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Bruce J. Summers is a senior vice president and chief financial officer at the Federal Reserve Bank of Richmond. R. Alton Gilbert is a vice president and banking advisor at the Federal Reserve Bank of St. Louis. Mary C. Lohmann provided research assistance.
began declining in 1980, when the Reserve Clearing and Banks began charging for payment ser- vices, as required by the Monetary Control Settlement of Act. This declining share, for both small- and large-dollar payments, appears to rep- U.S. Dollar resent a major shift in the operation of the U.S. dollar payments system. Our paper Payments: Back examines the implications of this shift for the Federal Reserve’s ability to fulfill its to the Future? mandate to safeguard the stability and efficiency of the payments system. In particular, we examine whether the prob- Bruce J. Summers and lems that existed in the payments system R. Alton Gilbert prior to 1914 will at some time reappear as the Fed’s operational role declines. It is The Federal Reserve System was important to consider whether the nation’s formed in 1914. Wide dissatisfaction with payments system has changed in ways that routinely expensive and slow settlement of make Reserve Bank services less essential interregional payments, as well as occa- for dealing with the problems that have sional disruptions of the payments system beset it in times past, and what the future caused by banking panics, are among the role of the Federal Reserve Banks should factors that led to its creation. Accordingly, be as payment processing systems con- an important purpose for creating the Fed- tinue to evolve. eral Reserve to serve as the nation’s central The following section examines the bank was to enhance the efficiency and operation of the payments system prior improve the stability of the nation’s pay- to the formation of the Federal Reserve, ments system. focusing on aspects of the system that At the time of the formation of the were considered defects by advocates of a Federal Reserve, the paper check was the central bank. Subsequent sections estab- principle means of making payment. The lish a conceptual framework for our anal- Federal Reserve attempted to fulfill its ysis and describe the payment services mandate for improving the check-collec- offered by the Reserve Banks and trends tion system by providing banks with a in their share of the total volume and national check-collection service.1 Since value of U.S. dollar payments processed it was the only institution with a nation- each year. The article then discusses rea- wide network of banking offices and sons for the declining Reserve Bank share settlement accounts for banks, it had an of payment processing and the implica- advantage in interregional check collec- tions of these trends for the payments tion. Over time, the Reserve Banks added system. new payment services to exploit the ad- vantages of new technology: wire transfer PROBLEMS WITH THE of reserves, a book-entry service for safe- PAYMENTS SYSTEM PRIOR keeping and electronically transferring ownership of government securities, and TO THE FORMATION the automated clearinghouse, designed as OF THE FEDERAL RESERVE an electronic alternative to checks. An analysis of the importance of The share of U.S. dollar payments pro- Reserve Bank payment services for the 1 For convenience, depository cessed through the Federal Reserve Banks banking industry in the United States institutions are called banks.
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requires a review of some banking history.2 on accounts of their depositors at par, By the mid-1850s, the dollar value of U.S. through local clearinghouses. The banks bank deposits exceeded that of banknotes, that imposed exchange charges generally and the value of transactions settled by were relatively small and located in more check exceeded the value of transactions isolated areas. settled by banknote. This growth in Collecting banks attempted to avoid check transactions required a system for these delays and exchange charges by clearing a large number of checks among using the services of correspondent banks. banks. Before the introduction of Federal Often depository banks (the banks of Reserve services, commercial banks first deposit) sent checks drawn on banks cleared checks drawn upon other local outside their communities to their cor- banks by channeling them through local respondent banks. The correspondents clearinghouses or delivering them directly would then send the checks to other banks to the local banks for payment. Typically, with offices near the paying banks, which, local checks could be collected quickly in turn, would present the checks to the and at par. paying banks over the counter. In this Collecting checks drawn on banks system of collection through correspond- outside a given community involved more ents, depository banks might receive less time and expense. When checks were pre- than the face amount of the checks, but sented directly to paying banks at their more than if the checks were sent directly place of business, the banks were required to paying banks. The correspondents by law to pay the face value of the checks. would split the collection fee (the differ- Banking law did, however, permit banks to ence between the face value of the checks pay less than the face amount of checks and the amount credited to the demand submitted for collection by indirect means, accounts of the depository banks) with the such as through the mail. The rationale other banks that had assisted them in get- for this deduction from the face amount, ting the checks to the paying banks. In called an exchange charge, was that remit- some arrangements, the correspondents ting payment could involve certain costs, would credit the demand accounts of including the cost of transporting coin or depository banks for the full amount of the bank notes from the paying bank to the checks being collected but would require collecting bank. Delays were another the depository banks to hold large demand expense to collecting banks, in addition balances as a form of compensation for to exchange charges. Under banking law, this service. Under either arrangement, a bank that received checks through the it was competition among correspondent mail became the collecting agent for the banks that tended to reduce the costs of bank that had sent them and was therefore collecting interregional checks. responsible for obtaining payment from The process of collecting checks itself. As a result, paying banks often through correspondents as a means of remitted funds to collecting banks several avoiding exchange charges led to some days after receiving checks through the notorious cases of checks passing through mail. the offices of many banks and traveling Despite the rationale for exchange over very long distances, relative to the charges, many bankers considered them actual distance between the depository a basic defect in the operation of the pay- bank and the paying bank. Many of the 2 The discussion of the check- ments system. Prior to the formation of the resulting delays and operating expenses collection system prior to 1914 Federal Reserve System, there were several could have been avoided through more and changes made by the Federal Reserve is based on major proposals and attempts by bankers direct collection channels. Competition Spahr (1926), chapters IV, VI, to eliminate exchange charges. Opposition among correspondent banks, however, and VII; Watkins (1929), to exchange charges was most common led to substantially reduced levels of chapter VI; and White (1983), among bankers in the larger cities, where exchange charges over time (Spahr, 1926, chapter 2. banks generally paid for checks drawn pp. 102–3).
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Although exchange charges declined and received certificates that served as substantially over time, many bankers claims on the gold; they cleared checks continued to view them as a fundamental through the clearinghouses and settled defect in the operation of the nation’s pay- their net positions with clearinghouse ments system. Congress responded to calls certificates. At times of relatively high for reform by giving the Federal Reserve a depositor demand for gold and currency mandate to improve the efficiency of the (banknotes and greenbacks), the clearing- payments system, and the Federal Reserve houses created additional certificates for responded by establishing a national net- interbank settlement, called loan certi- work of offices for collecting checks. Be- ficates. Banks that borrowed these addi- cause the Federal Reserve Act forbids the tional certificates from their clearinghouse Reserve Banks from paying exchange pledged some of their commercial loans or charges to banks, the Reserve Banks estab- other securities to the clearinghouse as lished the practice of accepting for deposit collateral. This process of accepting bank only those checks drawn upon banks that loans as collateral and issuing loan certifi- 3 Under the Federal Reserve’s had agreed to pay the Reserve Banks at cates had the effect of increasing the Regulation J, which governs the par.3 Although the Federal Reserve was not monetary base. Members of the clearing- collection of checks and other granted legal authority over the exchange house could use the gold and currency in items by Reserve Banks, an charges set by individual banks, its domi- their vaults to meet the demand of their “item” does not include a nant operational role in check collection depositors without concern that they check that cannot be collected eventually made collection at par (zero would have insufficient cash assets to at par. Further, the Reserve exchange charges) a national standard for cover net debit positions at the clearing- Banks are required to accept the banking industry. house. cash and other items at par. Another problem with the operation of On several occasions after clearing- 4 After passage of federal bank- the payments system prior to the forma- houses had created loan certificates for ing legislation in the 1860s, tion of the Federal Reserve in 1914 was their members, clearinghouse members the paper currency in circulation the occasional disruption of the payments also suspended currency payments to their comprised notes issued by system caused by banking panics. When depositors. While creation of loan certi- national banks and greenbacks events caused depositors to lose confi- ficates helped banks respond to unusually (fiat currency issued by the United States Treasury). dence in the safety of their deposits, they large demands for currency, the loan Because national banks were demanded payment in gold coin, bank- certificates were used primarily to settle required to back their notes 4 notes or greenbacks. Banks located out- interbank positions with the clearing- with U.S. Treasury securities side the major financial centers maintained house. Banks were obligated to pay their deposited with the Treasury large shares of their cash assets in deposits depositors gold or currency but did not Department, the public consid- with major banks in the financial centers, always do so when their inventories were ered national bank notes as particularly New York City, and they inadequate to meet the demand of their safe as gold coins, even during tended to respond to depositors’ substan- depositors.5 Instead, during some general banking panics. tial cash withdrawals by drawing down suspensions of currency payments to 5 Some have criticized the deposits with these banks. Sprague (1910), depositors, banks paid their depositors national banks in New York City in his analysis of banking panics in the small-denomination loan certificates, for suspending currency pay- national banking era, emphasized that the issued by their clearinghouses, which ments when they still had large concentration of bankers’ deposits in a served as substitutes for currency in emer- amounts of gold and currency small number of banks in New York City gency situations (Andrew, 1908). in their vaults. These critics made the banking system vulnerable to Before the creation of the Fed, when maintain that the banks were disruption. banks in major financial centers suspended too concerned about meeting Bankers attempted to cope with panics currency payments to depositors, major their legal reserve require- ment—vault cash (gold and through cooperative arrangements imple- disruptions in the payments system re- currency) that equalled or mented through their local clearinghouses. sulted. There is evidence that these sus- exceeded 25 percent of their During normal times, activities of the pensions, each of which lasted only one deposits—rather than using all clearinghouses were limited largely to or two months during the period from of the cash in their vaults to check clearing and settlement: Banks the Civil War through 1914, seriously meet demands of their deposi- deposited gold with the clearinghouses disrupted economic activity, including tors (Dewald, 1972).
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interregional and foreign trade, partic- involves discharging the payment obliga- ularly in 1873 (Sprague, 1910, pp. 71–82) tions. To illustrate the distinction between and in 1893 (pp. 119–210). these two functions, consider the clearing The Federal Reserve System, modeled and settlement of checks among banks after the clearinghouses of the period, was that are members of a clearinghouse. authorized to deal with panics by increas- Banks rely on the clearinghouse to perform ing bank reserves through discount win- the clearing function when they exchange dow loans.6 Its creators assumed that checks drawn on each other. Then the government sanction would lessen the clearinghouse calculates the multilaterally impact of banking panics, and an experi- netted payment obligations due to and due ence in 1914, just before the Fed was from each clearinghouse participant. Banks created, may support this assumption. The participating in the clearinghouse have outbreak of war in Europe triggered runs various options for settling these obliga- on U.S. banks. However, the Aldrich- tions. Members of the clearinghouse can Vreeland Act of 1908 had authorized clear- agree to settle using cash or more likely the inghouses to put into circulation emergency deposit liabilities of a private bank, which issues of national banknotes, which had might also be a member of the clearing- been printed and stored for such an event. house, or through another institution. Roberds (1995), who finds that the real Alternatively, settlement could be accom- economic impact of the panic of 1914 was plished through the transfer of reserves smaller than that of prior panics, argues maintained at the Reserve Banks. Using that the difference can be attributed to Federal Reserve Bank liabilities to achieve government sanction for the emergency interbank settlement is important from a issuance of national banknotes. public policy perspective for at least two reasons: First, reliance on Reserve Bank liabilities contributes to the robustness of CONCEPTUAL FRAMEWORK settlement arrangements and reduces the This section describes some concepts moral hazard that might result if all pro- that are fundamental to understanding the viders of payment services relied upon a operation of the payments system and the small number of large commercial banks as role of the Reserve Banks. settlement intermediaries. Second, it is by offering Fedwire and net settlement services Clearing and Settlement to clearinghouses that the Federal Reserve In describing Reserve Bank services, is able to exert an indirect form of supervi- it is useful to distinguish between two sory influence on the safety and soundness processes: the clearing of payments and of private clearing arrangements, since the interbank settlement of payment obliga- Federal Reserve lacks statutory authority tions. Most Reserve Bank services over the operations of clearinghouses. (See combine the clearing and settlement Juncker, Summers, and Young, 1991.) functions, although the Reserve Banks also offer interbank settlement services, Network Effects with the clearing of payments among the According to the literature on indus- banks performed through private chan- trial organization, an industry has network 6 See Dwyer and Gilbert (1989) nels. The implications for the payments effects if the value of a service to a cus- and Roberds (1995). During system of declining Reserve Bank opera- tomer depends on the number of other the 1930s, the Federal Reserve tions depend on which function of the customers using the service. These net- was not effective in dealing Fed is affected more: clearing or settle- with banking panics. One view work effects have important implications is that banks relied on the ment. for industry structure and competitive Federal Reserve to deal with Clearing comprises three main steps: behavior (see Economides and White, the panics, and the Fed did not processing payment instruments, deliver- 1994; Katz and Shapiro, 1994). fulfill its role as the central ing them to paying banks, and calculating Because the payments system has bank in the face of bank runs. interbank payment obligations. Settlement some of the characteristics of a network
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6 S EPTEMBER/OCTOBER 1996 industry, it is also important to consider One alternative, of course, to using the role of network effects in its operation. the Fed’s network is to develop a private To illustrate, consider the value of mem- network for interregional check clearing. bership in a check clearinghouse to banks Developing such an alternative would have with offices in a community where several been especially difficult prior to 1980, banks conduct business. Initially, each however, when the Reserve Banks pro- bank sends payment instruments to each vided payment services to member banks of the other banks demanding payment in only, free of explicit charge. Prior to pas- currency for checks that are presented. sage of the Monetary Control Act of 1980, Then, two of the banks in the community which required the Reserve Banks to decide that they can reduce their operating charge for their services, almost all of the costs—and the risk of having currency lost banks that cleared a high volume of inter- or stolen—by arranging for their messen- regional checks were members of the gers to meet at an intermediate point and Federal Reserve System. A rival to the Fed exchange checks. The two banks agree to for interregional check clearing would settle among themselves by debiting and have had to convince banks to pay a posi- crediting balances they hold with each tive charge per check (compared to a zero other, rather than moving currency about charge per item in the Fed’s system) or the community. withdraw from Fed membership and This clearing and settlement arrange- rely on the new private system. Once the ment would be even more efficient if these Reserve Banks began assessing check- two banks were to get a third bank to join clearing charges and requiring all banks them, clearing checks among the three to maintain reserves, the private systems banks under rules they agree to adopt as a for check clearing became more viable clearinghouse. In the same way, this clear- alternatives to the clearinghouse services inghouse would be even more valuable for of the Reserve Banks. its members if additional banks joined. If Industries with strong network effects these network effects are strong enough, also tend to be highly concentrated. If pri- there will be one check clearinghouse in vate payments networks were to supplant the community, and all banks with offices the role of the Reserve Banks, this develop- there will be members. ment would raise antitrust issues with In an industry with network effects, respect to access to the payments system. the first entity to develop a network has Thus, the declining role of the Reserve an advantage over later entrants. To be Banks in processing payments and the successful in developing a rival network, development of private systems for check the new entity must convince many partic- clearing compel us to examine the issues ipants to switch to its network simul- of competition and monopolies in the taneously, since the value of a network to nation’s payments system. each participant depends on the number of other participants using the network. Many years ago, the Reserve Banks devel- FEDERAL RESERVE BANK oped a dominant network for interregional SERVICES check clearing, which gave the Federal This section reviews the laws and Reserve leverage over the operation of Federal Reserve policies that govern the the payments system. Even if some banks activities of Reserve Banks as providers of did not like the rules under which the payment services. It also describes the Reserve Banks offered payment services principal payment and payment-related or the process innovations favored by the services provided by the Reserve Banks. Fed, those with a lot of interregional The appendix describes the payment checks to clear found it advantageous to services of the Reserve Banks in more use the Fed’s clearing and settlement detail and discusses major changes in the network. services over the years.
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Further, Reserve Banks have access to priv- MCA GUIDELINES FOR PRICING ileged supervisory information concerning BANK SERVICES the condition of banks, which they may The following section of the Monetary Control Act use to protect themselves from losses in (MCA) specified guidelines for the pricing of Reserve providing payment services and related Bank services: credit. In addition, they can create reserves “Over the long run, fees shall be established on the to meet the liquidity needs of banks. basis of all direct and indirect costs actually incurred in providing the Federal Reserve services priced, includ- Law and Policy Governing Reserve ing interest on items credited prior to actual collection, Bank Services overhead, and an allocation of imputed costs which The Reserve Banks provide payment takes into account the taxes that would have been paid services under the authority of the Federal and the return on capital that would have been provid- Reserve Act, as amended over the years. ed had the services been furnished by a private busi- The terms and conditions under which ness firm, except that the pricing principles shall give they provide services are governed by due regard to competitive factors and the provision of regulations of the Board of Governors an adequate level of such services nationwide.” and implemented through Reserve Bank Thus, the basis for the Federal Reserve’s setting the operating circulars.7 prices of its payment services below levels as specified The Monetary Control Act of 1980 in this section of the MCA is inadequate competition in (MCA) was a watershed for the Reserve markets for payment services or an inadequate level of Banks as providers of payment services. services in at least some regions of the nation. Prior to passage of the MCA, the member banks in the Federal Reserve shouldered a required reserve burden which they could Background satisfy through only two forms of non- The Reserve Banks function as bank- earning assets: deposits held in accounts ers’ banks: Banks that use the Fed’s pay- with the Reserve Banks and vault cash. ment services maintain reserve balances Banks that were not members of the Fed at the Reserve Banks and have access to system were not burdened by this require- credit from the Fed. All transactions cleared ment. Provision of “free” payment services through the Reserve Banks are settled on a by the Reserve Banks was viewed as an gross basis; that is, the value of each trans- offset to the reserve requirement burden.8 action is settled through a debit or credit But the MCA changed all that: to a bank’s reserve account. Occasionally, debits and credits resulting from use of the 1. It extended the reserve require- Fed’s payment services can cause a bank ments of the Federal Reserve to all to miss its target for reserves, or they can depository institutions. cause a negative reserve balance. Reserve 7 2. It granted all depository institu- Operating circulars are detailed Banks lend reserves to banks that are tem- tions access to the discount window instructions concerning particu- porarily short of funds, including both lar banking services, including and to Reserve Bank services. account services, payment ser- intraday credit (daylight overdrafts) and vices, and the discount window. overnight credit (discount window loans 3. It required the Reserve Banks to Some apply uniformly to all 12 or overnight overdrafts). The Reserve charge explicit fees for their services. Reserve Banks, while others Banks also serve as fiscal agents to the fed- apply to the services of individ- eral government by providing payment Under the MCA, the Reserve Banks’ ual Reserve Banks. services to the United States Treasury and revenue from fees on their payment to various other government agencies. services must, over the long run, equal or 8 For an analysis of the value of “free” Reserve Bank payment Reserve Banks have special privileges exceed the cost of providing the services services to member banks rela- and powers as suppliers of payment services. plus a markup to reflect the tax rates and tive to the opportunity cost of For example, they have legal authority to profit rates of private-sector firms (see their required reserves, see present checks for same-day settlement shaded box on MCA guidelines). Thus, Gilbert (1977). later in the day than do private banks. the MCA subjects the Reserve Banks to
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S EPTEMBER/OCTOBER 1996 market discipline similar to that faced by new costs for handling a quasi-payment commercial firms: Reserve Banks must instrument, the Board decided to deny the provide services efficiently, price them credit card industry access to the check competitively, and meet the market’s stan- clearing infrastructure of the Reserve Banks dards for quality services. Further, they (Brimmer, 1967). Accordingly, the Reserve must be careful to gauge the profitability Banks play no role in processing credit card of new service offerings. transactions. Instead, a private-sector infra- Since passage of the MCA, the Federal structure has grown up to support this Reserve Board has also issued guidelines important component of the payments that specify in more detail the conditions system. under which Reserve Banks may provide In contrast to this decision on pro- payment services. The guidelines issued in cessing credit card slips, the Board agreed, June 1981, state that “the System should at approximately the same time, to requests be prepared to remove itself from the pro- from bankers that the Reserve Banks pro- vision of those services that can be sup- vide operational support for the nascent plied more efficiently by the private sector, automated clearinghouse (ACH) as a unless there are overriding public interest method of processing payments. The ACH considerations for maintenance of an represented a desirable alternative to checks operational presence by the System” (Fed- that would require new automation sys- eral Reserve Regulatory Service 7–191). tems and significant start-up costs. Be- Further, the Board of Governors’ May 1990 cause these start-up costs would have been policy statement on the role of the Federal difficult for the private sector to absorb, Reserve in the payments system sets ad- the Board permitted the Reserve Banks to ditional conditions to be met before the take on this new operational responsibility. Reserve Banks may offer new payment ser- Payment Services of the vices: “the service should be one that other providers alone cannot be expected Reserve Banks to provide with reasonable effectiveness, Cash Services. The Reserve Banks provide scope, and equity” (Federal Reserve Regu- coin and currency to banks on demand latory Service 7–145.1). Thus, the MCA, and receive excess coin and currency from together with Federal Reserve Board poli- banks; the banks’ reserve accounts are cies, establishes market-oriented criteria debited and credited for the value of these for determining whether and how the transactions. However, Reserve Banks do Reserve Banks are to provide services. not charge banks for cash services, since While these formal and explicit condi- the Board has determined that cash tions under which Reserve Banks may services are a central bank function. continue to offer existing services or enter new payment markets were developed after Check Clearing. The offices of Reserve Banks passage of the MCA, earlier decisions by the throughout the nation receive checks from Board of Governors suggest something banks for collection, and the proceeds from about the Federal Reserve’s philosophy in the collection of these checks are credited to providing services. In particular, there is evi- the reserve accounts of the depositing banks. dence that, well before the MCA, the Board The timing of credits reflects the length of wished to proscribe Reserve Bank involve- time required for the Reserve Banks to present ment in the processing of new types of the checks to the banks on which they are payment instruments. In the second half of drawn (paying banks) and to receive pay- the 1960s, for example, the Federal Reserve ment, which is made by debiting the reserve came under some pressure from bankers to accounts of the paying banks. To facilitate this adapt its check-clearing services to handle process, the Reserve Banks operate a national the processing of credit card sales slips. For system for transporting checks to the paying a variety of reasons, including concern over banks. Reserve Bank check-collection services the public sector’s shouldering significant include both the clearing function (receiving
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CALCULATING THE FED’S SHARE The calculations in Tables 1–3 are based on three categories of checks processed by Federal Reserve Banks: those issued by the federal government, U.S. postal money orders, and all other checks (referred to as “commercial checks”). Commercial checks processed in the United States include “on-us” checks—checks drawn on the banks where they were first deposited. Since “on-us” checks do not have to be cleared between banks, in all three tables we have subtracted them from the totals for inter- bank checks processed in the United States. For example, the figures for 1980 in Table 1 were calculated in this manner: Annual Reports of the Board of Governors include the numbers of checks processed by the Reserve Banks each year. The Annual Report for 1980 indicates that the Reserve Banks processed 15,721 million commercial checks, 705 million government checks, and 117 million postal money orders. The number for commercial checks, however, reflects double counting: Checks received by one Reserve Bank that were sent to another Reserve Bank for collection were counted as checks processed by each bank. Beginning in 1982, the Annual Reports eliminated this double counting of com- mercial checks. The numbers for 1982 are available with and without the double counting: The number of commercial checks processed without double counting is 94 percent of the number with double counting. Applying this 94 percent adjustment to the data for 1980 yields an estimate of 14,777.7 million commercial checks, and 15,599.7 million for total checks, including government checks and postal money orders. The total number of commercial checks in the nation in 1980 is estimated as 42 percent of the number of commercial checks processed by the Reserve Banks. We divided the number of checks the Fed processed by the percentage of checks that it processed to arrive at the total number of commercial checks issued in the United States in 1980: 14,777.7m/.42 = 35,185 million. Of these 35,185 million checks, approximately 29.6 percent, or 10,414.8 million, were “on-us” checks. We subtracted the “on-us” checks from the commercial checks, then added the federal government checks and the U.S. Postal orders to arrive at the total number of interbank payment items processed in 1980: 35,185m – 10,414.8m + 705m + 117m = 25,592.2 million. In Table 2, the average estimated value of a check in 1980 was $792, and the aver- age estimated value of an “on-us” check was $867. Average check values in these tables are based on the values in the 1979 Atlanta Fed Check Study, adjusted for infla- tion and other factors. The values for checks processed by the Federal Reserve are actual, except that 1980 data have been adjusted for the double counting that was used in Federal Reserve reporting systems at that time. We multiplied the number of commercial checks by the average value per check (35,185 million ϫ $792) to arrive at a total value of $27.9 trillion for checks processed in the United States in 1980. We then subtracted the estimated value of “on-us” checks (10,414 million ϫ $867 = $9.0 trillion) and added the value of federal government checks ($599 billion) and postal money orders ($6 billion) to arrive at a total value of $19.4 trillion. In Table 3, we divided the number of payment items that the Federal Reserve Banks processed by the total number of interbank payment items processed in the United States (as calculated in paragraph 3, above) to arrive at the Federal Reserve’s share of payment-items processing for 1980: 15,599.7 million / 25,592.2 million = .61, or 61 percent.
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checks and presenting them to paying banks) government agencies. These services in- and the settlement function (debiting and clude issuing and redeeming U.S. Treasury crediting reserve accounts). securities as well as securities of other U.S. Automated Clearinghouse. Banks that use agencies. the Federal Reserve’s ACH service instruct Net Settlement. Banks that are members Reserve Banks to pay other banks (ACH of private clearing organizations may credit entries) or to receive payment from decide to settle their mutual obligations other banks (ACH debit entries). These through multilateral netting. If a private entries are processed through the computer clearing service uses the net settlement facilities of the Reserve Banks (clearing func- services of the Reserve Banks, the net debit tion), and entries are posted to the reserve and credit positions of the private banks accounts on the settlement dates designated are settled through entries to their reserve by the banks (settlement function). accounts at the Reserve Banks. Safekeeping of Definitive Securities and Noncash Collection. Reserve Banks accept TRENDS IN CLEARING AND definitive securities (securities in paper SETTLEMENT form) for safekeeping. This service, how- The Reserve Banks’ share of total inter- ever, is now largely limited to securities bank payments has declined since 1980 for used to collateralize government deposits at least three of the four principal types of and discount window loans. The Reserve payment instruments: checks, large-value Banks collect interest coupons and funds transfers, and large-value securities matured securities and credit the proceeds transfers. Tables 1, 2 and 3 show the de- to the reserve accounts of banks that own clining Reserve Bank components for both the securities. the volume and the value of interbank pay- Wire Transfer of Funds. Banks with re- ment transactions. We have not been able serve accounts at Reserve Banks may initiate to develop a time series on the share of the transfers of their reserves to other banks volume and value of ACH payments through the Fedwire funds transfer service. processed by the Reserve Banks. Fedwire is a real-time gross settlement system. Fedwire funds transfers are pro- Check Clearing cessed electronically and are final when Table 3 indicates a significant decline in accepted for processing by the Reserve the Reserve Banks’ share of interbank check Banks. A final payment is one which is clearing, in terms of both volume and unconditional and irrevocable. Clearing value.9 Between 1980 and 1994, the Reserve and settlement is virtually simultaneous. Bank’s component of interbank check- Fedwire is described as a large-value funds clearing volume declined by about one- transfer service because it is designed to third, from an estimated 61.0 percent to facilitate interbank funds transfers (Horii 39.3 percent, while its check-value compo- and Summers, 1994). nent declined from an estimated 48.5 per- Wire Transfers of Securities. Ownership cent to 24.9 percent. These declines are of United States government securities and consistent with a conventional interpreta- some agency securities is recorded in the tion of major changes in the interbank check clearing market, including (1) the introduc- securities accounts held by the Reserve Banks. 9 Interbank check clearings are Banks can transfer ownership of these se- tion of Reserve Bank pricing for services, mandated by the MCA, (2) a fairly rapid so-called “transit items,” for curities via the Fedwire securities transfer which the payor (check writer) development of alternative private-sector service, and each transfer is final when ac- and payee have accounts at dif- cepted by the Reserve Banks for processing. channels for check clearing, and (3) adop- ferent banks. These are in con- tion by the Board of Governors of same-day trast to “on-us” checks, for Fiscal Agency. The Reserve Banks provide settlement amendments to Regulation CC. which the payor and payee account, custodial, and payment services to These amendments to Regulation CC, have accounts at the same the U.S. Treasury and to a variety of other effective January 1, 1994, changed the bank.
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Table 1 Volume of Interbank Non-Cash Transactions (in millions of transactions) 1980 1985 1990 1994 Type of Payment FR Total FR Total FR Total FR Total Check1 15,599.7 25,592.2 16,687.0 33,489.8 19,304.0 39,670.0 17,149.0 43,637.4 ACH2 227.0 –– 585.0 –– 1,435.0 –– 2,379.0 2,521.8 Large-Value 25.8 39.0 45.0 69.9 62.6 99.9 72.0 117.5 Funds Transfer 3 Securities Transfer4 –– –– 7.7 7.7 10.9 12.9 12.6 19.1 Card N/A –– N/A –– N/A 10,478.1 N/A 13,681.0
Sources: Annual Reports of the Board of Governors of the Federal Reserve System and the Bank for International Settlements. 1 See Shaded Box, page 10. 2 Total ACH volume represents Federal Reserve commercial and government items plus items processed exclusively by private-sector arrangements. The figures for Federal Reserve volumes are taken from actual, recorded data. The source of the estimate for the pri- vate-sector volume is the National Automated Clearing House Association. The private ACH processors active in 1994 included the Arizona ACH, Hawaii ACH, New York ACH, and Visa ACH. Data for private ACH processors for periods before 1994 are either not avail- able or incomplete. Note that the majority of items handled by private ACH processors are also delivered to the Federal Reserve for processing, to gain access to endpoints serviced only by the Federal Reserve. In 1994, for example, the total number of items actually originated and received by private ACH operators was estimated to be 521 million; of these, only 143 million were also delivered exclusively within the private arrangements. 3 The total volume of large-value funds transfers is the sum of Fedwire funds transfers and Clearing House Interbank Payments System (CHIPS) transfers. 4 Total number of Fedwire securities transfers plus adjusted gross volume estimates for the securities transfers of the Government Securities Clearing Corporation (GSCC) and the Participants Trust Company (PTC). The GSCC estimates were adjusted downward by sub- tracting the number of end-of-cycle transfers made through Fedwire, to avoid double counting. All securities transfers of the Government National Mortgage Association (GNMA) were processed through PTC; they could, however, have been processed by Fedwire, had the Federal Reserve chosen to provide such services to GNMA.
rules under which banks pay each other return the checks or pay the collecting for checks. Before implementation of the bank through a Fedwire funds transfer by same-day settlement provisions, a bank the close of business the same day. The presented with checks directly by another paying bank is not allowed to charge the private bank could either pay the collect- collecting bank a fee for same-day settle- ing bank the following business day or ment. Banks may waive these rules for the charge the bank a fee for payment the timing of check presentment and means same day. Reserve Banks, in contrast, deb- of payment if they wish (Fitzgerald and ited the reserve accounts of paying banks Macoy, 1993; Crockett, 1994b). Reserve the same day they delivered the checks to Bank check collection volume through the banks, and the Reserve Banks did not September 1994 was 12 percent below the pay fees for this privilege. When private volume for the same period in 1993. This correspondents complained that these decline is attributed largely to same-day rules gave the Reserve Banks an unfair settlement (Marjanovic, 1994b). advantage, the Fed adopted the same-day settlement regulation, which says that if a Automated Clearing House (ACH) collecting bank presents checks to the The Reserve Banks are the dominant place of business of a paying bank before processors of ACH payments. They handle 8 a.m. local time, the paying bank must all government-related transactions and a
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Table 2 Value of Interbank Non-Cash Transactions (in trillions of dollars) 1980 1985 1990 1994 Type of Payment FR Total FR Total FR Total FR Total
Check1 9.4 19.4 10.1 31.9 13.2 43.5 12.6 50.6 ACH2 0.3 –– 2.1 –– 4.7 –– 8.4 9.1 Large-Value 47.9 85.0 109.1 187.5 199.1 421.1 211.2 506.6 Funds Transfer3 Securities Transfer4 –– –– 74.2 74.5 99.9 108.1 144.7 170.0 Card N/A 0.1 N/A 0.2 N/A 0.5 N/A 0.7
Sources: Annual Reports of the Board of Governors of the Federal Reserve System and the Bank for International Settlements. 1 See Shaded Box, p. 10. 2 The value of transactions handled by the Federal Reserve plus the value of transactions handled solely by private ACH processors (see Table 1, footnote 2). For 1994, the estimated value of ACH transactions processed solely by the private sector was about $700 billion. 3 The sum of the value of Fedwire funds transfers and Clearing House Interbank Payments System (CHIPS) transfers. 4 The sum of the value of Fedwire securities transfers, plus the value of the adjusted gross volume for the Government Securities Clearing Corporation (GSCC) plus the value of Participants Trust Company (PTC) adjusted gross volume. See Table 1, footnote 4, for more details.
Table 3
Federal Reserve Share of Interbank Non-Cash Transactions Check ACH Large-Value Funds Transfers Securities Transfers Year Volume Value Volume Value Volume Value Volume Value (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent)
1980 61.0 48.5 –– –– 66.2 56.4 –– –– 1985 49.8 31.7 –– –– 64.4 58.2 100 100 1990 48.7 30.3 –– –– 62.7 47.3 84.5 92.4 1994 39.3 24.9 94.3 92.3 61.3 41.7 66.0 85.1 large share of commercial transactions. the fact that these private organizations However, their present share of the volume receive 20 percent of total ACH entries. and value of interbank ACH transactions, However, some of the ACH entries these pri- which exceeds 90 percent, does not appear vate organizations receive are routed through to be sustainable. In addition to the Re- the Reserve Banks for processing. serve Banks, three private organizations In this paper, the volume of ACH pay- process ACH payments: the Arizona ments attributed to the Reserve Banks is Clearing House Exchange, the New York that actually processed by the Reserve Clearing House, and Visa USA. The finan- Banks, whether the originating institutions cial press cites the share of ACH payments delivered the information on ACH entries processed by the Reserve Banks at about to the Reserve Banks or to private proces- 80 percent, with these three organizations sors. This method of calculating the com- processing the remaining 20 percent (Mar- ponent of ACH payments processed by janovic, 1995a,b). This statistic is based on the Reserve Banks is consistent with the
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method of calculating the component of 1994. The volume component fell from checks processed by the Reserve Banks. For 66.2 percent to 61.3 percent, and the value instance, checks counted as processed by component fell from 56.4 percent to 41.7 the Reserve Banks include those deposited percent. While the reasons for the rise in by the banks of first deposit, and by banks the CHIPS component of large-value funds that serve as intermediary correspondents transfers are complex, they are related in for the banks of first deposit. part to the rapid growth of international The high Reserve Bank share can be payments. The Reserve Banks have not attributed to the unique circumstances considered the settlement of foreign surrounding the development of the ACH exchange and other international transac- payment mechanism, which was initially tions to be part of the mission of Fedwire, subsidized by the Reserve Banks. Signifi- and, therefore, they have not attempted to cant developments in the market for ACH design the Fedwire service to meet the services in the last five years, relating to specific funds-transfer needs of that changes in technology, banking structure part of the market. They have, however, and the entry of private providers, will responded to the market for funds- almost surely combine to reduce the pro- transfer services, and to new record- portion of ACH payments processed by keeping requirements resulting from the Reserve Banks. anti-money-laundering legislation, by adopting a new format for funds transfers Large-Value Funds Transfer over Fedwire that is based on the stand- The Reserve Banks guarantee finality ards of the Society of Worldwide Inter- of funds transfers among banks over Fed- bank Finance Telecommunications (SWIFT). wire; private banks that receive funds Conversion to the new format will be transfers over Fedwire do not have to be completed by the end of 1997. concerned that the transfers will be re- Another factor that may have reduced versed by the Reserve Banks because of the the Reserve Banks’ share of large-value failure of the sending banks to fund their funds transfers is the Federal Reserve’s pay- payments through the Reserve Banks. ments system risk-reduction program, Casual observers of the market for large- which in recent years has increased the value funds transfer might conclude that appeal of multilateral netting for banks. The the Federal Reserve would have a virtual risk-reduction program, which has placed monopoly on this service. The information significant emphasis on containing the in Tables 1, 2, and 3, however, indicates amount of intraday credit provided by the that this conclusion would be incorrect. Reserve Banks, has probably stimulated use Large banks that are members of the Clear- of alternatives to Fedwire for clearing large- ing House Interbank Payments System value transactions.10 On the other hand, the (CHIPS)—a wholesale wire-transfer net- risk controls adopted by CHIPS, which have work owned and operated by the New increased the cost of funds transfers over York Clearing House—use that system as that system, have tended to offset the effects an alternative to transfers over Fedwire for of the Reserve Bank’s risk-reduction large-value funds transfers. Members of measures. CHIPS net their interbank obligations multilaterally and settle these obligations Securities Transfer as a group at the end of the day using Fed- As with funds transfer, the casual wire funds transfers. They use CHIPS observer might conclude that the Federal largely for settling the dollar side of for- Reserve has a virtual lock on the market eign exchange and for other international 10 For a description of the policy for securities transfers. In fact, however, of the Federal Reserve on day- transactions. the Federal Reserve has restricted the light overdrafts and payments The component of total large-value range of U.S. Treasury securities and system risk, see Richards funds transfers (over Fedwire and CHIPS) agency securities for which the Reserve (1995). handled by Fedwire declined from 1980 to Banks serve as depositories and provide
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14 S EPTEMBER/OCTOBER 1996 transfer services. As a result, private sys- ernment securities transfers, can be tems for clearing and settling transactions expected to cause significant further involving these securities have developed. reductions in the Reserve Bank component For example, the Participants Trust Com- of large-value securities transfers. In addi- pany (PTC) now serves the entire market tion, continued increases in the use of new for clearing and settlement of Government types of retail (small-value) payments National Mortgage Association (GNMA) instruments, in which the Reserve Banks securities. are not active, could erode further their Private-sector arrangements for net- role in the processing of retail payments ting securities transactions are also becom- generally. ing more attractive to banks. The Govern- ment Securities Clearing Corporation REASONS FOR THE (GSCC) has developed a multilateral net- RESERVE BANKS’ ting service for future-dated U.S. govern- DECLINING SHARE OF ment securities transactions, and it is in INTERBANK PAYMENTS the process of testing an enhanced service that will support netting for same-day Tables 1, 2 and 3 indicate that the transactions. Introduction of this service Reserve Banks’ historically important role by GSCC will likely trigger a significant in providing clearing services has been further decline in the Reserve Banks’ share declining, although it is still significant. of government and agency securities trans- Changes in technology and in banking fers. Table 3 indicates that Fedwire’s share structure have reduced the Reserve Banks’ of the volume of securities transfers de- advantages in providing the dominant net- clined from 100 percent to 66.0 percent work for clearing and settlement of pay- between 1985 and 1994. The Reserve Bank ments. In addition, the policies of the share of the value of securities transfers fell Board of Governors have stimulated a from 100 percent to 85.1 percent over the greater role for the private sector in same period. clearing interbank payments. Card Transactions Technology New technology is perhaps the single As we noted earlier, the Reserve Banks most important force leading to new ini- do not clear payments made by cards. tiatives for processing payments in the Table 1 shows that credit-card transactions private sector. Within the last decade or have grown rapidly in recent years and by so, the costs of both computer processing 1994 accounted for about 18 percent of and data communications have fallen the number of payments made by credit dramatically. As a result, automated pro- card, check and ACH. If payments based cessing systems are now within the finan- on other types of cards, such as debit cial reach of individual institutions as well cards and stored-value cards, grow rapid- as private clearinghouses. At one time, ly relative to older types of payments ACH processing required large mainframe instruments, the percentage of all retail computer systems. Now, very powerful, payments processed by the Reserve small, and relatively inexpensive micro- Banks can be expected to continue processors are able to handle large declining. volumes of transactions. Moreover, value- In summary, the Reserve Banks’ added networks offer a wealth of national components of both the volume and the and even international data communica- value of interbank payments have declined tions pathways, including networks with for small-value retail and large-value sufficient control and security features to wholesale funds and securities transactions handle electronic payment transactions. since about 1980. Prospective develop- Thus, dramatic reductions in costs have ments, including introduction by GSCC facilitated the development of alternative of multilateral netting for same-day gov- networks for payment processing func-
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tions that were once the primary domain change large volumes of checks and other of the Reserve Banks. payment instruments directly, without relying on a processing intermediary. Banking Structure Regional interstate banking has also Federal Reserve Policy reduced the advantages of the Federal The Federal Reserve has strongly Reserve in interregional check clearing. embraced market techniques that promote Banking concentration resulting from the more efficient payment operations. Expli- rise in interstate banking has increased the cit pricing of Federal Reserve payment proportion of transactions handled by services, introduced by the MCA, has elim- banks as “on-us” transactions, which by- inated subsidies to banks that use Reserve pass interbank clearing and settlement Bank services. In addition, explicit pricing channels. Further, bank holding companies of intraday, reserve-account overdrafts has have been able to organize payments clear- increased the costs of using Reserve Bank ing among their affiliated banks on a re- services for banks with relatively large gional basis, often by establishing regional intra-day overdrafts (Richards, 1995). processing centers. Today, the country is Finally, the Federal Reserve Board’s action experiencing a major new interstate bank- in January 1994 requiring same-day check ing movement as a result of the Riegle-Neal settlement helped to reduce the barriers to Interstate Banking and Branching Efficiency check clearing between private parties. Act of 1994. More and more, interstate Accordingly, within the last 15 years, the banking extends network efficiencies to pri- explicit cost of using Federal Reserve pay- vate institutions throughout the country, ment-processing services has been put on thus eroding the Fed’s interregional check- more comparable terms with private-sector clearing advantage.11 alternatives, and artificial legal barriers to The last 10 or 15 years have seen the private clearing have been removed. formation of national clearinghouses for Federal Reserve Board policy has also both paper and electronic transactions. For limited the involvement of the Reserve example, in 1991, Visa USA began offering a Banks in the payments system by restrict- national ACH processing service. Further, ing the scope of their services. For in- the New York Clearing House has expressed stance, the Federal Reserve declined to pro- interest in expanding the geographic scope vide services for clearing and settling credit of its ACH service and connecting its pro- card sales slips and book-entry transfers of cessing network to other private sector GNMA securities. The limitations on the providers, such as Visa (Marjanovic, scope of Reserve Bank payment services 1995a,b). With respect to check clearing, have facilitated the development of private the National Clearing House Association, systems for clearing and settling payments. formed in 1992, arranged the clearing of an estimated 2 million checks per day in 1994 Outlook for Fed Payment Services (Marjanovic, 1994a). Similarly, the Elec- Technology, banking structure, and tronic Check Clearing House Organization Federal Reserve policy will likely continue (ECCHO) which was introduced in 1990, to influence payments processing, certain- was clearing an estimated 1 million checks ly for the foreseeable future. The outcome 11 Berger and Humphrey (1988) per day by 1994, on the basis of electronic is likely to be a continuation of the trends conclude that nationwide inter- cash letters (Crockett, 1994a). Banks are shown in Table 3—declines in the com- state banking would reduce the also active in establishing consortia to ponents of various types of interbank resources used in check collec- exchange retail transactions in ATM and payments processed by the Reserve Banks. tion. In addition, they estimate point-of-sale networks. Formation of these that it would reduce the share Indeed, because virtually all the factors of total checks processed by private networks for clearing payments discussed in this paper have emerged rela- Reserve Banks by between 43 reflects, to some extent, the increased con- tively recently, the trends in Table 3 could and 60 percent over a 10-year centration of banking in recent years. A few accelerate, at least for small-value pay- period. large banking organizations now can ex- ments such as checks and ACH.
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SOME IMPLICATIONS OF however, might also lead to distortions in REDUCTIONS IN RESERVE the pricing of payment services that would result from collusive behavior by BANK SERVICES a few large, nationwide branching organi- Trends in the processing of payments zations. by Reserve Banks have implications for the efficiency of the payments system and for Federal Reserve as Payments System Rule the risk of disruptions in the operation of Maker. The success of innovations in the payments system. improving the efficiency of the payments system requires cooperation among Implications for Efficiency providers of payment services. For in- stance, the Fed and the banking industry Subsidy for use of Reserve Bank Services. agreed many years ago to encode checks Prior to 1980, the Reserve Banks did not with magnetic characters (the MICR line) charge member banks explicit fees for use that make it possible for banks to sort of their payment services. In the 1970s, checks by machine. This innovation would the Reserve Banks may have compounded have been of little value if it had been the inefficient use of resources in the pay- adopted by only a few banks. Another ex- ments system by subsidizing the collection ample involves the truncation of checks in of local checks through the establishment the collection process: To maximize the of Regional Check Processing Centers benefits of truncation (in which the actual (RCPCs). Because RCPCs provided same- paper check is taken out of circulation), day check crediting to the reserve accounts the first bank that handles a check would of collecting banks for checks drawn upon convert the paper instrument into an elec- banks located in the same area, many local tronic instrument and send the payment check clearinghouses could not compete information on the check through the col- and closed down (Frodin, 1984). While lection system electronically. Such an in- the establishment of RCPCs may have accel- novation would require the cooperation of erated the speed of collection, it created virtually all banks. additional incentives for banks to use the Prior to 1914, the payments system of Fed for check clearing rather than con- the United States functioned without a tinuing direct exchanges of checks among 12 mechanism by which banks could co- nearby banks. Recent declines in the use of operate in adopting innovations to make Fed payment services reflect more efficient interregional check collection more effi- use of resources resulting from the elimina- cient. Clearinghouses played such a role in tion of the subsidy provided by “free” their local communities. There was, how- Reserve Bank services. ever, no national clearinghouse to coor- 12 For a description of RCPCs and Implications of Interstate Banking. Ineffi- dinate change for the national payments analysis of their implications for ciency in the check-collection system prior system. Banks collected checks drawn on the efficiency of the payments to 1914 reflected, to a large extent, the lack banks located in distant cities through a system, see Morris (1974, of nationwide banking organizations. High correspondent banking system that often 1975a,b); White and routed checks to paying banks indirectly, Torgerson (1974); and exchange charges and lengthy delays in Viswanathan and Mayo check collection that resulted from arrange- to avoid the exchange charges of paying (1975). ments to avoid exchange charges would banks. Indirect routing of checks increased have been reduced or eliminated by nation- the expense and length of time in check 13 Jessup (1967) reports that wide banking.13 The spread of nationwide collection. Since its formation, the nonpar banks (those imposing interstate banking reduces the chances that Federal Reserve has functioned as the exchange charges) tended to be located in unit banking de facto national coordinator of the the declining role of the Reserve Banks in states. This observation sup- payment processing will produce a return payments system. The role of Reserve ports the claim that nationwide to the kind of payments system ineffi- Banks as major providers of payment ser- branch banking would have ciency that existed prior to the formation vices has been important in facilitating a reduced or eliminated exchange of the Federal Reserve. Interstate banking, number of improvements in the efficiency charges.
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tional role for the Reserve Banks, the SAME-DAY SETTLEMENT: RISK Federal Reserve Board, with its broad regu- REDUCTION FOR COLLECTING latory power, can continue to promote BANKS payments system efficiency. An important Prior to the implementation of the Federal example of the Board’s use of this regula- Reserve’s same-day settlement regulation, banks that tory authority to promote efficiency in collected checks through correspondents generally the check-collection system is its recent received payment in the form of credits to their bal- introduction of same-day settlement for ances at correspondent banks. Under the new regula- checks, which took effect in January 1994. tion respondent banks can send checks directly to The Fed’s same-day settlement regulation sets the rules under which collecting paying banks and receive payment the same day via banks present checks and receive payment wire transfers of funds to their reserve accounts at the same day without paying fees to paying Reserve Banks. Adoption of same-day settlement, there- banks. The authority for this action of the fore, gives respondent banks more options for limiting Board is derived from the Expedited Funds their exposure during periods of financial distress. For Availability Act of 1987, which granted the relatively small banks, however, the cost of collecting Board regulatory authority over interbank checks through direct presentment may exceed the risk payment relationships for purposes of pro- of collecting through correspondents. The operating moting efficiency of the payments system. costs of collecting checks through direct presentment Implementation of the change did not re- include the costs of sorting checks and arranging for quire a large operational role for the Re- couriers to present them directly to the paying banks. serve Banks; in fact, it has caused a decline Even in times of financial stress in the banking indus- in the check collection volumes of the try, relatively small banks that rely on correspondents Reserve Banks (Marjanovic, 1994b). for check collection are more likely to continue using Increased concentration of the bank- correspondent bank services than to switch their check- ing industry through interstate banking collection operations to direct presentment. can facilitate innovation through coopera- tion among the banks themselves, inde- of the payments system, including the fol- pendent of the Fed’s efforts. The evidence lowing: suggests that, in the past, there were too 1. Elimination of nonpar banking.14 many banks for effective cooperation. 14 Some authors challenge the Associations of relatively small numbers of idea that actions of the Reserve 2. Addition of the MICR line to large banks, however, can work out agree- Banks to eliminate nonpar checks, making them readable by ments on innovations that benefit a major- banking improved the operation check-sorting machines. ity of their members. For instance, the of the payments system. See banks that formed ECCHO agreed to ac- Baxter (1983). The literature cept electronic transmission of information on exhange charges provides 3. Creation of the automated clearing- conflicting views of this subject. house. about checks as legal presentment. In See Frankel (1995); Gilbert March 1995, the New York Clearing House (1991); and Salop (1990). 4. Expedited processing of return announced that its members had reached For purposes of this section, it items after passage of the Expedited similar agreement (Marjanovic, 1995c). is sufficient to argue that, given Funds Availability Act. These examples illustrate innovation in the limited power Congress the payments system through voluntary granted to the Reserve Banks 5. General promotion of check imag- association. over the operation of the pay- ing and electronic presentment Large numbers of banks are able to ments system, the Federal (Marjanovic, 1996). coordinate the clearing and settlement of Reserve was effective in estab- payment instruments other than checks, lishing clearance of checks at par as the standard for the Will the benefits of this leadership and and to adopt innovations. For example, banking industry only because innovation be lost if the Reserve Banks Visa and Mastercard coordinate their pay- of the major role of the Reserve have a substantially smaller role in the ment operations for thousands of their Banks in check clearing and processing of payments in the future? member banks. The growth of regional settlement. Not necessarily. Even with a smaller opera- ATM networks indicates that many
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18 S EPTEMBER/OCTOBER 1996 bankers can work together to provide ATM If the Reserve Banks’ check collection services for their customers. The National volumes fall substantially in the future, Automated Clearinghouse Association and their capacity to clear checks is re- (NACHA) sets rules and standards for duced accordingly, they may no longer be ACH, even though it does not itself pro- able to fulfill the role of check clearer of cess ACH payment items. Finally, there are last resort. In periods of financial stress, well established institutional arrangements this situation could put an extra burden of for setting standards for various aspects of responsibility on the banking industry for the payments system. Thus, past expe- ensuring the safe operation of the payments rience with check collection in the United system. Banks collecting checks would States may exaggerate somewhat the need to be vigilant in managing their risk importance of the Reserve Banks as pro- when choosing correspondents and in viders of payment services in facilitating agreeing to forms of settlement for checks innovation in the payments system. presented directly to paying institutions. In this context, the Federal Reserve’s Access to Payments Systems. When the Regulation F, “Limitations on Interbank Reserve Banks provided the dominant Liabilities,” mandates careful management nationwide system for banks to clear and of such interbank relationships. settle payments, access to the payments system was determined by legislation and Implications for Risk the operating rules of the Reserve Banks. Does the declining role of the Reserve As private organizations emerge to rival Banks in processing payments increase the the Reserve Bank’s nationwide clearing and risk of payments system disruption? The settlement arrangement, access will be answer depends on the nature of the determined at least in part by these private shocks to the payments system. organizations. Various agencies of the gov- ernment and the courts might become Bank Runs. Prior to the formation of the involved in settling disputes on the condi- Federal Reserve System, depositor runs tions under which private arrangements were the most important source of risk to for clearing and settling payments may banks. The Fed can deal with threats origi- exclude some providers of payment nating from depositor runs by injecting services.15 reserves into the banking system through open-market operations and discount Check Clearer of Last Resort. Issues window loans. In addition, federal deposit raised by the role of the Reserve Banks as insurance limits the vulnerability of banks check clearer of last resort have implica- to depositor runs. tions for both efficiency and risk. The rise in Reserve Bank check clearing during the Securities Transfers. Another possible Texas banking crisis during the second shock to the payments system would be half of the 1980s and early 1990s illus- the disruption of arrangements for trans- trates the role of Reserve Banks as check ferring ownership of securities. Is it clearer of last resort (Clair, Kolson and important that the Reserve Banks retain Robinson, 1995). When major banks head- a major role in processing securities quartered in the Southwest were in serious transfers in order to minimize the effects financial trouble, respondents turned to of such shocks on the payments system? the Fed for check collection because they Alternatively, are private arrangements 15 did not want to suffer disruptions and pos- for securities transfers sufficiently See Carlton and Frankel sible losses resulting from the failure of sound to minimize the chances of such (1995) for analysis of a court case involving a dispute over their correspondents (see shaded box, shocks? access of a bank to Visa for page 18). Given their major role in check Parties to securities transactions must issuing credit cards. Carlton and processing, the Reserve Banks can absorb be able to trust their agents to perform Salop (1996) discuss the issue additional check volume when circum- as contracted. For instance, individual of access by firms to joint ven- stances disrupt other check-collection channels. investors in corporate stock must trust tures in a variety of cases.
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19 S EPTEMBER/OCTOBER 1996 their brokers to execute trades according Settlement Using Liabilities of Private to their orders. They must also trust that Banks: Moral Hazard and Systemic Risk. the organizations established to clear Another source of shock to the U.S. pay- trades and settle obligations among bro- ments system could result from the failure kers will be effective in settling trades. of a major bank used for settlement by a For investors in U.S. Treasury and agency significant number of other banks. Prior securities, banks function as their agents to 1914, banks settled payment obliga- by holding securities with the Reserve tions among themselves by transferring Banks and with private depositories. When ownership of deposit liabilities at private the investors decide to sell, the banks use banks, and major disruptions occurred Fedwire or a private system to transfer when customers lost confidence in the ownership of the securities and settle the nation’s money center banks. Given the trades. For investors in securities trans- declining role of the Reserve Banks in pro- ferred through privately operated systems, cessing payments, the future might bring the risk of not receiving the securities increased public reliance on a few large they have paid for, and the risk of not banks for settling payment obligations. If receiving cash for securities they have it does, the government might need to sold, depends on the reliability of netting ensure the survival of those banks, to pre- arrangements among members of the vent disruption of the payments system. systems. This reliance on a few large banks at the Securities transfers through private heart of the payments system could systems have not created problems for the amplify any moral hazard in bank supervi- operation of financial markets, because sion and regulation. Since the failure of these systems are well designed. In ad- the bank would be too disruptive to the dition, active oversight by authorities such payments system, participants in the as the Federal Reserve has ensured that financial system could assume that there such private arrangements have the con- would be little risk in transactions with trols and guarantees needed to make them those banks, including the purchase of reliable. In particular, the guidelines for their short-term liabilities. operation of delivery vs. payment systems that were released by the Federal Reserve Multilateral Clearing Arrangements and Board on June 15, 1989, refer to various Systemic Risk. Systems for clearing pay- controls, including liquidity safeguards, ments among banks can be designed to credit safeguards, and open-settlement avoid the moral hazard outlined above. accounting. Consider, for instance, the design of As long as the private systems for CHIPS. Federal Reserve policies that apply securities transfers are appropriately super- to the operation of private large-dollar vised and maintain adequate risk controls, funds-transfer systems such as CHIPS the migration of securities transfers from include the requirement that such systems the Reserve Banks to private systems have means to ensure settlement in the would not appear to create problems for event of a default by a major participant. the operation of financial markets. The fol- Since these arrangements would prevent lowing sections indicate, however, why the major disruptions in the payments system Fedwire service for transferring funds and in the event of the failure of a particular securities remains essential for the settle- bank, investors in bank equities and liabil- ment of obligations among members of ities cannot assume that any one bank is these private systems. These sections also essential to the operation of the payments discuss the limited authority of the Federal system. Reserve over the operations of private We argue that the Reserve Banks must clearing organizations which is derived continue to offer Fedwire services to facili- from the role of the Reserve Banks in pro- tate access to reserve accounts and espe- viding settlement services. cially, to ensure the integrity of net settle-
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20 S EPTEMBER/OCTOBER 1996 ment arrangements. Banks that use the net the nation’s payments system. In fact, the settlement services of Reserve Banks in Federal Reserve appears to be somewhat their transactions with private payments- unusual among central banks in that it clearing systems must have a mechanism does not have explicit statutory powers like Fedwire for transferring reserves, to related to the supervision of clearing orga- cover their net debit positions. At times, nizations. Some of the private clearing these banks must borrow reserves from organizations have implemented new risk each other to cover their net debits. Fed- controls to ensure settlement in the event wire enables them to transfer securities of default by any of their members. These electronically, both to provide collateral to actions indicate some of the Fed’s regula- lenders, and to post collateral with Reserve tory clout under current limitations on its Banks for discount window borrowing. statutory authority. It is unclear, however, Authority of the Federal Reserve over whether the Fed’s indirect influence on the operations of private clearing organiza- private clearing organizations through its tions rests principally on the role of the role as provider of settlement services will Reserve Banks as providers of settlement be sufficient to ensure the safety and sound- services, since the Fed has no statutory ness of the payments system in the future. authority for central bank oversight of pri- vate clearing organizations. As a service CONCLUSIONS provider, the Federal Reserve can make The Federal Reserve Banks’ role in safe-and-sound operation of clearing orga- processing payments—in terms of both nizations a condition to their using its volume and value—has declined since interbank settlement services. The Board 1980, when Congress enacted legislation stated its standards for the operation of requiring the Reserve Banks to charge for private clearing organizations in Decem- their payment services. This decline can be ber 1994, in a policy statement titled expected to continue or even accelerate in “Privately-Operated Large-Dollar Multilat- the future. While the declines in the shares eral Netting Systems.” The threat of of payments processed by the Reserve Banks discontinuing its settlement support for following pricing of the services represent a such clearing organizations, however, is a more efficient use of payments system re- very blunt supervisory instrument. For sources, the declining role of the Federal example, the Fed could disrupt clearing- Reserve Banks in payments processing has house operations, and therefore the other important implications for the effi- payments system, by withdrawing its ciency and stability of the payments system. settlement services. The simple fact that One of these implications relates to the Fed could itself trigger an immediate innovation. In the past, the actions of the operational crisis by withdrawing support Reserve Banks to foster innovation in the for settlement calls into question the payments system relied on the status of the Federal Reserve’s willingness ever to Reserve Banks as major providers of pay- invoke such a harsh action. ment services. Will the Reserve Banks’ The trends in the U.S. dollar payments declining role in payments processing system described in this paper indicate a eliminate the Fed’s leadership in innova- major shift toward greater reliance on pri- tion? Not necessarily. The Federal Reserve vate arrangements for clearing both small- Board has broad authority to promote safe dollar and large-dollar payments. Increased and efficient payment methods undertaken privatization of the U.S. dollar payments bilaterally between depository institutions, system and a concomitant decline in the especially in the check-collection system. operational role of the Federal Reserve This authority is independent of the Re- Banks raise questions about the adequacy serve Banks’ operating role in the pay- of the Federal Reserve’s supervisory ments system. In addition, the growing authority to fulfill the original Congres- concentration of the banking industry sional mandate for ensuring the stability of through interstate banking is facilitating
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innovation by cooperating groups of banks Baxter, William F. “Bank Interchange of Transactional Paper: Legal and that would have been more difficult when Economic Perspectives,” Journal of Law and Economics (October there were many more separate banking 1983), pp. 541-88. organizations. Berger, Allen N., and David B. Humphrey. “Interstate Banking and the At the same time, the growth of pri- Payments System,” Journal of Financial Services Research (1988), vate payment networks raises some impor- pp. 131-45. tant new issues with respect to competi- tion. In the past, access to the payments Blommestein, Hans J., and Bruce J. Summers. “Banking and the Payment System,” in The Payment System: Design, Management, system was determined largely by law and and Supervision, Bruce J. Summers, ed. International Monetary Fund, by Federal Reserve policies; now some of 1994, pp. 15–28. the issues involving access to the new pri- vate payments arrangements will be settled Brimmer, Andrew F. “Bank Credit Cards and Check-Credit Plans: in the courts. Development and Implications.” Remarks presented to a Joint Does the declining role of Reserve Luncheon of Commercial Bankers and the Board of Directors of the Federal Reserve Bank of San Francisco, August 3, 1967. Banks in processing payments increase the risk of disruption in the operation of the Carlton, Dennis W., and Alan S. Frankel. “Antitrust and Payment payments system? The answer depends on Technologies,” this Review (November/December 1995), pp. 41-54. how banks in bilateral and multilateral Carlton, Dennis W., and Steven C. Salop. “You Keep on Knocking but private clearing arrangements settle their You Can’t Come In: Evaluating Restrictions on Access to Input Joint obligations. Settlement through debits and Ventures,” Harvard Journal of Law and Technology (Summer 1996), credits to accounts at private banks would pp. 1-34. make the system vulnerable to disruption in the event of sudden failure by banks Clair, Robert T., Joanna O. Kolson, and Kenneth J. Robinson. “The Texas Banking Crisis and the Payments System,” Economic Review, Federal that provide settlement services. Fortunately, Reserve Bank of Dallas (First Quarter 1995), pp. 13-21. the settlement services of the Reserve Banks can limit this risk—to banks, and to the Crockett, Barton. “Electronic Bad-Check Notices for Corporations Federal Reserve in its role as lender of last Expected Soon,” The American Banker (January 6, 1994a), p. 17. resort. To facilitate the use of reserves for ______. “Fast Clearing Off to Slow Start, Poll Finds,” The American interbank settlement, whether net or gross, Banker (May 12, 1994b), p. 18. Reserve Banks should continue offering Fedwire funds and securities transfer ser- Dewald, William G. “The National Monetary Commission: A Look vices and net settlement services. The Back,” Journal of Money, Credit and Banking (November 1972), pp. 930-56. Federal Reserve System is able to influence the practices of clearinghouses primarily Dwyer, Gerald P., Jr., and R. Alton Gilbert. “Bank Runs and Private by setting conditions for their use of the Remedies,” this Review (May/June 1989), pp. 43-61. settlement services of the Reserve Banks. Economides, Nicholas, and Lawrence J. White. “Networks and The Fed does not have statutory authority Compatibility: Implications for Antitrust,” European Economic Review to act as the supervisor of clearing organi- (1994), pp. 651-62. zations. It is not clear at this time whether the Fed’s limited influence over clearing “Federal Reserve in the Payments System,” 7-145.1. Federal Reserve organizations will be adequate to maintain Regulatory Service, 7•48. the safety and soundness of the payments “Federal Reserve System Guidelines for the Provision of Financial system as the share of payments cleared Services,” 7-191. Federal Reserve Regulatory Service, 7•51. through private channels continues to rise. Fitzergerald, Robert M., and Ian W. Macoy. “Check-Processing Rule Means Efficiency, Competition,” The American Banker (July 7, 1993), REFERENCES p. 17. Andrew, A. Piatt. “Substitutes for Cash in the Panic of 1907,” Quarterly Frankel, Alan S. “Monopoly and Competition in the Supply of Money Journal of Economics (August 1908). Reprinted in O. M. Sprague, and Payment Services.” Memorandum, November 1995. History of Crises under the National Banking System, U.S. National Frodin, Joanna H. “Fed Pricing and the Check Collection Business: Monetary Commission, Senate Document No. 538, 61 Congress, 2nd The Private Sector Response,” Business Review, Federal Reserve Bank Session, Government Printing Office, 1910, pp. 434-59. of Philadelphia (January/February 1984), pp. 13-22.
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Gilbert, R. Alton. “Utilization of Federal Reserve Bank Services by Spahr, Walter E. The Clearing and Collection of Checks, The Bankers Member Banks: Implications for the Costs and Benefits of Publishing Co., 1926. Membership,” this Review (August 1977), pp. 2-15. Sprague, O.M. History of Crises under the National Banking System, Gilbert, Richard J. “On the Delegation of Pricing Authority in Shared U.S. National Monetary Commission, Senate Document No. 538, 61 Automatic Teller Machine Networks,” in Electronic Services Networks: Cong. 2 Sess, Government Printing Office, 1910. A Business and Public Policy Challenge, Margaret E. Guerin-Calvert Summers, Bruce J. “Risk Management in National Payment Systems,” and Steven S. Wildman, eds., Praeger Publishing, 1991, pp. 115-44. in The New Financial Landscape: Forces Shaping the Revolution in Banking, Risk Management and Capital Markets, OECD (1995), pp. Horii, Akinari, and Bruce J. Summers. “Large-Value Transfer Systems,” in 253-280. The Payment System: Design, Management, and Supervision, Bruce Veale, John M., and Robert W. Price. “Payment System Float and Float J. Summers ed., International Monetary Fund, 1994, pp. 73-88. Management,” in The Payment System: Design, Management, and Jessup, Paul F. The Theory and Practice of Nonpar Banking, Supervision, Bruce J. Summers, ed., International Monetary Fund, Northwestern University Press, 1967. 1994, pp. 145-63. Juncker, George R., Bruce J. Summers and Florence M. Young. “A Primer Viswanathan, P., and Cesar Mayo. “A Note on ‘The Fed’s RCPC on the Settlement of Payments in the United States,” Federal Reserve Performance,’” Journal of Bank Research (Spring 1975), pp. 70-71. Bulletin (November 1991), pp. 847-58. Watkins, Leonard L. Bankers’ Balances, A.W. Shaw Company, 1929. Katz, Michael L., and Carl Shapiro. “Systems Competition and Network White, Eugene N. The Regulation and Reform of the American Banking Effects,” Journal of Economic Perspectives (Spring 1994), pp. 93-115. System, 1900-1929. Princeton University Press, 1983. Marjanovic, Steven. “The Fed Buys Banctec Check-Image Storage White, Hubert D., and David A. Torgerson. “A Comment on ‘The Fed’s System,” The American Banker (February 1, 1996), p. 18. Performance: What Does it Imply for EFTS?’” Journal of Bank ______. “Arizona Clearing House Chief Eyes Expansion,” The Research (Autumn 1974), pp. 193-96. American Banker (August 18, 1995a), p. 16. ______. “Chemical Joins ACH That Is Taking On the Fed,” The American Banker (January 25, 1995b), p. 14.
______. “N.Y. Clearing House Sets Deadline for Electronic Presentment,” The American Banker (March 23, 1995c), p.1. ______. “PEOPLE IN THE NEWS: Clearing House Group Names President,” The American Banker (November 15, 1994a), p. 18. ______. “Citi, 4 Other Join Clearing House Group,” The American Banker (December 7, 1994b), p. 16. Morris, Russell D. “The Fed’s Regional Check Processing Performance: What Does it Imply for Electronic Funds Transfer?” Journal of Bank Research (Summer 1974), pp. 86-91. ______. “The Fed’s RCPC Performance: A Reply,” Journal of Bank Research (Winter 1975a), pp. 257-59. ______. “A Response,” Journal of Bank Research (Spring 1975b), pp. 72-73. Richards, Heidi Willmann. “Daylight Overdraft Fees and the Federal Reserve’s Payment System Risk Policy,” Federal Reserve Bulletin (December 1995), pp. 1065-1077. Roberds, William. “Financial Crises and The Payments System: Lessons from the National Banking Era,” Economic Review, Federal Reserve Bank of Atlanta (September/October 1995), pp. 15-31.
Salop, Steven C. “Deregulating Self-Regulated Shared ATM Networks,” Economics of Innovation and New Technology, (1990), pp. 85-96.
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Appendix
PAYMENT SERVICES OF THE The Reserve Banks accept for FEDERAL RESERVE BANKS collection checks (cash letters) drawn on banks located within the same territory, as Cash Services well as checks drawn on banks located in 16 The Reserve Banks have a government other Federal Reserve territories. The monopoly on issuing currency, which they high degree of cooperation among the process for banks. They also process coin Reserve Banks in processing interterritory issued by the United States Mint. Reserve checks, and especially in debiting and Banks process cash deposits and shipments crediting reserve accounts of banks located without charge to banks, at least for a throughout the nation, facilitates an certain basic level of service, since this efficient nationwide check-clearing and is considered a government function. settlement system. In accepting deposits of currency and The Reserve Banks accept shipments meeting orders for currency, the Reserve of checks in various degrees of sorting, Banks maintain the quality and the including unsorted, sorted by Federal integrity of the currency stock. They Reserve territory, or sorted by the banks on employ sophisticated processing equip- which the checks are drawn. Since sorting ment that separates currency fit for cir- checks by territories or by the banks on culation from unfit currency, which is which they are drawn is costly, the banks destroyed. Reserve Banks also identify that send checks to the Reserve Banks counterfeit notes, relying on the anti-coun- already sorted are charged less than the terfeiting features built into the design of banks that send checks unsorted and rely the official currency. on the Federal Reserve Banks to sort them. Like correspondent banks, Reserve Check Clearing Banks credit the accounts of the depositors Since their formation, the Reserve of checks according to published avail- Banks have provided a nationwide check ability schedules. That is, the depositors clearing service. Check processing now are able to count on receiving credit for takes place at 11 of the 12 Reserve Bank checks drawn on banks located in different head offices, 24 of the 25 branches, 11 Federal Reserve territories according to a regional check-processing centers published time schedule, regardless of the (RCPCs), and one additional facility. The Federal Reserve’s ability to present the Reserve Banks cooperate in managing this items within that schedule. Any float that system in a highly-integrated manner and results from mismatching the time of cred- 16 Cash letters are bundles of share some facilities and mechanisms, iting the accounts of the depositing banks checks accompanied by regis- including a national transportation system and the time of presentment to and debit- ters that list the contents of the for transporting checks. bundles and the total value of ing the accounts of paying banks is a cost the items they contain. These Each Federal Reserve check-processing of doing business for the Federal Reserve. bundles are called “cash let- office serves an official territory, which is Float is factored into the base costs recov- ters” because settlement for designated by routing numbers encoded at ered through explicit fees.17 the checks is in cash-equivalent the bottom of checks. A territory may In recent years, the Reserve Banks funds, subject to the rules gov- include a small but highly concentrated have provided a variety of value-added erning the return of checks. area, such as a city, or a larger area with check-clearing services, particularly 17 For a discussion of how float banks dispersed across a large region. electronic information services demanded arises, is controlled, and what it Routing numbers are the de facto national by check-clearing customers. Banks that costs, see Veale and Price standard for check-clearing territories receive cash letters (bundles of checks (1994). throughout the United States. written by depositors) from the Reserve
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Banks can receive electronic transmissions a large organization like the Federal that show the account numbers and dollar Reserve System, with its established tech- values of individual checks, information nical infrastructure and its extensive that normally would be physically pre- access to capital, was in a position to sented later in the day. Timely availability invest in a venture of this magnitude, for of this information greatly aids banks in which the return was still uncertain. More- offering cash-management services to their over, the volume of payments at ACH’s large corporate customers. inception was not sufficient to justify the In addition, the Reserve Banks are costs of the large initial investment for beginning to offer electronic check-deposit most companies. An exception was the and presentment services, as well as trun- New York Clearing House, which chose cation services, for banks that elect to to handle the processing for ACH transac- settle checks in this manner. Reserve tions in the Second Federal Reserve Banks recently have begun to offer image- District. Over the years, the Arizona processing services both to commercial Clearing House and Visa USA, Inc. have banks and to the U.S. government. For also established successful ACH processing example, images of government checks are operations. The Chicago Clearing House captured and stored in archives, facilitating also attempted to offer an ACH processing federal government investigations and service but discontinued its service after a claims settlements that involve payment by few years. check. In addition, commercial image ser- vices are now being provided to banks, Safekeeping of Definitive Securities especially services designed to expedite and Non-cash Collection check adjustments and returns. The Reserve Banks continue to provide definitive safekeeping and non- Automated Clearinghouse cash collection services to depository The automated clearinghouse (ACH) institutions, but on a significantly reduced is an electronic alternative to check scale in comparison to earlier years.18 processing. In fact, the ACH was originally Definitive securities are paper instruments, most attractive as a means of converting such as bonds issued by state and local payroll disbursement and other recurring governments. Safekeeping for such securi- money transfers from check-based transac- ties includes accepting them under a trust tions to electronic transactions. The ACH agreement, collecting interest coupons, is both a credit and a debit payment mech- and redeeming matured securities. Today, anism; that is, customer banks can make only three Federal Reserve offices provide payments and withdrawals from accounts these services as priced services, although within the system. Use of ACH debit they do so for depository institutions entries increases the efficiency and speed located throughout the United States. of transactions such as insurance Each Federal Reserve Bank does safe- premiums and mortgage payments, and keep securities it accepts as collateral for they facilitate the concentration of cash by discount window loans and/or in its role treasurers of businesses that maintain as fiscal agent. The demand for such ser- demand deposit accounts at large numbers vices eventually will disappear completely of banks. as all securities are converted from paper The Reserve Banks began providing to book-entry form, with ownership 18 ACH services to the United States Treasury recorded and transferred electronically in Non-cash items are handled on and commercial banks in 1972. The the records of depositories. a collection basis, meaning that principle and interest are credit- federal government was a pioneer in con- Wire Transfer of Funds and Securities ed to the accounts of banks verting its own paper-based check with securities in safekeeping payments to ACH. At its inception, ACH Banks can transfer reserves among when collected, not on the processing required a very significant themselves electronically through the basis of a published availability investment in computer technology. Only Fedwire funds transfer service. This is a schedule.
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real-time gross settlement service that pro- counterparty will pay for the securities. vides final payment. Each transfer is Since the Reserve Banks assume any processed separately without a netting of risk from the transfer of reserves over Fed- payment messages among banks (gross wire, the Fedwire funds transfer service is, settlement), and the transfer of funds is together with federal deposit insurance final, which means that it cannot be and the discount window, part of the fed- reversed. If a bank sends a payment eral safety net for the banking system. It’s message over Fedwire and later fails while important to note that, given the high its reserve account is overdrawn, the volume, value, and velocity of wire trans- Reserve Bank holding the overdrawn fers, the Fedwire service is able to operate reserve account cannot recover funds from efficiently as a real-time gross settlement the receiver of the payment message. The system only because the banks that use finality of Fedwire funds transfers make Fedwire have access to significant amounts them a unique type of payment, quite dis- of intraday credit from the Reserve Banks. tinct from other payment services pro- When the Reserve Banks agree to process vided by the Reserve Banks. For instance, Fedwire funds transfers on behalf of finan- the Reserve Banks do not guarantee that cially troubled institutions, they essentially credits to reserve accounts resulting from guarantee payments by these institutions, check collection are “good funds.” If a thereby providing confidence to counter- Reserve Bank cannot collect from a bank parties receiving the payments and con- on which the checks have been drawn, it tributing to the stability of the payments has the right to reverse the credits to the system. The Reserve Banks manage the reserve account of the depositing bank. risk in providing this guarantee through a Fedwire funds transfer is a natural combination of operational and financial monopoly, in that only the Federal Reserve controls. can provide final settlement of reserves An important milestone in the Fedwire transfers. funds and securities transfer services was Reserve Banks began providing the the introduction of explicit pricing of Fed- Fedwire funds transfer service in 1918 via eral Reserve intraday overdrafts on April telegraph. Today the Reserve Banks 14, 1993, to provide banks an incentive to operate a highly-sophisticated computer limit their use of intraday credit (Richards, network with more than 8,000 on-line 1995; Summers, 1995). connections to the Fedwire funds transfer system. The Fedwire securities transfer Fiscal Agency service dates to 1967, when the Reserve One of the roles of the Federal Reserve Banks agreed with the United States Trea- Banks is to serve as a fiscal agent for the sury to begin converting U.S. Government U.S. government. The Reserve Banks pro- securities to book-entry form. The vide services to the United States Treasury computer system of the Reserve Banks and to a variety of other government agen- became the depository for ownership of cies, as requested by the Treasury the government securities. The Fedwire Department. For example, they collect securities transfer service is also a real- checks, process ACH transactions, and time gross settlement service, providing make wire transfers on behalf of the fiscal for the simultaneous delivery of securities principals. They provide a variety of cash and payment in final funds on the books of management services for government the Reserve Banks.19 This delivery-versus- agencies, including collection, cash payment feature of securities transfers over concentration, and letters of credit. In addition, they service the public debt and, 19 The Reserve Banks maintain Fedwire limits the risk to participants in book-entry securities accounts the market for government securities, through the Fedwire securities transfer for banks just as they maintain because a seller of securities can transfer service, provide operational support for funds accounts in which banks ownership to a counterparty in a transac- the secondary market in U.S. government hold reserves. tion without concern about whether the and agency securities. Approximately 12
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26 S EPTEMBER/OCTOBER 1996 percent of the annual operating expense of provisional net settlement service rep- the twelve Reserve Banks is attributable resent “good funds.” If a Reserve Bank is directly to their role as fiscal agents (Fed- not able to collect the net debits from eral Reserve Planning and Control System). members of a group, it may reverse the entries made to the reserve accounts for Net Settlement the net settlement. Net settlement is a service provided by One reason depository institutions the Federal Reserve Banks to a group of have a strong interest in using the Federal banks that clear payments among Reserve for interbank settlement is that themselves, net their interbank positions, virtually all depository institutions in the and settle their net debit and credit United States hold reserve accounts at positions through entries to their reserve the Reserve Banks (Blommestein and Sum- accounts. These arrangements can be clas- mers, 1994). They are uniquely positioned sified as “final” or “provisional.” Net to meet the needs of clearinghouses with a settlement entries classified as final are not diverse membership, since virtually all the reversible by the Reserve Banks, whereas clearinghouse members would hold provisional entries are reversible. accounts with the Reserve Banks. In addi- In December of 1994, the Board of tion, the Reserve Banks are able to offer Governors of the Federal Reserve System their natural monopoly advantage of pro- issued a policy statement governing large- viding final settlement in central bank value arrangements, which establishes the money, rather than in terms of the conditions that such arrangements must liabilities of another private bank. meet to operate and to gain access to Fed- eral Reserve net settlement services.20 Large-value settlement arrangements include electronic funds transfers (for example, the Clearing House Interbank Payments System or CHIPS) and electronic securities clearing and settlement (for example, the Government Securities Clearing Corporation or GSCC). To mini- mize the systemic risk associated with large-value netting arrangements, the new policy statement requires that these arrangements be designed to achieve final settlement. Members use Fedwire to settle their net debit obligations resulting from net settlement. Also, one private ACH ser- vice and one check-clearing arrangement use Fedwire for net settlement. The Reserve Banks also provide settle- ment services for small-value payments to approximately 160 local and regional clearinghouses throughout the country. The small-dollar settlements are for a variety of netting arrangements, predomi- nantly check clearinghouses, but also for credit card systems and ATM and POS net- works. Settlements for these netting arrangements are provisional. The Federal 20 Federal Reserve Press Release, Reserve does not guarantee that credits to December 21, 1994, Docket reserve accounts resulting from use of its No. R-0842.
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