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Evolutionary Change: The Federal Reserve's Role in the Payments System

Tatiana Schneiderman Boncompagni
Edina High School
Edina, Minnesota

Technological innovation and international commerce have revolutionized the U.S. payments system. The rise of both electronic payment options and cross-border monetary transactions have spurred several analysts to reevaluate the role of the Federal Reserve in this industry.

Historically, the Fed has enhanced the stability and efficiency of a domestic paper-based system; however, the evolving payments industry calls for a reassessment of Federal Reserve functions. Leonard Fernelius, former senior vice president of Federal Reserve Financial Services at the Minneapolis Fed and now a consultant with the International Monetary Fund (IMF), emphasizes, "In 20 years the world will have changed and with it, the role of the Fed."

On the one hand, the future environment of the payments system favors a minimized role for the Federal Reserve as a financial service provider. Electronic financial services have paved the way to realizing new economies of scale, which have in turn catalyzed widespread bank consolidation. As a result of the trend toward consolidation, private industry has become capable of offering services currently provided by the Federal Reserve.

On the other hand, future conditions necessitate continued, and perhaps expanded, Fed regulation. Borders—either interstate or international—have diminished impact on the payments industry. The fading importance of these geographical frontiers emphasizes the need for adequate supervision of interdependent payment networks. These two conditions—technological innovation and diminished borders—require that the Federal Reserve simultaneously contract its participatory functions and expand its regulatory functions in the payments industry.

The US payments system is no exception to the technological revolution sweeping the world. Electronic innovations such as magnetic ink character recognition and check truncation have redefined the payments system. In the future, check clearinghouses will no longer send actual checks back to their respective banks. Instead, most financial transactions will occur electronically, thereby eliminating circuitous routing and rural accessibility problems which have heretofore justified some Fed clearinghouse functions (Caskey and Sellon 79).

Networks such as the American Bankers Association Automated Clearinghouse (ACH) and Electronic Depository Institution are realizing new economies of scale. Because these efficient payment organizations maximize profitability, they drive firms toward both merging business locations and expanding territorial coverage. For example, over the past five years, Norwest Banks has consolidated its 90 banks down to 40 while entering the markets of 10 new states at the same time. The monetary gains from Norwest's reduction of "brick and mortar offices" funded the acquisitions of United Banks in Colorado and other private firms in Arizona, New Mexico and Texas (Ebert).

The payments system, especially the new technologically advanced payments system, models closely a decreasing cost industry (Miller 20). Consequently, the current trend toward bank consolidation and interstate banking is likely to continue and grow.

Another benefit of bank consolidation underscores "the economies of scope" present in the previously mentioned technological advancements. Economies of scope occur when the provision of multiple services entails increasing returns to scale which are more profitable than single service provision (Weinberg 7).

The "naturally oligopolistic" organization of the electronic payments industry allows firms to provide multiple services with the same computer base. For example, a customer may access any information, from computerized check collection to ACH services, on the same electronic connection. Moreover, by avoiding the high fixed costs of establishing electronic networks, firms price their services at rates which encourage the public to use these more efficient payment options; both consumer and retailer benefit from the increased utilization of electronic services (Weinberg 19).

In the past, the Federal Reserve has been instrumental in coordinating the transactions of some 15,000 private firms in the United States alone. However, since the future electronic payments system closely models a decreasing cost industry of few firms, that function of the Fed will become outdated. The automated teller machine (ATM) industry displays such oligopolistic characteristics; in 1993 four ATM networks commanded a 53 percent market share (Caskey and Sellon 92). The Federal Reserve will be less responsible for coordinating financial transactions; rather, coordination will be performed either internally or collusively with other large firms.

The possible dangers of oligopolistic behavior—price stickiness and price collusion—are dismissed by some analysts because they believe few firms can be sufficiently competitive in this industry (Fernelius, Raskind). Yet, these same observers concur that the Federal Reserve, as a final insurer of fair pricing, should continue regulating and supervising the pricing of services. True, the Justice Department could assume this responsibility as it does for other trade industries. However, either guardian must also be equipped to combat another oligopolistic tendency: restrictive access.

Norwest banker Steven Ebert insists, "The payments system requires some kind of insurance that no firms will be restricted access." Herein lies the role of the Fed as provider of services. Because the Federal Reserve cannot legally mandate universal accessibility in a privatized industry, limited provision of services by the Fed guarantees equal treatment (Miller 21). In the future, if and when innovation eliminates the motivation for discrimination, this last function of the Federal Reserve will become unnecessary.

The Federal Reserve should not be afraid of changing its policies: What appears suitable at one time may seem ridiculous at another. Although the Monetary Control Act of 1980 (MCA) was heralded as an efficiency enhancer in a very different market, technological innovations since 1980 have made inappropriate the MCA requirement that the Fed match its costs with revenue.

The Federal Reserve should not be obligated to match its cost if its future function is characterized as guardian rather than participant. Indeed the requirement of matching revenue to costs has already impeded technological development in the payment option of debit cards (Raskind).

The Federal Reserve, in an effort to retain market share, frustrated Visa/Mastercard from promoting this payments option. In the early '80s, the corporation was already equipped with the necessary computer networks to jump-start the use of debit cards, which has considerable spillover benefits. Furthermore, since debit card transactions would make use of computers normally idle at night, the increase in production possibilities would incur few opportunity costs.

When the Fed finally granted Visa/Mastercard the right to provide this financial service, the industry quickly gained consumer acceptance (Raskind). Last year Point of Sale News reported that the number of installed debit card terminals had doubled to 344,000 units in 1994 alone (Caskey and Sellon 82).

The Federal Reserve has also allowed the corporation to process small value transactions for the National Automated Clearinghouse. Only Visa/Mastercard and the National Check Clearing Association, a consortium of 35 to 50 large banks engaging in multilateral exchange, have received net settlement capability. Although these transactions are ultimately finalized by the Federal Reserve, the success of these two organizations foreshadows the privatization of this current Fed function. Peter Raskind, senior vice president of the Corporate Products Group at First Bank, recognizes this as a sign of the times: "Clearinghouses and electronic payment services are making inroads into the Fed's turf and it scares them."

The Federal Reserve's fear of losing check volume to bypass options has inhibited the spread of efficiency-enhancing payments services. Without the revenue-match-costs distraction of the Monetary Control Act, the Fed could focus on maximizing the efficiency of the payments system—the real key to maximizing social welfare.

While the role of the Federal Reserve as a provider of services becomes less and less necessary in the years to come, its role as regulator becomes more and more important. Supervision of commercial banks includes investment safety inspections and private clearinghouse examinations in order to protect the banking industry from crises comparable to the Panic of 1907.

In today's global economy, the consequences of such failures increase exponentially. "Any shock," says the IMF's Fernelius, "reverberates throughout the system." International electronic clearinghouses such as the Clearinghouse Interbank Payment System (CHIPS) and the Society for Worldwide Interbank Financial Telecommunications (SWIFT) mold the future of the payments system. This new environment demands careful supervision and regulation (Summers 86).

The first concern is domestic regulation. The president of the Federal Reserve Bank of Minneapolis, Gary Stern, stresses that the "certifying" power of supervision "adds to banks' credibility, assuring customers, domestic and foreign, that the institution meets solid prudential standards." He continues, "This assists the bank and the system as a whole in attracting and retaining resources to the long-range benefit of the economy" (Stern 8).

Raskind applies this principle: "When our bank wants to do business, we always take a look at their payments system and ask ourselves, 'Can we trust it?'" This attitude implies that the degree of "trust" foreign banks have in the US payments system has a direct influence on the volume of transactions this nation receives. The Federal Reserve has an integral role in establishing that dependability—so much so that Mr. Raskind believes that without Fed regulation, "the whole thing would come down like a house of cards."

The second concern is international regulation. The huge inflows and outflows of monetary transfers demand adequate oversight and knowledgeability on a daily basis. Furthermore, the new interdependent conditions require international oversight with the freedom to cross borders. Currently the Bank for International Settlements stands as something of a global guardian by imposing certain requirements such as standardized deposits of bank capital.

However, many economists advocate a much more influential international regulatory committee. Perhaps the countries of the G-7 will recognize that if interdependent monetary transactions persist at such high volumes, a cooperative form of supervision must be created (Summers 88).

The Federal Reserve thus encounters the challenge not only to ensure the integrity of the US payment system but also to improve that of the entire world. Fernelius currently heads IMF's efforts to promote the establishment of modern payments systems in developing countries. He calls attention to the fact that "the rest of the world is not where we are. To think truly globally, we are obligated to share our expertise with newly industrialized countries."

In the final analysis, the US payments system is indeed changing. Ultimately the key to the Federal Reserve's involvement in the payments system is flexibility. Technological innovations have forced the Federal Reserve to re-examine its role in the industry. The future will bring a substantially less significant role for the Fed as provider of payments services; however, this will be offset with a substantially more important role as regulator.

The Fed should not mourn this loss of visibility because it will be accompanied by celebrations of economies of scale and scope. Moreover, contracting the provider-of-services side of Fed functions will complement its expanding responsibilities to the global community. "And," as Fernelius sighs, "never fear, we still have a long way to go."

Works Cited

Caskey, John P. and Gordon H. Sellon, Jr. "Is the Debit Card Revolution Finally Here?" Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter 1994, 79-95.

Ebert, Steven. Personal interview, Norwest Bank, Minneapolis, Feb. 6, 1995.

Fernelius, Leonard W. Personal interview, Edina, Minn. Feb. 10, 1995.

Miller, Preston J. "The Right Way to Price Federal Reserve Services," Quarterly Review. Federal Reserve Bank of Minneapolis, Summer 1977, 15-22.

Raskind, Peter E. Personal interview, First Bank, Minneapolis, Feb. 1, 1995.

Stern, Gary. "A Nation's Commercial Banks and Central Bank Are Reflections of Each Other," The Region. December 1994, 4-9.

Summers, Bruce J. "Clearing and the Payment Systems: The Role of the Central Bank," Federal Reserve Bulletin. February 1991, 81-91.

Weinberg, John A. "Selling Federal Reserve Payment Services: One Price Fits All?" Economic Quarterly. Federal Reserve Bank of Richmond, Fall 1994, 1-23.