For tonight's forum I would like to look with you at some significant changes we see happening in the retail payments system of the U.S. and consider some of their implications. These changes will require new responses from the Federal Reserve Banks, and from the banking industry.

By "retail payments" I mean most of the noncash payments made by consumers and businesses. This excludes cash, and excludes large-value payments such as those made through Fedwire and CHIPS.

We are looking at checks, ACH direct deposit and direct debit, debit cards, credit cards, Internet bill payment, and emerging electronic payment choices.

The big new realization this year is that the decline in the use of checks in America has begun. Our best guess is that it began in the mid-1990s, and that total check volume has been declining by perhaps 3 percent per year since then.

For us in the Federal Reserve this really has been a 2002 realization. Last year we were not talking about a decline in the use of checks.

Now, it nearly dominates our thinking about retail payments. Three developments have influenced us.

First, we saw the results of the comprehensive study of check volumes, and of the uses of checks and electronic payments, organized by our national Retail Payments Office and published near the end of 2001. This study enabled us, and many others, to realize that the number of checks written in the U.S., as of 2000, was considerably lower than previous estimates. The number was somewhere in the forties of billions, which is a lot of checks, but not the sixty to seventy billion previously estimated.

Second, we saw a follow-on analysis by staff at the Board of Governors, just published in the August Federal Reserve Bulletin. This very interesting paper added to the Retail Payments Office study some additional data from a smaller survey conducted in the mid-1990s, and concluded that check volumes have been declining for at least a few years.

And third, we have reports from most of the major correspondent banks in the U.S., that their check volumes in 2002 are running below 2001, as are our Reserve Bank check volumes.

So, we have both statistical studies and real-world evidence that checks are in decline. Meanwhile, every form of retail electronic payments is growing.

Let me give you just a few significant figures. We estimate that U.S. consumers and businesses wrote about 49 billion checks in 1996, and about 42 billion in 2000. While checks were declining, credit card payments grew by 44 percent, to 15 billion. ACH payments grew by 50 percent, to 5.6 billion. And, the biggest change, debit card transactions grew from about 1.4 billion in 1996 to about 8.3 billion in 2000. When you think about how many people pay for their groceries and their gas these days, I think you can see what is driving some of this growth in debit card use.

If anything the pace of change is likely to accelerate in the coming years. Retailers and major billers show ever-greater interest in reducing their handling of paper checks. Every year more retailers are starting to convert checks into electronic transactions at the point of sale, and then hand the check right back to the customer.

Also, major billers are looking to convert checks into electronic ACH payments in their lockbox operations. American Express has started to do so, and I hear that some large credit card processors intend to start next year.

Internet bill presentment and bill payment are likely to grow substantially beyond their current levels.

And ACH direct deposit, for payroll, dividends, retirement benefits, and other purposes, still has lots of room to grow.

With nearly all of the growth in retail payments happening on the electronic side, and checks declining at, say, 3 percent annually, electronic volumes will surpass check volumes by about 2006.

There always will be checks in the U.S. Probably there will be many billions of checks for the forseeable future. For the long run, though, it is a declining product, a conclusion which has significant implications for all of us.

I like to say that no organization in America has done more over the past 30 years to promote a more electronic payments system than the Federal Reserve. As just one example, we subsidized the ACH for nearly 15 years, both before and after the Federal Reserve began to price its payment services, just to help it to stay alive when too few businesses were using it for too few payments. So, we are glad to see the paper check system declining, and electronic mechanisms growing. Electronics can reduce costs, reduce risks, and accelerate payment flows and collection of funds.

Our business problem is that check collection is our biggest business. And now it is a declining business. We are quite prepared to see our check volumes diminish, and to reduce the scale of our check operations. However, we really will be challenged to continue to provide check collection services for every depository institution in the country, and to recover the full costs of our services in fees, as volume declines.

As check usage declines, the unit cost to collect a check will increase, given the high fixed and quasi-fixed costs in the paper check system. So, the Reserve Banks have to work smarter, and re-engineer, and find every way, large and small, to reduce costs, and generate revenue from value-added services to our customers.

We have been at work in this direction for some years now, including migration to a new standard national automation platform, so that every one of our 45 check processing offices across the country will use the same software, and have its check sorters driven by computers in our national data centers. We know that we will have to make many more changes, and we are hard at work now to look at the future as best we can, and plan for the changes that will enable us to continue to collect checks and recover costs. We will be eager to tell you much more about this as we proceed.

When it comes to the implications for banks, you will be well aware of them, and the effects on each of your banks will differ according to your customer base, your services and ways of generating revenue, and so forth. However, in broad strokes here are a few implications that might be helpful in your own strategic planning.

For many banks, checks generate a lot of revenue. Even with "free checking", fee income tends to be substantial. Fees for bounced checks, and for overdrafts on checking accounts, can be significant. The balances in most checking accounts cost banks little or no interest. And even the fees for new supplies of checks amount to quite a bit at some banks. A steady decline in the use of checks could mean a steady decline in these revenue streams.

When merchants convert checks into ACH payments at the point of sale, those merchants no longer come to a local bank each evening with a pile of checks to collect, and of course that takes some revenue away. Moreover, they may be consolidating all of the ACH payments from all of the stores in their chain with one bank, maybe across the country.

It is interesting to realize that merchants, and billers, are going to be influencing the choices that a bank's customers make about payments. When the merchant discourages checks, or converts the checks, or pushes debit card use, that affects bank revenues.

The banks provide the customer accounts, with balances in them, upon which all the payment mechanisms depend. And the banking system provides the essential infrastructure for these mechanisms, including the electronic networks and the ACH, which is the low-cost, electronic way to move money between accounts. Meanwhile, new payment choices, often built or driven by non-banks, ride on top of the bank accounts and the infrastructure. They could not work without the banks and the banks' systems, but these new mechanisms will displace a lot of revenue tied to the paper check. Banks will have to make up this revenue in new ways, and may be hampered by some of the high-profile attention that new fees, such as ATM fees, for instance, have received over the years.

Banks will be bearing the costs of continuing to offer checking services, while competing with electronic payment providers that do not have to offer paper-based services. The competition can focus only on electronics, while the banks cannot, at least not in the foreseeable future.

So, like the Reserve Banks, commercial banks, large and small, have some challenges to address.

One challenge we all should take up as an essential objective, is to make check collection less costly. To do so, we have to make the check system a lot less paper-intensive and a lot more electronic. We have to move away from the traditional model of handling each paper check several times in two or three different banks, with a couple of legs of air or ground transportation in between. I think the prospects for rising costs and declining revenues may inspire more banks to try electronic check presentment, or ECP, in one form or another, if they can see that it will reduce costs. ECP, backed up by check image services, when brought to scale, can reduce costs and help banks to provide high-quality services to their customers.

The Reserve Banks have been working to promote ECP and to offer image services for many years now. In fact, nationally we present electronically about 22 percent of the checks we collect. Now we have a new national check image capture and archival system coming into production, offering new services, including letting a bank access our archive via the Web to retrieve any or all of its check images.

Some of the largest banks in the country also are building systems and testing processes to increase the use of ECP, and to make check images available to each other. And all major service bureaus are offering image services to their bank customers.

Up to now, many may have been looking at ECP and check image technology as interesting options which might work well in particular niches. The changes now visible in retail payments are likely to "up the ante" for the banking industry. Declining check volumes are likely to compel broader efforts to get costs out of the check system. More electronics and less handling of paper will help us to do so.

As a final bit of news in this regard, please take note of some new Congressional legislation, called the "Check Truncation Act" or "Check 21". The Federal Reserve Board played a leading role in working with the banking industry, consumer groups, and others to bring forward a proposal to facilitate electronic collection of checks, buttressed by image technology. Among other features, this legislation would make printed copies of images legally equivalent to the original checks under certain conditions.

At the Boston Reserve Bank and across the Federal Reserve System we find ourselves facing an environment we wanted to bring about: the decline of the paper check, at long last, and the rapid ascendancy of electronic choices for American consumers and businesses. We have many adjustments to make, no doubt with difficulty. This is where we should be, though, given our mission to support a more effective and efficient payments system.

Some of our challenges will be your challenges, too. We look forward to working with you and continuing to help each other.