The Evolving Role of the Federal Reserve in the Payments System
Good morning. It's a pleasure to be with you here in New Orleans at this comprehensive and exciting conference. Just looking at the program serves as a reminder of how fast the pace of change is now in a wide range of technologies and financial service products. And it also highlights how important payments system issues have become to both central banks and the financial services industry. Over the years values, volumes, and the potential for risk have escalated to the point that the consideration of payments systems is a key focus in central bank meetings in Basle, in government policy-making around the world, and in the board rooms of major financial and nonfinancial companies everywhere. And it's not just the massive impact of the wholesale business that attracts attention and concern. Retail payments draw keen interest both because of the potential presented by technological change and because of the intense interest of bank and nonbank competitors alike in capturing the consumer and business market for new payment types and information services.
Of course, some of the keen interest in this conference reflects the health if not the sheer global dominance of the U.S. financial industry in general, and U.S. banks in particular. The U.S. banking system is as well capitalized, and profitable as it has been at any time in its history--a model for and envy of a world that just ten or fifteen years ago could find little to praise about it. How has this been accomplished? Sound macroeconomic policies, focused on low inflation and ever-lower budget deficits, of course, are critical. But just as critical has been the determination of U.S. banks and financial institutions more generally to develop new products, improve risk management techniques, adopt new technologies, and focus on both service quality and efficiency as never before. Reflecting this, the industry is experiencing a massive and ongoing consolidation process, and has produced institutions that thrive on global competition and seek to maximize the profit potential in every aspect of the business.
The beneficial impact on the payments system of this progress is obvious. Through central bank processing systems alone now go $1.8 trillion in funds and book entry security transfers, nearly 14 million ACH payments, and almost $2.0 trillion in gross settlement entries for private net settlement systems on a daily basis. This is done with an ease and operational reliability that belie the technical complexity involved, and that would have been a dream only a few years ago. Levels of private and Reserve Bank daylight credit are recognized, monitored, and, if necessary, capped; extensive contingency facilities exist; compatible message formats ease the exchange of payments instructions between systems, and expanded hours create greater overlap in the hours of international payments systems facilitating timely settlement. Even in the mundane world of check processing, new processing techniques, digitized imaging, the gradual willingness of banks to receive presentment data electronically and the excitement about new retail payments methods to replace the check auger well for a complete transformation of the retail payments process. Moreover, as more institutions see payments as a profit center, and as they are challenged by new nonbank entrants, the inevitability of such a transformation becomes obvious.
But the more things have changed for the better, the more they remain the same. Large, globally-oriented financial institutions are linked by the payments system in a web of interconnectedness that grows in complexity with the size of the institutions involved. Systemic problems may be less likely due to newly developed risk management techniques and more sophisticated bank supervision, but the cost of such problems, if it could ever calculated, likely dwarfs any previous estimate. Moreover, given technological change, systemic problems could spread more quickly than ever before, dramatically increasing the scale and scope of a problem, should one occur. Expanded hours for funds transfers now exist, but does the increasing importance of payments and securities systems require 24 hour a day, seven day a week operations? The development of real-time national gross settlement systems is an important step forward for central banks around the world. However, there is a natural tension between such systems and the more efficient net settlement processes that reduce the number of transactions and improve efficiency, but make the size and nature of the risks involved less transparent. Technology provides the easy blurring of any distinction between electronic wholesale and retail payments systems providing the potential for values to grow in systems not broadly designed for such use.
Finally, despite all the industry's efforts for decades, we are really not much closer to eliminating the paper involved in retail payments--U.S. businesses and consumers wrote 65 billion checks last year, and the organizations represented in this room had to process and clear them. It's a profitable business, to be sure, and one that increasingly results in faster availability and lower float, but one that cries out for faster, easier-to-use and more electronic alternatives that enhance information flow as well as payment settlement. The ACH is nearly 30 years old, but, except for significant progress by the U.S. Treasury, and for direct payroll deposits, this form of electronic payment has not reached its potential. Clearly, consumers want more control over payment initiation, a fact that has spurred innovation in any number of access technologies. But which one of these offers the best prospects for broad-based change? These are the challenges that have brought you to this conference, and these are the challenges that confound the private sector and the Federal Reserve alike.
Amid this environment of continual evolution and challenge, what is the role of the Federal Reserve System? The System began with the mandate to make nationwide payments possible, and it has pursued that task as a regulator, as a competitively-driven participant, and, as a catalyst for change in such areas as payments system risk, MICR encoding, ACH technology, and digitized image standards and processing. The System's presence in the wholesale arena is a given; today's markets would find it difficult to function without the immediate finality and intraday central bank credit those systems provide.
However, with the advent of interstate banking, a nationwide private sector retail payments system can and perhaps should become predominant. Nonetheless, I would argue that this development in no way diminishes the role of the Federal Reserve. Rather, the need for central bank involvement in the fundamental issues of payments system accessibility, efficiency, and integrity is as important as it ever has been given the extent and pace of potential change. The System's processing role may well diminish with the consolidation of the U.S. banking system, but the more overriding central bank role in the payments system must remain strong and evolve with the industry. I see this evolution occurring in response to four basic goals.
First, the Federal Reserve needs to ensure that the U.S. payments system supports economic growth. A highly efficient payments system provides liquidity to fund the money and capital markets that are the lifeblood of economic progress. Indeed, these markets have been a foundation for this country's growth and are unambiguously the broadest, deepest, and, in many senses, the best in the world. How can this important aspect of payments systems be fostered and encouraged going forward? I would argue that an efficient payments system has at least two critical characteristics: open access and a competitive, level playing field. Over the years, working as a major participant and a regulator, I believe the Federal Reserve has acted to increase access and foster competition. I believe it should remain committed to those important hallmarks in the future as well.
Can these important payments system hallmarks be preserved without a major operational role for the Reserve Banks? Perhaps, but the commitment of the Federal Reserve to providing access to the payments system at fair prices and reasonable service levels is recognized by smaller depository institutions as important. Moreover, in times of turmoil or change, Reserve Bank processing facilities provide an alternate source of service to private-sector intermediaries that can help normalize payment flows. Finally, by fairly competing with the private sector--as I believe on balance the System has over the period since the passage of the Monetary Control Act--the payments system as a whole becomes more efficient. Going forward, I believe the Federal Reserve must continue to work diligently to ensure that competition is enhanced.
Now, I think this can be done through regulation, and through innovative service offerings. Several examples come to mind. First, the Federal Reserve Board has requested public comment on the pros and cons of extending the presentment deadline for private-secctor same-day settlement. This creates a larger daily window during which the private sector arguably can compete directly with Reserve Bank presentment services. There is a cost, especially to the paying bank, but this is an extension of existing regulatory policy that warrants consideration. On the service side, the Reserve Banks are developing a new automated net settlement process. This system will support same-day finality over Fedwire for private sector net settlement services and will enhance the finality and ease of use of such services. This should provide a basis for the development of new depository institution services that provide options to the use of Federal Reserve payment services. The Reserve Banks are also working closely with their customers and other constituencies to develop and deliver innovative national and local check services and enhanced ACH services that will help the banking industry respond effectively to their corporate and retail customers.
Finally, innovation in processes of both initiating and accessing payment networks abounds as a result of technological change. We see expanding use of debit cards, smart cards, and internet transactions, to cite a few examples. I believe the Federal Reserve needs to understand the nature of this innovation and to continually evaluate whether the new products and systems act to strengthen the payments system or, potentially, to weaken it. I do not believe that this calls necessarily for either additional regulation or a Reserve Bank operational presence. As these instruments and payments methods evolve, if abuses or public policy concerns result, regulatory issues related to consumer protection, privacy and security may need to be considered.
In addition, I do not rule out a Federal Reserve role in providing leadership in the tough issues of standards-setting, and, perhaps, some form of back-office service for which it may be, at least initially, the best alternative. One example that comes to mind here might be the provision of image archive services--if image technology were to be used more extensively in either the forward collection or return process. For a time, it might be possible for the Reserve Banks to leverage the knowledge and technology acquired to support Treasury digitized image efforts, speeding the absorption of this technology and potentially developing a market for other competitors.
As a second goal, the Federal Reserve should ensure that payments system risk is well managed, both domestically and internationally. Here, as I noted earlier, we've come a long way, both in the world in general, and in the U.S. payment system particularly. But I also would argue that we cannot afford to be complacent.
Several areas strike me as important for ongoing risk management work. Real-time gross settlement systems have come into being in most of the industrialized world, but progress is slower in developing and transitional countries. Private sector net settlement systems continue to offer much in the way of transaction efficiency and lower intraday liquidity requirements and are bound to be attractive for those reasons. Such systems can make risks less transparent than they would be on central bank books, but the trade-off of risk and cost is not easily assessed. The Federal Reserve's new net settlement service may provide a hybrid alternative here that can address both efficiency and risk concerns.
Hours of system operation need to be evaluated to ensure support for the continuing increase in traffic and risk. Retail electronic payments systems need to be viewed on a continuum with wholesale systems, with an eye to ensuring that transaction pricing and service levels do not have the unintended effect of increasing risk. Finally, data security is a critical element in risk management and I believe the Federal Reserve must remain committed to the search for better and better methods of safeguarding electronic transactions.
As a third goal, the Federal Reserve should ensure that payments systems are resilient in the face of expected and unexpected crises. The major challenge to system resiliency facing the world is preparing and implementing the systems needed for century date change. Reserve Bank payments systems are on track to becoming century date compliant by mid-year 1998, and at that time the complex period of customer testing will formally begin. Customer testing will be extremely important. It is essential that you test your critical systems, including your interfaces with Reserve Banks, as early and as comprehensively as possible.
On the regulatory side, the System has issued advisories alerting depository institution management to risks and establishing compliance benchmarks and required reporting. Every supervised institution will be examined for year 2000 readiness by June 1998, and this will continue until the millennium change. The Federal Reserve is also studying contingency scenarios, aware that no matter how perfect the planning is, something can go wrong. Knowing how to respond, and what can and cannot be done is important, both as we make progress in implementation and face the reality of January 1, 2001.
Finally, last, but certainly not least on my list of goals, the Federal Reserve must ensure that it works with the industry in mutually shaping the payments system of the future. Last year, the Rivlin Committee asked private-sector payments system participants to consider five scenarios for Federal Reserve involvement in the retail payments system--from exiting to a more proactive operational leadership role. In over 50 meetings nationwide, payments system participants told System management over and over again that the Federal Reserve should remain a competitive provider of retail services for the good of the overall payments process, and develop a stronger leadership role in improving that process and moving retail payments to electronic form.
Of necessity, such a leadership role hinges on the ability to coordinate disparate players around a series of critical issues, and establish appropriate goals for retail payments system development. Challenges abound: how to educate the consumer about the advantages of electronic payments; how to sort through the pluses and minuses of dynamic, competing technologies, and how to coordinate among the participants of a very decentralized network of more than 10,000 banks and other service providers.
I believe the Federal Reserve can be critical here as collaborator and educator. Since 1995, the Federal Reserve in collaboration with NACHA, the local ACH Associations, the U.S. Treasury, and the Social Security Administration has carried out marketing campaigns to financial institutions, selected industry sectors and non-profits about the benefits of direct deposit and direct payment. In the wake of the Rivlin effort, we will engage further in customer-focused ACH market research to better understand the barriers to ACH use and how to fashion incentives that will produce a broader user base.
In the area of emerging payments, the work of the Rivlin Committee will continue. The Committee will work with the industry to form a senior-level advisory group to advance the mutual understanding of the cost-benefit trade-offs of broad-based retail payments change, and the various forms in which such change could occur. The Federal Reserve's current efforts with the Treasury on its EFT99 mandate, on financial EDI, and on an E-check pilot will certainly be useful here in informing both the System and the industry of the operational and market realities of these new products.
In closing, I think we would all agree that the pace of change in the payments system is as fast and daunting as at any time in recent memory. In the face of such change, it's tempting to cling to old models and roles as an island of stability. However, to do so would be to thwart the benefits change can bring. I believe the Federal Reserve, no less than the private sector, must embrace the changes taking place but with a clear focus on the fundamentals--accessibility, efficiency, and integrity. In that regard, working with the industry becomes ever more important. Models of partnership between the System and the industry have been established over the years--now is the time to carry these forward into the emerging payments world. As I see it, the Federal Reserve can work with you:
- as a mediator, building consensus through operational experience and through work on such often overlooked areas as standards development;
- as a co-innovator, bringing technology and new and enhanced services to participants in new ways;
- as a technology developer, applying the benefits of image efforts for the Treasury to commercial check processes;
- as a co-educator, teaching depository institutions the benefits of financial EDI, increasing the use of electronic payments, and working to increase corporate and consumer knowledge and use of the ACH and other forms of electronic payments; and
- as a collaborator, in assessing market needs, trends, regulatory needs, if any, in defining the goals and the framework of the U.S. payments system of the future.