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April 2001
Annual Report Essay
Thoughts on the Fed's Role in the Payments
System
Edward J. Green
Senior Policy Advisor
Federal Reserve Bank of Chicago and
Richard M. Todd
Vice President
Federal Reserve Bank of Minneapolis
The views expressed in this paper are solely those of the authors,
and not necessarily those of the Federal Reserve Bank of Minneapolis,
the Federal Reserve Bank of Chicago or the Federal Reserve System.
Technological and institutional innovations, including the growth
of the Internet and of interstate banking, have enhanced the prospect
for rapid evolution of the U.S. payments system. The Federal Reserve
is collaborating with other payments system participants to facilitate
this change. The Fed has undertaken to foster the efficiency,
integrity and accessibility of the payments system, and that commitment
will remain as timely when the change is complete as it is today.
However, as in every significant transformation of the economic
environment, all institutions must monitor, and if necessary realign,
their strategies, to ensure that they continue to support their
respective goals under the emerging conditions. Although forethought
cannot frame an all-embracing plan that will be sound regardless
of what the future brings, it can identify a general strategic
direction that supports the institution's enduring goal and provides
the agility needed to take best advantage of emerging circumstances.
Thus, while no one knows whether the U.S. payments system will
evolve rapidly or slowly, responsible institutions will already
be considering how they can best serve the public if and when
current policy achieves the transition to a new generation of
payment instruments.
In that spirit, we suggest an approach to keeping the Reserve
Banks' role as payment services providers well aligned with the
Fed's mission. We draw on both general economic and business principles
and also the specific principles that Congress and the Federal
Reserve have adopted over time to ensure that the Reserve Banks'
service-provider role embodies good public policy. 1
These considerations lead us to recommend a strategy for Reserve
Bank payment services provision that gives top priority to services
closely related to interbank settlement. For most other payment
services under our strategy, the transition to the next generation
of payment instruments would prompt the Reserve Banks to make
a transition as well, toward promoting efficiency, integrity and
accessibility primarily by means other than direct service provision—such
as participation in the setting of standards, the drafting of
model legislation and the regulation of payment services markets.
Our reasoning about the Federal Reserve's strategy toward the
emerging payments system starts from the idea that specialization
is beneficial to most organizations and has specific additional
benefits for the Federal Reserve System. That specialization promotes
efficiency is one of the most basic and firmly established principles
of economics and a widespread working assumption in management
theory as well. It implies that agents in the economy—institutions,
as well as individuals—tend to serve the public best by focusing
their resources and efforts on their respective areas of special
strength, rather than by each attempting to do the broadest range
of tasks that it can manage at a merely competent level.2
Since we regard economic analysis corroborated by historical evidence
as indicating that a central bank's most critical functions in
the payments system revolve around settlement of interbank payments,
we view these functions as a central bank's area of primary payment
services strength.3
Applying the specialization principle to the Fed, we thus recommend
that specific services comprising, or closely related to, the
Reserve Banks' core interbank settlement functions should have
highest strategic priority among the Reserve Banks' payment services
activities.
This recommendation is strengthened by some considerations specific
to the Federal Reserve System. The Fed is, preeminently, the U.S.
central bank, responsible for monetary policy, aspects of financial
supervision and regulation, and oversight of the functioning of
the payments system. Direct provision of payment services may
support these functions in some respects, but it also creates
potential difficulties with them in others. Governance structure
is an example. A regionally oriented structure of 12 distinct,
independent corporations has contributed to central bank independence
and public accountability by providing a coherent institutional
basis for the Reserve Bank presidents' role in making and implementing
monetary policy. However, as the U.S. banking industry has become
more integrated nationwide, an integrated governance structure
for the provision of Federal Reserve payment services has become
practically indispensable. Because the central bank functions
and payment services within each Reserve Bank share some common
support and overhead, such as information technology staff and
facilities, the governance arrangements for the two types of functions
cannot be kept completely distinct. As a matter of logic, even
if moving de facto to joint governance of the 12 Reserve Banks
in a broad sphere of decision making would prove to be key to
enabling Federal Reserve financial services to recover their costs
in a competitive market, such a market test would not conclusively
show such consolidation to be desirable. A cost-recovery test
for priced financial services is not designed to reflect the burden
(or, conceivably, the benefit) that consolidation might entail
for monetary policy and other such central bank functions.
A further consideration in favor of the Reserve Banks playing
a specialized role in the payments system concerns maintaining
an overall relationship of mutual deference between the Fed and
the private sector. The Fed's reputation as a trustworthy and
neutral organization focused on broad public objectives is an
indispensable asset in meeting its public responsibilities. That
asset can be put at some risk if banks, other commercial firms
or the general public perceive the Reserve Banks to be encroaching
on activities that the private sector can perform efficiently
and equitably.4
These various considerations do not have the stark consequence
that the Reserve Banks should never participate in markets beyond
what is required to discharge the Fed's core central-bank responsibilities.
They do suggest, however, that such participation be undertaken
cautiously, when careful consideration shows that the several
alternative means of attaining the Fed's payments system objectives
are clearly inferior.
Near the end of this article, we apply the ideas introduced
here by developing a list of specific observations and recommendations
concerning the Fed's role in the payments system. If the payments
environment evolves as we anticipate, these recommendations would
focus the Reserve Banks' payments provider role more tightly.
The more focused role we envision is consistent, we believe, with
current Federal Reserve legislative authority and policy. 5
Some current activities would be phased out if their policy rationales
became less salient. 6
By recommending that the Federal Reserve should specialize in
some activities in which we think it has a comparative advantage,
we are by no means advocating that those activities should be
reserved to the Fed alone. Nor do we advocate that other activities,
otherwise appropriate for the Reserve Banks, should be proscribed
by law or regulation solely on this account. To the contrary,
institutions' spheres of comparative advantage are best identified,
and the institutions' respective activities accordingly shaped,
through a continuous process of open and vigorous competition.
The Fed's Payments System Objectives and
Tools for Achieving Them
The efficiency, integrity and accessibility of payment services
are the well-established goals of the Federal Reserve with regard
to the payments system. (See The Federal
Reserve's Objectives Regarding the Payments System and Payment
Services Provision.) Direct provision of payment services
is one means to attain these goals, but it is not the only means
that the Fed can and does use. To facilitate a balanced view on
the role of service provision in the Fed's pursuit of payments
system objectives, we outline in this section a variety of methods
available to, and largely in use by, the Fed. This survey sets
the stage to consider which options the Fed should use in a particular
situation and, in particular, when it should take on the role
of payment services provider.
The Federal Reserve has pursued its payments system goals in
part through direct provision of payment services. As a nationwide
complex of institutions, the Reserve Banks can address payments
system access issues directly, by providing interbank payment
services to all banks on equivalent terms. They can also address
integrity issues by making their services very reliable as well
as accessible, and by offering them to failing institutions as
well as healthy ones. The hard part is to meet the access and
integrity objectives through direct service provision without
falling short on the efficiency objective. However, the Monetary
Control Act of 1980 (MCA) requires the Reserve Banks to be cost-effective
enough to recover the costs of their directly provided services,
including adjustments for taxes, the cost of capital and other
private-sector expenses, from the fees they charge their customers.
According to a priced-services accounting system that has been
in place for almost 20 years and has survived significant internal
and external scrutiny, the Reserve Banks have met the MCA's requirements.
In that sense, the Fed has successfully provided wide access to
a set of reliable and efficient services for many years, in furtherance
of its general goals for the payments system.
Provision of payments system services by the Reserve Banks continues
to be guided by the White Paper. This guidance was reaffirmed
and amplified during the 1990s, when Federal Reserve Chairman
Alan Greenspan asked then-Vice Chair Alice Rivlin to head a committee
reviewing the Reserve Banks' role in providing payment services,
especially automated clearinghouse (ACH) and check clearing. On
the basis of internal analysis as well as extensive public testimony,
the Rivlin Committee reported in early 1998 that the Reserve Banks
should continue to provide ACH and check clearing services.7
Besides direct provision of services by the Reserve Banks, there
are other ways to pursue the Fed's goal of maintaining a U.S.
payments system that serves the public well. Perhaps the simplest
alternative is to rely on private market institutions to provide
efficient, reliable and accessible payment services. Economic
theory implies that, in an ideal environment, private competition
will lead to efficient arrangements for producing and distributing
services that are of optimal quality and available to all at prices
appropriately reflecting marginal cost. Experience suggests that
this actually occurs, at least approximately and sufficiently,
for many goods and services in the U.S. economy. Competition is
also generally accepted to be especially successful in promoting
long-term innovation and efficiency in many markets. In the payments
system, private competition is already the primary mechanism for
ensuring access to low-cost, reliable services for consumers and
nonfinancial businesses. Deferring to private market provision
of interbank clearing and settling services is also an option
the Fed can consider in pursuing its payments system objectives.
For some services, such as the clearing of interbank credit card,
ATM and debit card payments, the Fed has largely done so.8
Economic theory also acknowledges conditions under which private
markets alone will not ensure efficient, reliable and equitably
accessible service provision, and there are concerns that these
conditions may prevail in some payment markets. For example, if
a provider's average cost of providing a service declines continuously
as its level of production increases, efficient production requires
that there be only one provider, in order to capture these economies
of scale. This is not necessarily a problem per se, because potential
entrants can provide competitive discipline to the incumbent provider
without actually having to enter the market themselves. Markets
subject to such potential competition are called contestable.
However there can be a problem for contestability if irretrievable
"sunk" costs associated with entering or exiting the industry
constitute a barrier to entry by a potential competitor. Under
these uncontestable-market conditions, the single private seller
could restrict output below the efficiently produced level, in
order to raise prices and increase profits. Alternatively, the
monopoly producer might be free to increase profits by reducing
the integrity of the product below the efficient level of product
quality. Because of higher prices and lower quality, some potential
consumers who would have been willing to purchase the service
at the efficient price and quality will, in effect, have lost
access to service.
This general description of a monopolized market is thought
by some to capture the situation that would prevail if the provision
of check clearing services to small, remote markets were left
to the private market. It is assumed, that is, that these markets
have only enough volume to support a single physical shipment
of checks per day, and that there are irretrievable sunk costs
to enter or exit the clearing business. Such conditions could
result in a single for-profit shipper with monopoly power over
check clearing services in that area. At best the banks in that
area would pay high prices for poor service. Fears of just this
outcome were frequently cited in the testimony of rural bankers
before the Rivlin Committee, and it is a traditional rationale
for the nonprofit Reserve Banks to provide check clearing services
at cost in rural areas.
Private competitors may also fail to achieve socially optimal
outcomes if efficient service provision requires using a single
shared resource, and the individual providers are unable to agree
on how to organize and manage the shared resource. On the one
hand, critical shared resources do not necessarily pose an insurmountable
problem to industry participants, as illustrated by the generally
successful operation of mutually owned and operated clearing institutions
in credit card, debit card and ATM networks. On the other hand,
neither can the viability of such institutions be taken for granted,
as suggested by the history of litigation and member "politics"
experienced by mutually owned clearing organizations such as Visa
and MasterCard. When unable to agree among themselves on how to
provide critical shared resources, industry participants may invite
a neutral (generally nonprofit) third party, including perhaps
a government or government-sponsored entity, to assist in arranging
for the needed services. Alternatively, public policymakers may
step in themselves, if the industry appears unable to arrange
the provision of shared services in a way that promotes efficiency,
integrity and accessibility. For example, historically the Reserve
Banks' entry into payment services provision partly reflected
the private market's inability to arrange for a single set of
accounts to effect interbank settlement. (For further details,
see Interbank Settlement and the Emergence
of Central Banks.)
Private market "failures" of these and other kinds can be addressed
in several ways. At least three broad alternatives to direct Reserve
Bank service provision can be identified: changing the environment
that gave rise to market failure so that private competition can
again be relied on; regulating the private providers; and arranging
for public or nonprofit service provision by an entity other than
the Federal Reserve.
The factors that give rise to a market failure may be inherent
in the industry's technology (as in the example above, with declining
cost and barriers to entry) or may reflect financial and institutional
circumstances (such as a price-fixing conspiracy supported by
a successful strategy of eliminating competitors by predatory
pricing). The former requires a fundamental technological solution,
if competitive forces alone are to be trusted. Through the passage
of time, and perhaps in response to initiatives promoted by the
Fed and other nonprivate entities, new technologies less likely
to lead to market failure may be devised. The same forces—time
and sometimes promotion by the Fed and others—may also be
required to develop new institutional arrangements that support
the introduction and usage of the new technologies. When successful,
the new technologies transform the competitive environment, eliminating
the market failures and permitting private competition to lead
to the desired outcomes. For example, several new technologies
designed to use electronic images instead of paper originals to
clear checks could eliminate the natural monopoly problem said
to plague rural check clearing markets today. The Fed is among
the institutions promoting and piloting these technologies. To
the extent that the Fed and others successfully convert the check
clearing business to electronics, the markets for both rural and
urban check clearing may be perfectly well served by private competition
in the future.
Market failure deriving from persistent financial or institutional
power is amenable to correction by legal intervention under antitrust
laws. If the market failure arose solely from historical or strategic
circumstances unrelated to the underlying technology, interventions
such as repealing legal obstacles to emerging competitors can
permanently correct the problem and again allow reliance on private
service provision. Sometimes the market failure involves a combination
of technological factors and historical circumstances. In these
cases, new technology and legal intervention may both be required
for private service provision to again lead to desired outcomes.
The Fed does not have direct authority or responsibility for antitrust
enforcement (except for limited authority related to bank mergers),
so it cannot directly pursue its payments system objectives through
this means. However, when warranted it can contribute significant
relevant information on the basis of its knowledge of payments
industry conditions and its economic research capabilities.
When the technology in an industry appears to be enduringly
inconsistent with good public policy outcomes under unfettered
competition, ongoing intervention by government or government-sponsored
regulators may be an effective alternative. In the context of
the payments system, specifically, the Federal Reserve System
currently acts as a consumer-protection regulator in consumer
payment and credit markets, under legislative authority. If it
wished, Congress could expand the Federal Reserve System's regulatory
powers over interbank payment markets, as an alternative to direct
provision of services by the Reserve Banks. 9
Although effective in principle, regulation can be difficult
to implement well over the long haul. In practice, it may sometimes
be more effective to charter a government body or nonprofit agency
to provide or subsidize certain services, rather than attempting
to regulate private providers. The historical origins of the Federal
Reserve System, discussed below, partly reflect these concerns,
as do the origins of other government-sponsored service providers,
such as public postal services. A somewhat different example is
the provision of scheduled air service to small cities under the
Essential Air Service program initiated in the Airline Deregulation
Act of 1978. In this case, the federal government has not established
a nonprofit provider but instead subsidizes private airlines to
provide the desired service (GAO 2000). And in Switzerland, the
Swiss Interbank Clearing (SIC) system, which settles interbank
payments via irrevocable transfers of funds held at the Swiss
central bank, was developed by a private joint venture, Telekurs
AG, in collaboration with the central bank. Check clearing also
takes place at Telekurs, under central bank supervision (Bank
for International Settlements 1993, pp. 361-363). The Fed could
use similar arrangements for services such as check clearing,
including in remote rural areas.
Specialization and the Core Functions of the
Reserve Banks in the Payments System
The central question of this article is: Which options should
the Fed use to advance its public policy goals for the payments
system, and, in particular, when should it take on the role of
payment services provider? Our answer, developed more fully in
subsequent sections of this paper, is tied to our view that the
unique strength of the Federal Reserve in the payments system
derives from its status as the U.S. central bank. We will infer
from this premise, and from the premise that specialization is
generally beneficial, that the way in which the Fed pursues its
payments system goals should be determined in large measure by
its core central-bank function. Before pursuing that line of reasoning
further, in this section we defend the general specialization
principle and characterize the core function of a central bank
in the payments system.
The benefits of specialization among nations were elucidated
early in the history of economics, most clearly by David Ricardo.
His key idea was that all countries benefit when goods are freely
traded and each country focuses its finite resources on producing
those goods in which it has a comparative advantage. As long as
countries have finite but different endowments of resources (natural
resources, human resources and capital), then specialization in
production combined with international trade tends to make available
the greatest amount of goods for consumers in each country. This
is one of the most widely accepted principles of economics.
The idea that specialization is beneficial is also widely assumed
to apply to firms and other organizations. At first glance, this
assumption may seem suspect. If Firm A has efficiently specialized
in producing good X, and firm B has efficiently specialized in
producing good Y, why couldn't a merged firm A+B remain equally
efficient at producing X and Y? After all, individual firms appear
to be free to expand not only their efforts but also the resources
they employ, whereas nations can only slowly expand their total
resource base. So why can't firms (and other organizations) avoid
the need to specialize by simply adding enough resources to perform
multiple diverse activities efficiently?
There is no hard and fast reason why organizations cannot expand
to perform a range of tasks well, but experience suggests that
the results are often disappointing. Perhaps the most familiar
evidence for the benefits of organizational specialization stems
from the demise of many of the conglomerates formed in the 1960s.
These were firms that combined, through mergers and acquisitions,
numerous diverse activities under a single management and ownership
structure. Over time, many of these entities underperformed their
less-diversified, more-focused competitors (Ravenscraft and Scherer
1987), and by the 1980s many were broken up in what Bhagat, Shleifer
and Vishny (1990, p. 2) refer to as the "deconglomeratization
of American business and a return to corporate specialization."
10
Although the frequently disappointing performance of large,
diversified organizations is not fully understood, experience
and theory suggest that there may be limits on how many different
activities can be managed effectively in a single organization.
No one manager can be truly expert on a wide range of products
and activities, so multiple management lines are required to maintain
an adequate knowledge base. It seems, however, that the effectiveness
of multiple management lines is often less than would be expected
by summing the results of their independent operation, perhaps
because of internal rivalries, or because of disputes and ambiguities
related to ex-ante incentives and ex-post rewards.
Although we recognize that the intellectual foundations of the
specialization principle for organizations are less complete than
those underlying Ricardo's comparative advantage concept for nations,
we believe that the principle is fairly strongly supported by
the weight of practical experience and by elements of financial
economics and of organizational studies. 11
How would the general principle of specialization be applied
to the Reserve Banks' role in the payments system? One implication,
we will argue, is that as a service provider the Reserve Banks
should place high strategic priority on services that the central
bank has special advantages in providing. Specifically, this strategic
core of payment services consists of maintaining deposit accounts
for private banks and providing short-term credit to, and effecting
transfers of balances among, those accounts as a means of settling
interbank obligations efficiently. 12
Our characterization of this core function relies on consideration
of both economic history and economic theory.
We define a central bank to be an institution that:
- has both the government and the commercial banks as account
holders;
- can influence overall interbank credit market conditions,
through its credit policies toward account-holding banks and
its intermediation on behalf of the government;
- has been given lead public policy responsibility for achieving
credit market conditions that foster prosperity and economic
stability—price stability in particular.
This definition reflects the fact that, historically, central
banks have been chartered to perform two functions. One is to
be an intermediary between the government and its lenders, enabling
the government to obtain credit by ensuring that implicit default
through inflation will occur only in genuine national emergencies.
13 The other
is to serve broad public interests as the trustworthy and neutral
apex of a hierarchy of banks that, in turn, provide the nonbank
public with accounts used to settle financial, business and personal
payments by transfer of balances. 14
Indeed, there is an economy of scope between these two functions
that gives the central bank a comparative advantage in serving
the latter. That is, since almost all banks need to transfer funds
from their customers to the government to pay taxes, the government's
bank is in a natural position to serve as apex. 15
The role as apex of the banking hierarchy puts the central bank
in a unique and distinguished position in the payments business.
As explained in more detail, this
role evolved out of market interactions, as correspondent banking
grew from provision of a passive service—simply maintaining
an account for respondents—to a role with respect to banks
that is closely analogous to the role that banks play with respect
to their nonbank customers—including netting, extension of
credit and concomitant monitoring of creditworthiness. Moreover,
just as private banks are often structured to avoid conflicts
of interest with their own nonbank customers, central banks evolved
in part to avoid conflicts of interest with banks. A foundry,
for example, would be loath to have its bank also be in the foundry
business. As lender to the foundry, the bank would have a legitimate
need for information regarding the foundry's customers. If the
bank also owned a foundry itself, the bank could abuse the information
obtained from the borrowing foundry to compete unfairly in their
shared business by stealing the foundry's most profitable customers.
For similar reasons, banks were reluctant to have a correspondent
bank that also did general banking business in the same market.
Market demand thus arose for a special-purpose intermediary
(that is, one that does not do business with nonbank traders)
that is able to play this role without the incentive conflicts
that a bank would have. Both private-sector and public-sector
intermediaries of this type exist, typically as nonprofit organizations
in order to further mitigate incentive conflicts. And both the
private- and public-sector special intermediaries are subject
to government oversight as well. 16
Examples within the private sector include mutually owned clearinghouses
for checks, credit card receivables (such as Visa), and electronic
funds and securities transfers as well as the bank-owned, government-regulated,
special correspondent institutions known as bankers' banks. 17
Examples within the government or government-sponsored sector
include specialized intermediaries such as central banks and certain
industry lenders (such as the Federal Home Loan Banks in the United
States, especially vis-a-vis thrift institutions before 1980).
The Reserve Banks—nonprofit entities created by an act of
Congress and supervised by a government agency, the Board of Governors
of the Federal Reserve System—are a case in point. The potential
for activities of a Reserve Bank to create conflict of interest
with commercial banks is controlled in three ways: by its nonprofit
status, by restrictions in its corporate charter (specified in
the Federal Reserve Act) and by the oversight of a federal government
agency, the Board of Governors of the Federal Reserve System.
The most blatant source of potential conflict of interest with
the banks that the Fed serves—lending by Reserve Banks to
nonbank borrowers—is ruled out (except in emergency conditions)
explicitly by charter restriction. And a combination of Reserve
Banks' nonprofit status and Board oversight is designed to control
conflicts of interest that might arise through the Reserve Banks'
discharge of their payments system functions.
This historically oriented description of the function of a
central bank in the payments system is consonant with a fast-developing—albeit
not yet mature—body of economic theory regarding the function
of central banks. 18
Together, history and theory suggest that there are two payments
system functions that a central bank is better able than other
institutions (except, perhaps, a clearinghouse) to perform for
banks. These core central-bank payment functions, which we explain
in the story on page 13, are analogous to the core functions that
banks provide to their customers.
- A central bank can manage in the broad public interest a
system of accounts that all banks are eligible to own, and that
they can use to settle interbank transactions.
- By extending credit to banks, a central bank can provide the
benefits of interbank payments netting immediate finality of
payments.
Its ability to perform these functions and, in particular, its
position of neutrality and trust among the public and the institutions
that it serves is the unique strength of a central bank as a provider
of payment services. From this finding, together with the general
principle that the public is best served when each institution
in the economy focuses its resources in its area of unique strength,
we conclude that these two functions form the core of the services
that should continue to be provided directly by the Reserve Banks,
and that they should receive the highest strategic priority among
the Reserve Banks' activities as providers of payment services.
The Reserve Banks' Role in Providing Other Services
The Reserve Banks' provision of accounts to banks and of final interaccount
settlement supported by central-bank credit only partially fulfills the
Fed's payments system goal. The Fed has also accepted the role of promoting
the efficiency, integrity and accessibility of a broad range of payment
services, notably numerous interbank clearing functions, whose good performance
depends on more than just access to the Reserve Banks' core payment services.
What tools should the Fed use to help assure good outcomes across this
full spectrum of payment services?
For some—probably very limited—range of services,
efficiency considerations alone may imply that direct service
provision by Reserve Banks is the right solution. The provision
of these services may be so technologically or institutionally
related to the Reserve Banks' core services that it would clearly
be much cheaper for the Reserve Banks to provide them in conjunction
with their core services than for them to be provided in any other
way. In economic terms, provision of these services is said to
be complementary to the provision of core services, resulting
in positive economies of scope. (See Functions
Complementary to the Core for a more detailed explanation
of these concepts and of how they might suggest that the Reserve
Banks should provide certain services outside the core.) The range
of payment services with high core complementarity is unclear
and can be determined only with detailed analysis that is beyond
the scope of this essay, but our a priori expectation is
that it is narrow.
Beyond the Reserve Banks' core services, plus possibly some
clearly complementary activities, provision of payment services
by the Reserve Banks should be considered as merely one option
among many for pursuing the Fed's goal. We see no reason to presume
that payments service provision is the best option. At a minimum,
the full range of options discussed above should be analyzed and
considered.
In analyzing these options, we would apply both the general
and Fed-specific versions of our specialization principle. The
general version was elaborated in the previous section. The Fed-specific
version involves a general sense of caution about complicating
Reserve Bank governance structures or putting the Federal Reserve
in the position of encroaching significantly on private-market
institutions, as discussed in the introduction. We now apply each
specialization principle to the question at hand.
As noted above, the general specialization principle provides
a rationale for the Reserve Banks to provide core interbank settlement,
accounting and credit functions. However, because we take as given
the Fed's goal of promoting the efficiency, integrity and accessibility
of the payments system more broadly, the general specialization
principle does not imply that the Reserve Banks should always
strictly limit their role as a payments provider to only those
core functions. Nevertheless, the general specialization principle
does suggest that core functions have the highest claim to be
performed directly by the Reserve Banks. The more remotely related
to the core a payments system objective is, the stronger are the
considerations in favor of using other policy tools to accomplish
it.
The Fed-specific benefit of specialization has to do with the
Fed's relationship with the general public and the banking industry.
We would argue the Fed was deliberately designed to decentralize
central bank policymaking and to minimize the extent of its head-on
competition with other financial intermediaries, in order to promote
its effectiveness in its core monetary policy and payments system
roles. Our argument—that activities that tend to burden Reserve
Bank independence or significantly aggravate the problem of direct
competition or conflict between the central bank and other financial
intermediaries have indirect costs that the Fed should not ignore—applies
to core as well as noncore functions to some degree. However,
in the case of core functions, there are few competitors and few
good alternatives. So the real force of this consideration applies
to noncore functions. There we see this consideration tending
to rank options such as Reserve Bank service provision or extensive
Federal Reserve System regulation lower than less-intrusive options.
Perhaps the most attractive means of meeting the Fed's goal,
when it is available, is to help ensure that private payment markets
are contestable. Recall that a contestable market is one in which
existing participants always face numerous actual or potential
rivals. When a large number of rivals are present in the market,
it can be termed competitive, in the usual sense. However, even
markets with one or just a few actual participants can still be
contestable, provided potential rivals can enter and exit the
market without incurring large irretrievable costs in the process.
In the absence of sunk costs of entry or exit, existing participants
are always competing not only against each other but also against
any number of nonparticipants who can enter the market if profits
appear abnormally high.
This potential competition promotes socially desirable results
in line with the Fed's payments system goal. Even when only a
single firm is actively providing a service, potential competition
prevents that provider from setting prices significantly above
competitive norms. More generally, it spurs existing participants
to innovate and adopt efficient new technologies, so as not to
be overtaken by a more progressive entrant to the market. For
the same reasons, existing participants cannot skimp on the quality
and reliability of their services or discriminate among customers
to a greater extent than is required for economic efficiency.
In other words, contestability disciplines market participants
to pursue efficiency, integrity and accessibility of services.
The Fed can, and already does, promote contestability in payment
markets. First of all, the Reserve Banks should ensure that when
they provide payment services, they do so in a way that does not
impede entry or exit in those markets or related payment markets.
As was mentioned earlier, the Reserve Banks make their core payment
services available to both incumbent providers and potential entrants
in various payment services, including some in which the Reserve
Banks do not participate directly. As a regulator, the Fed can
try to ensure that its regulations do not inadvertently create
unnecessary barriers to entry into or exit from payment services
markets. Through its oversight of the payments system and its
research capabilities, the Fed can also seek to highlight regulatory
or institutional entry and exit barriers that are the responsibility
of other agencies, institutions or lawmakers. Finally, the Fed
can work with the payments industry to facilitate the adoption
of new technologies and institutions that ease entry and exit
barriers. Possibly the clearest current example would be to facilitate
the adoption of technologies and institutional arrangements for
electronic check clearing, in order to trivialize the effects
that small volumes and long distances can have on check clearing
markets for small and remotely located banks. By facilitating
the adoption of new electronic clearing methods, the Fed could
help ensure contestability and consider an orderly withdrawal
from its current role as a provider of check clearing services.
Another potentially effective option for achieving the Fed's
payments system goals is to shift some regulatory or service provision
activities to other governmental, nonprofit or cooperative entities
whose core functions better suit them for these tasks. For example,
the Reserve Banks already utilize the U.S. Postal Service to perform
some routine transportation and delivery functions in remote areas,
and the Reserve Banks do not directly compete with the mutually
owned organizations (such as Visa and MasterCard) that serve as
trusted third parties in the credit card payments clearing market.
A related option would be for the Reserve Banks to contract with
other organizations to provide certain payment functions, using
an open bid process and imposing restrictions if necessary to
ensure integrity and accessibility. Either way, the Fed would
retain its oversight role, as well as the option to enter into
direct service provision or impose more extensive regulation if
needed (up to the limits of its statutory authority). However,
as long as these other entities meet the Fed's objectives in these
markets, the Fed would be free to better focus its resources on
its core activities.
The examples above illustrate that the Fed has at least some
alternatives to direct service provision for assuring the efficiency,
integrity and accessibility of the payments system. Based on the
advantages to the Fed of specializing its payments system role,
we conclude that the Reserve Banks should provide core interbank
settlement services, plus any closely complementary services.
Beyond that, the Fed should consider its full range of tools but
exercise caution regarding intrusive options such as direct service
provision or extensive regulation.
Some Specific Implications
Here we apply the general conclusions derived in the previous
sections to specific choices confronting the Fed at the beginning
of the 21st century.
The Fed should continue to provide an interbank funds transfer
system of unquestionable strength, quality and efficiency.
There is fairly strong international consensus that central-bank
operation of an interbank settlement system directly based on
transfers of balances among banks' reserve accounts is an effective
way to ensure the security and integrity of that system of interbank
settlement. 19
That is, given the limitations of current technology and that
which is likely to be available in the near future, there is thought
to be an economy of scope between maintaining reserve accounts
and providing funds transfers among those accounts. An interbank
settlement system should provide ease of use and fast throughput
with impeccable data security, reliability and risk controls.
The very high standards for these attributes that are appropriate
in the large-value context imply a stronger economy of scope than
exists in the retail-payments case.
The Reserve Banks currently meet those standards with their
internal network of computers and their specialized hardware and
software that allow depository institutions to directly initiate
funds transfers, subject to Fed risk controls. Continuing to meet
these standards in today's rapidly evolving technological environment
will require an ongoing and well-targeted effort to upgrade hardware
and software and retain critical staff. The Fed will need to stay
abreast of numerous developments in communications, security and
encryption, software and hardware to ensure that its core systems
retain their strength and integrity as they evolve to support
the emerging products, standards and access channels that the
financial sector will demand to achieve efficiency and boost productivity.
An uncompromising commitment to ensure both efficiency and strength
(security, reliability, etc.) in core interbank settlement services
should be the Reserve Banks' highest payment services priority.
Payment services whose value added stems primarily from payments
clearing rather than interbank settlement will generally not be
core payment functions of the Reserve Banks.
The Reserve Banks' involvement in payment services is sometimes
held to contribute to the Federal Reserve System's core central-banking
functions, such as monetary policy, banking supervision and financial
stabilization. To the extent these arguments are limited to what
we have termed core payment services, chiefly interbank settlement
services (including provision of short-term credit to facilitate
net settlement), they are consistent with our own suggestion here.
However, some commentators appear to argue that the Reserve Banks'
provision of a broader array of services, including check clearing
and ACH, significantly enhances the Fed's ability to carry out
its central-banking functions.20
We are not convinced. Other central banks, such as the Bank
of England, appear to have performed their central-banking responsibilities
well with no such broad involvement in payment services. While
this may in part reflect historical differences in the payment
and banking industries in these other countries, even in the United
States the relevance to central banking of the Reserve Banks'
role in activities such as check clearing has diminished sharply
over time. When the Fed was founded, checks constituted the principal
means of interbank payment, so check clearing then constituted
essentially a core service according to our characterization.
Even later, when wire transfers had supplanted checks as the primary
tool for direct interbank settlement, checks remained almost the
sole form of consumer and small business noncash payment. Through
its involvement in check clearing along with wire transfers, the
Fed could provide services to almost the entire payments system
during periods of banking instability and may also have derived
a broad understanding of commercial bank payments activity and
an ability to manage failing institutions. These advantages are
now diminishing considerably, as payment services organized without
direct Reserve Bank participation, such as credit and debit cards,
take an increasing share of the payments market and commercial
banks' payments activity. No one suggests that the Reserve Banks
need to provide these emerging and maturing payment services in
order to conduct monetary policy, stabilize markets or supervise
banks, and we believe the same is true for the comparable payment
markets the Reserve Banks are in already. In light of the great
diversity and rapid evolution of modern means of making retail
payments, we do not see provision of a handful of those means
as an effective way for a central bank to monitor and understand
the payments industry. The Fed has, and must have, other ways
to do that.
The advantages of having commercial payment intermediaries
serve the public in the Reserve Banks' traditional noncore market
niches are likely to increase as electronic payment options expand.
The Reserve Banks historically had a prima facie advantage over
commercial banks as a nationwide payment services provider, because
banks faced legal and regulatory obstacles to providing a full
spectrum of customer services nationwide. Those obstacles no longer
exist. The Federal Reserve Banks also specialized historically
in providing interbank payment services to banks that were only
marginally profitable to serve on a commercial basis because of
factors such as location in a sparsely populated area.21
We anticipate that such factors will be of little or no relevance
in the electronic payments environment of the future, and that
this is a significant reason why the Fed should promote migration
to electronic payments. If these two traditional Reserve Bank
market niches diminish as we expect, so will the need for the
Reserve Banks to provide nonsettlement payment services that commercial
firms are unable or unwilling to replicate. Then the costs that
a central bank incurs by competing broadly with commercial banks
(including correspondent banks) in various other service lines
are likely to become salient.
The Federal Reserve's policy on its role in the payments
system should explicitly recognize promotion of contestable payment
markets as a key tactic in the Fed's pursuit of its payments system
goal. At the same time, pursuit of electronic payment technologies
should be considered primarily as a means for promoting contestability,
rather than as an end in itself or as a direct means of pursuing
the Fed's goals.
As stressed by Board of Governors Vice Chairman Roger Ferguson
(1998), promotion of contestable payment markets has become a
key Fed tactic. Its status should be formally recognized. Then
the Fed would promote a transition to an electronic payments environment
that enhances the contestability of payment markets. This would
allow the Fed to achieve its payments system goal through greater
reliance on private competition, with a reduced role by the Reserve
Banks as direct providers of noncore payment services.
The Fed should give high priority to supporting the Multilateral
Settlement System.
As we reflect on emerging payment trends and the Fed's payments
system priorities, we have come to view the Reserve Banks' Multilateral
Settlement Service as a good example of how a Reserve Bank service
can promote contestable markets and improve the payments system
overall. The Multilateral Settlement Service, introduced in 1999,
makes it simple for a group of any two or more banks to submit
a settlement file listing debits and credits to be applied to
their accounts at the Fed.22
The Reserve Banks first process the debits, applying Fedwire-equivalent
risk controls to ensure that each paying bank has the funds or
authorization to cover the amount debited. Assuming this is the
case, the Reserve Banks then process the credits as irrevocable
final payments to the receiving institutions, all on the same
day that the settlement file was submitted. This service provides
low-cost, direct access to same-day interbank settlement for groups
(of banks) of any size, without regard to the underlying transactions
that generate their mutual debits/credits or any requirement that
the underlying transactions be processed or handled by the Reserve
Banks.23 It has
the potential to provide a safe, convenient, reliable and efficient
means of settling the interbank obligations generated by all forms
of emerging commercial payment vehicles. Barriers to entry in
the payments clearing market are thereby reduced, because groups
of banks can enter a wide range of payments clearing activities
in the knowledge that they will not have to also establish their
own safe and reliable settlement mechanism. We would make the
continued enhancement of the Multilateral Settlement Service a
priority for the Fed.
Federal Reserve market share is not a public policy goal
per se.
Effective competition from private firms may result in a declining
payments market share for the Reserve Banks. As long as the Reserve
Banks are conducting their business capably, such loss of market
share should not be a cause for concern about the efficiency,
integrity or accessibility of the payments system. It is often
simply a sign that a private firm is currently the more effective
form of organization to achieve those results. In the absence
of evidence that the Reserve Banks are being supplanted by monopoly
or oligopoly providers in a noncontestable market, a decrease
in market share should normally be viewed as neutral or positive.
Conclusion
We have noted that the Fed can pursue its payments system goals
by several means, and not just by providing payment services directly.
We have argued that the Fed should prioritize its activities in
the payments system in a way that makes best use of its character
as a specialized institution—a central bank—and that
most effectively supports its overall mission by de-emphasizing
noncore activities that intrude significantly on the private sector.
We have drawn several more specific implications from this approach.
Our suggested principles thus countenance a configuration of
Reserve Bank payment services that would differ from what exists
today. We emphasize that this is a long-term vision. If it were
to be adopted, then the transition to it would have to be managed
with care and foresight.
This essay has focused on the Reserve Banks' involvement in
the payments system as providers of payment services. In closing,
we would draw attention to the numerous other forms of involvement
in the payments system that the Fed maintains, apart from its
role as a service provider. In fact, when the public thinks about
the Fed's leadership in the payments system, it is largely—and
justly—those other forms of leadership that come to mind.
We therefore think the Fed should continue to pursue payments
system monitoring and leadership by other means as well. The Fed
has traditionally participated with industry, government and academic
representatives on initiatives such as the setting of technical
standards and the drafting of model payments legislation. It can
play a critical role in those efforts by promoting new institutions
and technologies that support a safe, reliable and efficient payments
system. The Fed's banking supervision and market stabilization
missions require it to understand the functioning of the payments
system. To this end, maintaining an ongoing dialogue with payment
providers will continue to be essential. Finally, the Fed has
contributed to its own understanding and to the making of good
public policy toward the payments system through its contributions
to basic research in monetary theory, the industrial organization
of payment mechanisms and related areas. Maintaining or strengthening
this tradition is also likely to become increasingly important.
Endnotes
References
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Annual Report
