I appreciate the opportunity to participate in this conference on the
payments system in transition, sponsored by the Payment Systems Development
Committee (PSDC). I wish to thank my co-chair on that Committee, Roger
Ferguson; my predecessor, Cathy Minehan; the other members of the Committee;
and the many staff members at the Board of Governors and the rest of
the System for organizing a timely conference and assembling an impressive
As you may know, in addition to my duties on the Payments System Development
Committee, I recently assumed the chair of the Financial Services Policy
Committee, the body responsible for formulating policy and for providing
executive oversight to the Federal Reserve’s payments services.
This is an assignment with intriguing challenges and opportunities,
to perhaps understate things a bit.
While all of our financial services confront significant issues, responding
to the changing retail payments environment is a top priority for me
at this time. In these comments, I will review how I intend to approach
this challenge, in the broadest sense. To be sure, Check 21, which may
in itself portend significant change in retail payments, is of particular
interest to this conference and, of course, to the Federal Reserve as
well. However, because others with much greater hands-on knowledge than
I addressed Check 21 in detail yesterday, I will focus this morning
on the more general policy issues ineluctably associated with the challenges
and opportunities inherent in the changing retail payments landscape.
In this regard, my major point is straightforward: A policymaker’s
overriding concern is improving the welfare of society as a whole. And
I am specifically thinking of social welfare in the sense that economists
use the term; that is, allocating resources to maximize the benefits
that society receives from them. This perspective is not one that leaders
of a private sector banking organization or other participants in payments
usually take, nor should it be. But for the Federal Reserve, an institution
created to further the public interest, net societal benefits are critical.
A focus on social welfare and resource allocation may sound of only
theoretical value, but it has some pertinent implications for how I
view both developments in the payments system and the manner in which
the Federal Reserve ought to respond to those developments. For example,
because of the focus on resource allocation, I, unlike the head of a
private firm, view social welfare from the vantage point of households.
This means that I support developments that in the aggregate improve
the welfare of households, even if in some sense they make some Federal
Reserve financial services, and related private firm services, worse
But let me be a bit more specific. Today I will discuss three implications
of a focus on social welfare. They are:
- First, there should be little doubt that the shift under way to electronic
payments and to the electronification of check is welfare enhancing,
since it appears to reflect advances in technology and changes in consumer
preferences rather than a response to government or other mandates.
This observation has implications for future roles of the Federal Reserve
- Second, the ability of markets to generally produce spontaneous and
“indigenous” changes in payments, along the lines I just
noted, suggests that the Federal Reserve and other government entities
must clearly demonstrate that a new product or service will improve
social welfare before offering it. Furthermore, Congress has required
the Federal Reserve to recover costs fully if a product or service is
to be considered welfare enhancing. If our product and service offerings
do not pass such tests, we could very well squander society’s
resources and/or displace potentially superior private sector alternatives.
If we do pass these tests, we ought to bring the product or service
- Finally, these same social welfare concerns must be brought to bear
on our existing businesses, where they were assumedly met when the products
and services were first offered. Indeed, I think we can make general
concerns about social welfare more concrete with regard to existing
retail business. In the near term the Federal Reserve must assure that
the size, reliability and capabilities of our retail infrastructure
supporting established services—that is, check and ACH [automated
clearinghouse]—correspond to market demand and lead to a market
with demonstrably more competitive pricing and service than would otherwise
occur. If we meet such a standard, I am confident that social welfare
is being enhanced.
I will elaborate on these thoughts as I proceed. But let me emphasize,
as I have in other forums, that these observations remain general and
are the product of iteration. It is through continuing dialogue with
you and other payments system participants, including end users, that
we can come to more definitive conclusions about retail payments and
the future role of the Federal Reserve. Such a dialogue is particularly
important in current circumstances, characterized as they are by rapid
change and heightened uncertainty.
Background and Context
I am sure that this audience is familiar with recent trends in retail
payments volumes, so I will not review the data in detail. Nevertheless,
a few observations are in order because they set the stage for the thrust
of these remarks. We all know that for years, if not decades, analysts
routinely predicted absolute declines in check volumes and that for
years the market refused to cooperate. However, more current and reliable
evidence from Federal Reserve sponsored research documented an outright
reduction in check volume occurring at some point between 1995 and 2000.
And these volume declines appear to have continued.
While check volumes have finally started to diminish, there has also
been a surge in electronic retail payments. In fact, a reasonable extrapolation
of recent trends, indeed perhaps a conservative extrapolation, would
have checks constituting less than half of noncash retail payments volumes
in just a couple of years. The bulk of the growth in electronic retail
payments has been in debit and credit cards. ACH has expanded rapidly
as well, but it is really a different “animal” from the
consumer’s perspective, as it is typically not the vehicle by
which the customer directly originates a payment.
Data from the survey of consumer finances, sponsored by the Board of
Governors, confirms these types of trends.1
While there was some increase in the use of very well
established forms of electronic banking, such as ATMs, the real explosion
in “electronics” and banking came in the use of instruments
such as debit cards. In 1995, about 18 percent of households used debit
cards whereas nearly 50 percent did in 2001. The rate of growth of automatic
bill payment during this period was also large but not quite as dramatic.
Quite interestingly, these types of trends were present across age and
The Societal Perspective
The data just cited have a bearing on my earlier observation about
focusing on social welfare. Before the decline in check volumes became
apparent, there was some sentiment that collective action, perhaps initiated
by government, needed to be taken to promote the transition from paper
to electronic retail payments. Underpinning this view was the observation
that checks are costly to process and to transport, so resources could
be saved by moving to electronics. The flaw in this reasoning was that
it did not account for the preferences of households and firms; that
is, benefits seemingly did not enter the calculation and thus overt
strategies to curtail check usage usually seemed heavy-handed and were
rarely implemented (at least in the United States).
The judgment not to “jump start” a shift in payments seems
wise in retrospect, given that the shift I noted a few moments ago in
the composition of retail payments resulted from the consequence of
market forces. On the consumer demand side, it seems that tastes are
changing, perhaps as a result of familiarity and comfort with electronic
processes, and no doubt for other reasons as well. Retailers are clearly
moving to check conversion at the point of sale and/or at the lock box.
On the supply side, providers no doubt are responding to demand and
also to the fact that technology makes it possible to offer electronic
products profitably. Irrespective of the causes, the key point is that
a change in the market is occurring spontaneously and mostly in areas
where the Federal Reserve is not involved. Hence, the transition is
the consequence of decisions and actions by market participants and
thus, virtually by definition, it is good for society as a whole.
A change that is good for society as a whole will almost certainly
not be good for every person or industry. Change almost necessarily
creates losers as well as winners. However, it is best to let the market
mechanism sort all of this out. We know that the transition from paper
to electronics is difficult for some firms, as it is for the Federal
Reserve and a sizable number of our staff. At the same time, it is important
to emphasize that the flexibility of our labor and product markets has
been a key to the long-run success of the U.S. economy and to our high
standard of living. The shift in payments instruments and associated
resource reallocations represent such flexibility in action.
My bottom lines so far are that, first, Federal Reserve policymakers
ought to focus on social welfare rather than alternative objectives
when considering financial services. Second, trends in payments that
reflect market forces rather than government intervention, with an important
exception which I will discuss shortly, represent welfare enhancing
outcomes. I now turn to applying these types of principles to the development
and modification of Federal Reserve services.
The Federal Reserve’s Role Going Forward
Let me discuss how this concern with social welfare affects my approach
to the provision of new services first. I will then discuss its effects
on modifications to our existing services, and then move on to conclusions.
New Services. I start with the view that the Federal Reserve
must pass a series of meaningful hurdles if it is to intervene and to
supplant the market in producing and delivering the “next generation”
of payments vehicles, a position that is underpinned by three complementary
observations. The first is the general reliance in our economy over
a long period on market solutions to changes in tastes, advances in
technology and fluctuations in relative prices. The second is the obvious
success of the market in moving retail payments toward electronics;
I previously commented that external mandates really played no role
The third reason for relying initially on market forces is that it
is consistent with principles that we in the Federal Reserve have long
espoused and have been guided by. These principles state that the Fed
should, as a general matter, provide retail payments services directly
only in cases where markets fail to operate effectively, where less
intrusive interventions are not effective and where we can recover our
costs. It is not enough, therefore, to simply point to cases where prices
seem “too high” or the market seems to move “too slowly.”
Instead, we must demonstrate the case for enhanced social welfare. Surmounting
these hurdles in a truly convincing fashion is not a trivial task, given
the uncertainty associated with measures of market failure and projections
of cost recovery.
For some observers, the rationale for the Federal Reserve to follow
these principles may be second nature, but it is worth briefly noting
why they are compelling. In the first place, the Federal Reserve has
no alternative but to follow the cost recovery mandate legislated by
Congress. Moreover, the cost recovery test reflects, at least in part,
a desire to ensure that an entity funded with tax revenues does not
take advantage of an unequal playing field to displace the private sector
firms that we typically rely upon in the United States. In a similar
vein, without market failure, there is no reason to believe that government
intervention in payments markets, or any market for that matter, will
lead to a superior allocation of resources. Finally, even if there is
market failure, it may be that a solution other than direct provision
of services is preferable because such an alternative could be relatively
cost effective and would likely make the greatest use of private providers.
A specific example of these principles in action may help. Perhaps
the most important recent retail payments initiative associated with
the Federal Reserve is not a new product or service but is instead an
effort to eliminate legal barriers to changing payments. The Check 21
legislation is an effort to align the law governing one type of payment—checks—with
advances in technology. That is, Check 21 gives a substitute check,
which can be produced from an electronic file, the same legal standing
as the original document. As such, the legislation may help remove barriers
that could otherwise prevent the marketplace from transitioning from
an existing payments regime to one that consumers and providers might
prefer. I should note parenthetically that the PSDC has been at the
forefront of the Federal Reserve’s effort to address these barriers
to changes in payments, and we hope to continue that role following
this conference. In any event, the Check 21 legislation does not rely
on direct service provision by the Federal Reserve and, while it addresses
certain obstacles to change, it does not mandate a specific outcome.
While I view the hurdles we set for ourselves as effectively making
the Federal Reserve conservative in its willingness to offer new products
and services, I do not view them as one-sided decision tools, set up
to prevent us from offering services. Where the hurdles are met, we
have a responsibility to be active in payments. In the right circumstances,
it may be appropriate for the Federal Reserve to act as a competitive
provider of payments services for reasons of efficiency and also because
the financial requirements of the Monetary Control Act imply a scope
of operations sufficient to cover costs.
Modifications to Existing Payments. Naturally, the concerns
about social welfare that I just emphasized apply equally to our existing
payments offerings. It may go without saying, but the major difference
is that at some point the services we offer have already met these hurdles,
or a set of tests that approximated these types of concerns. Simply
put, we are not starting with a blank slate when applying concerns of
social welfare to our existing operations.
While evaluating existing services that current policymakers have essentially
inherited has its challenges, it also allows for more specific application
of social welfare criteria. For example, determining actions the Federal
Reserve should appropriately take in the face of the changing retail
payments landscape requires at a minimum analyses of market competition
and structure (that is, industrial organization) and of end user demand.
If there is little end user demand, cost recovery could be difficult
and claims about market failure as the cause for the absence of a product
or service are suspect. If market structure and other factors suggest
that adequate competition would not exist absent our involvement, we
have a better chance of passing social welfare and cost tests. These
considerations lead in turn to a more specific formulation of a social
welfare test for our existing payments services, to which I previously
alluded: The Federal Reserve must assure that the size, reliability
and capabilities of our retail infrastructure supporting established
services—that is, check and ACH—correspond to market demand
and lead to a market with demonstrably more competitive pricing and
service than would otherwise occur.
This principle provides a workable framework for making social welfare
concerns useful in a changing retail payments environment. It recognizes
that, depending on market conditions, contraction of Federal Reserve
financial services may improve society’s well-being. At other
times maintaining or even expanding services is appropriate in order
to increase benefits. We can, therefore, be analytical in response to
transitions in payments.
I will now turn to consideration of the implications of this principle
for the Federal Reserve’s check and ACH services, starting with
the check situation.
Check. In check, the reduced demand for paper checks, reflecting
market forces already discussed, has led to overcapacity for us and
for the paper check processing industry overall, an industry which is
generally characterized by many participants and competitive pricing.
In response to this development and concern for societal benefits, we
are reducing our check processing infrastructure. Clearly, this downsizing
also conforms to the MCA [Monetary Control Act], which requires that
we fully recover costs. Restructuring and other cost cutting actions
have been undertaken to return us to full cost recovery in check by
2005. If they do not, and the planning for such a contingency is already
under way, we will take additional aggressive steps, be that further
reductions in infrastructure, in product lines or what have you, to
accomplish the goal. Any investment in our paper check infrastructure,
naturally, will also reflect the future prospects for what can only
be called a declining industry.
While the future of check looks challenging, the fact that the demand
for check processing is declining does not mean that all services related
to the paper check will necessarily diminish. As the desire to eliminate
the paper check after it has been written grows, there may in fact be
increased demand for certain services, such as maintaining an image
archive of checks or converting checks into ACH payments. Here, too,
the critical factors determining the Federal Reserve’s role relate
to social welfare and to the general principle I articulated about competition
and demand. Let me briefly elaborate.
Historically, concern has been expressed from time to time that a diminished
Fed check infrastructure might reduce direct access to processing services
at competitive prices, particularly for small financial institutions
in relatively remote locations. But the forces propelling the increased
use of electronic payments, as well as efforts associated with implementation
of Check 21, might mitigate concerns about access and, in fact, such
mitigation may occur rather rapidly. Why? Previously, it might have
been quite costly for a check processor to enter a remote location if
that processor did not have a network already in place to transport
the physical items. With such a barrier to entry, competition would
suffer and markets with monopolistic supply and pricing could emerge.
Federal Reserve check processing services were viewed as one means of
addressing such concerns.
With the need to pick up the physical check perhaps eventually eliminated
in the new retail payments landscape, one might imagine that even banks
located in physically remote areas could have many firms with the ability
to enter their markets at low cost. But reduced barriers to entry may
not help if there are few firms prepared to enter in the first place.
And we might not expect many firms to offer the services needed to process
what amounts to an electronic message with check information. As I will
discuss momentarily, markets for the processing of electronic payments
also tend to monopoly. In this case, active Federal Reserve participation
in the electronic check market might very well be welfare enhancing;
at this point, it is simply too early to tell.
The reference to electronic retail payments is a natural transition
to discuss our ACH business, so let me turn to that topic.
ACH. The ACH business is a growing one in which the Federal
Reserve already has considerable market share. But market share is not
the Federal Reserve’s objective, and so one question is: From
a social benefit viewpoint, how should the Federal Reserve respond to
increasing demand for ACH services?
Just as was the case for check, we make concerns for social welfare
real in this case by looking at issues of market structure and demand.
Thus, my question must be addressed in view of the fact that the ACH
is characterized by economies of scale and “network effects.”
As just intimated, these characteristics typically lead to highly concentrated
markets and to the potential for too little output and unduly high prices.
I view the current role of the Federal Reserve in ACH—that of
major provider—as an effort to deal with these concerns and thereby
enhance social welfare. Moreover, as the primary provider of services
in a market with just two suppliers, the Federal Reserve makes society
better off by maintaining the structural integrity of the system, including
making reasonable investments in its reliability and assuring that the
system adequately serves its customers.
Moreover, the Federal Reserve faces not only increased demand for existing
ACH services but also demand for enhanced features and functionality.
ACH is increasingly transitioning to a more flexible system geared to
a broad range of retail transactions, such as point-of-sale and lock
box conversion of checks, debit card transactions and greater frequency
of one-time payments initiated by telephone and the Web. We are making
changes to the ACH system to support such transactions given the legitimate
market demand they reflect. As we continue to see changes in ACH, I
will welcome constructive discussion as to how the Federal Reserve’s
role and the roles of other participants should evolve to enhance societal
Anyone active in the retail payments business faces significant challenges
over the next year or two and over the longer term as well. This is
true of the Federal Reserve, but we are not just “another player”
in this business; we are a public institution, and therefore, our overriding
objective is to improve social welfare. This objective, together with
changes under way in the marketplace and with our historic role in retail
payments, has led me to three initial conclusions.
- To the degree that the move to electronic payments from paper checks
represents the preferences of households and firms, it makes society
better off and is a desirable outcome. It should be encouraged.
- Over the long run, the Federal Reserve must pass several rigorous
tests to offer new products with the ultimate goal of improving social
welfare by, in part, not displacing through its actions products and
services the market would otherwise provide. At the same time, we
should recognize that there may be instances where societal benefits
could be maximized by the Fed’s direct provision of retail payments
services; clearly, such cases need to be identified objectively.
- Modifications to the Federal Reserve’s current array of retail
payments services can generally make society better off, if such modifications
are responsive to demand and result in more competitive pricing and
provision than would otherwise occur.
In closing, I look forward to further consideration and discussion
of these conclusions. Your input is essential to assuring that our direction
continues to serve society as a whole.
1 See Lorretta J. Mester.
in the Use of Electronic Payments: 1995-2001.” Federal
Reserve Bank of Philadelphia Business Review. Third Quarter. 18-20.