TEN Magazine

President’s message Pursuing a safe, secure and reliable payments system : What can history tell us? n recent years, the way we make individuals that can be payments has undergone a dramatic identified only through I change. Online banking and bill a Web address. In many payment, debit cards, greater credit card ways, though, these risks usage and smart cards rapidly are replacing our mirror what we have seen use of cash and checks, which have made up before in the development the traditional payments system throughout of our payments system. U.S. history. This payments revolution is far A common feature in the from over, with transactions through enhanced history of our payments mobile phones and new developments in system is that consumers, identification and authentication technologies financial institutions, the on the horizon. business community and For all of us, this evolving electronic public authorities all have payments system is bringing with it many played important roles in benefits, including lower costs, and greater helping to contain risk and build confidence. convenience and control when making Because this experience may shed some light payments. Also, we now have the ability to on the fundamental issues and risks, it is worth make payments on an instantaneous basis—an taking a brief look at how our payments system important feature for those of us engaged in has evolved to the present and the lessons that online shopping and last-minute bill paying. we have learned. At the same time, though, this new payments system is raising a vari- Wildcat banking ety of concerns, including identi- One of the earliest experiments in U.S. ty theft, data breaches, unauthorized payments history was when banks were allowed access to one’s financial accounts, misuse of to issue their own bank notes as a means of sensitive information and computer break- payment. Before the Civil War, most states downs. Some of us may already have firsthand authorized the banks they chartered to issue experience with such risks, having been targets bank notes or paper money in each bank’s of phishing attacks or victims of stolen credit own name. These notes were to be secured by card numbers or data breaches. a comparable amount of government bonds Part of these risks would appear to be or other acceptable assets deposited with the unique—a new technology is involved, new state banking authority. Banks were further players are providing payments services, and required to stand ready to redeem their notes electronic payments often go to businesses or for gold or silver coins upon the request of any WINTER 2008 • TEN 1 noteholder. For any bank that failed to do so, doubt, inefficient. In fact, people often had to state authorities could close the bank and sell carry silver and gold coins just to be sure they the pledged securities to pay off the remaining could conduct business in distant locations. A noteholders. variety of private and public responses were On the surface, this framework appeared initiated to deal with the inherent problems. to establish a secure payments system, but a For example, private brokers would collect number of problems eventually arose. Most bank notes from merchants and individuals important, if the pledged securities declined and, for a fee or discount, would then present in market value, whoever held the notes could these notes to the issuing banks for redemption be less than fully secured and would have in gold or silver. Several publications even arose trouble finding someone to accept them at to report these discounts and thus extend such face value. The wide array of bank notes in information to a wide group of individuals and circulation—and the resulting opportunities merchants. for counterfeiters—further added to these Sound banks performed a similar role in questions of acceptability. collecting the notes of other banks and then Beyond this, a number of states even presenting them all at once for redemption. allowed bankers to buy depreciated bonds and The eventual solution to this seemingly then exchange them for notes on the basis of chaotic system was to make paper money the bond’s higher par value or issue price. This a more direct function of the government, oversight provided an instant profit to banks starting first with national bank notes, which in addition to the interest they could earn on had tighter standards for pledged securities, the bonds, thus encouraging some bankers and eventually leading to Federal Reserve to issue much greater volumes of notes. Such notes, whose issuance depends on the public incentives led to what became known as wildcat demand for currency and the Federal Reserve’s banking—one of the most colorful times in monetary policy operations. U.S. banking history. A handful of bankers with less than stellar reputations located their Payments by check banks in backwoods areas among the wildcats. After the wildcat banking era, our These inaccessible locations prevented people payments system began to change in other from coming in and redeeming notes for gold and even more significant ways. Deposits that and silver, thus enabling the wildcat bankers to could be withdrawn by checks quickly became continue capturing the extraordinary profits on the focal point of what was an emerging their inadequately backed currency. payments system. In comparison to notes, Although there is still debate about how checkable deposits demonstrated some notable severe the problems and losses were with advantages. People and businesses no longer wildcat banking, this system was, without had to carry as much currency around, and 2 WINTER 2008 • TEN checks proved to be especially ideal for large the return process on unpaid checks and to transactions and for transferring money over a provide prompt notification to the bank and distance. the customer who received the check. Like bank notes, though, checks have not been without problems. Anyone accepting a Lessons to be learned check bears the risk that a check might be a What can we learn from these experiences, forgery or have been written against an account and how do such lessons apply to the new with insufficient funds to cover it. payments revolution? While other forms of ID theft and financial Perhaps the most important things we fraud have drawn more of the headlines recently, can learn are that our payments system has the risks associated with checks are significant not been without risk during the different and certainly familiar to many businesses stages of its development and that consumers, and continue to draw their attention. These businesses, financial institutions and public risks, in fact, were portrayed some years ago authorities must all play a role in containing in the movie “Catch Me If You Can,” based risks and protecting those making and receiving on the life of a master of check forging, Frank payments. Abagnale, and his ability to easily pass off The basic issue in our payments system— fraudulent checks on unsuspecting parties. In historically and now—is in verifying the an interesting twist to that story, Abagnale now soundness of a payment and authenticating helps law enforcement agencies and businesses its source. With wildcat banking, people were design better systems for controlling the types sometimes faced with the issue of whether of check fraud and ID theft he had mastered. to accept the notes of a bank they knew To deal with the risks inherent in accepting little about. Similar problems arose with the checks, merchants, bankers and others now introduction of checks and not knowing if employ a number of approaches. These range someone had sufficient funds to cover the from asking for several pieces of identification checks they wrote. These verification issues from anyone cashing a check to using check were further complicated by the large number verification systems and penalty fees for bad of banks issuing notes and the enormous checks. Other steps include requiring cashier’s volume of checks being written. checks or bank letters of credit to make a major Now we are seeing a repeat of this problem purchase, and placing holds on the use of with electronic transactions, where individuals funds or shipment of goods until after a check and businesses may receive payments from has time to clear. Public laws further provide unknown sources and be at risk from a recourse for victims of check fraud. In addition, fraudulent exchange. Both consumers and banking regulations and clearinghouse rules businesses can be victims, and the efficiency, contain provisions designed to speed up integrity and prospects for a successful, WINTER 2008 • TEN 3 innovative payments system can be jeopardized of consumers when they conduct transactions as a result. One further complication in through electronic terminals from their electronic banking is the proliferation of accounts at financial institutions. By setting a different payment channels—credit, debit, common platform for all financial institutions ACH, wire or PayPal—along with a wide and consumers to follow, this act provided an array of payment instruments—cards, important impetus to electronic banking and computers, phones and cell phones. Each may help establish a framework for additional of these combinations may have different public actions. vulnerabilities and thus different arrangements Another example of public-private and rules with regard to user safeguards and cooperation is the development of ACH for security, authentication processes, liability, and small electronic payments in which the Federal error resolution and responsibility. The result Reserve System and the National Automated is confusion and increased payments risk. Clearing House Association (NACHA) have Should electronic payments be addressed worked together as payments providers to in a manner similar to wildcat banking, where develop a framework and rules that facilitate the federal government eventually took over the safe, efficient and reliable movement of and standardized how currency would be small electronic payments among parties.

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