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The Dichotomy Becomes Reality: Ten Years of the Federal Reserve as Regulator and Competitor

Excerpt from the Minneapolis Fed's 1991 Annual Report

June 1, 1992


Leonard W. Fernelius Senior Vice President

The Dichotomy Becomes Reality: Ten Years of the Federal Reserve as Regulator and Competitor

A revolutionary endeavor in government regulation and enterprise was launched in 1980 with the passage of the Depository Institutions Deregulation and Monetary Control Act. Known as the Monetary Control Act (MCA), the law, among other things, authorized the Federal Reserve System (Fed) to compete for business with the same financial institutions that it also regulates—dual role that is unique in America's economy. Specifically, the Fed was ordered to begin pricing its financial payments services, such as check collection and electronic funds transfer, and to offer those services to all financial institutions in direct competition with the private sector—the same private sector that must abide by Fed regulation. On one hand, the Fed was authorized to enhance efficiency through competitive business practices; on the other, the Fed had a responsibility to regulate its competitors to ensure the safety and soundness of the payments system.

While it may be a relatively arcane law in the annals of contemporary legislative action, the MCA did much to change the nature of America's financial services system. Likewise, it has been both derided and praised, criticized and defended. Ten years ago, critics said a quasi-governmental agency could not compete effectively with the private sector and they predicted that the Fed would soon fail and drop out of the market; some also said that forcing private companies to compete with their regulator was unfair—akin to playing a football game against a team whose star quarterback doubled as the game's referee.

Today, the criticism has ebbed. Not only has the Fed's payments function survived, but it has also operated beyond expectation. After initially losing check volume during the first years of the MCA, the Fed eventually recovered and now maintains a steady presence in the market. In addition, the private sector—for the most part—has come to realize that the purpose of payments system regulation is not to give the Fed a competitive advantage; rather, it is to help improve the overall efficiency and security of the system.

But all is not rosy for the Fed. The second decade of the MCA brings new challenges. Reductions in check volume for the Fed will likely occur, putting pressure on the district banks to manage costs of production accordingly. Still, with its willingness and drive to innovate, the Fed expects to be an important part of the second decade of the MCA. Also, just as in the 1980s, the dual role of the Fed as regulator and competitor will continue to shape the Fed's position in the payments system. This continuing role is evidenced in the Expedited Funds Availability Act (EFAA) of 1987. EFAA sets strict guidelines on the time a financial institution may hold a check before making the funds available to a depositor, and it requires the Fed to enforce those guidelines—a role that further extends the Fed's regulator/competitor position.

For most Americans, the nation's payments system is a mundane matter. The fact that the check they write at the grocery store will eventually be debited from their account, or the fact that their payroll check will be automatically credited to their account via electronic transfer is rarely cause for concern. In that respect the payments system becomes a sort of utility, or another form of infrastructure—it's important but it's also taken for granted. However, unlike a broken gas main or downed power line that affects a relatively small area, a failure in the payments system can have devastating consequences that could ripple through the nation's economy and even to other countries.

The payments system is one of the first places where financial problems become obvious, and serious problems involving one or more financial institution's inability to meet its payment obligations would have major repercussions throughout the financial services industry. Not only is it imperative to have the most efficient possible payments system, but it's also crucial that the payments system be safe and sound. Therein lies the crux—and the seeming conundrum—of the Fed's responsibilities: to help ensure the efficient viability of a complex and important payments system through competitive business practices, and to regulate its competitors to guarantee the safety and soundness of the nation's financial backbone.

The Challenge: Fed as Regulator and Competitor

Can the Fed Compete?

The obvious answer to the question of the Fed's competitive fitness lies in its track record. As expected when the Fed first introduced its prices for check services in August 1981, it lost volume. Specifically, the Fed lost 19.7 percent of its check volume during the first month of pricing. From August 1981 to April 1983, the average monthly volume was about 22.4 percent lower than that of July 1981. Also, during those transition years the Fed was unable to recoup its costs through priced service revenues.

But the Fed bounced back, and since 1984 has recovered its costs for check processing, cash and funds services. Today, just as it did before the enactment of the MCA, the Fed—including its 12 district banks and 25 branch banks and offices—processes about one-third of the nation's check volume.

Not only has the Fed proven its ability to compete, but it has also met one of the congressional intents of the MCA, namely, to improve the overall efficiency of the nation's payments system. It's possible to quantify this efficiency claim by tracking output along with the real, or inflation- adjusted, costs of production for Fed payments system operations. As the graph (on Page 17 of THE REGION magazine) attests, while inflation rose steadily from 1983 to 1991 (from base-year 100 to 136.75 in 1991), the Fed's average unit costs for payments system operations actually declined (from 100 to 99.39). Likewise, since the Fed had stable costs, it follows that the Fed also had stable prices. At the same time that real costs were declining, the Fed's output was increasing. Total checks processed were about 12.9 billion for the entire Fed System in 1983, and in 1991 the total reached about 15.6 billion.

Can a competitor regulate in a fair manner?

The Fed's ability to compete, however, masks the regulatory controversy that has embroiled it during the past decade. For example, while the Fed has recovered its costs since 1984, there is debate surrounding the Fed's method of computing its costs and prices. And, while changes in presentment times have improved the Fed's performance and significantly reduced the amount of float, those changes gave rise to criticism that the Fed unfairly manipulated regulations to improve its own performance.

When the MCA was debated, it was acknowledged that the Fed would have an unfair price advantage since—as a federal regulator—it was not subject to tax and capitalization costs that affected the private sector. To address this inequality, a private sector adjustment factor (PSAF) was created for the Fed to account for "the taxes that would have been paid and the return on capital that would have been provided had the services been furnished by a private business firm." But the PSAF didn't settle the controversy and soon after the MCA's implementation, some competitors began calling on Congress to investigate the Fed's pricing policies.

The U.S. General Accounting Office (GAO) and congressional committees have investigated whether the Fed has operated its payments services in a fair manner. In 1982 the GAO released a report that criticized the Fed for its slowness in adjusting its fees to a level that was adequate to recover its full costs—as mandated by the MCA. The GAO estimated that by supposedly underpricing its services the Fed had, in effect, reduced its income potential and thus held back over $100 million from the U.S. Treasury (and hence American taxpayers) in both 1982 and 1983.

The GAO report was followed by joint hearings of the Commerce, Consumer and Monetary Affairs Subcommittee and the Domestic Monetary Policy Subcommittee of the House Committee on Banking, Finance and Urban Affairs. The hearings produced additional complaints from the private sector about the adequacy of the Fed's internal accounting system, along with suggestions that the Fed has an unfair competitive advantage as a federal regulator. Specifically, the charges relating to the Fed's regulatory status concerned the Fed's exemption from presentment fees (fees charged by some financial institutions for presentments later than established deadlines) and the Fed's unlimited ability to operate its check business across state lines, an option not available to financial institutions. Some critics also suggested that all Fed payments operations should be placed in an autonomous corporation, leaving the Fed with only its role as regulator of the payments system.

But the House Committee on Banking found no evidence of wrongdoing by the Fed and reiterated the intention of Congress that the Fed should continue to serve its dual role as a regulator and competitor. However, the committee also found that the Fed had not been giving proper weight to the objective of fair competition in its pricing and other operational decisions. Accordingly, the Fed agreed to consider the impact of its business decisions in light of industry competition, a commitment that still exists today. Currently, all major operating changes proposed by the Fed undergo a rigorous process of research and analysis, including public comment, to determine the competitive impact of its decisions.

Aside from the processes and the procedures that are in place to ensure that the Fed operates in a fair and competitive manner, the Fed has adopted its own unwritten code of fair play that has been labeled a "Chinese Wall." The reference to the Great Wall of China is used to describe the separation of the Fed's payments function from the regulatory activities of the bank. This Chinese Wall is more than just a colorful phrase, it's a serious commitment. The Minneapolis Fed, for instance, is insistent that its account managers never talk about regulatory or loan activity with financial institutions. This policy extends to staff and officers at every level of the bank. Financial institutions that hope for a price break on services because they may have borrowed funds from the Fed, for example, are disappointed. There is no linkage between the Fed's payments services and its regulatory or lender roles.

Amid all the considerations of competitive fairness, it's important to remember that the Fed's motivation for its business actions does not stem from bureaucratic hubris or to earn exorbitant profits. The purpose of including the Fed as an active, competitive player in the payments system is to improve the efficiency of that system for the public good.

On the issue of competitive advantage, it should be noted that the same element that is reputed to give the Fed its advantage—its federal regulator status—is also a competitive albatross. The Fed, unlike its private counterparts, must offer its services to all financial institutions and cannot pick and choose with whom it wants to do business; the Fed also cannot greatly vary the terms of its business relationships; it has little pricing flexibility; it cannot provide the full range of services offered by the private sector; and, perhaps most importantly, every change in price and every consideration for improvements in service must bear the scrutiny of thousands of financial institutions and their respective trade associations, as well as a highly structured approval process. Any change in operational policy by the Fed must be publicly posted in advance, giving the private sector a unique opportunity to preview the planned moves of one of its competitors.

It is also important to remember that the Fed is not immune to the demands of regulation—payments system changes mandated by the regulatory arm of the Fed also apply to the Fed's operational arm. This leads to a final point about the Fed's dual role as regulator and competitor: Far from being a burden to its regulatory responsibility, the Fed's operational involvement makes it a better regulator. The Fed's operational role provides valuable insight to senior management that would otherwise not be available to the Fed, and this "hands on" exposure to payments services makes the Fed a better informed regulator. This is not a breach of the Chinese Wall. While the Fed's payments services operations are performed at the district level, it is the Federal Reserve Board in Washington, D.C., that approves pricing structures for the banks, and it is the Board that proposes regulation and seeks comment from the private sector. The Fed's district bank examiners work under the direct supervision of the Board. For example, there are about 70 examiners at the Minneapolis Fed and its Helena branch responsible for the examination of 93 state-chartered banks and 737 holding companies in the Ninth District. These examiners have no working relationship with the operational arm of the Minneapolis Fed and Helena, and the same is true at other Fed district banks. It is only at the senior management level of the district banks and at the Board where the regulatory and operational experience comes together to provide deeper insight into the nation's financial system. This insight proves especially valuable during times of financial crisis when the Fed—along with other agencies and the private sector—is relied upon to make timely and informed decisions, some of which may have major implications for the country's payments system.