Gary H. Stern
Federal Reserve Bank of Minneapolis
The Payments System in Transition Sponsored by the Payments System
October 30, 2003
I appreciate the opportunity to participate in this conference on the payments system in transition, sponsored by the Payment Systems Development Committee (PSDC). I wish to thank my co-chair on that Committee, Roger Ferguson; my predecessor, Cathy Minehan; the other members of the Committee; and the many staff members at the Board of Governors and the rest of the System for organizing a timely conference and assembling an impressive agenda.
As you may know, in addition to my duties on the Payments System Development Committee, I recently assumed the chair of the Financial Services Policy Committee, the body responsible for formulating policy and for providing executive oversight to the Federal Reserve’s payments services. This is an assignment with intriguing challenges and opportunities, to perhaps understate things a bit.
While all of our financial services confront significant issues, responding to the changing retail payments environment is a top priority for me at this time. In these comments, I will review how I intend to approach this challenge, in the broadest sense. To be sure, Check 21, which may in itself portend significant change in retail payments, is of particular interest to this conference and, of course, to the Federal Reserve as well. However, because others with much greater hands-on knowledge than I addressed Check 21 in detail yesterday, I will focus this morning on the more general policy issues ineluctably associated with the challenges and opportunities inherent in the changing retail payments landscape.
In this regard, my major point is straightforward: A policymaker’s overriding concern is improving the welfare of society as a whole. And I am specifically thinking of social welfare in the sense that economists use the term; that is, allocating resources to maximize the benefits that society receives from them. This perspective is not one that leaders of a private sector banking organization or other participants in payments usually take, nor should it be. But for the Federal Reserve, an institution created to further the public interest, net societal benefits are critical.
A focus on social welfare and resource allocation may sound of only theoretical value, but it has some pertinent implications for how I view both developments in the payments system and the manner in which the Federal Reserve ought to respond to those developments. For example, because of the focus on resource allocation, I, unlike the head of a private firm, view social welfare from the vantage point of households. This means that I support developments that in the aggregate improve the welfare of households, even if in some sense they make some Federal Reserve financial services, and related private firm services, worse off.
But let me be a bit more specific. Today I will discuss three implications of a focus on social welfare. They are:
I will elaborate on these thoughts as I proceed. But let me emphasize, as I have in other forums, that these observations remain general and are the product of iteration. It is through continuing dialogue with you and other payments system participants, including end users, that we can come to more definitive conclusions about retail payments and the future role of the Federal Reserve. Such a dialogue is particularly important in current circumstances, characterized as they are by rapid change and heightened uncertainty.
I am sure that this audience is familiar with recent trends in retail payments volumes, so I will not review the data in detail. Nevertheless, a few observations are in order because they set the stage for the thrust of these remarks. We all know that for years, if not decades, analysts routinely predicted absolute declines in check volumes and that for years the market refused to cooperate. However, more current and reliable evidence from Federal Reserve sponsored research documented an outright reduction in check volume occurring at some point between 1995 and 2000. And these volume declines appear to have continued.
While check volumes have finally started to diminish, there has also been a surge in electronic retail payments. In fact, a reasonable extrapolation of recent trends, indeed perhaps a conservative extrapolation, would have checks constituting less than half of noncash retail payments volumes in just a couple of years. The bulk of the growth in electronic retail payments has been in debit and credit cards. ACH has expanded rapidly as well, but it is really a different “animal” from the consumer’s perspective, as it is typically not the vehicle by which the customer directly originates a payment.
Data from the survey of consumer finances, sponsored by the Board of Governors, confirms these types of trends.1 While there was some increase in the use of very well established forms of electronic banking, such as ATMs, the real explosion in “electronics” and banking came in the use of instruments such as debit cards. In 1995, about 18 percent of households used debit cards whereas nearly 50 percent did in 2001. The rate of growth of automatic bill payment during this period was also large but not quite as dramatic. Quite interestingly, these types of trends were present across age and income groups.
The data just cited have a bearing on my earlier observation about focusing on social welfare. Before the decline in check volumes became apparent, there was some sentiment that collective action, perhaps initiated by government, needed to be taken to promote the transition from paper to electronic retail payments. Underpinning this view was the observation that checks are costly to process and to transport, so resources could be saved by moving to electronics. The flaw in this reasoning was that it did not account for the preferences of households and firms; that is, benefits seemingly did not enter the calculation and thus overt strategies to curtail check usage usually seemed heavy-handed and were rarely implemented (at least in the United States).
The judgment not to “jump start” a shift in payments seems wise in retrospect, given that the shift I noted a few moments ago in the composition of retail payments resulted from the consequence of market forces. On the consumer demand side, it seems that tastes are changing, perhaps as a result of familiarity and comfort with electronic processes, and no doubt for other reasons as well. Retailers are clearly moving to check conversion at the point of sale and/or at the lock box. On the supply side, providers no doubt are responding to demand and also to the fact that technology makes it possible to offer electronic products profitably. Irrespective of the causes, the key point is that a change in the market is occurring spontaneously and mostly in areas where the Federal Reserve is not involved. Hence, the transition is the consequence of decisions and actions by market participants and thus, virtually by definition, it is good for society as a whole.
A change that is good for society as a whole will almost certainly not be good for every person or industry. Change almost necessarily creates losers as well as winners. However, it is best to let the market mechanism sort all of this out. We know that the transition from paper to electronics is difficult for some firms, as it is for the Federal Reserve and a sizable number of our staff. At the same time, it is important to emphasize that the flexibility of our labor and product markets has been a key to the long-run success of the U.S. economy and to our high standard of living. The shift in payments instruments and associated resource reallocations represent such flexibility in action.
My bottom lines so far are that, first, Federal Reserve policymakers ought to focus on social welfare rather than alternative objectives when considering financial services. Second, trends in payments that reflect market forces rather than government intervention, with an important exception which I will discuss shortly, represent welfare enhancing outcomes. I now turn to applying these types of principles to the development and modification of Federal Reserve services.
Let me discuss how this concern with social welfare affects my approach to the provision of new services first. I will then discuss its effects on modifications to our existing services, and then move on to conclusions.
New Services. I start with the view that the Federal Reserve must pass a series of meaningful hurdles if it is to intervene and to supplant the market in producing and delivering the “next generation” of payments vehicles, a position that is underpinned by three complementary observations. The first is the general reliance in our economy over a long period on market solutions to changes in tastes, advances in technology and fluctuations in relative prices. The second is the obvious success of the market in moving retail payments toward electronics; I previously commented that external mandates really played no role in this.
The third reason for relying initially on market forces is that it is consistent with principles that we in the Federal Reserve have long espoused and have been guided by. These principles state that the Fed should, as a general matter, provide retail payments services directly only in cases where markets fail to operate effectively, where less intrusive interventions are not effective and where we can recover our costs. It is not enough, therefore, to simply point to cases where prices seem “too high” or the market seems to move “too slowly.” Instead, we must demonstrate the case for enhanced social welfare. Surmounting these hurdles in a truly convincing fashion is not a trivial task, given the uncertainty associated with measures of market failure and projections of cost recovery.
For some observers, the rationale for the Federal Reserve to follow these principles may be second nature, but it is worth briefly noting why they are compelling. In the first place, the Federal Reserve has no alternative but to follow the cost recovery mandate legislated by Congress. Moreover, the cost recovery test reflects, at least in part, a desire to ensure that an entity funded with tax revenues does not take advantage of an unequal playing field to displace the private sector firms that we typically rely upon in the United States. In a similar vein, without market failure, there is no reason to believe that government intervention in payments markets, or any market for that matter, will lead to a superior allocation of resources. Finally, even if there is market failure, it may be that a solution other than direct provision of services is preferable because such an alternative could be relatively cost effective and would likely make the greatest use of private providers.
A specific example of these principles in action may help. Perhaps the most important recent retail payments initiative associated with the Federal Reserve is not a new product or service but is instead an effort to eliminate legal barriers to changing payments. The Check 21 legislation is an effort to align the law governing one type of payment—checks—with advances in technology. That is, Check 21 gives a substitute check, which can be produced from an electronic file, the same legal standing as the original document. As such, the legislation may help remove barriers that could otherwise prevent the marketplace from transitioning from an existing payments regime to one that consumers and providers might prefer. I should note parenthetically that the PSDC has been at the forefront of the Federal Reserve’s effort to address these barriers to changes in payments, and we hope to continue that role following this conference. In any event, the Check 21 legislation does not rely on direct service provision by the Federal Reserve and, while it addresses certain obstacles to change, it does not mandate a specific outcome.
While I view the hurdles we set for ourselves as effectively making the Federal Reserve conservative in its willingness to offer new products and services, I do not view them as one-sided decision tools, set up to prevent us from offering services. Where the hurdles are met, we have a responsibility to be active in payments. In the right circumstances, it may be appropriate for the Federal Reserve to act as a competitive provider of payments services for reasons of efficiency and also because the financial requirements of the Monetary Control Act imply a scope of operations sufficient to cover costs.
Modifications to Existing Payments. Naturally, the concerns about social welfare that I just emphasized apply equally to our existing payments offerings. It may go without saying, but the major difference is that at some point the services we offer have already met these hurdles, or a set of tests that approximated these types of concerns. Simply put, we are not starting with a blank slate when applying concerns of social welfare to our existing operations.
While evaluating existing services that current policymakers have essentially inherited has its challenges, it also allows for more specific application of social welfare criteria. For example, determining actions the Federal Reserve should appropriately take in the face of the changing retail payments landscape requires at a minimum analyses of market competition and structure (that is, industrial organization) and of end user demand. If there is little end user demand, cost recovery could be difficult and claims about market failure as the cause for the absence of a product or service are suspect. If market structure and other factors suggest that adequate competition would not exist absent our involvement, we have a better chance of passing social welfare and cost tests. These considerations lead in turn to a more specific formulation of a social welfare test for our existing payments services, to which I previously alluded: The Federal Reserve must assure that the size, reliability and capabilities of our retail infrastructure supporting established services—that is, check and ACH—correspond to market demand and lead to a market with demonstrably more competitive pricing and service than would otherwise occur.
This principle provides a workable framework for making social welfare concerns useful in a changing retail payments environment. It recognizes that, depending on market conditions, contraction of Federal Reserve financial services may improve society’s well-being. At other times maintaining or even expanding services is appropriate in order to increase benefits. We can, therefore, be analytical in response to transitions in payments.
I will now turn to consideration of the implications of this principle for the Federal Reserve’s check and ACH services, starting with the check situation.
Check. In check, the reduced demand for paper checks, reflecting market forces already discussed, has led to overcapacity for us and for the paper check processing industry overall, an industry which is generally characterized by many participants and competitive pricing. In response to this development and concern for societal benefits, we are reducing our check processing infrastructure. Clearly, this downsizing also conforms to the MCA [Monetary Control Act], which requires that we fully recover costs. Restructuring and other cost cutting actions have been undertaken to return us to full cost recovery in check by 2005. If they do not, and the planning for such a contingency is already under way, we will take additional aggressive steps, be that further reductions in infrastructure, in product lines or what have you, to accomplish the goal. Any investment in our paper check infrastructure, naturally, will also reflect the future prospects for what can only be called a declining industry.
While the future of check looks challenging, the fact that the demand for check processing is declining does not mean that all services related to the paper check will necessarily diminish. As the desire to eliminate the paper check after it has been written grows, there may in fact be increased demand for certain services, such as maintaining an image archive of checks or converting checks into ACH payments. Here, too, the critical factors determining the Federal Reserve’s role relate to social welfare and to the general principle I articulated about competition and demand. Let me briefly elaborate.
Historically, concern has been expressed from time to time that a diminished Fed check infrastructure might reduce direct access to processing services at competitive prices, particularly for small financial institutions in relatively remote locations. But the forces propelling the increased use of electronic payments, as well as efforts associated with implementation of Check 21, might mitigate concerns about access and, in fact, such mitigation may occur rather rapidly. Why? Previously, it might have been quite costly for a check processor to enter a remote location if that processor did not have a network already in place to transport the physical items. With such a barrier to entry, competition would suffer and markets with monopolistic supply and pricing could emerge. Federal Reserve check processing services were viewed as one means of addressing such concerns.
With the need to pick up the physical check perhaps eventually eliminated in the new retail payments landscape, one might imagine that even banks located in physically remote areas could have many firms with the ability to enter their markets at low cost. But reduced barriers to entry may not help if there are few firms prepared to enter in the first place. And we might not expect many firms to offer the services needed to process what amounts to an electronic message with check information. As I will discuss momentarily, markets for the processing of electronic payments also tend to monopoly. In this case, active Federal Reserve participation in the electronic check market might very well be welfare enhancing; at this point, it is simply too early to tell.
The reference to electronic retail payments is a natural transition to discuss our ACH business, so let me turn to that topic.
ACH. The ACH business is a growing one in which the Federal Reserve already has considerable market share. But market share is not the Federal Reserve’s objective, and so one question is: From a social benefit viewpoint, how should the Federal Reserve respond to increasing demand for ACH services?
Just as was the case for check, we make concerns for social welfare real in this case by looking at issues of market structure and demand. Thus, my question must be addressed in view of the fact that the ACH is characterized by economies of scale and “network effects.” As just intimated, these characteristics typically lead to highly concentrated markets and to the potential for too little output and unduly high prices. I view the current role of the Federal Reserve in ACH—that of major provider—as an effort to deal with these concerns and thereby enhance social welfare. Moreover, as the primary provider of services in a market with just two suppliers, the Federal Reserve makes society better off by maintaining the structural integrity of the system, including making reasonable investments in its reliability and assuring that the system adequately serves its customers.
Moreover, the Federal Reserve faces not only increased demand for existing ACH services but also demand for enhanced features and functionality. ACH is increasingly transitioning 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. We are making changes to the ACH system to support such transactions given the legitimate market demand they reflect. As we continue to see changes in ACH, I will welcome constructive discussion as to how the Federal Reserve’s role and the roles of other participants should evolve to enhance societal benefits.
Anyone active in the retail payments business faces significant challenges over the next year or two and over the longer term as well. This is true of the Federal Reserve, but we are not just “another player” in this business; we are a public institution, and therefore, our overriding objective is to improve social welfare. This objective, together with changes under way in the marketplace and with our historic role in retail payments, has led me to three initial conclusions.
In closing, I look forward to further consideration and discussion of these conclusions. Your input is essential to assuring that our direction continues to serve society as a whole.
1 See Lorretta J. Mester. 2003. “Changes in the Use of Electronic Payments: 1995-2001.” Federal Reserve Bank of Philadelphia Business Review. Third Quarter. 18-20. [PDF]