The Region

Reserve Banks in Evolving Payments System

As Thomas Gainor and Leonard Fernelius retire, after serving the Federal Reserve Bank of Minneapolis for 75 years, they share comments on their careers and assess the Federal Reserve's place in the payments system and share their visions of its future role.

Published June 1, 1993  | June 1993 issue

Thomas Gainor*
First Vice President
Federal Reserve Bank of Minneapolis
Retired May 1, 1993.

As the Federal Reserve banks contemplate the U.S. payments system of the 21st century and the role they should play in the evolution of that system, they must refer early and often to their "prime directive," that is, their mission in payments. That mission, simply stated, is to ensure that the nation has a safe and efficient means for transferring funds—readily available to small financial institutions as well as large ones—and to institutions and their customers in remote areas of the country as well as in money centers. Over its approximately eight decades of existence, the Reserve banks have pursued that mission by serving as providers of services, and as administrators of regulations designed to carry out and implement the laws that govern the payments system. Recognizing the potential conflict in that dual role, the Federal Reserve banks have structured their organizations to assure that the management of each role is separate and independent of the other.

In contemplating the requirements of the payments system of the early 21st century, one logical question is whether the Fed's long-standing role as provider should continue, or whether the central bank's role should be focused more exclusively on public oversight of the payments system. During the Fed's history, the financial services it provides have been the subject of spirited debate focusing on questions of public vs. private, competitive equity, the role of the market and the diverse needs of financial institutions and the economy.

Several arguments support continued direct Reserve bank participation, among them that the Reserve banks as participants can influence the direction of the market to serve the public interest, that, through their presence they can innovate to achieve competitive efficiencies in ways that a mere regulator could not. Counterpoints have been raised that the financial services market by itself is the best determinant of the needs of the country's financial system, and that private market participants have the talent, the resources and the competitive motivation to create and maintain an efficient payments system. Both sides of the debate have vocal proponents, and while the Federal Reserve is certainly an interested party, it cannot afford to be parochial in defense of its operational presence. As the environment for financial services changes, the Fed must continually keep in mind its public purpose: a strong economy served by a strong, secure, efficient payments system. Its continued presence or its diminished presence as a service provider must continue to be measured against that standard.

As a practical matter, the payments services of the Reserve banks have become, over the years, an important part of the fabric of the country's payments system. They are paying their way, recovering full costs including a profit, and arguably are providing quality service consistent with their public mission. A zero-based look at the economy and the payments system from the perspective of an unfettered free marketeer might conjure up a different system. However, the fact that the U.S. payments system works, and works as well as any in the world, places the burden of proof on those who would advocate drastic change.

The market for payments services consists of a complex interaction of financial institutions, service providers, industry groups, hardware and software vendors, corporate treasurers and the general public. In that environment, a question is how and to what extent the public interest is best served by central bank involvement in the interaction of those parties as they respond to the changing service environment.

For instance, an ongoing issue affecting the country's financial system is that of the nature and geographic coverage of the payments services available to the public. An efficient, electronically based system might, under a regime dictated solely by profit maximization, exclude certain services to small, remotely based financial institutions. To the extent that happens, the segment of the country's population served by those institutions would be denied competitive services. That possibility alone might argue for the continued presence of the central bank as a provider to assure that basic financial services are available to the populations of small rural as well as large urban communities. As industry consolidation and high-capacity electronic processing become pervasive, a continuing operational presence by regional Reserve banks might be the best assurance that rural America will continue to be served with viable, efficient financial services.

While it is not the Fed's job to regulate social behavior, the efficiency and competitiveness of the U.S. payments system represent public values. It may be an appropriate assertion of the public interest for the central bank of the United States to propose to Congress ways in which the country's payments system could be made more efficient and thus more competitive. For instance, when competent studies provide evidence that electronic payments are demonstrably more efficient than paper payments, perhaps the central bank should take the initiative to promote, either operationally or legislatively, migration toward the more efficient alternative. A cogent argument can be made that such action is consistent with the mission of the central bank. In the case of cash payments, operational analysis would support the premise that penny coins are outdated and inefficient, and that their viability as a medium of exchange has evaporated. Similarly, the circulation of a socially acceptable dollar coin to replace dollar bills could lead to economies in the public and private handling of currency. Changes of that nature are based on political rather than market judgments, but the central bank could provide the weight of its analysis and recommendations to support and encourage informed political decisions.

As the requirements of the U.S. payments system evolve over the next decade, the question of the Fed's role will continue to be raised both internally and externally. If the strength and efficiency of the payments system is understood to be an important national interest, the central bank should retain an abiding interest in its safety and efficiency. An ongoing operational role for the Reserve banks strikes me as the logical way to serve those objectives. More important than the operational presence itself, however, is the opportunity it provides for the central bank to represent the public interest in the day-to-day evolution of the payments system.

Innovation in any field depends upon the ideas and initiatives of people familiar with that field. The Reserve banks, by reason of their long-standing operational experience in payments services have people with the knowledge, motivation and expertise to participate in practical exploration of improvements. Further, because of the regional orientation of the Reserve banks, their staffs bring to bear on the process of change an appreciation for the needs of small and remote as well as large urban institutions. The grassroots wisdom, values and common sense associated with the smaller institutions served by the Reserve districts and the needs of the public they serve should not be lost sight of as the payments system is modernized.

Recognizing that the central bank is but one of many participants in the evolution of the U.S. payments system, the Reserve banks, nevertheless, are the principal representatives of the public interest in this complex process. Several constructive courses of action are possible, all of them consistent with the dual role of Reserve banks as providers of service and representatives of the public interest. Most promising in my view would be for the Reserve banks to serve as focal points for identifying those payments-related issues most in need of resolution and bringing market participants together to expedite solutions.

The Reserve banks are logical parties to facilitate the objective interaction of government, corporate, financial, consumer and technological interests in the search for directions for the future, to determine where common action may be appropriate and to expedite consensus-building and standard-setting. The public objective of that undertaking would be to facilitate the process of making the U.S. payments system as efficient, competitive, secure and responsive as any in the world, taking advantage of the unique advantages offered by this country's highly developed technological base.

Where this process identifies impediments to progress, for example shortfalls in the application of technology, the Reserve banks should consider making investments that hold the promise of advancing efficiency in the payments system. The use of public funds for such undertakings could be likened to the work done by land grant universities whose public-supported research has advanced the cause of U.S. productivity over the years. Needless to say, the product of such research would have to be publicly available to all participants in the U.S. payments system, public or private. That research could be devoted to technology, to legal issues or to operational issues, but the overriding purpose would be improving efficiency and minimizing risk.

In summary, I see the Reserve banks over the next decade as active participants in the evolution of the payments system. Their public purpose will be well-served by:

  • A continued presence in the provision of services, albeit a diminishing one as paper transactions are supplanted by electronic payments.

  • Active public leadership in building national consensus as to the direction and pace of change in the U.S. payments system.

  • Sponsoring economic, technical, legal and operational research as needed to contribute to an informed decision process.

  • Active public leadership in the national standard-setting process associated with payments services.

  • Targeted investments to advance promising payments-related technology.

The Federal Reserve banks have both the interest and the talent to be innovative, constructive participants in the ongoing evolution of the U.S. payments system. Their public/private and regional/national character as well as their operational knowledge and experience place them in a unique position to provide informed, objective contributions as the process goes forward.

Reserve Banks in the Evolving Payments System: An Imperative

Leonard W. Fernelius*
Senior Vice President
Retiring Aug.1, 1993

Touch rewind and fast forward and there comes into view a stream of images that sharpens the focus of, and supports the case made by, my colleague Tom Gainor that the Federal Reserve System should continue to be an active participant in the evolving domestic—and global—payments systems. The case becomes imperative, in my mind, when the cyclorama is superimposed against the backdrop of our democratic heritage in which consensus about change is difficult to achieve, but can occur when public and private sector forces jointly forge the solutions.

In a sense, today's environment, a multifaceted financial structure of robustly competing interests, is not much different from that of the time when the Fed received its mandate to improve the system—except that now it must continually earn its role for that purpose.

A sample recounting of the major milestones occurring over the years provides a platform supporting this postulate:

  • In the '60s Fed research and development to convert the MICR Common Machine Language of the American Bankers Association into practical application gave form, and substance, to an engineering concept for check automation.

  • System initiatives on par clearance, regional check processing centers (RCPCs) and immediate settlement in the '70s conditioned the industry and its user public to accept wide-scale accelerated funds movement within a paper-based technology.

  • The current automated clearinghouse (ACH) system was transformed from early independent regional projects into a nationally integrated system by Fed policy statements and operation of clearinghouses and Fed/government pilot tests.

  • In the last five years, check truncation, electronic MICR check and image technology have moved through district Fed tests and are now positioned to boost another round of productivity gains in the industry.

  • Finally, the Fed earned its way by meeting the stringent requirements of the Monetary Control Act of 1980 (MCA) to recover its costs and speed payments. MCA worked as well to stimulate innovation and increase competition.

This dose of history is interesting but it says nothing about the most important and fundamental adjustment made by Fed staffers whom, I believe, have now generally subscribed to the cardinal principles of responsive customer service and high-quality output products.

All of the above changes happened because of cooperative work between the Fed and the private sector. Cause and effect has occurred in both directions over time and throughout the playing field.

The notion of a public/private partnership to cooperatively sponsor change is key to success and an inherent feature of the central bank's historical relationship. The Fed, without an operational presence in the market, would not be in a position to detect the need for change, unable to fashion workable solutions and not engender sufficient respect from the users to effect smooth implementation of change. On the other hand, the private sector, whose focus is—and should be—on maximizing institutional profit, will not seek out the broad public missions or organize itself to identify systemic weaknesses in the infrastructure and voluntarily devise necessary solutions. Evidence of the former is unfolding today in the program under development by the Fed, with consultation from private banks, to control and reduce intra-day credit exposure.

The Expedited Funds Availability Act of 1988 (EFAA), which required that financial institutions give earlier credit for check deposits, is illustrative of an imposed solution to deal with a public policy issue. One could argue, and perhaps prove, that the EFAA route is the more costly of the two alternative approaches.

As the global marketplace grows and evolves, and cross-border payments increase, there will be issues such as standards, liability, timeliness and efficiency that, again, can best be addressed in the partnership forum.

The environment in which the Fed delivers products and services to financial institutions will change markedly next year as certain inherent advantages it had will disappear as a means to "level the playing field" among all providers. Further, consolidation in the banking industry will reduce the Fed's customer base and squeeze its flexibility to experiment with new products to attract and retain business. On the premise that its continuing role in the service arena must be "earned," the Fed must offset whatever shrinkage in revenue occurs by increasing productivity or adding value to existing products. Of necessity, the emphasis on responsive customer service must be kept in the forefront.

Indeed, it is imperative that the Fed continue to be a partner with private organizations to shape continuing modernization of the payments mechanism—an essential support vehicle for the nation's economic system.

Together, Thomas Gainor and Leonard Fernelius have served the Federal Reserve Bank of Minneapolis 75 years and have witnessed dramatic changes in the Federal Reserve's role in the nation's payments system; this year they are retiring. We asked them to prepare final comments on their careers and, in the these essays, Gainor and Fernelius assess the Federal Reserve's place in the payments system and share their visions of its future role.