference $ $

Baltimore 4,666,612 4,736,649 71,087 Lewiston 966,727 1,096,608 128,781 Vlndoor Looks 8,122,812 8,686,489 618,127 Clows land 1,278,668 1,674,871 400,818

The reasons for paying for oorreepondent oheok

oolleotion servioes through compensating balanoes are not

entirely dear. Part of the reason is the faot that the

deposit of oheoks for oolleotlon automatically generates deposits, and detailed monitoring of oolleoted balanoes nay be a task of oonslderable difficulty for smaller banks.

Prom the seller's standpoint, banks are notoriously

slse oonsolous, and, other things oqual, larger banks would prsfer to be paid in deposits to bsoone larger banks. In

Knight's survey none of the reporting correspondent banks

lndloated that it offered oheok oolleotlon servioes on a fee basis.**

®Knight, "Innovations and Trends in Bank Aooount Analysis," Table Jf. 130

Bobert Knight suggested that the basis for payment

▼la compensating balanoes Is the balanoes generated through oheok oolleotlon services.^ If this were the oase a shift of oheok oolleotlon serrioes to the Pederal Beserre would open the way for payment on a fee basis# and may tend to lnorease oompetltion for the sale of other correspondent serrioes by reduolng the respondent's dependence on correspondent banks looated in geographic proximity.

Overall, the results presented in thle chapter do not appear to be unique to the areas analysed. It should be expeoted# therefore, that the proliferation of Pederal Beserre Regional Cheok Processing Centers will hare a substantive lmpaot on the relationship of respondent and oorrespondent banks that will be detrimental to the profitability of correspondents as a elase and benefiolal to respondents as a olass.

9Ibid. CHAPTBB V

EXPECTATIONS PROM REGULATION J

Thla ohapter Is oonoemed with anticipating tha

•ffacts of ths November 9, 1972* amendment to Psdoral

Reserve Regulation J on ths relative profitability of

various classes of ooaaeroial banks. The analysis is

oonoerned with ooaparing asset and profitability measures

between olasses of banks and dobs not, therefore, consider .1 seoondary effeots that aay ooour due to shifts in the

pattern of oheok oolleotion beoause of the amendment.

As disoussed in Chapter I, it should be expected, a priori, that banks that are permitted to defer payment for their oustomers' oheoks for one day should be more profit­ able than banks that are not permitted to do so, other things equal. It should also be expeoted that if suoh an advantage existed prior to the amendment, the advantage would disappear.

The advantage to deferred payment banks should oome about due to the operation of two faotors. First, by deferring payment for Its oustomers* oheoks for one business day, a country bank, historically, would have had a permanent pool of investment funds larger by an average day's presentments than a oity bank of equal slse. That is,

131 132 It should be expeoted that lnvestable funds per dollar of denand deposit would be higher for deferred payaent banks*

Second, banks that are able to defer payment hare one business day to reaot that Is not available to laaedlate payaent banks. Increased reaction time reduces the risk of

Illiquidity due to unusually large deposit withdrawals* and

It should be expeoted, therefore, that deferred payaent banks would hold a saaller proportion of highly liquid, near-oash assets In their portfolios relative to olty banks.

Beoause, on average, yield Is Inversely related to liquid­ ity, deferred payment banks would be expeoted to gain a higher return per dollar Invested than would laaedlate payaent banks•

Comaorolal banks are not totally dependent on the

Federal Reserve for oheok oolleotlon. Clearinghouses, oorreepondent deposits and oheok exohange agreements are utilized when they are justified on the basis of faster oolleotlon time. A laok of slgnlfloant dlfferenoes In earnings and asset measures between olty and country banks would Indicate that the extra-Federal Reserve oolleotlon system has negated the potential advantage of the deferred payaent system.

To analyze these postulations the population of ooaaerolal banks In the United States was divided Into twenty groups, and a series of hypotheses was tested. The 133 grouping* wore by size, by payaent statue prior to

November 9* 1972* and by Pederal Beserve membership. The

distribution of banks among the twenty groups Is oontalned In Table 2B.

TABLE 28

DI8TRIBUTI0V OF V W B S B OF BA1K8 BT SI21, FEDERAL RB8EEVB MMBBRSBIP AID FAMEIT 8TATU8 AM CM DEOIIBKB 81, 1971

Mentor Banks l e n d a t o r Banks D n u d Deposits Total (in millions) laaedlate Deferred iHedlate Deferred

0 - 2 20 751 141 2,660 2,682 2 - 1 0 228 2,868 260 2,621 6,987 1 0 - 1 0 0 209 1,256 265 648 2,476 100 • 400 80 109 16 20 224 400 4 62 29 0 0 91

Totals 719 6,012 779 6,849 12,269

Sourest Call Report, Tear lad. 1971, FDIC*

The size groupings were seleoted to oorrespond with

Pederal Beserve groupings for assignment of reserve require- ments to member banks. A slight dlfferenoe In groupings

ooourred beoause this study based Its size olasslfloations

on total demand deposits whereas the Pederal Beserve

olasslfloations are based on net demand deposits, a measure whioh nets unoolleoted oheoks and balanoes due from other banks against total demand deposits. It was assumed that 1 3 ^ the Federal Beserve eeleoted the five eize oategoriee ae approximately representing banks with different oharaoters of business. It was further aseuaed that distinctions observed by the Pederal Beserve are not precisely defined by the net demand deposit groupings and that the total deaand deposit groupings utilised in this study contain banks of similar oharaoter.

Although the oharaoteristlo of Interest in this study was the inaediate or deferred payaent status of the banks in eaoh else group* it was deolded that the size groups should also be segregated by Federal Beserve membership•

This segregation was made beoause dlfferenoes in reserve requirement burdens and other regulatory requlreaents render the two groups not wholly comparable with respect to earnings expectations.

A further olasslfloatlon* based on holding oompany affiliation, was rejeoted. Although it may be suggested that holding oompany affiliation Improves the earnings of smaller affiliates* a reoent study by Talley found no slgnlfioant lnorease In profitability of a group of aoqulred banks relative to similar sized Independent banks in the same market area.1

^Samuel H. Talley* "The Effect of Holding Company Acquisitions on Bank Performance*" Staff Boonomio Studies (unpublished* Board of Governors of the Federal Beserve System* Washington* D.C.* 1971)* 135 Analysis

Analysis of the first sffsot desoribed abors was based on the ratio of earning assets attributable to deaand deposits to deaand deposits. Beoause of wide dlfferenoes in reserve requiresents applied to nonaenber banks aaong the states this aeasure was applied only to aeaber banks. Earning assets attributable to deaand deposits were defined as follows* (V-l)

Bd . E - jj3D (1 - rCD) + T (1 - rT ) + P Pp + bJ wherei

Bd m earning assets attributable to deaand deposits

B ■ total earning assets CD ■ certificate of deposit liabilities

*c d * reserve requlreaent on oertlfioate of deposit liabilities

T * other tlae deposits

rf ■ reserve requlreaent on other tlae deposits

P Pp ■ Pederal Punds purchased

B * other funds borrowed

This oonstruotlon aakes the siapllfylng assuaptlon that banks do not hold nonearning assets as reserves against tlae deposit withdrawals in ezoess of legal requlreaents.

The following hypotheses related to the ratio» B^/d were tested In the study, where Bd is as defined above, and d is total deaand deposits. 136

1JHq For member banks in size class A the ratio Eg/d

for immediate payment banks is equal to the r* ratio Eg/d for deferred payment banks.

2JHQ For member banks in size class B the ratio Eg/d

for immediate payment banks is equal to the

ratio Eg/d for deferred payment banks.

3JHQ For member banks in size class C the ratio Eg/d

for immediate payment banks is equal to the

ratio Eg/d for deferred payment banks.

4JH0 For member banks in size class D the ratio Eg/d

for immediate payment banks is equal to the

ratio Eg/d for deferred payment banks.

5JH0 For member banks in size class E the ratio Eg/d

for immediate payment banks is equal to the

ratio Eg/d for deferred payment banks.

Where size groups were defined as follows:

Size group A = 0*< total demand deposits ^ 2,000,000

Size group B = 2,000,000

10,000,000

Size group C = 10,000,000 < total demand deposits^

100,000,000

Size group D = 100,000,000 < total demand deposits^

400,000,000

Size group E = 400,000,000 total demand deposits 137 The alternative hypotheses 1JH^ through 5JHA were

that ratio E^/d ie larger for deferred payaent banks than for ianediate payaent banks in eaoh of the respective groups•

In the absence of prior knowledge oonoeming the distribution of the ratio it was decided to eaploy a nonparaaetrio test to evaluate the hypotheses. Three nonparaaetrio tests are particularly applioable to testing for attribute difference between two groups, Chi Square,

Kolaogorov-Smirnov one tailed test, and the Hann Whitney U test.

The Chi Square test is not satisfactory for the purpose of this study beoause, while it peraits stateaents as to the siailarity of distributions of two sets of statistios, it does not identify whioh paraasters of the two distributions differ. Beoause the interest of this study is with the location and not with the variance or other paraaeters, the Chi Square test is not satisfactory.

The Kolaogorov-Salrnov (K-S) test and the Mann-

Whitney (M-W) test both test for location and both rely on ranking of observations rather than on the absolute values.

The K-S test relies on ouaulatlve distributions of obser­ vations, and the M-W relies on individual observations.

Beoause H-V Is aore powerful than K-S for a given snaple 138

size greater than 20, it was deolded to utilize the 2 Mann-Whitney U teat to teat hypotheses 1JB0 through 5JH0 .

The ratio E^/d waa computed for eaoh of the ten member bank aub-groupa, Summary results are shown in

Table 29. The values of the ratio B4/d for eaoh of the pairs

of aub-groupa by size were ranked in order of size and the U statistic waa oomputed. The U statistic was normalized

by oomputlng the Z atatlatio whioh is normally distributed

with zero mean and unit variance. These results are also

oontalned In Table 29. The "X" column oontalns the

arlthmetlo mean value for eaoh bank olaaa, and the "3M

column oontalns the standard error.

TABU 29

CMFUTAIIOIS FOR RATIO l/d FOR XWBBR BARKS BT 8X2B AMD PAWIMT STATUS AS OP DBCMBB SI, 1971

laaedlate Banka Deferred Banka Daand Depoaita — (in aillione) I 8 X 8 U 2

0 - t 1.187 0.419 1.178 8.848 10,060.0 -1.148 2-10 1.126 0.S92 1.222 0.478 802,188.0 -8.287 10-100 1.087 0.195 1.168 0.196 171,472.0 -4.821 100 - 400 0.828 0.284 0.988 0.126 8,295.0 -8.868 400 + 0.806 0.110 0.868 0.127 804.0 -1.882

2A oomplete description of thla algorithm la oontalned in Sidney Siegel, Nonparametrlo Statistics for the Behavioral Solenoes. (New Yorki HoGraw-Hlli Book Co., 1982}• 139 Five ratios were employed to measure the seoond

effect• as follows*

1* Liquidity* Cash and due from banks + U.S.

Government seourltles/Total assets*

2* Liquid Investments* U.S* Government seourities/

Total assets* 3* Average Return* Total ourrent operating revenue-

Trust lnoome/Total earning assets*

*t* Average Yield* Interest* dividends and servioe

charges on seourities and loans/Total loans and

seourities*

5* Profitability* Net lnoome/Total assets.

A total of forty-five hypotheses were tested in comparison of asset and profit ratios between olty and oountry banks* Numerically* the hypotheses were identified as 6jh0 through 50JBo * The form of the hypothesis statements was ldentioal throughout and may be characterised by the following statement of hypothesis 6j h 0 *

Sj Hqi The liquidity ratio for immediate payaent

member banks of slse group A is equal to the

liquidity ratio for deferred payaent member

banks of sice group A*

Hypothesis 7JHC concerned nonmember banks in sice group A* and so on through the slse groups with nine hypotheses for iko eaoh ratio* As Is indloated in Table 28, there wars no nonaeaber banks in size group B, so that nine hypotheses oorer the entire population*

Stateaent of the hypotheses nay, thus* be simplified as followsi

6JH0-UtJH0 i The liquidity ratio for lanedlate

payment banks Is equal to the liquidity

ratio for deferred payment banks (by

respeotlve size groups and nenbership

status)•

15JH0-23JH0i The liquid InTestaents ratio for

immediate payment banks is equal to the

liquid investments ratio for deferred

payment banks.

2J*JH0-32JH0 i The average return ratio for immediate

payment banks is equal to the average

return ratio for deferred payment banks*

33JHo-*UJH0i The average yield ratio for immediate

payment banks Is equal to the average

yield ratio for deferred payment banks*

The profitability ratio for Immediate

payment banks Is equal to the profit-

ability ratio for deferred payment banks* Ikl

The alternative hypotheses 6JH^ through 50JHA ere as follow*I

6JHA-l*fJHA i The liquidity ratio for lmaedlate payment

banks Is higher than the liquidity ratio

for deferred payment banks (by

respectIts aeabershlp and slse groups)•

15JHa -23JHa i The liquid Investments ratio for

laaedlate payment banks Is higher than

the liquid Investments ratio for

deferred payment banks*

2*WHa -32JHa i The average return ratio for deferred

payment banks Is higher than the average

return ratio for Immediate payment

banks*

33JHa -JHJHa i The average yield ratio for deferred

payment banks Is higher than the average

yield ratio for Immediate payment banks*

42JHa -50JHa i The profitability ratio for deferred

payment banks Is higher than the

profitability ratio for Immediate

payment banks*

The methodology employed to test hypotheses 6jh0 through

50JHo was ldentloal to that employed to test hypotheses

1JH0 through 5JH0 * Relevant data are contained in Tables

30 through 39* A rejection level of Of ■ *01 was employed for all tests* Table 40 oontalns a summary of hypotheses tests* I*f2

lilU 90 CCMPUTATIOM8 FOR LIQUIDITY RATIO FOR Mil BEE BASKS AS OF DBCMBSR 51, 1071

Zaaodlato Banka Oaf#rr«d Banks Daaaad D#poaita (la allliona) I 8 I 8 0 2

0 - 2 0.371 0.177 0.378 0.162 10,367.0 •0.749 2-10 0.816 0.115 0.828 0.116 314.800.0 -1.993 1 0 - 1 0 0 0.301 0.100 0.284 0.088 178.493.0 -2.166 100 - 400 0.805 0.116 0.273 0.089 3,261.0 -2.968 400 + 0.804 0.078 0.270 0.065 666.0 -2.070

XABLB 81

CaiPOTATIORS FOR LIQUIDITY r a t i o f o r s o w w b b e BARKS AS OF DBCMBSR 31, 1971

Taa#dlat# Banka D#f#rr#d Banks Dm a n d Deposits (la allliona) I S T 8 U Z

0 - 2 0.349 0.140 0.367 0.148 168.614.0 •2.082 2-10 0.802 0.113 0.812 0.118 691.099.0 -2.308 1 0 - 1 0 0 0.266 0.087 0.256 0.100 77,615.0 -2.139 100 - 400 0.239 0.077 0.246 0.171 116.0 80* 400 + IA IA IA IA IA IA

*Ih# 2 atatiati# approximate# th# normal distribution if the nusbar of obterrations in th# larger group, ij, #xo##d# 20* In this oat# Kg equals 20* Th# Talu# la th# Z ooltap for th# ocapariaon la th# oritioal value of I for a on#-tailed t«at at th# 0*01 level. 1^3

TABLE 82

COCPUTATIOIS FOR LIQUID X IV I8 9 I1 IT 3 RATIO FOR UMBER BMKS AS OF DECBCBXR 81, 1971

S naadlata B u ka D a fa rra d Banka

(In aillllona) X 8 I 8 U 2

0 - 2 0*268 0*179 0*261 0*184 10,618*0 -0*621 2-10 0*138 0.112 0*206 0*106 292,907*0 -8 *6 4 0 1 0 -1 0 0 0*162 0*098 0*168 0*076 190,689*5 •0*48 0 100 - 400 0*120 0*069 0*119 0*066 4,866*0 -0 *0 1 1 400 + 0*109 0*054 0*107 0*065 87 4.0 -0 .2 1 3

TABU 88

(XMPUTATIOKS FOR LIQUID IITO31MBITS RATIO FOR VOMJMBBt RUES AS OF DECMBER 81, 1971

laaadiata BankaD a fa rra d Banka Dmuad Dapoalta (In allliona) I 8 T 8 0 Z

0 - 2 0*288 0*130 0*260 0*186 162,767*0 -2*647 2-10 0*200 0*109 0*209 0*111 692,448*0 -2 *0 4 1 1 0 -1 0 0 0*164 0*088 0*166 0*098 79,688.0 -1*678 100 - 400 0*140 0*071 0*184 0*187 107*0 80* 400 + u IA IA IA I t I t

*8aa footnota, Tabla 81*

r TABU M

COIPUTATIOH8 FOR A7KRA0B RRTORH RATIO FOR MBfBER BARKS AS OF D R C M R SI, 1971

Zniidltti Banka Dafarrad Banks Dm and Dapoaita (in millions) X 8 I 8 V Z

0 • 2 0*0776 0*0882 0*0791 0*0678 9,761*0 -1*249 2-10 0*0766 0*0665 0*0625 0*0680 807,208*0 -2*664 1 0 - 1 0 0 0*0822 0*0978 0*0988 0*0884 169,269.0 -5*468 100 - 400 0*0791 0*0776 0*0824 0*0564 8,808*0 -1.499 400 + 0*0670 0*0794 0.0662 0*0702 888.0 -0*094

T A B U 85

COCFOXATIOVS FOR ATRRAOB RBTBRM RATIO FOR R O M M ERR BARKS AS OF DBCOIBRR Si, 1971

SModlata Banka Dafarrad Banka Dm o d A Dopoolts (in millions) Y S Y 8 0 Z

0 - t 0*0940 0*0870 0*0881 0*0626 186,429*0 -0*118 2-10 0*0700 0*06SS 0*0908 0*0656 496,795*0 -6*766 1 0 - 1 0 0 0*102S 0*0909 0*1094 0*1165 81,082.0 -1*148 1 0 0 - 4 0 0 0*0879 0*0688 0*0900 0*0628 145*0 80* 400 + HA HA HA HA HA HA

‘h i foot not*, Tnbla SI* 1 *5

TABU 86

CCMPUIATIOIS FOR AVESA91 T1BLD RATIO FOR m m BARKS AS OP DBCMBSR 81, 1071

Raaadlata Banka Dafarrad Banka Pea and Dapoaita (in nilliona) T 8 I 8 U 2 S s o o l o o o l e s 0 - 2 0.0714 4 1 6 • ^ 0.0742 0.0629 9.602.0 -1.872 Q+* 2-10 0.0698 0.0766 0.0622 807.608.0 -2.917 1 0 - 1 0 0 0.0762 0.0660 0.0B14 165.019.0 -4.061 100 - 400 0.0708 0.0762 0.0622 8.767.0 -1.828 400 + 0.0696 0.0692 0.0582 891.0 -0.068

T A B U 87

CCMPUTATIOIS FOR AVSRAQB TIKLD RATIO FOR V O M M B B BARKS AS OP DBCMBSR 81, 1971

liaaadiate Banka Dafarrad Banka Doiand Dapoaita (in ailllona) I S I 8 U 8

0 - 2 o o oo 0.081 0.088 0.077 187,170.5 -0.088 2-10 0.0482 0.0882 0.0697 492,110.0 -8.996 1 0 - 1 0 0 0.0907 0.0996 0.1085 80,086.0 -1.488 100 - 400 0.0462 0.0808 0.0689 142.0 80* 400 + HA IA IA IA IA

*Saa footnota, Tabla 81* Ik6

TABUS 88

CCMFUTATIOIS FOR PROFITABILITY RATIO FOR MJkfBRR BARKS AS OF DRCBIBKR 81, 1671

laaadlata Banka Dafarrad Banka Daaand Dapoaita (in allliona) 7 S I S U 2

0 - 2 0.0080 0.0149 0.0068 0.0106 10,571.0 -0.672 2-10 0.0089 0.0096 0.0100 0.0096 291,468.0 -3.T49 1 0 - 1 0 0 0.0094 0.0109 0.0112 0.0121 171,168.0 •8.190 1 0 0 - 4 0 0 0.0074 0.0068 0*0094 0.0068 8,653.0 -2.172 400 + 0.0082 0.0017 0.0074 0.0022 648.0 -2.160

XABLS 89

G(MP0TATI0I3 FOR PROFITABILITY RATIO FOR BORCMBSR BARKS AS OF DSCBIB5R 81, 1971

Xanediata Banka Dafarrad - 3 Daaand Dapoaita (in allliona) I S I V 2

0 - 2 0.0094 0.0161 0.0091 0.0186 186,292.0 -0.239 2-10 0.0077 0.0086 0.0118 0.0105 483,551.0 -7.418 1 0 - 1 0 0 0.0116 0.0126 0.0131 0.0141 82,027.0 -0.865 1 0 0 - 4 0 0 0.0094 0.0042 0.0116 0.0078 187.0 80 400 + Rl RA RA RA RA RA

aS w footnota, Tabla 81, 11*7

Table k O summarizes the results of hypothesis testing.

TABLE 40

RESULTS OP HYPOTHESIS TBSTIRO* RATIO

Liquid Average Average Profit­ Bank Group Vd liquidity Investaents Return Yield ability

A - Member V V IH M 1 A - Von* saber 1 R V ■ H B - H saber R VRRRR B - V o a a b i r 1 V R RR C - Msaber R 1 I R R R C - Horasaber V V M I I D - Msaber R R I V V ■ D - Votamber I V V 1 V E - Maiber V K V ■ I I

*R indicates tha null hypothesis w i rejeeted in favor of the alternative hypothesis* H lndloates the null hypothesis eras not rejected*

InteroretatIon

In general, the results In Table 1*0 lndloate that the relative performance between laaedlate and deferred banks was not slgnlfloantly different In the saallest and largest bank groups, but was slgnlfloantly different within aedlua sized bank groups. Belatlre perforaanoe ooaparlsons of nonaeaber banks generally parallels that of aeaber banks with the exoeptlon of the 10 - 100 ailllon size group. 148

A feasible explanation of the general pattern is as followsi Very swell oountry banks are typically located aowe distance froa finanoial centers so that nost of their customers* oheoks are received over the counter or through

Informal exchange arrangements with other local banks*

Thus* relatively few oheoks are reoelved by these banks for payment on a deferred basis* and they do not differ sub­ stantially with regard to payment from their olty counter­ parts*

The very large deferred payment banks typically are located in regional finanoial centers that do not oontaln

Federal Beserve offloes* but do oontaln clearinghouses providing for "immediate” payment for oheoks cleared.

Examples of such cities would be Hartford, Columbus,

Indianapolis, Milwaukee, and Phoenix*

Cheoks drawn on these large "country" banks and deposited in banks that are not members of the paying bank's olearlnghouse were typloally oolleoted through correspondents that are olearlnghouse members* Thus, while large oountry banks had deferred status relative to the Pederal Beserve system, the proportion of the value of oheoks paid that were presented by the Federal Beserve was not substantial. Thus, as with the very small banks, they did not differ significantly from their Federal

Beserve olty counterparts with regard to overall oheok payment* 1U9 For member banks In the size range from two to one hundred Billion In demand deposits* and for nonaenbers

In the two to ten Billion range* liquidity ratios do not differ slgnlfloantly* but oountry banks exhibit higher average yields and higher profitability* Country banks also exhibit higher values for the ratio E&/d.

An aooeptable Interpretation of the results for aedlua sized banks Bay be found In a standard banking test* suoh as Robinson.3 Banks are expeoted to hold a primary liquidity reserve in U.S. Government seouritles and, to a lesser extent, balances with other banks, In relation to the dally variability of demand deposits. In addition to the prlnary reserve* however* banks are also expeoted to hold a seoondary liquidity reserve of somewhat less liquid, higher yielding assets, for oontlngeneies.

Assuming that the size and aakeup of the seoondary liquidity portfolio Is related to reaotion time, and assuBlng that the primary reserve Is not, the Table ttO results for mediua sized banks is not lnoonslstent with the hypothesis that deferred payment banks are more profitable beoause they are deferred payment banks.

The results of the tests for nonmember banks In size olass C are not oonsistent with the above Interpretations

^Roland I. Robinson* The Management of Bank Funds. (New York* MoGraw-Hill Book Co.,Tl962). ----- 150 for sodium sited banks* Analysis of Tables 35* 37* end 39 reveals two facts that help resolve the differing results within the else olase.

First, while the grouping differences are not statistically significant at the level speolfled, the difference In the means are all In the direction of higher earnings rates for deferred payment banka* Hypotheses

29JHqi 38JH0 , and would be rejected at alpha levels of 0 .13* 0*075* end 0*187* respectively* The seoond faot apparent from analysis of the tables

Is that In all three earnings performance measures the means for the two nonnember bank groups In else olass C are sub­ stantially higher than the means for every other bank group* It Is reasonable to oonolude, therefore, that oharaoter- lstlos of nonnember banks In that slse group, other than payment status, sufficiently dominate earnings performance to oreate a high level of within olass homogeniety*

Conclusions

In view of the analytloal results and the Interpre­ tations applied to those results the following oonoluslons have been drawn with respeot to the expeoted lnpaot of

Regulation J on the relative perfomanoe of Immediate and deferred payment banks* Plrst, for very small banka and very large banks the amendment to Begulatlon J will not have a significant impact on the relative profitability of

Immediate and deferred payment banks* For member banks with demand deposits between two and

one hundred million dollars and for nonmember banks with demand deposits between two and ten million dollars, oountry banks are expeoted to beoome less profitable relative to olty banks. This adjustment is expeoted to come about as a result of shifts in asset holdings as well as relative declines in earning assets as a per oent of total assets.

For nonmember banks with demand deposits between ten and one hundred million dollars the Regulation J amendment is not expeoted to have a significant lmpaot on the relative profitability of immediate and deferred payment banks. This conclusion is based on an assumption that the faotors unique to this bank olass dominating 1971 earnings are permanent and not transitory. CHAPTER VI

SUMMARY AND CONCLUSIONS AND RECOMMENDATIONS

The prtfttadiTig- three ohapters presented the analysis of three dletlnot but related phenoaena* Thie ohapter suaaarlses the findlnge of each, and ooneldere the ooablned effeot of the Federal Reserve Systea Payments Meohanlea

Prograa.

The suaaary eeotlon treats eaoh topic in the order of the ohapters containing the analysest direct oost effects of

RCPCs, indireot correspondent banking effeots of RCPCs and profitability effeots of the Regulation J aaendaent* The section laaedlately following the suaaary contains reooaaendatlons for further related study* The final section of this ohapter oontalns a discussion of the overall effeot of the Federal Reserve prograa and states oonoluslons with regard to the lapaot on industry struoture as well as the attalnaent of Federal Reserve objectives*

Direct Cost Effects

Chapter III of this study desorlbed a teohnlque for estiaatlng the variable dlreot oost of transit oheok processing at oonaerolal banks and applied the teohnlque to a representative group of Regional Cheok Processing Center

152 banka to estimate gross direct oost savings due to the

establishment of RCPCs. The results permit statements as to

the likelihood of the Federal Beserve System meeting Its

oost reduction objectives. Further* the analysis permits

Identification of the conditions under which the Federal

Reserve system should expect favorable results*

Chapter III specified that the direct oost function for demand deposit processing In commercial banks takes the following formi

o - bo • Vt1 • »S2 • Vd3 and oomputed the marginal oost of transit processing In the form i MO? - bj. • b0 . V?!*1 • vg2 • »J3.

Utilising 1970 Functional Cost Analysis data from

150 banks having demand deposits greater than $50 million* with ordinary least squares regression In the Log form of the above function* the following values were derived as estimates for the parameters of the oost funotlon.

bQ - 0*316

bx * 0.1274526

b2 ■ 0,4404892

* 0.4229242

The marginal oost computations resulted in an estimate of the average for large correspondent banks of #0.0125 for transit item processing. 15* Analysis of the parameters lndioated that all were

slgnlfloantly lest than 1 , but that tha aua of b^f b2 , and

b^ was not slgnlfloantly different from 1. This finding

led to the conclusion that economies of scale do not exist

for direct variable oost of check processing In large banks, for a given proportionate alx of volumes.

The computed value for marginal oost Is of the order of magnitude found in the studies by Fenner and by Cox1 that were dlsoussed In Chapter II. The absenoe of eoonomles of scale In the function, however. Is contrary to Cox's oonoluslon. Cox's result Is likely attributable to a ohange

In the mix of items over bank else.

Application of the oost results to volumes reported and estimated by Federal Reserve banks In oomblnatlon with aotual and projected Federal Reserve processing oosts rssulted In a series of estimates for the effeot of regional processing oenters on 1973 dlreot cost of collecting oheoks.

The estimates varied aooordlng to the assumptions on volumes and Federal Reserve processing oosts. The range for eaoh oenter analysed was as follows*

1Linda Fenner, The Check Collection System. A Quantitative Description (Chicagoi Rank Li.i n t on Institute, 1970) and Edward Cox, The Outlook for the nation's Check Payments System1 *970-1980 (Washington. D.C.i Amerloan Bankers Association, 1970). 155 Center Low Estimate* High Bstimate* Baltimore, Maryland I (308,^30) | 207,023 Lewiston, Maine 19.330 67.942

Windsor Looks, Conneotiout (1,103.026) (517.436) Cleveland, Ohio (676,524) (498,878)

"Values in parentheses indicate negative savings*

These results led to the conoluslon that the

Federal Beserve System is thus far failing to meet its

direct oost reduction objeotlve at Windsor Looks and

Cleveland. Comparative analysis of the results for the

four centers lndioated that the oritloal variable in

determining the suooess of the oost reduotlon program is

the relationship between the volume of regional Items oomlng

from respondent banks and the new volume reoelved by the

BCPC.

In oases where the Pederal Beserve Center merely

replaoes a clearing network operated by the banks, aggregate

oosts tend to rise. On the other hand, in oases where the

BCPC eliminates the correspondent as a redundant prooessor,

oosts tend to deoline. As a first order approximation It would appear that in those oases in whioh the large

correspondent bank group contributes more than approximately

thirty per oent of new volume to an BCPC, the Federal

Beserve will not achieve its oost objective* The thirty per oent value was not tested parametrloally* 156 Indirect Correspondent Banking Bffeots

The fourth ohapter of this paper dlsouased the antlolpated effeot that regional centers will hare on the relationship between respondent and correspondent banks*

The ohapter also estlaated the oost of the centers to oorrespondents and the gain to respondents* One Interesting side benefit of the analysis was an opportunity to view the disparity between the oost of correspondent servloes to the respondent and the value reoelved by the correspondent*

This disparity exists because of differing reserve require­ ments •

The analysis In Chapter XV applied the results of

Bobert Knight's survey of unit balanoe requirements2 to volume estimates derived In Chapter XIX in order to estimate the Interbank balanoe requirement reductions available due to the opening of speolfio RCPCs. Actual reserve require­ ment rates and national average earnings rates were applied to the estimated balanoe requirements in order to estimate losses to oorrespondents and gains to respondents* Gross reductions In lnoome to oorrespondents were partially offset by reduotions In the oost of processing oheoks from respondents*

2Robert B* Knight, "Innovations and Trends In Bank Aooount Analysis" (remarks presented at the National Correspondent Banking Seminar, New Orleans, Louisiana, Ootober 30, 1972). The results, based on the average unit balanoe requirement found by Knight, were as follows*

Balanoe Cost to Gain to Center Requirement Correspondents Heapondenta Respondents Baltimore $60,025*980 Lewiston 13 * 126,260 Windsor Looks 46,lMt,980 Cleveland 21 * 300,300

The Federal Reserve is effectively creating a monopoly in the collection of looal oheoks, in those areas where it is establishing RCPCs, by prloing the oorre­ spondents out of the market. In so doing, it is not only transferring the oost of oheok oolleotion from the private to the public sector, but also it is effectively transfer­ ring a substantial portion of the private seotor benefit to respondent banks as a olass*

Correspondent banks that traditionally derived substantial income from the sale of oheok oolleotion servioes faoe a challenge in developing substitute services to maintain their hlstorio profitability positions or aooeptlng reduoed earnings frdm the loss of a market.

Respondent banks that have traditionally purchased oheok oolleotion servioes should be expeoted to reap windfall profits at the publlo's expense. 158 Profitability and the Regulation J Aaendaent

Chaptar V of this paper described a ooaparatlve

analysis of bank groups designed to anticipate the effeot

that the November 9, 1972 aaendaent to Pederal Reserve

Regulation J will hare on the relative profitability of

olty and oountry banks. The aaendaent requires all banks to pay for oheoks presented on the day of presentaent. This

eliminates a praotloe under whloh banks located outside

Pederal Reserve offloe oltles previously paid for their oheoks on the day after presentaent.

Banks were grouped into five site classes, by Pederal

Reserve membership, and as to payment praotloe. Data from the Deoeaber, 1971 Report of Condition and Statement of Inooae were used to ooapare various asset and earnings relationships bstwsen laaedlate and deferred payment banka, within the same size and Pederal Reserve membership oatsgorles. Msaber banks were not ooapared with nonaeabers and site group lines were not orossed.

In generalv the conclusions were that deferred payment banks were neither more profitable nor less liquid than thslr lmasdlate payment counterparts in the smallest and largest bank groups. Purther, in the smallest and largest groups, deferred pajment banks did not appear to have more money to invest per dollar of demand deposit. 159 For banks in the size range between two million and

one hundred million in demand deposits, however, deferred

payment banks appeared to have been more profitable than

their oity counterparts. These banks also appeared to have

had more money to Invest per dollar of demand deposit

liability.

It was oonoluded from the analysis that medium-sized

oountry banks should ezpeot to ezperlenoe a deoline in

earnings relative to their olty counterparts. The absenoe

of significant dlfferenoes within the large and small bank

groups oan be explained by the faot that for those two

groups the Federal Beserve Bank presentments typloally do

not oonstltute the bulk of oheoks received for payment.

Considerations for Further Besearoh

Programs to effeot major ohange in the payments

meohanism, both ongoing and potential, raise a number of

Important questions for the banking industry in general,

and the Federal Beserve System in partloular, as well as

for the nonbank users of payments servioes. This seotlon

identifies oertaln major questions that should be researohed

as payments meohanism ohange beoomes increasingly widespread.

Although the Federal Beserve System has stated

repeatedly that its objeotlve in the BCPC prograa is the

reduction of oheok oolleotion oosts, it nay be that the program would be defensible on other grounds even If oost 160 reduction objectives were not met. The following are three areas in which research may demonstrate the social desira­ bility of RCPC's.

1. RCPC's may reduce the risk of loss to banks from faster return of unpayable checks. Although data are not made available on the losses of commercial banks from acceptance of checks that are not collectible, they are believed to be substantial. Under the assumption that the likelihood of loss increases with the time required to determine that a check is unpayable, it would be expected that RCPC's would reduce the risk of loss by reducing collection and return time, 3 2. It has been shown by Miller and Orr that the balances held by business firms increase with increased uncertainty in the net flow of funds. It is likely, therefore, that both RCPCSb and the Regulation J amendment result in aggregate savings through reductions in unpro­ ductive asset holding by reducing the uncertainity in corporate cash flow.

3. It is conceivable that Federal Reserve RCPC's, because of their profusion as well as their access to the

Federal Reserve telecommunications network, will become nodes of a national network for widespread use of electronic

3Merton H. Miller and Daniel Orr, "A Model of the Demand for Money by Firms," The Quarterly Journel of Economics. LXXX (1966) 413-35. 161

funds transfers. Further researoh end analysis is required

to Identify the requirements and potential economies of such

a system*

The Federal Reserve program, both RCPCs and the

Regulation J amendment, have had the effeot of reducing

oheok float in the banking system and, as time passes, It

should be expeoted that other programs will be instituted

that will further reduce oheok float. The possibility of

substantial reduction or elimination of oheok float raises

important issues in bank-to-bank relationships, bank-

oustoner relationships, and oorporate oash management praotloes as well as In the management of the money supply by the Federal Reserve. Although oheok float Is usually regarded as an lnefflolenoy In the banking system, It has olearly been institutionalised and oapltalised suoh that Its elimination may oause disruptions that may or may not be soolally desirable*

One final question that has been raised elsewhere Is worthy of note in this paper* Regardless of whether the

Pederal Reserve program is meeting Its oost reduotlon objeetlve. It Is olear that the Federal Reserve Is lnoreaslng Its subsidy to oheok oolleotion* At some point. Federal Reserve subsidies may prove to be a roadblook to the development of a more efflolent payments system beoause a banks may lose their lnoentlve to reduoe aggregate oosts*

**Thls problem was suggested to the author by Donald Hester in a oonversation during the summer of 1971* 162

Conclusions and Recommendations

The conclusions that can be drawn froa this study

are as follows* First, the Federal Reserve System is

generally not currently neeting its oost reduotion objec­

tives in Implementing Regional Check Processing Centers at

Windsor Looks end Cleveland and the oonditions that oause

this failure may reasonably be expeoted to exist In many

large metropolitan areas* In the two oenters named, the

opposite condition pertains, and the total oost of oheok

processing is increasing beoause of the RCPC program.

Second, in pursuing its RCPC program, the Federal

Reserve is in all likelihood dismantling its predecessor

system, the correspondent banking oolleotion network*

Rarller studies of the correspondent network have concluded

that its users were pleased with the level of servioe,

indicating that there was not a demand for the RCPC prograa

from the banking oommunlty, in terms of servioe levels*

The RCPC program, by offering oheok oolleotion

servioes without charge, oreates a windfall for respondent

banks that traditionally have purohased suoh servioes from

oorrespondents* This windfall will be partially offset in many oases by a reduotion in profitability due to the

Regulation J amendment* 163 The analysis did Indicate that there are oertaln conditions under whloh Federal Reserve RCPCs can accomplish the System's oost reduotion objectives* In those areas In whloh large banks do not exist and* therefore, are not providing looal oheok oolleotion servioes, RCPCs can reduoe oheok oolleotion oosts* A review of Table 1 In Chapter III, however, lndloates that RCPCs are being plaoed predominately

In large metropolitan areas where the likelihood of suooess

In terms of the oost reduotion objective must be considered as relatively low*

These results bring forward two questions of publlo policy relative to the Federal Reserve System and Its

Independent nature. The first question Is, as a matter of publlo priorities, Is it desirable to Increase the Federal subsidy of the oheok oolleotion industry* While there Is olearly considerable value to maintaining an effeotlve payments meohanism, there Is a legitimate polloy question of whether suoh a meohanism should be operated as a publlo or a private enterprise, espeolally In the absenoe of demon­ strable soale economies.

The seoond Issue Is related to the first, but Is more general In nature. The question of Interest Is, does the

Federal Reserve System's independence with respeot to monetary polloy Imply that Independence from Congress Is also required in performing Its other legislatively assigned funotlons* I6 if

The litigation that delayed the Implementation of the

Regulation J amendment resulted In a finding that the

Federal Reserve System has the authority under law to

specify the oondltlons under whloh it oolleots oheoks,

without a requirement for legislative review or publlo

hearing. In view of the possibility that the Federal

Reserve may have erred in the RCPC segment of its payments

meohanism program, the system's independence to disburse its

revenues should perhaps be reoonsldered in the Congress, Federal Reserve oheok oolleotion expenditure, for dlreot

oosts, will have increased from about 165*5 million in

19715 to nearly #100 million in 1973.6

^Board of Governors of the Federal Reserve System, "Functional Expense Report Annual, 1971" (unpublished, Washington, D,C«, 1972).

^Estimate provided by the Division of Federal Reserve Bank Operations, Board of Governors of the Federal Reserve System. APPENDIX A

SURVEY FORM DISTRIBUTED BY SELECTED FEDERAL RESERVE

BANKS AND UTILIZED FOR COMPUTATION OF v£ 0

INCOMING CHECKS BY SOURCE

# of ♦ of % of # % of * Source Items Items on US* on OS

Teller Function (Include night deposit)

Correspondents (same city)

Correspondents (other FRB Zones)

Clearinghouse

FRB

Nonoorrespondent Banks (Dlreot Presentment)

Other

Total

*Do not Include items In this oategory whloh are received as DDA items for other banks* 165 APPEN DIX B

LIST OP SURVEY BANKS UTILIZED

FOR COMPUTING Vg©

First Federal Reserve District

Mains Banks

Mains National Bank Northsast Bank N. A*

Connecticut Banks

Hartford National Bank Connsotlout Bank and Trust

Boston Banks

First National Bank of Boston National Shaunut National Bank

Fourth Fodsral Reserve District

Cleveland Trust Company Central National Bank of Cleveland National City Bank of Cleveland Soolety National Bank

Fifth Federal Reserve Dlstrlot

Maryland National Bank, Baltimore Riggs National Bank, Washington, D.C.

166 SELECTED BIBLIOGRAPHY

Books

Alhadeff, David A* Monopoly and Competition in Banking. Berkeleyi University of California Press, 195*+•

Careon, Deane, ed. Banking and Monetary Studies. Hoaewood, Illinois« Rlohard D. Irwin, Inc., 1 9 6 3 ,

Cohen, Kalman J«, and Hammer, Prederiok S. Analytical Methods In Banking. Homewood, Illinois1 klohard D. Irwin, Ino., 1 9 6 6 .

Commission on Money and Credit. Private Financial Institutions. Englewood cliffs, li.J.i Prentloe- HallTTno • X9 6 3 .

Draper, N. B., and Smith H. Applied Regression Analysis. New York* John Viley A Sons, 1 9 0 6 .

Finney, Katherine. Interbank Deposits. New Yorkt Columbia University Press, 19j>8. Friedman, Milton. The Optimum Quantity of Money and Other Essays. Chloagoi Adeline Press, 1$6$.

Gurley, John G., and Shaw, Edward S. Money in a Theory of Plnanoe. Washington, D.C.i Brookings Institute, WUT

Hogg, Robert V, and Craig, Allen T. Introduction to Mathematical Statistics. New Yorki MaoMllian Company, 1965* PatinkIn, Don. Money. Interest and Prices. New Yorki Harper and Row, Publishers, 1 9 6 5 .

Blohardson, Dennis W. Electronic Money« Evolution of an Electronic Funds Transfer System. Cambridge, Maes.i MIT Prisif 1970e

Rlohmond, Samuel B. Statistical Analysis. New Yorki Ronald Press, 190*+• 16? 168

Robinson, Boland I. The Management of Bank Funds. Mew Yorki MoGraw-HllI Book Coapany, 1962,

Shapiro* Jesae M., and Whitney, D. Raneon. Elementary Analysis and Statletloe. Coluabua, Ohloi Charles B. Merrill Publlahlng Co., 1 9 6 7 •

Siegel, Sidney* M««pfi"fetrlo Statlatloa for the Behavioral Solenoes. New Yorki MeGraw-Hlll Book Coapany, 19^6.

Published Studlea

Bank Administration Institute. An Bleotronlo Network for Interbank Payment Communications. dhloagoi Bank Administration Institute, 1969*

Bell, Praderlok W«, and Murphy, Nell B. Coats in Commerolal Banking. Boston1 The Pederal Reserve Bank of SoaHonT 1968. Cox, Bdward. The Outlook for the Nation*a Cheok Payments System 1970*1966. Washington. D.d.i The American Bankers Assoolahlon, 1970. Fenner, Linda and Long, Bobert V. The Cheok Collection System A Quantitative Dsaorlptlon. Chloagoi Bank Administration Institute, 1970.

Garvey, George. Deposit Velocity and Its Slanlfloanoe. New Yorki The Pederal Reserve Bank of New York, 1959 (Monograph). Graaley, Lyle B. A Study of Seals Boonowles In Banking. Kansas City, Mo.t The federal Reserve iank of Kansas City, 1962 (Monograph)• Han, Paul. Phase I-II Report1 Research on Improvements of the Payments Heohanism. Atlantai Georgia Teoh Besearoh Institute, Georgia Institute of Tsohnology, 1971. Llpis, Alan H. Phase III Report1 Besearoh on Improvements in the Payments Meohyilsn.Atlantai Georgia Teoh Besearoh Institute, Georgia Institute of Tsohnology, 1972. National Association of Supervisors of State Banks. A Profile of State Chartered Banking. Washlngton, D.C.i National Assoolatlon of Supervisors of State Banks, 1971* 169 Articles in Learned Journala

Alhadeff, David A., and Alhadeff, Charlotte P. "An Integrated Modal for Coaaerolal Banka.” Journal of Finance. XII, No. 1 (1957), 24-43.

Auerbaok, Irving. "Should Federal Beeerve Float Be Abolished and its Cheok Aotlvlties Curtailed?” Journal of Finance. XX, No. 3 (1965)# 490-503.

Baltensperger, Ernst. "Costs of Banking Activities-- Interaotion Between Bisk and Operating Costs.” Journala w T r s of s - Monev. w i : Credit and Banklna. IV. No. *1 . "Eoonoales of Soale, F i n Site and Concentration in Banking." Journal of Money. Credit and Banking. IV, No. 3 (1972)467-448.

Bauaol, William J. "The Transaotions Demand for Cash.” ^ e Quarterly Journal of Boonoalos. LXXXI (1967),

Benston, George E. "Branoh Banking and Eoonoales of Soale.” Journal of Flnanoe. XX, No. 2 (1965)*

. "Eoonoales of Soale and Marginal Costs in Bank Operations.” National Banking Bevlew. II, No. 4 (1965). 507-49. . "Eoonoales of Soale of Flnanolal Institutions.” Jou|M(^l o^Moner. Credit and Banking. IV, No. 3

Broaddus, Alfred. "The Banking Struoture.” Monthly Review. The Federal Beserve Bank of Biohaond, November, 1971. pp. 2-7+.

Brunner, Karl and Meltzer, Allen H. "Eoonoales of Soale and Cash Balanoes Beoonsidered.” Quarterly Journal of Boononloe. LXXXI (1967)* 422-36.

. "The Plaoe of Flnanolal Internedlaries in the Transmission of Monetary Polioy." Aaerloan Eoonoalo Bevlew. U I I (May, 1963)* 372-82.

Caoy, J. A., and Bedford, M. E. "Commerolal Bank Profitability! 1961-71." Monthly Bevlew. The Federal Beserve Bank of Kansas City, Septeaber- Ootober, 1972, pp. 15-24. 170

Cagan, Phillip. "The Demand for Currency Relative to the Total Honey Supply." Journal of Political Boonomy. August, 1958, pp. 308-28.

"Changes in Banking Structure, 1953-62." Pederal Beserve Bulletin. Septsnbsr, 1963* PP* 1191-£°* Clarke, John J. "An Item is an Iten is an Itea," Business Lawyer. CXXVXIX (November, 1969)* 109-19* "Correspondent Banking." Monthly Review. Pederal Beserre Bank of Kansas City, Haroh-Aprll, 1965* PP* 9-16.

Cousins, James A. "Toward a Less Cheok Society•" Notre Dame Lawyer. XLVII, No. 1 (1971). 1165-1290.

Edgeworth, Francis X. "The Mathematical Theory of Banking." Journal of the Royal Statistical Soolsty. LX IMarch, 1080).

Friedman, Milton. "The Demand for Money1 Some Theoretloal and Emperlcal Results.” Journal of Political Economy. LXVII (1 9 6 9 ) 327-51* "The Giro, The Computer and Cheokless Banking." Monthly Review. The Federal Reserve Bank of Rlohaond, April, 1 9 6 6 , pp. 2-5.

Gramley, Lyle E. "Postwar Trends In Dlstrlot Bank Earnings." Monthly Review. The Pederal Reserve Bank of Kansas City, Sepbember-Ootober, 1962, pp. 10-15*

______. "The Relationship of Bank Size and Bank Earnings." Monthly Review. The Pederal Reserve Bank of Kansas City, December, 1961, PP. 3-9*

. "The Relationship of Bank Size and Bank Earnings— Some Further Considerations." Monthly eylew. The Pederal Reserve Bank of Kansas City, february 1962, pp. 3-10. Greenbaum, Stuart I. "Costs and Production In Commercial Banking." Monthly Review. The Federal Reserve Bank of Kansas City, Maroh-ipril* 1966, pp. 11-20.

. "A Study of Bank Costs." National Banking Review. IV, No. (19 6 7). ^15-3^

Haslem, John A. "A Statistical Analysis of the Relative Profitability of Coaaerolal Banks." Journal of Plnanoe. XXXXX (1968), pp. 367-7 8 . 171

Hester, Donald D,, and Zoellnlr, John P. "The Delation Between Bank Portfolios and Bantings." Review of Boongalos and Statlatloa. XLVIII, No. 1* (1966)•

Knight, Robert B. "Correspondent Banking, Part Ii Balances and Servloes.” Monthly Review. The Federal Reserve Bank of Kansas City, November, 1970, pp. 3-1** •

. "Correspondent Banking, Part IIi Loan Participations and Fund Flows.” Monthly Review. The Federal Reserve Bank of Kansas City, December, 1970, pp. 12-2**.

. "Correspondent Banking, Part lilt Aocount Analysis," Monthly Review. The Federal Reserve Bank of Kansas City, beoember, 1971. PP. 3-17. . "The Impaot of Changing Cheok Clearing Arrangements on the Correspondent Banking System.” Monthly Review. The Federal Reserve Bank of Kansas City, December, 1972, pp. Ilf-24.

Kramer, Robert L., and Livingston, W. P. "Cashing in on the Checkless Soolety." Harvard Business Review. XLV (September-Ootober, 1967), lUl-i+9 .

Lawrence, Robert J., and Lougee, Duane. "Determinants of Correspondent Relationships," Journal of Money. Credit and Banking. II,/ No. 3 (1970), 358-69.

Meltzer, Allen H. "The Demand for Money1 The Bvidenoe from the Time Series." Journal of Political Economy. LXXI (1963), 219-U6.

Miller, Merton H., and Orr, Daniel. "A Model of the Demand for Money by Firms," Quarterly Journal of Economics. LXXX (1966), 1*13-35.

. "The Demand for Money by Firms1 Extensions of Analytical Results." Journal of Finance. XXIII (1968), 735-59. Mitchell, George W, "Effects of Automation on the Struoture and Funotions of Banking." American Boonoalo Bevlew. LVI (May 1966).

"More on Correspondent Banking." Monthly Review. The Federal Reserve Bank of Kansas City, July-August, 1965. PP. 1^-23. 172

Morris, Bussell D. "A Note on the Transactions Demand for Cash,'' Quarterly Journal of Boonomlos. LXXXV (August 1971), 5^6-547.

Odon, Rlohard S. "Alternatives to the Present Cheok Collection System." Stanford Law Review. February, 1968, pp. 571-93.

Orr, Daniel and Mellon, W. G. "Stoohastlo Reserve Losses and Expansion of Bank Credit." American Boonomio Review. LI (1961).

Poole, William. "Commerolal Bank Reserve Management In a Stoohastlo Model." Journal of Flnanoe. XXIII (December, 1 9 6 8 ), 769 -9 1 .

"Reoent Changes In the Struoture of Commercial Banking." Federal Reserve Bulletin. March, 1970, pp. 195-210.

Ritter, Lawrenoe S., and Atkinson, Thomas R. "Monetary Theory and Polloy In the Payments System of the Future." Journal of Money Credit and Banking. II. No. Jf (19/6), W - 5 0 3 .

Sohwelger, Irving, and MoGee, John S. "Chioago Baulking." Journal of Business. XXXIV, No. 3 (1961), 203-366.

Sprenkle, Case M. "Large Eoonomlo Units and the Transactions Demand for Money." Quarterly Journal of Eoonomlos. LXXX (1966), *1-36-42.

Tobin, James. "The Interest Elastlolty of the Transaotlons Demand for Cash." Review of Eoonomlos and Statistics. XXXVIII (1 9 6 6 ).

. and Bralnard, William C. "Flnanolal Intermedi­ aries and the Effectiveness of Monetary Controls." American Eoonomlo Bevlew. LIII (May, 1963), 383-400.

Yeslev, Joel M. "Defining the Product Market In Commerolal Banking." Eoonomlo Review. The Federal Reserve Bank of Cleveland, June-July, 1972, pp. 17-31. 173 Trade Journals. Magazines^ and Newspapers

"Banka Told to Re-evaluate Correspondent Relationships." American Banker. November 16, 1971* P« 1+. Carr, Hobart C. "Pricing Correspondent Banking Services." Bankers Magaslne. Summer, 1967.

"A Cashless Society Isn*t Here." Business Week. June 5. 1971, pp. 104-06. Clarke, John J. "Hard Figures and Considered Judgement on Progress Toward a Checkless Society." Amerloan Banker. February 17» 1 9 6 7 , p. 5+.

"1970 Correspondent Banking Survey." Amerloan Banker. Deoember 18, 1970, p. 57* "Bleotronlo Money." Forbes, IC (April, 1967). 42-1*6.

"Fed Haste to Open RCPCs Causing Problems at Banks, Continental Illinois Offloer Says." Amerloan Banker. April 17. 1963. P. 1+. Fenner, Linda M. "Bill Payment Systems1 What the Future Holds•" Magazine of Bank Administration. February, 1$71• PP« 20-24+, -

Head, Robert V, "The Cheokless Society." Datamation. XII (Maroh, 1967). 22-2?. Livingston, W. Putnam. "Banks and the Payment System Potential." Bankers Magazine. CLIII, No* 4, 6l-65«

"MAPS Group Asks Major Effort by Banks for Paperless Entries, Automated Clearings*" Amerloan Banker. Ootober 15. 1970, pp. 1+.

"Money Goes Bleotronlo In the 1970's*" Business Week. January 13, 1968. Odle, Harry V. "How Smaller Banks Rate Correspondent Services." Burroughs Clearing House. LV, No. 11 (1971). 19-21+1 "What Cost Bank Servloee." Bankers Magazine. Autumn, 1967.

White, Hubert D., and Morris, Russell D. "Payments System Progress." Bankers Magazine. CLIV, No. 4 (1971), 12-16. l?k

"Will Associations Fit Into ths Checkless Society." Savings and Loan Hews. XXXVIII (May, 196?), 23-35.

Unpublished Studies

Benjamins, Garry L. "Correspondent Banking In Illinoisi Evidence of Credit Flows and Pricing Praotioes." Unpublished working paper, The Federal Reserve Bank of Chloago, October, 1971* Cox, B., Dana, A. W,, and Zledler, H. M. "A Teohno-Eoonomlo Study of Methods of Iaproving the Payment Mechanism." Menlo Park, Califomla* Stanford Researoh Institute, 1966. "Final Report of the Legal/Legislative Task Foroe of the Monetary and Payments System Planning Committee." Washington, D.C., The Amerloan Bankers Association, Maroh, 1971*

Illinois Institute of Technology, Researoh Institute. "Design of a Communications System for Interbank Information Exohange." Chloago, Bank Administration Institute, 1968.

Jaoobs, Donald P., Moag, Joseph S., and Lerner, Eugene M. "The Impact of the Electronic Transfer Meohanlsm on Bank Structure." Washington, D.C., The Amerloan Bankers Association, October, 1970.

Knight, Robert E. "First Two Months of D and J— An Appraisal." Unpublished working paper, The Federal Reserve Bank of Kansas City, February, 1973*

Payments Systems, Incorporated. "The Impaot of Banking Innovation and Technology on the Future of the Bank Stationers Industry." New Zork, 1969*

Perry, Robert A. "Another Look at Federal Reserve Float," Unpublished Thesis, Stonier Graduate Sohool of Banking, Rutgers University, June, 1969*

"Report of the Operatlons/Teohnology Task Foroe to the MAPS Planning Committee." Washington, D.C,, The Amerloan Bankers Association, Maroh, 1971* 175 Special Committee on Paperless Entries. "SCOPE Recommendations." Los Angeles and San Franelsoo Clearing House Associations, August* 1970*

Sprenkle, Case M. "Effects of Large Flra and Bank Behavior on the Demand for Money of Large Firms." Working paper, Washington, D.C., The Amerloan Bankers Association, December, 1970.

"Study of Cheok Collection System." John H. Wurts, Chairman. New York, The Federal Beserve Bank of New York, 195*** Whetstone, John T., 111. "The Quantitative Investigation of the Feasibility of and Best Looatlon for Regional Cheok Clearing Centers." Unpublished Masters thesis, Massachusetts Institute of Technology, June, 1971*

Federal Beserve System Documents

"The Florida Project." Atlanta, Georgia, The Federal Beserve Bank of Atlanta, 19&9* Freed, Blohard H. "The Cost of the Payments Mechanism to the Natlon*s Commercial Banks." Washington, D.C., Board of Governors of the Federal Beserve System, July, 1971.

"Functional Expense Report." Washington, D.C., Board of Governors of the Federal Reserve System, various dates•

Letter to Donald G. Barnes, Assistant Dlreotor, Board of Governors of the Federal Beserve System from the Federal Beserve Bank of Boston, dated April 16, 1973.

Letter to Donald G. Barnes, Assistant Dlreotor, Board of Governors of the Federal Beserve System from the Federal Reserve Bank of Cleveland, dated April 16, 1973. Letter to Donald G. Barnes, Assistant Dlreotor, Board of Governors of the Federal Reserve System from the Federal Beserve Bank of Blohmond, dated April 11, 1973. Mahoney, Roberta and Morrissey, Joseph. "A Report on the Effeot of Proposed Change In Regulation J on the ' Volatility of Member Bank Reserves." Washington, D.C., Board of Governors of the Federal Reserve System, June 21, 1972. 176 Norrisi Russell D* "An Analysis of Cost Implications of Pederal Reserve Regional Clearing Centers• " Washington, D.C., Board of Governors of the Pederal Reserve System, January, 1973* . "Techniques for Estimating Transit Volume." Unpublished working paper, Washington, D.C., Board of Governors of the Federal Reserve System, November, 1972.

"Proposal for a Regional Cheok Clearing Center in the Washlngton-Baltlmore Area." Rlohmond, Va., The Pederal Reserve Bank of Rlohmond, February, 1968.

"Proposed RCPC Clearing System for the Fourth Pederal Reserve District." Cleveland, Ohio, The Pederal Reserve Bank of Cleveland, October, 1972.

"Proposed Regional Cheok Clearing System for the Fifth Pederal Reserve Distrlot." Rlohmond, Va., The Pederal Reserve Bank of Rlohmond, August, 1972.

"A Regional Cheok Processing Center Proposal for the State of Maine." Boston, The Pederal Reserve Bank of Boston, February, 1972.

"A Regional Cheok Processing Center Proposal for South­ western New England." Boston, The Pederal Reserve Bank of Boston, July, 1972.

Snyder, Eugene E. "A Study of the Cost of the Government Payment Meohanlsm." Washington, D.C., Board of Governors of the Pederal Reserve System, June 17» 1971. "Statement of Polloy on the Payments Meohanlsm." Press Release, Board of Governors of the Pederal Reserve 8ystem, June 17, 1971* "Statement of Guidelines for Regional Cheok Processing Canters." Press Release, Board of Governors of the Pederal Reserve System, February 2, 1972.

"Statement by the System Steering Committee on Improving the Payments Meohanlsm." Press Release, Board of Governors of the Pederal Reserve System, February 2, 1972. "Statement of Intention to Amend Regulations D and J." Press Release, Board of Governors of the Pederal Reserve System, Maroh 27, 1972. 177 "Statement Announcing Amendments to Regulations D and J." Press Release, Board of Governors of the Pederal Reserve System, June 21, 1972*

Whetstone, John T., Ill, and Hutchens, Jens H., Jr. "Current Pederal Reserve Payments Meohanlsm Expenses." Washington, D.C., Board of Governors of the Pederal Reserve System, September, 1970.

Other Government Documents

Pederal Deposit Insurance Corporation. Annual Report. Washington, D.C., various years.

Mitchell, George W. Statement presented before the Legal and Monetary Affairs Subcommittee of the Committee on Government Operations, U.S. House, February 19, 1966. (Mimeographed).

U.S. Congress. House. Committee on Banking and Currenoy. Subcommittee on Domestic Plnanoe. Reports on Banking Questionnaires. 88th Cong., 2nd sees., Washington, D.C., U.S. Government Printing Office, 1964.

U.S. Congress. House. Government Operations Committee. Pederal Reserve System— Cheok Clearance Float. B. Rept. 1335, 89th Cong., 2nd sees., Washington, D.C., U.S. Government Printing Offloe, Maroh 17# 1966.

Speeches

Cooley, Rlohard P. Speeoh before the 96th Annual Conven­ tion, The American Bankers Association, Miami, Fla., Ootober 14, 1970. (Mimeographed)

Franols, Darryl R. "Where Is Banking Headed In the 1970's?" Speeoh before the Wlsoonsln Bankers Association, Bank Exeoutlve Seminar, University of Wlsoonsln, Madison, Wlsoonsln, February 3> 1971# (Mimeographed.) Golenbe, Carter H. "A New Ball Game for Banking." Remarks before the Annual Seminar for Correspondents, New England Merohants National Bank, Boston, April 7, 1972. (Mimeographed.) 178

Johnson, Herbert E., and Blokerv Charles S. "Economic Implications of the Checkless Sooiety." Speeoh presented at the American Bankers Association Cheokless Sooiety Committee meeting, Washington, D.C., June 20-21, 1987* (Mimeographed*)

Knight, Bobert E* "Innovations and Trends in Bank Aooount Analysis.* Beaarks at the National Correspondent Banking Seminar, New Orleans, Louisiana, Ootober 38* 1972. (Mimeographed.)

Malsel, Sherman J* "Flnanolal Aspeots of the National Eoonomlo OutlookSpeeoh before the National Agricultural Outlook Conference, U.S. Department of Agriculture, Washington, D.C., February 23, 1971* (Mimeographed*)

Mayo, Bobert P. "The Challenge for Banking In the Seventies." Bemarks at the Group I, Iowa Bankers Association Meeting, Sioux City, Iowa, February 12, 1971* (Mimeographed.) Mitchell, George W. "Automation and Banking Structure." Beaarks at the Amerloan Institute of Banking, Philadelphia Chapter, Forum, Maroh 8, 1968. (Mimeographed.)

* "Banks and Money." Beaarks at the Annual Convention of the Mlohlgan Bankers Association, June 29, 1968. (Mimeographed.)

______. "Can 'Good* Money Drive Out Bad." Bemarks at the American Management Assoolatlon, New York, Maroh 24, 1971• (Mimeographed•) . "Confrontation Within Banking! Maohlnes Versus Bankers or Bankers with Maohlnes." Proceedings of the National Autonation Conference. I960. New Yorki American bankers Association, 1966, PIP* 35-42•

______. "Everybody’s Problem— The Movement of Money." Bemarks at the International Conference of the Financial Executives Institute, Chloago, October 22, 1969* (Mimeographed.)

. "The Needle in the Paper Staok." Bemarks at the Senior BAnklng Forum of the Amerloan Institute of Banking, Kansas City, Missouri, Maroh 19, 1970. (Mimeographed.) 179 . "Paying and Being Paid— The Convenience and Economies of Electronic Transfers of Funds." Beaarks at the Annual Stockholders Resting, Federal Reserve Bank of Boston, October 14, 1971. (Mimeographed.)

. "Our Changing Banking Structure," Remarks at the Annual Convention of the Maine Bankers Association, June 14, 1968. (Mimeographed.)

. "Tomorrow's Money as Seen Today." Remarks at the 1966 Annual Stockholders Meeting of the Federal Reserve Bank of Boston, October 6, 1966, (Mimeographed.)

Sherrill, William W. "Banking at the Crossroads." Remarks at the 1971 National Automation Conference, Amerloan Bankers Association, New York, May 3. 1971* (Mimeographed•)

Miscellaneous

"Bleotronlo Money and Payments Meohanlsm." Annual Report of , Boston* The Federal Reserve Bank of Boston,

Gallagher, J. Richard. "Automation Alternatives for Small Banks." Proceedings of the National Automation Conference, New torki Amerloan Bankers Association, 1907, pp# 225-47, Moving Money In the Seventh District. 1971 Annual Report of the Federal Reserve Bank ot Chloago, 1972,

Uniform Coc^araial Code. Mundelein, Illinois 1 Callagan anti Company, 1947*