Payments System Issues and Challenges

Gary H. Stern
Federal Reserve Bank of Minneapolis

BITS Conference
June 15, 2005
Washington, D.C.

Good morning. It's a pleasure to be here. I appreciate the opportunity to discuss payments issues with a group that's at the forefront of technological innovation for the financial services industry. I've spent some time reflecting on how to add value to a forum with the theme "The Road Ahead," and in that spirit, I will make three main points:

First, although providers of payments services—including the Fed—face many challenges, the overall state of the U.S. payments system is excellent, and the economic benefits derived from the system are enormous.

Second, the positive state of the payments system largely reflects market forces, not government planning or intervention.

Third, given the current state of the payments system, the role of markets in achieving this outcome, and the limitations on a central body to address perceived problems, the Federal Reserve should be quite careful before intervening in these markets.

I am, of course, speaking only for myself and not for others in the Federal Reserve.

Overall State of Payments

I have been chair of Federal Reserve's Financial Services Policy Committee (FSPC) for two years now, and at times this has been a challenging responsibility. Consider where we in the Federal Reserve have had to focus our efforts over these years:

  • Emphasizing efficiency and keeping prices for electronic services low while offering improved quality as demanded by customers;
  • Planning the "next generation" of our electronic services in the midst of major changes in demand and in the technology of supply; and
  • Reducing our infrastructure for the processing of checks at a time when massive cost cutting by itself is insufficient to recover costs.

Of course, this brief list ignores the myriad of specific projects and initiatives covering a host of payments activities, but it is intended to provide a high-level sense of priorities. I should note as well our ongoing improvements in resiliency and in the security of our systems, related both to the continued implications of the post-9/11 world and to offering payments in an Internet environment.

The effort to downsize our infrastructure is particularly daunting at times. We recognized belatedly that check volumes began a pronounced and sustained decline sometime in the second half of the 1990s, leaving us with excess processing capacity and a significant financial deficit. I suspect some other providers find themselves in similar circumstances.

But it would be a serious mistake, in my view, to confuse the challenges that providers face with a true assessment of the state of payments. As an economist, I would be worried if providers of a service have what some call the "quiet life." That implies monopoly pricing, lack of innovation, and other traits which may benefit providers but which are not good for consumers, nor, most likely, the economy.

In that vein, I sometimes think that those of us involved in payments on a daily basis lose sight of the forest for the trees—that is, we tend to focus excessively on challenges and fail to appreciate how efficient and effective the system really is. After all, the payments system supports our $11 trillion economy—it is truly the plumbing which facilitates the multitude of transactions our level of economic activity requires—and much of the time producers and households give the payments system virtually no thought whatsoever. Access, integrity, and effectiveness are normally taken for granted, and that's all to the good.

I have the sense that I am not alone in taking this view. As part of my FSPC role, I attend conferences such as this where the state of payments is discussed, including the major meeting in October of 2003 here in D.C. sponsored by the Federal Reserve. While we all may have a "wish list" of desired improvements, a comprehensive assessment of discussions at these conferences reveals that from a public policy perspective the payments system does not appear to be facing serious, fundamental problems. It largely does what it is supposed to do and does it well, and it seems able to adapt effectively to the changing needs of end users.

Given this state of affairs, it is worth considering what has brought us to this favorable position. In my view, it is giving markets preeminence in determining the direction and evolution of the payments system.

Role of Market Forces

The smooth functioning of and range of choices available in our payments system are major accomplishments. While I think the Federal Reserve has played a constructive role in this outcome, we do not claim nor deserve the bulk of the credit—many institutions contribute to the effectiveness and efficiency of the U.S. payments system. Indeed, the credit should go to a system which has the flexibility to adjust to the desires of households. All the white papers in the world that called for an end to the paper check did not produce that outcome. Instead, it is occurring primarily in markets where the Federal Reserve has no role as a service provider (for example, credit and debit cards) and as households "spontaneously" change their behavior over time.

Taking this household-centric view may seem odd for a service provider that has to recover costs. But because we in the Federal Reserve wear two "hats"—participant and regulator—and because we are a public policy institution as distinct from a private sector provider, we have a special responsibility to view payments in the context of societal benefits and to promote the broad public interest.

A practical implication of this analysis and stance is a preference—from my perspective a very strong preference—to permit market forces to shape payments system developments insofar as possible. This preference is, after all, consistent with the general principles we follow throughout our economic affairs. There are certainly important roles for government to play in our economy, but when the overall trend is positive—as it is for payments—I don't believe there are significant gains from government responses to every deviation from that trend along the way. Uncertainty in the market during periods of transition and a sense of unsettledness among providers as transitions are worked through are not in themselves sufficient reasons for government responses to sort these issues out ahead of natural market processes. So what should be the role of the Fed?

Role of the Federal Reserve

I would expect that this audience would have natural sympathies for the market-oriented views I have expressed, given your experience and success in the private sector. And in that vein, you may wonder why I even need to bring these themes up. Well, because on occasion, some in the private sector seem to prefer that we in the Federal Reserve take a more definitive and aggressive approach, and specify with certainty (or as much certainty as possible) our future plans, for example, with regard to check offices, to business-to-business payments standards, to security and privacy issues, and possibly even to interchange fees. So let me be a bit more specific about why I think complying with those requests in a way that would ostensibly reduce uncertainty would often be a bad idea.

First, we do not possess perfect foresight. I am aware of one head office building in the Federal Reserve designed in the late 1960s on the premise that the "checkless society" was just around the corner. It has turned out to be a very long corner indeed, and in the meantime this District had to operate in a building ill-equipped for high-volume check processing. Perhaps somewhat ironically, we were subsequently surprised that check volumes actually started to decline since our market intelligence did not pick up this reversal in trend until several years after the fact. Recently, we have witnessed lots of private sector innovation in converting paper to electronics and in expanding the range of electronic alternatives per se. It is possible that we underestimated the ability of computing and communications technologies to make electronics reliable, inexpensive, and accessible, especially in an environment where end users are becoming increasingly familiar and comfortable with the technology.

The second, and more compelling, consideration suggesting a restrained role for the central bank in promoting payments system change is the clear and legitimate lack of consensus surrounding many important issues. This is, I think, evidence that market forces are still sorting out these matters. Consistent with my earlier observation, we generally want to leave resolution of competing processes and products to the market when we can. The hurdle confronting central bank innovation in payments presumably should be quite high, requiring either convincing evidence of market failure and/or the existence of barriers to progress which will not otherwise be addressed. Further, for those "improvement opportunities" which have been identified, it is only a bit of an exaggeration to say that, desirable though they may be, each payments system participant would prefer that others make the investment, bear the bulk of the costs, establish the new processes, and work out whatever kinks arise.

The issue of standards-setting in payments provides an illustrative case in point. Numerous participants have asserted that a significant barrier to further expansion of electronic payments—take business-to-business payments, for example—is a lack of standards and therefore that a valuable role for the Federal Reserve would be to intercede to resolve the matter. This could be, but the literature on standards adoption does not overwhelmingly support the efficacy of government intervention. As my colleague Jim Lyon has pointed out: "The available research provides relatively little reason for confidence that a policymaker will be able to determine with certainty either the correct standard to endorse or the proper time to endorse it. Moreover, even if these issues could somehow be overcome, the proper choice may depend on the relative importance attached to the welfare of those who have already adopted one of the competing standards choices and those who have yet to do so. Further complicating the situation is the reality that some standards may remain such for only a relatively short period of time given the dynamic nature of technology." Thus, there would seem to be a considerable burden of proof on a central bank considering direct intervention to resolve conflicts over standards.

Another example of well-founded caution in my judgment is in the area of fees associated with retail payments. Those who pay the various fees associated with retail payments, whether they be retailers, banks, or households, have in the past and sometimes in the current period called on government to regulate those fees because they are "too high" or, less frequently, "too low." But the government cannot go on "gut feeling" in these cases. We must rely on solid evidence that markets are failing, that current price setting is reducing benefits that should accrue to society, and the like. In my experience, that evidence is often lacking, the issues are often more complex than immediately presented, and it is far from obvious that government intervention will improve the situation.

Even in cases where markets do not operate perfectly, we must keep in mind the fact that there could be large costs to society when the government is too prescriptive and proceeds too far too quickly. These costs could manifest themselves in reduced innovation, higher costs for payments services, and fewer effective payments alternatives than would otherwise develop and emerge if private sector participants are permitted to compete and the winners to flourish. We have to be exceedingly careful that central bank initiatives do not have a chilling effect on the private sector.

Does this mean the central bank must never act? No. But where there might be a role for the central bank, it is more likely to be in productively encouraging reliance on market forces by facilitating changes in the legal and regulatory infrastructure where it appears to inhibit innovation. Federal Reserve support of Check 21 legislation is an example of such an approach, although it is far too early to assess both the full ramifications of Check 21and how rapidly and how far the move from paper to electronics will proceed over the next several years. We in the Federal Reserve are committed to this evolution, and clearly we are in the midst of reducing our check-processing infrastructure appreciably while maintaining service to a broad and diverse base of customers. Given current plans, we will have gone from 45 to 22 check-processing locations by the end of next year. I think this is a significant response to changing market conditions by any "standard."

Still, it is fascinating to contemplate what more may have to be done to achieve further electronification and to reduce our commitment to the "old technology." Will significant price changes and/or changes in processing windows and availability schedules be required and, if so, can these steps be justified on cost-benefit grounds? These questions are simply illustrative of issues we confront as the marketplace and technology continue to evolve.


Let me quickly summarize these remarks before inviting your comments, questions, and objections. There is no doubt that payments system change continues apace. It is preferable from my perspective that such change be driven by market forces, and it appears that largely has been the case. Central bank intervention should be reserved for cases characterized by broad and compelling societal benefits.

At the same time we, like you, have a business to run, and in this regard there is no shortage of practical, on-the-ground challenges. I highlighted some facets of check processing this morning because they are illustrative of these challenges and of policy considerations as well. As the downsizing of our check infrastructure, the Check 21 legislation and implementation, and the ongoing substitution of electronics for paper demonstrate, there remain important questions about ultimate equilibrium in this segment of the business. And there are important policy matters for the Federal Reserve to determine: the scale of our long-run commitment to this business and the magnitude and rate of change consistent with society's preferences.


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