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 regulatesdual 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 sectorthe 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
unfairakin 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
sectorfor the most parthas 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 guidelinesa role that further extends the Fed's regulator/competitor
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 infrastructureit'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 cruxand
the seeming conundrumof 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 Fedincluding its 12 district banks and 25 branch
banks and officesprocesses 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
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 sinceas a federal regulatorit 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 costsas 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
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 advantageits federal regulator
statusis 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 regulationpayments 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 Fedalong with other agencies and the private sectoris relied upon to make
timely and informed decisions, some of which may have major implications for
the country's payments system.