Gary H. Stern
Federal Reserve Bank of Minneapolis
Emerging Payments Conference
Federal Reserve Bank of Chicago
May 30, 2003
I first want to thank the Federal Reserve Bank of Chicago for the invitation to participate in this conference, one of several on the payments system the bank has held in recent years. Conducting research and analysis of payments is a valuable and appropriate role for a central bank. I congratulate the Chicago Fed for vigorously carrying out this charge.
This conference addresses what payment networks may look like in the longer term, as well as how trends in consumer and corporate demand, technology and economic conditions affect near-term developments. These issues are important to the Federal Reserve, given our significant role as a provider of retail and wholesale payments services. Moreover, and somewhat distinct from the direct provision of services, the Federal Reserve as a central bank has a strong interest and role in payments system developments.
While we all need to respond to prospective changes in the environment, the track record of predictions of the future state of payments systems is not good, to be generous. In perhaps the most recent example of unexpected payments developments, many astute observers across the industry were surprised by the findings of our Retail Payments Research Project; check volumes in 2000 were appreciably lower than many had predicted and appeared to have peaked in the mid 1990s.1
Given the difficulty in forecasting the direction that payments might take and, hence, the particular role the Fed might play, a constructive alternative is to articulate general principles that can help guide and set expectations for our future activities. It is particularly important for a public institution like the Federal Reserve to take such a principles-based approach.
So my objectives today are twofold: first, to review some established principles that have long helped us decide about our overall role and about new initiatives and, second, to discuss issues involved in establishing principles for altering our existing businesses, particularly retail payment operations. By way of preview, I will suggest that existing principles guiding the Federal Reserve's role in payments are valuable for delimiting both new activities and our initiatives in wholesale payments.
But when it comes to the retail side, where the marketplace is in the midst of substantial change, existing principles may not be fully adequate, and accordingly we need to think long and hard about how to proceed in this arena. The Federal Reserve has to strike an appropriate balance between remaining an effective participant in retail payments while assuring that the private sector has ample opportunity to innovate and to prosper as markets evolve. There may be tension here since it is not clear how aggressive the Federal Reserve should be, and in the second part of these comments I will explore this tension and several aspects of its resolution. Further, let me emphasize that my intent today is not to be definitive but rather to begin a dialogue on this subject.
The Federal Reserve has long thought conceptually about its role in the payments system. Perhaps the most well known discussion of such concepts is the so-called White Paper which articulated roles for the Federal Reserve in supporting the integrity and efficiency of, and access to, payments systems.2 A number of other efforts, including the Rivlin Committee report, also identified principles, as does the Monetary Control Act.
Based on this work, there are two principles that seem well established and accepted as guiding Federal Reserve payments policy. The first is that the Federal Reserve should not provide new payments system services unless markets are failing and the Federal Reserve has a unique comparative advantage in providing the service.
Breakdowns in the payments system can be quite costly and some of these costs arise because of what economists call market failures, whereby too little or too much of a good or service is produced. In some cases of market failure in the payments arena, the Federal Reserve may be uniquely situated to correct the problem. While it is not the only area where market failures might arise and where we might have a comparative advantage, I believe Federal Reserve involvement in interbank clearing and settlement through Fedwire provides a prime example of how we implement this first principle.3 I think a reasonable case can be made that our continued commitment to enhancing the functionality of Fedwire can be justified by this same principle, namely correcting market failure where we have a comparative advantage. Changes to Fedwire reflect our intent to assure that a plethora of standards, communication protocols and networks do not reduce the efficiency of the interbank market. The Federal Reserve is well positioned to help ensure that wholesale payments are conducted effectively and with as low a resource cost as possible.
The second principle guiding our activities is that the Federal Reserve should utilize the full range of its tools to improve payments system performance. Through its central bank role, including regulatory authority, the Federal Reserve can identify and correct weaknesses in payments system infrastructures, provide information to payments system participants and help overcome coordination problems, among a host of other tasks. Because many of our tools are less costly than direct service provision and may not be available to the private sector, we may want to favor these alternatives, where possible, to achieve broad payments system objectives.
The check business provides two excellent examples of the application
of this principle: (1) the Check 21 legislation. As you know, Congress
is in the process of considering legislation, originally proposed by the
Federal Reserve in late 2001, that aims to facilitate the transformation
of paper checks into electronic files (truncation) during processing.
(2) Research. Our research on check volumes, already noted, provided vital information that may not have been produced without our involvement.
Clearly, the Federal Reserve's payments system activities reach beyond research and legislative changes and beyond wholesale payments. We have significant market share in the provision of check and Automated Clearinghouse (ACH) services. In the next few minutes, I will review: (1) some of the binding and, by the way, appropriate limits on our current retail activities, (2) initial thoughts that could help guide activities within those broad limits, (3) examples of activities that are generally consistent with these initial thoughts and (4) questions suggesting that additional work on principles is necessary.
One binding limit on our retail operations is our commitment to remain an active participant for the foreseeable future. It is clear to most serious observers that mass voluntary retreat from these businesses by the Federal Reserve is not now a serious option. This is in part because there are well-developed expectations about banks' ready access to payments services that would conflict with the Federal Reserveas a public entitysimply exiting these businesses. The large market share of the Federal Reserve implies that leaving these existing businesses could be highly disruptive.
A second commitment binding our actions in retail payments is that they adhere to the established principles I earlier articulated, namely those governing provision of new services and promoting reliance on tools beyond service provision. These general guidelines, while circumscribing Federal Reserve actions somewhat, do not provide sufficiently specific guidance in the face of a dynamic market. Indeed, general limits on our actions actually highlight the tension we face. If the Federal Reserve does not respond effectively to changes in customer demand or competitive pressures in existing markets, we will cease to be viable providers of payments services and will, de facto, exit the business. On the other hand, if the Federal Reserve responds so aggressively to competition as to eliminate viable private sector alternatives, we will risk violating the spirit of our established principles.
In this vein, while there may on occasion be public policy reasons for the Federal Reserve to try to lead developments in retail payments, I think the Rivlin Committee had it right when it said: Private sector innovation has been the key driving force behind the evolution of the U.S. retail payments system and will almost certainly continue to be so in the future.
Establishing more precise principles to help focus our response to this tensionthat is, remaining viable without stifling private sector initiativesis a priority. To help narrow the range of possibilities, I will offer a suggestion that, with additional work, might serve as the basis for one or more well-articulated principles in the future. Specifically, the Federal Reserve should ensure that the size, reliability and capabilities of its basic retail infrastructure supporting established services corresponds to market demand.
This tentative principle offers some guidance on expansion, contraction and focus of our resource allocation. The basic infrastructure/already- established services aspect of the principle focuses our resources on current activities and, by implication, this is a fairly narrow focus. The matching of size, reliability and capability to market demand implies that as we maintain our existing services, we can expand them and/or make investments to keep them operating in a robust and effective fashion. More specifically, there should be room to alter our existing activities so that a more desirable technology, for example, can be used to offer the functional equivalent of an existing service.
The correspondence of size and demand means we also must narrow our operations if and when demand falls. Our cost-revenue objective requires this response in any event.
As indicated earlier, there are several ways in which our actions already reflect these thoughts. One is that, given the realization that the Federal Reserve's check processing infrastructure 4 is too large and too costly, we are in the process of reducing this infrastructure. Second, for the last several years, the Federal Reserve has engaged in a major effort to shift to a common platform to process checks. Standardization allows us to reduce long-run costs, improve the flexibility and resilience of our operations and meet demand from customers who operate nationally.
A third illustration is provided by the ACH, which appears to be shifting to a more flexible system geared to a broad range of retail transactions such as point-of-sale and lock box conversion of checks, debit card transactions and greater frequency of one-time payments initiated by telephone and the Web. The Federal Reserve is in the process of ensuring that our ACH system will accommodate changes in volume and in the nature of the payments it processes.
There are several areas, however, where I recognize weaknesses with the incipient principle that links the Federal Reserve retail payments infrastructure to demand. For example, (1) is it tenable to have a clear division between new products subject to the established principles and modifications to existing products subject to another set? How would such a division be policed?
(2) What risks should we assume in estimating and responding to market demand? If we count only demand as interest expressed in the form of signed contracts, we will surely be slow in offering desired services. Our tolerance for risk in this example would be too low. However, if we provide new services without any real commitment from customers, we will surely get ahead of markets. Determining the level of risk to assume and the state of demand, therefore, are key to our viability, as they presumably are to other providers. However, because the Federal Reserve is a public institution with unique responsibilities and objectives, selecting an acceptable level of risk is a complex matter.
(3) How do we balance our cost-recovery mandate with assuring ease of access? This is an issue because covering a wide geographic region in order to facilitate access can be quite costly, thus making our financial targets difficult to meet. Pricing our products based on the cost of providing the service to a single customer would facilitate, by definition, cost recovery but could raise questions about our commitment to access.
(4) How do we respond to new private sector payments services that might substitute for our own? The nature of our response has implications for our ability to remain an effective direct participant in payments systems and possibly for our commitment to address market failure as well.
Many are confident that the future payments system will differ in important ways from that prevailing today. Knowing what the differences will be with any confidence, however, is a different story. In the face of this uncertainty, perhaps the best we can do is to articulate principles to help us determine the response to future developments, a step that is particularly important for a public institution like the Federal Reserve. In this spirit, I have articulated two principles that are reasonably well established and have helped the Fed determine what sorts of new payment activity it should enter.
I have also discussed a principle to help us determine how we might modify our existing payments operations, particularly on the retail side. Although the principle offered seems consistent with our current actions, I recognize that it needs additional attention. In any event, though, I am convinced that principles such as these will be essential as the Federal Reserve proceeds in payments.
1 Geoffrey R. Gerdes and Jack K. Walton. The Use of Checks and Other Noncash Payment Instruments in the United States. Federal Reserve Bulletin, August 2002, 360-374.
3 This point is developed in more detail by my colleagues at the Chicago and Minneapolis Reserve Banks in Edward J. Green and Richard M. Todd. Thoughts on the Fed's Role in the Payments System. Annual Report Essay, Federal Reserve Bank of Minneapolis, April 2001.
4 For details of this restructuring see, Federal Reserve Banks Announce Changes to Increase Efficiency in Check Services as Check Volumes Decline Nationwide. February 6, 2003.