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Functions Complementary to the Core

2000 Annual Report

April 1, 2001


Edward J. Green Senior Policy Advisor, Federal Reserve Bank of Chicago
Richard M. Todd Former Vice President and Advisor to the CICD
Functions Complementary to the Core

An economy of scope exists when there is a technological reason to produce several goods or services jointly rather than separately. For example, since jet fuel, gasoline, heating oil, lubricating oil and so forth are all constituents of petroleum that are gotten by "cracking" the petroleum into the separate constituents of its mixture, there is an economy of scope in operating a refinery. It is obviously better to produce all of these products jointly than to try to produce them separately.

In central banking, there could be an economy of scope between a core function and a payments function outside the core. In such a case, if the central bank performs the core function, the public is well served (other things being equal) by having it perform the additional function as well.

As an example, we are inclined to think that the Fed's Multilateral Settlement Service enables depository institutions to take advantage of an economy of scope between settlement services and risk management services utilizing the Fed's Account Balance Monitoring System (ABMS). The ABMS is a computer system that provides the option to monitor, in real time, the reserve account of a depository institution. This system is used for risk management of Fedwire, the Reserve Banks' real-time gross settlement system for large-value payments. Recently, the Federal Reserve established the Multilateral Settlement Service, which enables check clearinghouses, credit card networks and other entities to use ABMS for risk management of their private (usually net settlement) payment arrangements. Given that the Fed has already built ABMS and is operating it for internal use, and that the incremental cost of granting access to these other entities is small, there is an economy of scope here.

The economy of scope in this central-banking example is much subtler than the one in petroleum refining. In fact, it is typically true that careful statistical analysis is required to document an economy of scope convincingly. When and if such an economy of scope does exist, it provides a prima facie reason for a central bank to expand its payments system activities in a particular, targeted way beyond its core functions.

Even where an economy of scope may demonstrably exist, one must weigh several questions before deciding that central-bank participation in a payments market is the best form of policy. For example, if the economy of scope were an artifact of regulation, then would revising or removing the regulation be preferable to expanding the role of the central bank? Does adoption of new technology (such as movement from paper-based check collection to electronic payments) remove an old economy of scope or create a new one, and, if so, should the range of central-bank activities be adjusted? We emphasize that an economy of scope is a threshold condition for the central bank to examine judiciously whether it ought to undertake an activity outside its core function, and does not alone constitute an open-and-shut case for such activity.

Return to: Thoughts on the Fed's Role in the Payments System