S EPTEMBER/OCTOBER 1996 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. F EDERAL R ESERVE B ANK OF S T. LOUIS 3 S EPTEMBER/OCTOBER 1996 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). F EDERAL R ESERVE B ANK OF S T. LOUIS 4 S EPTEMBER/OCTOBER 1996 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.