Evolutionary Change: The Federal Reserve's Role in the Payments System
Tatiana Schneiderman Boncompagni
Edina High School
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
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
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:
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
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
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
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
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
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
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
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."
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,
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,
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.