The Federal Reserve and the U.S. Retail Payments System
In our paper Bob Eisenmenger and I have described examples of the Federal Reserve undertaking important initiatives in the U.S. retail payments system. The examples include:
- Fostering the development of new computer-driven check sorting equipment to help to bring automation to the check clearing process, 40 years ago;
- Stepping forward to provide operational support for the automated clearing house, or ACH, America's first retail electronic payment mechanism, during the 1970's, when hardly anyone was familiar with the "direct deposit" and "direct payment" products of the ACH;
- Using regulatory authority and operational services to implement an act of Congress, the Expedited Funds Availability Act of 1987, so that consumers who deposited checks could enjoy the use of their money earlier while risks in the banking system were reduced;
- And a lengthy research and development program during the 1980's and 90's to test the application of digitized image technology to check processing.
These examples help to illuminate the essence of the Federal Reserve's roles, as participant and as regulator, in the national payments system. That essence is to serve the public interest; to improve continuously the way the system works for American consumers and businesses, making it more efficient, more reliable, and safer.
We can take a number of lessons from the examples in our paper. These lessons can help us to understand better the significance of those past undertakings, and may help us to think about the roles the Federal Reserve might play in the evolving future retail payments system.
One lesson is that, at least occasionally, innovations with potential benefits for the overall payments system, and indeed for society, will languish, unless the Federal Reserve or some other entity with broad-based, longer-term benefits in mind will pursue them.
Some of us here at the Federal Reserve Bank of Boston saw this vividly when we started to explore digitized image technology in 1984. Some equipment manufacturers and large banks had believed for some time that the technology - basically, taking electronic pictures of checks and being able to store them and transmit them - could do a lot to improve check processing and collection if it worked, and especially if it could produce good-quality images on the high-speed check sorters used by large banks with the largest volumes of checks. However, high-speed check image technology had not been developed.
Nobody knew whether it would work. It would be expensive to find out, and the money spent to find out might be spent for nothing. So, nobody had acted on this possibility, until the Federal Reserve did.
Over a period of about 10 years the Federal Reserve spent over 20 million dollars, to develop a specific service for the U.S. Treasury, but also to advance everyone's knowledge. Once the research had shown that the technology would work, the manufacturers and the banks moved ahead with their applications for it. And so did the Reserve Banks, in the check services they provide to depository institutions.
This same understandable reluctance or inability for most private entities to step forward without a clear business case led to the Federal Reserve's operational role in the Automated Clearing House, or ACH. When the ACH began in the early 1970's "direct deposit" and electronic bill payment were new ideas that did not offer near-term profit opportunities. The expected longer-term benefits of a more electronic payments system for the country motivated the Federal Reserve to mobilize its resources to support the ACH and subsidize it for more than a decade.
A second, related lesson is that the Federal Reserve can be effective as a collaborative partner to implement ideas initiated by others. The idea for the ACH, for instance, was developed by the clearinghouses in California and other banking industry leaders, in the United States and in Europe. The U.S. bankers needed operational support to bring the idea to life as a national electronic payment mechanism. The Federal Reserve, led by Governor George Mitchell, helped the banking industry to move its own good idea ahead.
Similarly, the banking industry, through a project of the American Bankers Association in the 1950's, invented the "MICR line" - those funny-looking black numbers printed on the bottom of paper checks in magnetic ink. That MICR line standard prepared for the automation of check-sorting, which into the 1960's still was done by hand. The banking industry and the Federal Reserve wanted to encourage several firms to develop a variety of solutions which could enable banks of all sizes to gain the benefits of automation, and enable all banks to gain the benefits of competition among multiple manufacturers. So, five Reserve Banks subsidized the testing of prototypes from five firms, for the benefit of all participants in the check system.
A third lesson is that the Federal Reserve's operational role in processing payment transactions adds to its capacity to improve the payments system. In the development of equipment to sort checks, the Federal Reserve did not just provide a financial subsidy. The Reserve Banks contributed the time and expertise of their check managers and staff, and used portions of their "live work" to test the prototypes.
In the late 1980's, after the Congress passed the Expedited Funds Availability Act to give consumers faster access to their deposited funds, the Federal Reserve Board was obliged to implement the Act with regulations. Due to the System's lengthy experience as a service provider, staff at the Board and in the Reserve Banks had developed detailed, expert knowledge about how checks were collected, and bounced checks were returned. In addition, they had been working for some time with senior operational people from a cross-section of the banking industry to develop ideas for improving the check return process.
This solid operational knowledge allowed the Federal Reserve to propose and subsequently adopt regulatory change which was both ambitious and practical, and effected important improvements in the check system.
As a final lesson for today, standards are essential for a unified national payment mechanism accessible to many participants, and support from an entity with a concern for the broad payments system, more than for its individual interest, sometimes is needed to put a standard in place.
The Federal Reserve has played three distinguishable roles in standards-setting. One has been to see the need for a standard earlier than others, and to take the lead in bringing parties together to develop a standard. In the work on check image technology, the Federal Reserve, with an eye toward the overall payments system, focused on the importance of banks being able to exchange check images produced by different systems, while most banks were focused on how to use the technology for internal efficiencies or services to their own customers. Thus, the Federal Reserve joined with the American Bankers Association to organize a standards work group, and led the work group that brought forward the current standard.
Another role has been to complement the standards work of the private sector and use regulatory authority to bring a standard into common practice. As part of the effort to implement the Expedited Funds Availability Act in 1987 and 1988, the Board of Governors proposed a check endorsement standard - a standard essential to accelerating the check return process - which for the most part had been developed by bankers, equipment-makers, and printers through the American National Standards Institute. The Board's standard settled the few remaining issues that competing firms had not been able to settle among themselves. Then, after a public comment process, the Board's regulatory authority ensured that the standard would be adopted widely and swiftly.
And a third role has been to help the private sector to get its standards into use. Over a ten-year period in the 1950's and 1960's the Reserve Banks worked with large and small depository institutions to persuade them to put that new magnetic ink onto the checks they provided to their customers. Then, in 1967, to support the industry further, the Reserve Banks announced that checks that did not comply with the standard would not be accepted for normal collection. This measure put the industry's own standard "over the top".
Our paper intends to show that the Federal Reserve has advanced the payments system and served the public interest in a variety of ways. What about the future?
The U.S. retail payments system will become more electronic. In its operational role, the Federal Reserve can help this trend along by leading and supporting efforts to make check collection more electronic, and efforts to enhance the ACH and promote its use.
New electronic payment mechanisms may not include much of an operational role for the Federal Reserve. Indeed, some of them may not even be operated by banks, although they may interface with bank-based mechanisms, such as the ACH, to settle the transactions done through non-bank channels. The Federal Reserve does not have to have a hands-on, operational involvement in all payment mechanisms to foster improvements in the payments system. However, such hands-on involvement has proven beneficial in the past, and if the System finds that a new operational role will serve public purposes in the future it should be prepared to assume that role.
In addition, the history Bob and I have reviewed demonstrates that the Federal Reserve can help to advance the payments system in other ways:
- As a collaborative partner;
- As a judicious, informed regulator;
- As a researcher;
- As an educator;
- As a developer and advocate for essential standards;
- And as a stakeholder with a unique combination of operational savvy, and commitment to continuous improvement of the overall payments system for the benefit of the public.