1994-1995 Essay Contest

First Place Essay

The Chinese Wall Between Competition and Regulation

Kathleen Biesterveld
Memorial High School
Eau Claire, Wisconsin


Though not obvious at the time, a monumental event took place when President Carter signed his name in approval of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) on March 31, 1980. In doing so, he was in fact erecting the very "Chinese wall" that would later prove to be perhaps the largest asset the payments system retains in contemporary society. The authorization that Carter gave with the stroke of his pen, was that the Fed was now to act as a competitor with the same institutions it regulates. Thus began a new period in which through striking a balance between offering and regulating services, the Federal Reserve was in essence defining its most efficient and effective role.

The Federal Reserve was now entitled to a dual function which outlined its objectives as both a regulator and a competitor. This sweeping change included that the Fed would now be acting not only as a general regulator, but as its own regulator; while also providing services as a clearing house. In this scenario, the "Chinese Wall" represents the separation of responsibilities within the Fed. This separation of duties provides the basis for the success of the Federal Reserve. The original and underlying responsibility of the Fed as a regulator is the preservation of stability, enhancement of efficiency, and the promotion of public confidence in the payments system.1 Astonishingly, the best way for the Federal Reserve to meet all of these objectives is through its actual participation in the payments system. Under the DIDMCA guidelines, the Federal Reserve was ordered to begin offering services to all financial enterprises, and also to begin charging a fee for these services.2 This new doctrine placed the Fed in direct competition with the private sector.

The most obvious and perhaps central advantage to the dual role lies in efficiency. Efficiency within the Federal Reserve is of utmost importance. The cost of processing payments is as high as $60 billion annually, or about one percent of GNP.3 In fact, one of the most compelling reasons for the actual establishment of the Federal Reserve was to promote efficiency through the attempted elimination of both presentment fees and "float" (the practice of intentionally slowing payment). And while steps were taken early on to address these inefficiencies, they were unsuccessful because of the lack of a national clearing system; the Fed's participation and competition within the system was needed.4 Unfortunately, it wasn't realized until 1980 that the dual function of the Fed could overcome these obstacles.5 Implementation of the DIDMCA aided in efficiency initially through the pricing mandate. The new prices helped end the vast overuse of the free services previously provided and helped satisfy the cost recovery objective of the MCA.6

Competition also helped efficiency through significantly decreasing the amount of float. This was done through starting an inter-territorial check transportation system and by offering later deadlines for receipt of checks. By 1982, the daily average of float was $1.8 billion, it had gone down almost five billion dollars in three years. Competition had, in effect, provided enough convenience to its customers that it began to override the incentive for float, thus more and more businesses discontinued using inefficient methods.7 Today, more than twenty percent of checks processed clear at least one day faster than prior to the Monetary Control Act.8 Yet another way that the Fed as a participant helped increase efficiency is through its emphasis on technological innovation. The Federal Reserve began its push towards innovation by enhancing products, beginning new check sorting techniques, and enlarging transportation arrangements. Interestingly, while working towards the common goal of increasing efficiency, the competition within the Fed's 12 district banks began to grow; this in turn, began influencing the private sector, spurring them towards innovation as well.9 In fact, since the implementation of the DIDMCA the Federal Reserve and the private sector have worked together towards technology and efficiency. One such case is the proposal to reduce the flow of paper checks through enlarging the volume of transactions eligible for interbank truncation.10 Here, the Fed worked with Commercial banks to initiate the Automated Clearinghouse (ACH), a computer based operation that clears and settles transactions electronically. This method is much more efficient than paper checks.11 Ironically, while efficiency relies on innovation, advancement itself is dependent on the efficiency of the payment system.12 It's quite obvious to see how dual role competitiveness has been the driving force behind ending inefficiency through improved quality and responsiveness.

Another area in which the participatory role has served the nation is in promoting stability and public confidence. In today's society it's easy to see how important the Fed really is. In fact, "virtually every good and service is dependent on the smooth functioning of the banking and financial markets."13 Every day, millions of Americans utilize the services provided by the payments system. Integrity is very important in maintaining an overall stability within the system. If there was little confidence in the Federal Reserve as a regulator, the entire system could become fragile. The need for stability is great. If the public loses faith in the system, they also lose faith in the value of their money. And when money no longer seems valuable, a possible impact is inflation.14 Consequently, this instability could "precipitate or intensify a general economic crisis."15 For instance, small institutions rely on the strength of the Fed to ensure their own viability.16 Through improving the system and increasing efficiency, the dual role of the Federal Reserve has helped strengthen the overall credibility of the payments system.

While the overall benefits are apparent, many still question whether the Fed can act as a regulator of its own competition in a fair and successful manner. In continuing to work towards a stronger and more efficient payments system, it's important to ensure that the Federal Reserve competes in complete fairness with the private sector. While there must be an equal balance between the roles of regulator and competitor, there must also be complete separation of the two. This is needed so the Fed is not given a comparative advantage by making regulations to aid itself. To remedy such inequalities as the Fed's price advantage, the Private Sector Adjustment Factor (PSAF) was created to adjust for the taxes that private businesses have to pay. The Fed also goes through an intense process of research and analysis to determine societal impacts of its decisions.17 In fact, in many areas the Fed service providers are at a competitive disadvantage. For instance, the Fed is obligated to extend services to all institutions and cannot pick and choose its business. The Fed also has little pricing flexibility and does not have the opportunity to offer the same range of services as the private sector.18

In accordance with the Fed's objective for fairness, the institution itself has a commitment aside from formal guidelines. This unwritten code has been dubbed the "Chinese Wall," and while this wall is not made of stone, it's a very real commitment to the "separation of the Fed's payments function from the regulatory activities of the bank."19 In fact, many Federal Reserve banks insist that there be no discussion between the employees of the two separate entities.

The dual role of the Federal Reserve as regulator and competitor has revolutionized many aspects of the payments system. Because the Fed acts as the very rock supporting the entire monetary system, it's important that the role it plays is one of security, fairness, and effectiveness. Giving valuable insight into the institution, the dual role and operational aspects enable the Fed to have direct involvement and consequently be more efficient, stable, and effective. Were it not for the "Chinese wall" and the dual role it provides, the payments system could not be nearly as advantageous.

Bibliography

Bauer, Paul. ECONOMIC COMMENTARY; Federal Reserve Bank of Cleveland. July 1, 1994

Fernelius, Leonard W. Federal Reserve Bank of Minnesota; 1991 Annual Report.

Hollis, Donald R. Commentary. Vice Pres. of The First National Bank of Chicago; Chicago, Illinois

Humphrey, David B. THE US PAYMENT SYSTEM: EFFICIENCY, RISK, AND THE ROLE OF THE FEDERAL RESERVE. Boston, MA; Kluwer Academic Publishers, 1990.

Johnson, Manual H. Vice Chairman, Board of Governors of the Federal Reserve System Conference Summary. Williamsburg, Virginia. May 25-26, 1988.

Newton, Maxwell. THE FED. New York, NY; Times Books. 1983.

Tailor, Gary. THE FEDERAL RESERVE SYSTEM. New York, NY; Chelsea House Publishing 1989.

Wiles, William. FEDERAL RESERVE BULLETIN. Vol. 76 No. 5, May 1990

Endnotes

1 Fernelius 1

2 Wiles 293

3 Humphrey 286

4 Fernelius 4

5 Fernelius 3

6 Wiles 296

7 Hollis 2

8 Johnson 2

9 Fernelius 9

10 Humphrey 285

11 Hollis 3

12 Bauer 1

13 Wiles 295

14 Taylor 28

15 Wiles 295

16 Fernelius 10

17 Fernelius 8

18 Bauer 10

19 Fernelius 8

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