The Region

Developing an Efficient Payments System

Published August 1, 1988  | August 1988 issue

Although the entrance of the Federal Reserve System into the check collection business wasn't expressly required under the Federal Reserve Act—it was allowed—some framers of the Act envisioned that the Federal Reserve banks would ultimately handle the collection of virtually all checks sent intercity and interdistrict. But that vision was not to be.

The Federal Reserve System was never alone in the intercity check collection business. Correspondent banks—commercial banks that provide banking services to other private banks—provided that service before the Fed came on the scene. However, 75 years ago commercial check collection systems in the United States resembled patchwork quilts: efficient intercity collection of checks through clearinghouse arrangements and often inefficient interregional collection systems with no regional or national framework. Private banking made limited attempts to incorporate intercity efficiencies on a regional scale, mainly in New England states, but without wide success. The newly created Fed entered the picture with the goal of creating a unified check collection system in which all banks would participate. On the other hand, correspondent banks had compelling profit incentives for maintaining their positions in the check payments industry — also as a means of competing for other banks' clearing balances not open to the Fed (such as payment of interest on balances). So, while the Fed did carve out a substantial niche, private banks continued to process the majority of intercity checks.

A second goal envisioned by the framers of the Federal Reserve Act was to establish a payments system where all banks would remit payment for checks at face value (or par). Nonpar banking occurred when banks would charge a small fee—referred to as "tollgates upon the highways of commerce" by Carter Glass—to remit for checks drawn upon themselves and sent from other banks for payment. Those fees, a minimum of 10 cents per check in many cases, often were levied against the payee-depositor's account. For example, a $25 check, drawn on a nonpar bank (Bank A), may be deposited in a bank in a neighboring town (Bank B). That bank then sends the check to Bank A for collection; however, Bank A charges a 10-cent fee and the depositor's account at Bank B is credited with only $24.90. For years nonpar banking was a lucrative source of income for small, country banks, especially in the Upper Midwest, a hotbed of nonpar banking that included some of the last states to prohibit the practice. Nonpar banking was a bane of the Federal Reserve System from 1913 until the early '70s, and the Minneapolis Fed was instrumental in bringing about the end of the practice.

As just described, Fed involvement in the check collection system was intended to bring about a unified national clearing system and the elimination of nonpar payment. But there was also another motive for bringing the Fed into the check processing business—to give the Fed a day-to-day operating role. Such a role would strengthen the Fed's durability, it was reasoned, and enhance its ability to carry out its other responsibilities, most notably to meet the financial crisis situation it was principally designed to prevent. Involvement in the daily business of the financial marketplace would give a practical purpose to the Fed, according to H. Parker Willis, one of the original framers of the Federal Reserve Act, who wrote in 1926:

[without check clearing, Fed banks] would become merely the holders of dead balances carried for the member banks without any service to them; and, since the business public abhors an idle or unnecessary institution ... it would not submit long to the needless burden created by such emergency institutions designed to put out financial fire.

For 75 years, then, the Fed has been an instrumental participant in the check clearing business; and, as in many other industries, there have been dramatic technological improvements that have greatly enhanced the efficiency of service. In 1962 automated check processing was introduced to the industry. Known as MICR (magnetic ink character recognition), it allowed banks to add a magnetic strip along checks that could be read by electronic machines. That technological breakthrough allowed banks to abandon manual, time-consuming tasks: sorting individual checks and posting payments to accounts. Such innovation inspired the more recent development of check truncation—a system that allows financial institutions to electronically record the information from a check and then send only that information to a bank, rather than sending the actual check. Other important electronic payment systems used by the Fed include Fed Wire, the Federal Reserve's large-dollar funds transfer service; and automated clearing houses, generally a small-dollar mechanism that allows for automatic electronic deposit of such things as Social Security, payroll checks and preauthorized insurance premium debits.

In conjunction with its role in the country's payment system, the Fed serves as a fiscal agent for the United States government, maintaining, in effect, the world's largest bank account. All checks drawn on the Treasury of the United States are paid at Federal Reserve Banks. Various government agencies deposit billions of dollars into the Federal Reserve Banks each year, and then draw billions of dollars out while conducting normal business operations. In addition, Federal Reserve Banks sell, service and redeem Treasury bills, bonds, notes and savings bonds to assist the Treasury Department in financing the national debt.

Another responsibility of Federal Reserve district banks that relates to the nation's currency is the job of physically maintaining the supply of money. District banks, which supply financial institutions with needed coin and currency, also receive shipments daily from those same financial institutions. That money is then verified, sorted and stored in the Fed's vault until it is needed. Unfit currency is destroyed and replaced by new currency.

The evolution of the Fed's role in the nation's payment system—from vague references in the Federal Reserve Act to that of a competing market player—came to its fruition in 1980 when Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). This Act, among other things, required Federal Reserve Banks to charge for financial services, such as processing checks, and opened the Fed's financial services to all depository institutions.

The Ninth District was delighted to note, in its 1920 annual report, that the volume of check collections at the Minneapolis bank had increased over 100 percent from the preceding year to exceed 21 million items annually—a dramatic increase from the 13,500 items processed the first year of operation. The Fed's role, of course, has grown considerably since the 1920s, as check usage has become more prevalent. In 1987 there were 840 million checks processed by the Minneapolis Fed, with about 15 billion processed by the entire Federal Reserve System.

In the late 1980s check truncation, which has been employed in recent years by the credit union and savings and loan industries, was tested by the Minneapolis Fed in the Upper Peninsula of Michigan and nearby regions of Wisconsin and Minnesota. That truncation program was an important step toward the goal of implementing check truncation nationwide.

The Minneapolis Fed keeps about $500 million in cash in its vault. Of the currency that comes into the bank every day, about 40 percent, or over $1 million, is unfit for recirculation and is destroyed. The money is replaced through the U.S. Bureau of Engraving.

See also:
Federal Reserve History
A New Law, A New Era, 1980 Annual Report
Dichotomy Becomes Reality: Ten Years of Federal Reserve as Regulator and Competitor, 1991 Annual Report
Expedited Funds Availability Act, The Region, August 1989