GAO

United States General Accounting Office

Report to Congressional Requesters

November 2000 FEDERAL RESERVE 

SYSTEM

Mandated Report on 

Potential Conflicts of 

Interest

GAO-01-160

Page 1 GAO-01-160 Federal Reserve System

Contents

Letter 3

Results in Brief 4

Background 7

The Federal Reserve Maintains Policies to Address Potential 

Conflicts of Interests 10

The Board Has Removed Some Disparities between the Private 

Sector and Reserve Banks in Providing Check and ACH Services, 

but Others Remain 15

Questions About the PSAF and Pension Cost Credits Have Raised 

Concerns About the Federal Reserve’s Pricing 22

The Federal Reserve Has Promoted the Use of its Products Through 

New Product Development and Marketing 29

Conclusions 36

Recommendations 38

Agency Comments 38

Appendixes Appendix I: Objectives, Scope, and Methodology 42

Appendix II: Check Relay 45

Appendix III: The Federal Reserve’s Pricing Process 51

Appendix IV: Comments From the Federal Reserve System 56

Appendix V: GAO Contacts and Staff Acknowledgments 59
Contents

Page 2 GAO-01-160 Federal Reserve System

Abbreviations

ACH automated clearinghouse

BHC bank holding companies

Board Federal Reserve Board

DRBOPS Division of Reserve Bank Operations and Payments Systems

EFAA Expedited Funds Availability Act of 1987

EPN Electronic Payment Network

FAS Financial Accounting Standard

FDIC Federal Deposit Insurance Corporation

Federal 

Reserve Federal Reserve System

FSPC Financial Services Policy Committee

GAAP generally accepted accounting principles

ITS Interdistrict Transportation System

MCA Monetary Control Act of 1980

MICR magnetic ink character recognition

NACHA National Automated Clearinghouse Association

OIG Office of Inspector General

PACS Planning and Control System

PSAF Private Sector Adjustment Factor

PSO Private Sector ACH Operator

RCPC Regional Check Processing Centers

Reserve

Banks Federal Reserve Banks
Page 3 GAO-01-160 Federal Reserve System

United States General Accounting Office

Washington, D.C. 20548

Page 3

Letr

November 13, 2000

Congressional Requesters:

This report responds to a mandate in the Gramm-Leach-Bliley Act of 1999 

for us to study the potential conflicts of interest faced by the Federal 

Reserve System (Federal Reserve) in its role as a central bank, payment 

services provider, and regulator of the banking system.1

 The payments 

system is the system of mechanisms, both paper-based and electronic, for 

moving funds among financial institutions throughout the nation. In this 

report, we discuss the Federal Reserve’s role in providing check collection 

and automated clearing house (ACH) services, which are often referred to 

as retail payments.2

 To encourage competition between the Federal 

Reserve and private sector providers of payment services, the Monetary 

Control Act of 1980 (MCA)3

 requires that the Federal Reserve charge fees 

for payment services that it once provided to its members free of charge. 4

The Federal Reserve comprises the Federal Reserve Board (Board) and 

Federal Reserve Banks (Reserve Banks). The Board provides oversight 

over the operations of the Reserve Banks and serves as a regulator of check 

collection in the United States. As the regulator of check collection, the 

Board establishes regulations for the Reserve Banks and their private 

sector competitors. The Federal Reserve also serves as a central bank and 

banking industry regulator. In fulfilling these varying roles, with their 

different goals, the Federal Reserve could potentially encounter conflicts 

of interest. 

To fulfill the mandate, our objectives were to (1) identify organizational 

relationships and differing goals within the Federal Reserve that could 

1

 Pub. L. No. 106-102 § 728 (1999). 

2

 Check collection refers to the process of sorting checks according to the bank on which 

they are written and presenting the checks to those banks for payment. ACH is an electronic 

interbank payments system used for small and recurring payments, such as direct deposit of 

payrolls or automatic payment of other bills.

3

 Pub. L. No. 96-221, Title I, § 107 (1980); 12 USC § 248a.

4

 In addition to commercial banks, thrifts and credit unions also purchase payment services 

from the Federal Reserve.
Page 4 GAO-01-160 Federal Reserve System

present a conflict of interest and identify Federal Reserve policies for 

managing or avoiding any conflicts; (2) identify any competitive advantages 

enjoyed by the Federal Reserve compared to its private sector competitors 

and evaluate the extent to which the Federal Reserve, through changes to 

its regulations and operating policies, has or has not removed them; (3) 

review how the Federal Reserve has priced its services; and (4) review 

Federal Reserve policies for developing and marketing its services.

We focused our review on the Federal Reserve’s retail payment services, 

which include check collection and ACH services. These activities account 

for almost 90 percent of the revenue generated by the Federal Reserve’s 

payments services. In addition to Federal Reserve staff, we interviewed 

private sector competitors, customers, and other concerned parties. We 

sought any indication or evidence of breaches of the Federal Reserve’s 

policies separating its various roles in the payments system. We also 

followed up on allegations raised by others of breaches of the Federal 

Reserve’s separations. We conducted our work in Hartford, CT; 

Washington, D.C.; Atlanta, GA; Boston, MA; New York, NY; Pittsburgh, PA; 

and Dallas, TX, between March and October 2000, in accordance with 

generally accepted government auditing standards. We requested 

comments on a draft of this report from the Board. The Board’s comments 

are discussed near the end of this letter and are reprinted in Appendix IV. 

We incorporated the Board’s technical comments where appropriate. 

Appendix I describes our scope and methodology.

Results in Brief The Federal Reserve has multiple goals and internal relationships that 

could potentially conflict, but the Federal Reserve has taken steps to 

manage these conflicts by separating staff engaged in its various roles 

when their interests could potentially conflict. These separations are 

designed to prevent the passage of information within the Federal Reserve 

that could provide the Reserve Banks with an advantage in their 

competition with the private sector. The separations also serve to limit the 

influence the Reserve Banks can exert on the Board as a regulator of check 

collection. The Board provides oversight of the Reserve Banks’ check 

collection and ACH operations and also serves as a regulator of the check 

collection system in the United States. In some cases, the goals of the 

Board as a regulator of check collection may not be consistent with those 

of the Reserve Banks, which compete with the private sector to maintain 

and/or expand their customer base. For example, to promote efficiency of 

the check collection system, the Board has sought to encourage 

competition by removing competitive advantages enjoyed by the Reserve 
Page 5 GAO-01-160 Federal Reserve System

Banks. In addition, some of the Federal Reserve’s competitors in check 

collection are banks that are subject to Federal Reserve examination, 

which may raise concerns that Reserve Bank staff involved in providing 

payment services could benefit from information about the operations of 

private sector competitors obtained during regulatory examinations. 

To address potential conflicts of interest, the Board maintains policies and 

procedures to ensure the separation of the various roles of the Federal 

Reserve, including policies against inappropriate communication between 

Reserve Bank staff who examine banks and Reserve Bank staff who 

provide payment services. In providing oversight of the Reserve Banks, the 

Board is involved in establishing policies that govern the payments and 

other operations of the Reserve Banks. When addressing general oversight 

issues, the Federal Reserve does not have policies that establish 

separations between Board and Reserve Bank staff. However, during 

regulatory rulemaking that affects the check collection system, under 

Board policy, Reserve Bank staffs are kept at arm’s length from the Board 

and are afforded no more access to the Board’s deliberations than other 

payment system participants. During our work, we found no evidence to 

suggest that the Federal Reserve has not adequately separated its multiple 

roles.

Because of inherent differences between the Reserve Banks and their 

private sector competitors, it is unlikely that all competitive disparities 

between them can ever be removed without changing the structure or 

nature of the various institutions. However, the Board has tried to remove 

some of the competitive advantages enjoyed by the Reserve Banks in 

providing check and ACH services to the banking industry. For example, in 

1992 the Board adopted the same-day settlement rule, which allows all 

check collection providers to obtain settlement for checks, without paying 

a fee, from any bank on the same day checks are presented. Prior to this 

change, only Reserve Banks could do this. The Board has proposed to 

remove some of the advantages Reserve Banks enjoy in providing ACH 

services by virtue of their dominant market share; however, private sector 

ACH operators (PSOs) said the proposal would not promote greater 

competition because it does not correct the pricing inequities that have 

resulted in an unfair competitive environment. Reserve Banks and their 

private sector competitors each have other unique advantages in 

competing for payments business that are likely to remain over time 

because the advantages are inherent to their natures and structures. 

Reserve Banks, for example, have automatic access to banks’ reserve 

accounts, a dominant market presence, and a later deadline to present 
Page 6 GAO-01-160 Federal Reserve System

checks to banks for same-day payment. Conversely, private sector 

competitors have more flexibility in pricing their services, negotiating 

terms and conditions, and choosing their customers. 

In setting prices, the Federal Reserve has complied with the requirement of 

Section 107 of MCA that the Reserve Banks recover total costs for the 

payment services it sells to depository institutions (priced services). MCA 

requires the Federal Reserve, when developing its prices, to include a 

private sector adjustment factor (PSAF) that is intended to simulate the 

costs of capital and other costs and profits that would apply to its private 

sector competitors. Developing the methodology for the PSAF has always 

been challenging because of the Reserve Banks’ unique structure and 

operation and a lack of perfectly comparable private sector competitors. 

However, the consolidation of the financial services industry and the 

changing nature of the payments industry have renewed questions about 

whether the current PSAF methodology should be revised to more 

accurately simulate private sector pricing conditions. The Federal Reserve 

is in the process of its periodic review of the methodology. Although the 

Federal Reserve plans to publish any revisions for public comment, it has 

not included non-Federal Reserve participants, such as industry officials or 

academics, when reviewing its PSAF methodology. By limiting the 

involvement of these groups to a public comment period, the Federal 

Reserve may be missing an opportunity to build on the varying perspectives 

these groups could provide throughout the process. In addition to 

questions about the PSAF, some competitors of the Federal Reserve 

question its use of credits to offset expenses allocated to payment services 

when developing prices. Although the Federal Reserve uses generally 

accepted accounting principles to account for its pension credits, the 

Federal Reserve’s use of the credits has been controversial because it has 

offset operating expenses for priced services and has allowed the Federal 

Reserve to meet its targeted return on equity, as required by MCA, without 

having to raise prices and/or cut costs.

The Reserve Banks have worked to actively develop and market payment 

products with the objective of developing a set of products and prices 

designed to appeal to a variety of banks, including those that operate 

nationally. The Reserve Banks’ marketing efforts include the maintenance 

of nationally coordinated sales staffs. The Reserve Banks differ in how they 

manage their sales staffs, with some of the Reserve Banks providing 

bonuses to sales staff, based on preset goals. The Federal Reserve’s process 

for approving and announcing new products varies on the basis of its 

assessment of the expected competitive impact of the product, or the 
Page 7 GAO-01-160 Federal Reserve System

extent to which the product represents a significant change that could have 

major policy or other implications. The Federal Reserve has shifted the 

review and approval that it requires for some products from the Board to 

the Reserve Banks in an effort to streamline the product development 

process. In addition, some products that may have once been the subject of 

a request for public comment in the Federal Register might now be 

introduced without a request for comment. This has raised concerns and 

misunderstandings among the Reserve Banks’ competitors about how the 

Federal Reserve applies its policies and procedures. Although Federal 

Reserve policies in this regard have been in place for some time, Federal 

Reserve implementation of the policies has, in some cases, changed over 

time. 

This report contains recommendations to the Federal Reserve to (1) solicit 

input from individuals from outside the Federal Reserve, including 

academics and industry officials, at an earlier stage in future reviews of the 

PSAF methodology and allow them to participate throughout the review 

process, perhaps including the evaluation of comments on any proposed 

PSAF revision, to determine if there are better ways to structure the PSAF; 

and (2) clarify its policies and procedures for introducing new products 

and product enhancements and make those policies more readily available 

to its private sector competitors. 

Background The Federal Reserve, the nation’s central bank, consists of the Board of 

Governors located in Washington, D.C., and 12 Reserve Banks with 25 

branches located throughout the nation. The Board is a federal agency, and 

the Reserve Banks are federally chartered corporations. The Board is 

responsible for maintaining the stability of financial markets, supervising 

bank holding companies and banks that are members of the Federal 

Reserve, and overseeing the operations of the Reserve Banks. The Board 

has delegated some of these responsibilities to the Reserve Banks, which 

also provide payment services to depository institutions and government 

agencies.

The Federal Reserve plays a significant role in the nation’s payment system. 

The 12 Reserve Banks with their 25 branches offer payment services to 

depository institutions. The Reserve Banks distribute currency and coin; 

provide funds transfer, automated clearing house, and securities transfer 

services; collect checks; and provide settlement services for depository 

institutions. The terms and conditions under which they provide payment 

services are governed either by regulations of the Board or by internal 
Page 8 GAO-01-160 Federal Reserve System

policies adopted by the Board in its oversight capacity and by the Reserve 

Banks’ operating circulars. Under the Federal Reserve Act, Reserve Banks 

are subject to the general supervision of the Board. This authority of the 

Board includes oversight of the Reserve Banks’ services to depository 

institutions, which is primarily conducted by the Division of Reserve Bank 

Operations and Payments Systems (DRBOPS). Payment transactions 

initiated by banks are settled through a debit or a credit to a bank’s account 

maintained for reserve or clearing purposes, or through the account of a 

designated correspondent. 5

Section 107 of MCA requires that the Federal Reserve charge fees for 

payment services that it provides to depository institutions. Prior to the act, 

the Federal Reserve provided payment services to its members without an 

explicit charge. MCA identifies the following as payment services for which 

the Federal Reserve should charge fees: check clearing and collection 

services, automated clearing house, wire transfer services, currency and 

coin services, securities safekeeping services, settlement services, and 

Federal Reserve float.6

 These payment services are referred to as priced 

services. MCA requires that the Federal Reserve recover all costs for priced 

services over the long run. In addition, MCA requires that the Federal 

Reserve calculate a PSAF to simulate the expenses and profits of a private 

sector firm providing such services.

The Expedited Funds Availability Act (EFAA) gave the Board additional 

authority to regulate the check collection system.7

 Prior to EFAA, the 

Board could promulgate rules for checks collected through the Reserve 

Banks. The Board’s Regulation CC, which implements EFAA, includes a 

number of provisions designed to improve and accelerate the collection 

and return of checks. Since the original drafting of Regulation CC in 1988, 

the Board has proposed a number of rule changes or amendments to the 

regulation. These have included various clarifying technical amendments 

to the regulation and other, more substantive changes. The more significant 

5

 A Federal Reserve account is an account that depository financial institutions maintain 

with a Reserve Bank. The balance in a Federal Reserve account is maintained for purposes 

of (1) satisfying the Federal Reserve’s reserve requirements and/or (2) settling payments 

cleared through the Reserve Banks. The balances in these accounts play a central role in the 

exchange of funds between depository institutions.

6

 Float is money that appears on the books of both the check writer (the payor) and the 

check receiver (the payee) while a check is being processed.

7

 Pub. L. No. 100-86, Title VI (1987).
Page 9 GAO-01-160 Federal Reserve System

of these proposed and actual changes by the Board to Regulation CC are 

detailed later in this report. Checks collected through the Reserve Banks 

are governed by Regulation J and Reserve Bank operating circulars.

The paper check is the dominant noncash payment mechanism used in the 

United States. Although no one is certain how many checks are written in 

the United States each year, Board staff estimated that the number is 

currently between 66 and 70 billion checks. A percentage of those checks 

are interbank checks, which are checks for which the depositary bank (the 

first bank at which a check is deposited) and the paying bank (the bank on 

which the check is drawn) are not the same entity. Interbank checks are 

cleared and settled through an elaborate check-collection process. In the 

check-collection process, depositary banks generally deposit checks with 

the Reserve Banks unsorted. Depositary banks can present checks to 

paying banks though several methods, which may or may not include other 

entities, such as clearing houses, correspondent banks, or Reserve Banks.8

A correspondent bank is a bank that holds deposits owned by other banks 

and performs a variety of banking services, such as check collection. In this 

report, we refer to competitors to the Reserve Banks in check collection as 

private sector competitors. 

ACH is an electronic interbank payments system used for small and 

recurring payments, such as direct deposit of payrolls or automatic 

payment of utility, mortgage, or other bills. There are only four ACH 

operators: the Reserve Banks and three PSOs—Electronic Payment 

Network (EPN), VisaNet, and the American Clearing House. An ACH 

operator is the link between the originating and receiving points of the 

transactions. The ACH operator receives the payment instructions from the 

originating depository institution, edits the information for proper format, 

sorts the transactions for distribution to the appropriate receiving 

depository financial institution, and settles the transactions between the 

originating and receiving depository institutions. In recent years, ACH has 

seen significant growth. From 1995 to 1999, the volume of commercial ACH 

transactions grew from 2.2 billion transactions to 3.8 billion transactions, 

an increase of almost 75 percent.9

 The Reserve Banks are the dominant 

provider of ACH services, with an estimated 85 percent of the market. As 

8

 The Federal Reserve System’s check processing operations includes 45 check processing 

sites.

9

 As the fiscal agent for the U.S. Treasury, the Federal Reserve Banks also process all federal 

government ACH transactions. 
Page 10 GAO-01-160 Federal Reserve System

one of the four ACH operators, the Federal Reserve participates in the 

development of new services and applications.

ACH transactions are governed by the National Automated Clearing House 

Association (NACHA), a nonprofit banking trade association that 

promulgates the rules and operating guidelines for electronic payments 

through the ACH network. The Reserve Banks incorporate NACHA rules by 

reference into their ACH operating circulars. The Reserve Banks’ operating 

circulars, which are subject to Board review, represent the agreements 

between the Reserve Banks and their customers on the terms and 

conditions under which the Reserve Banks will provide ACH services. 

PSOs have similar agreements in place with their customers.

The Federal Reserve 

Maintains Policies to 

Address Potential 

Conflicts of Interests

The Federal Reserve has multiple, potentially conflicting roles in the 

payments system but generally has policies in place to address conflicts of 

interest that could arise. Many of the potential conflicts within the Federal 

Reserve derive from the goals and internal relationships of the Federal 

Reserve itself. The Board provides general oversight of the operations of 

the Reserve Banks and has a regulatory rulemaking role in check 

collection. The policies also separate Reserve Bank staff engaged in 

different types of activities, such as payments operations and supervisory 

examinations. The Federal Reserve maintains policies and procedures to 

ensure the separation of the Board and Reserve Banks when the Board is 

engaging in regulatory rulemaking. However, these policies and procedures 

allow Board staff to communicate with the Reserve Banks to fulfill its 

oversight responsibility. 

Federal Reserve Structure 

Leads to Complex 

Relationships Between the 

Board and Reserve Banks in 

its Various Roles 

The structure of the Federal Reserve, which includes the Board and the 

Reserve Banks, with each having different roles, contributes to the 

potential for conflicts of interest in the payments system. The Board 

provides general oversight of the Reserve Banks, but it is the Reserve 

Banks that provide payment services to the banking industry. The Board 

also has a regulatory rulemaking role for check collection. In this role, the 

Board serves as a regulator of both the Reserve Banks and its private sector 

competitors, establishing the regulations with which they must comply in 

check collection. Federal Reserve policies provide for separations between 

the Board and Reserve Banks when the Board is engaging in regulatory 

rulemaking for check collection. However, these separations do not apply 

when the Board is acting in its general oversight role. 
Page 11 GAO-01-160 Federal Reserve System

The Federal Reserve describes its role in the payments system as providing 

payment services to promote the integrity and efficiency of the payments 

mechanism and to ensure the provision of payment services to all 

depository institutions on an equitable basis in an atmosphere of 

competitive fairness. Federal Reserve officials said that as a payments 

system participant and central bank, the Federal Reserve has roles that are 

integrally related, enhancing the integrity of the payment process. For 

example, the Federal Reserve’s final and irrevocable Fedwire funds 

transfer service10 reduces the risk that failure of one bank could be 

transmitted rapidly to other banks. In addition, in order to carry out its 

responsibilities as central bank, the Federal Reserve may provide payment 

services to troubled depository institutions that other providers of payment 

services may not serve because of the risks involved. This helps to ensure 

that the inability of a depository institution to make or process payments 

will not trigger its insolvency and that the institution’s problems can be 

resolved in an orderly fashion with minimum disruptive effects.

The Board regulates the collection of checks with the goal of enhancing the 

efficiency of the check collection system. However, the goals of the Board 

in establishing regulations may not be the same as those of the Reserve 

Banks, which actually provide payment services and are competing against 

other entities to provide check collection. For example, the Board has 

engaged in rulemaking efforts in the past that were intended to remove 

some of the competitive advantages the Reserve Banks enjoyed over their 

private sector competitors in check collection. Although these efforts have 

addressed some competitive disparities, they have worked against the 

competitive interests of the Reserve Banks in their competition for check 

collection business.

Unlike its regulation of check collection, the Board does not exert any 

regulatory authority over the ACH system, but it provides general oversight 

over the Reserve Banks as ACH operators. The Reserve Banks’ ACH 

service is a common enterprise among the 12 Reserve Banks and is the 

largest in the United States. The Reserve Banks’ operating circulars affect 

PSOs that sometimes must use the Federal Reserve’s ACH service to 

complete transactions for their customers. The Reserve Banks’ operating 

10 The Fedwire funds transfer system is one of the two primary large-dollar electronic 

payments systems in the United States. Fedwire allows depository institutions to transfer 

funds on their own behalf or on behalf of their customers; most Fedwire payments are 

related to domestic transactions.
Page 12 GAO-01-160 Federal Reserve System

circulars represent the agreements between the Reserve Banks and their 

ACH customers on the terms under which the Reserve Banks provide ACH 

service. The operating circulars for ACH are the same for each Reserve 

Bank. Depository institutions are free to use any ACH operator they 

choose, but most use the Reserve Banks to send and receive ACH 

transactions. The Reserve Banks’ share of the ACH market is estimated to 

be about 85 percent, with three PSOs sharing the remaining 15 percent. It is 

often the case that a depository institution that uses a PSO for its ACH 

transactions sends funds to a depository institution that uses the Reserve 

Banks for its ACH transactions. Thus, it is likely that the PSOs will have to 

use the Reserve Banks to complete many of their ACH transactions 

because a depository institution is more likely than not to be a user of the 

Reserve Bank’s ACH service. Because PSOs are dependent on the Federal 

Reserve to do their business, they must abide by the Reserve Banks’ 

operating circulars for depository institutions that use its ACH service. 

Reserve Bank staff have said that when the PSOs use the Federal Reserve’s 

ACH system, they do so as agents for the Reserve Bank’s customers. 

Therefore, the Reserve Banks’ operating circulars exert influence on how 

their competitors provide ACH services.

In addition to its roles as a provider and regulator of the payments system, 

the Federal Reserve has regulatory authority over bank holding companies 

operating in the United States and for state banks that are members of the 

Federal Reserve. In exercising this authority, the Federal Reserve inspects 

the operations of bank holding companies and examines state banks. The 

Board also reviews and approves or disapproves applications from these 

institutions to engage in a variety of activities, including acquiring or 

merging with other institutions. These roles can provide the Federal 

Reserve with proprietary information about the operations of these 

institutions and could conflict with its role as a provider competing with 

some of these same banks for retail payments business. These roles could 

also provide the Federal Reserve with the ability to affect its competitors’ 

businesses through regulatory actions or the approval or disapproval of 

competitors’ applications to expand their operations.

Federal Reserve Policies 

Establish Separations 

Between Potentially 

Conflicting Roles

Because of its structure and varying roles, the Federal Reserve maintains 

policies and procedures that establish separations, or Chinese walls, 

between functions whose interests could potentially conflict or that could 

provide the Federal Reserve with an inappropriate advantage in competing 

with the private sector in selling payments services. In general, Federal 

Reserve policies bar Reserve Bank staff with responsibilities for priced 
Page 13 GAO-01-160 Federal Reserve System

services, unless acting in the capacity of president or first vice president in 

a Reserve Bank, from also having responsibility for monetary policy, bank 

supervision, or lending areas. These policies also explicitly state that 

actions relative to a bank in the monetary policy, supervisory, or lending 

areas will be made without regard to whether that bank uses Reserve Bank 

priced services or is an alternative provider of such services. Except for the 

Reserve Bank president, first vice president, branch manager, or persons 

acting in these capacities, Reserve Bank personnel involved in monetary 

policy, bank supervision, or the lending function may discuss payments 

services with a bank only when necessary to carry out their 

responsibilities. Other Federal Reserve staff with payments services 

responsibilities can discuss monetary policy, bank supervision, or lending 

with a bank only when the information discussed is general in nature or is 

public. Federal Reserve policy states that Reserve Bank personnel involved 

in monetary policy, bank supervision, or the lending function may provide 

confidential information obtained in the course of their duties to Reserve 

Bank priced services personnel only when such action fulfills an important 

supervisory objective, preserves the integrity of the payment mechanism, 

or protects the assets of the Reserve Banks. In such cases, information is to 

be provided on a need-to-know basis and only with the approval of senior 

management.

The Board’s policies also govern its relationship with Reserve Banks when 

the Board is engaging in regulatory rulemaking efforts involving check 

collection under Regulation CC. Because these efforts can potentially 

affect the competitive position of the Reserve Banks as well as that of their 

competitors, the Reserve Banks’ standing in the rulemaking process is to 

be no different from that of their competitors in the check collection 

business. The Reserve Banks are allowed to provide comments when the 

Board requests them in its rulemaking efforts, but they are to be afforded 

no additional access beyond that given to any other institution engaged in 

the check collection business. Board staff said that after enactment of 

EFAA, they consulted with Reserve Bank staff during the initial 

development of Regulation CC. However, as they gained experience in their 

role as a regulator of the check collection business, they realized that it was 

important to establish and maintain an arm’s-length relationship. However, 

to their private sector competitors and other outside observers, the 

separation may not be apparent because the Board and Reserve Banks are 

not viewed as distinct entities. 

Within the Board, potential conflicts are avoided through information 

access standards and organizational separations that determine which 
Page 14 GAO-01-160 Federal Reserve System

Board staff are to have access to which types of information. Under these 

standards, supervisory information is to be provided to staff on a need-toknow basis. Board staff said that these policies ensure that staff do not 

have access to information that could present a conflict.

Separations Between Staff 

in Some Instances Do Not 

Apply in Others

Except as stated above, Board staff interact with Reserve Bank staff 

involved with check collection when the Board is considering changes to 

Regulation CC, but only in a manner parallel to how it would consult with 

another interested party. Board staff have consulted with Reserve Bank 

staff involved in check collection, ACH, and all other priced services with 

regard to the Reserve Banks’ operating circulars. As stated earlier, the 

Board does not exert regulatory authority over the ACH system. However, 

the Board does exercise general oversight over the Reserve Banks in how 

they provide ACH services, as it does for all priced services. Therefore, 

Board staff interact extensively with Reserve Bank staff when reviewing 

changes to the Reserve Banks’ ACH operating circulars. Although changes 

to the Reserve Bank’s operating circulars are not regulatory changes, they 

may directly influence the ability of PSOs to compete for business. As 

described in more detail later in this report, the Federal Reserve has 

recently considered making changes to the Reserve Banks’ ACH operating 

circulars in the areas of pricing and deposit deadlines. In the course of 

considering these changes, the Board has issued two requests for comment 

in the Federal Register. This process does not represent a regulatory 

change; therefore, Federal Reserve policies do not require a Chinese wall 

between the Board and the Reserve Banks.

Board staff said they also talk frequently with Reserve Bank staff engaged 

in the payments business during the process of developing and pricing 

Federal Reserve payment products. As described later in this report, the 

Board has interacted extensively with Reserve Bank staff as it oversees 

development of both check and ACH products and prices for those 

products. The Board and Reserve Bank staffs explained that they also 

interact in calculating the PSAF number and integrating it into the final 

pricing schedule, which is ultimately approved by the Board. The Board is 

also charged with approving new check and ACH products. However, 

approval authority for some product enhancements and service changes 

has been delegated to the Reserve Banks. Federal Reserve policy does not 

require separations between Board and Reserve Bank staff in these 

functions, but Board staff said that the different missions of the Reserve 

Banks, in developing prices, and the Board, in overseeing the process, 

serve to keep them, in effect, separate. 
Page 15 GAO-01-160 Federal Reserve System

During our review of Board and Reserve Bank documentation from the 

payment service pricing and product development process, as well as 

requests for comment regarding possible changes to Regulation CC, and 

interviews with Board, Reserve Bank, and private sector competitors’ staff, 

we found no evidence of breaches in the separations of these functions 

during our work.

The Board Has 

Removed Some 

Disparities between 

the Private Sector and 

Reserve Banks in 

Providing Check and 

ACH Services, but 

Others Remain

Because of inherent differences between the Reserve Banks and their 

private sector competitors, it is unlikely that all competitive disparities 

between them can ever be removed without changes in the structure or 

nature of the various institutions. They are likely to continue to enjoy 

certain advantages over each other in check collection and ACH. The 

Board has undertaken efforts to address the competitive disparities that 

exist between the Reserve Banks and the private sector in providing check 

collection and ACH services to depository institutions. Many of the 

competitive disparities between the Reserve Banks and the private sector 

banks have focused, and continue to focus, on the presentment of checks 

in check collection.11 For ACH, disparities involve the ability of the Reserve 

Banks to charge PSOs and their customers and to require PSOs to comply 

with Reserve Bank deposit deadlines. PSOs, on the other hand, are unable 

to charge the Reserve Banks and make the Reserve Banks comply with 

their deposit deadlines. Although the Board has tried to address some of 

the disparities that have existed between itself and the private sector for 

both check collection and ACH, other disparities continue to exist. 

Both the Reserve Banks and 

Their Competitors Enjoy 

Unique Advantages 

The Reserve Banks compete against a variety of private sector providers in 

the payments business, and both sides have unique advantages. In check 

collection, the Reserve Banks compete primarily against larger banks 

whose correspondent banking business includes check collection; or they 

compete against private clearing houses whose membership includes 

banks of a variety of sizes. Although the Reserve Banks and their 

competitors provide similar services, there are certain inherent differences 

between them, many of which derive from the different legal 

responsibilities, structures, and pricing practices of the Reserve Banks and

11 Check presentment occurs when the checks are delivered to the paying banks for 

payment and the paying banks must decide whether to honor or return the checks.
Page 16 GAO-01-160 Federal Reserve System

their competitors.12 In ACH, the Reserve Banks compete with three PSOs.

Because it is the central bank of the United States, the Federal Reserve 

maintains the reserve accounts of U.S. depository institutions. This allows 

the Federal Reserve to settle all payments transactions by debiting and 

crediting the accounts of banks or their correspondents that use the 

Federal Reserve to provide their payments services. Competitors of the 

Federal Reserve do not have this option and must therefore develop 

alternative means to settle transactions, which will often eventually involve 

the Federal Reserve.13

The Reserve Banks’ nationwide presence as a provider of both check 

collection and ACH services gives it an advantage in providing both 

services. Although there is no legal prohibition against a private sector 

entity developing such a presence, no other provider of either service 

enjoys such an advantage. A major feature of this advantage with regard to 

check collection is the Federal Reserve’s Check Relay network, which is 

described in more detail in appendix II. Check Relay provides the Reserve 

Banks with an integrated nationwide air and ground transportation 

network to move checks between Federal Reserve locations. None of the 

Reserve Banks’ competitors choose to maintain such an integrated system, 

although they also use commercial air transportation, most of which is 

provided by a single company. Although the existence of Check Relay is 

generally seen by its competitors as an advantage to the Reserve Banks, 

Reserve Bank officials said that it is necessary to maintain such a system 

because it is the most efficient and cost-effective way to ensure the 

transportation of its checks and provide rapid availability of funds, 

particularly for checks destined to remote areas. In addition to Check 

Relay, the Reserve Banks use other means to transport checks around the 

country. For example, they engage in “air freight forwarding,” which 

involves putting checks on commercial flights. However, Check Relay 

serves as an advantage because it provides a level of certainty to the 

Reserve Banks’ air transportation. Without it, the Reserve Banks would be 

more reliant on commercial suppliers of air transport, over whose 

schedules the Reserve Banks would have less control.

12Check Collection: Competitive Fairness Is an Elusive Goal (GAO/GGD-89-61, May 12, 

1989). 

13 The Reserve Banks offer net settlement services to facilitate the final settlement in central 

bank money of transactions made through private sector clearing arrangements. This 

service makes it easier for these arrangements to compete with Reserve Banks.
Page 17 GAO-01-160 Federal Reserve System

Private sector payments providers also enjoy some advantages in 

competing for payments business. One advantage is the greater flexibility 

enjoyed by private sector providers in pricing their products. The Federal 

Reserve’s pricing methodology is largely driven by MCA and its own pricing 

principles; however, private sector providers are generally free to price 

their products as they see fit, sometimes tailoring their prices to individual 

customers on the basis of the desirability of the customer’s business. 

Correspondent bank officials we interviewed said that they sometimes see 

payment services as one part of their overall relationship with another 

bank and will therefore price payments services in such a way as to 

encourage the relationship rather than to cover the costs of providing 

them. A similar advantage enjoyed by competitors to the Federal Reserve is 

the ability to “bundle” or combine certain services for specific customers. 

For example, private sector competitors can price check collection 

services they provide to another bank at a certain level with the 

understanding that the bank will also purchase other services from the 

correspondent. The other services will often be nonpayment services that 

are not offered by the Federal Reserve. Private sector competitors agreed 

that these are advantages that they have over the Federal Reserve, which 

publishes standard prices for specific services. They also said that it is 

helpful for them to know what the Reserve Banks charge for specific 

services so that they can tailor their own prices when competing for 

business.

The Federal Reserve’s competitors are free to compete for any business 

they desire and to refuse business that they consider unprofitable or 

otherwise undesirable. Because of its central bank status, the Federal 

Reserve seeks to ensure the efficiency of the payments system. One aspect 

of this is that it provides services, at its prevailing prices, to banks 

regardless of the attractiveness of their business. Some banks may be 

remotely located, have a generally low volume of payments business, or be 

of questionable creditworthiness and therefore may not be attractive 

business partners for some providers. Some correspondent bank officials 

said that in such instances it is unlikely that they would refuse service to 

such institutions, but they would probably price their services in such a 

way as to discourage these banks’ business. However, they acknowledged 

their prerogative to refuse service to any bank with which they did not wish 

to do business. 
Page 18 GAO-01-160 Federal Reserve System

The Board Addressed the 

Most Important Competitive 

Difference in Check 

Collection, but Others 

Remain

In 1989, we found that the most important competitive difference between 

the Reserve Banks and their private sector competitors in check collection 

was the Federal Reserve’s unique ability to obtain settlement of checks 

from any bank on the same day that checks are presented without having to 

pay for the privilege.14 Other collecting banks were generally required to 

pay for same-day settlement because they had no legal leverage to demand 

similar treatment from paying banks. In 1992, the Board amended 

Regulation CC by adopting the same-day settlement rule, which decreased, 

but did not entirely remove, this difference. The same-day settlement rule 

requires a paying bank to settle, or provide funds, on the day of 

presentment for checks presented by a private sector collecting bank, 

without the imposition of presentment fees, if the checks are presented at a 

location designated by the paying bank by 8:00 a.m. local time. After the 

establishment of the same-day settlement rule, the check volume presented 

by private sector collecting banks increased, and the Reserve Banks saw 

their volume decline. 

The Board’s same-day settlement rule did not remove all the disparities that 

exist between the Reserve Banks and the private sector collecting banks. 

For example, other disparities include differences in presentment time and 

location. Reserve Banks can obtain same-day settlement for checks 

presented to a paying bank before the Reserve Bank’s cut-off hour, 

generally 2:00 p.m.; the presentment time for private sector competitors is 

8:00 a.m. Depository institutions sometimes choose to vary these deadlines, 

for instance through clearing house arrangements, as permitted by 

Regulation CC and the Uniform Commercial Code. The Board requested 

comment on the effect of removing the disparity by shifting the 

presentment time from 8:00 a.m. to 2:00 p.m., which would provide the 

private sector collecting banks with the same presentment rights as the 

Reserve Banks. However, banks and corporate businesses who commented 

on these proposals generally did not favor changing the same-day 

settlement deadline, primarily because the additional costs incurred by 

paying banks and businesses would outweigh benefits gained by the 

collecting banks.15 During interviews, some private sector competitors 

14 GAO/GGD-89-61.

15 Because collecting banks are also paying banks, they must balance their competing 

interests. In their capacity as paying banks, the change in presentment time would have 

complicated their cash management, and that of some of their customers, offsetting any 

benefit from their collecting bank activities.
Page 19 GAO-01-160 Federal Reserve System

suggested that a better solution would be to hold the Reserve Banks to the 

8:00 a.m. deadline rather than to extend the deadline for private sector 

check processors. However, Federal Reserve officials said that such a 

change would delay the collection of some checks and make the check 

clearing system less efficient overall. Reserve Banks also have more 

latitude than their private sector competitors in where they can present 

checks to banks for payment. However, in response to a Federal Reserve 

request for comment on this issue, most private sector competitors who 

commented stated that the Reserve Banks’ flexibility had not significantly 

affected their ability to compete. Accordingly, the Board did not remove 

this regulatory disparity.

Proposed Changes to the 

Reserve Banks’ ACH 

Operating Guidelines 

Address Disparities in 

Delivery Deadlines, but 

PSOs Said Pricing 

Disparities Remain

In response to concerns raised by NACHA and the PSOs, the Board 

proposed several changes to the Reserve Banks’ ACH pricing structure and 

deposit deadlines. The Board’s proposed changes to deposit deadlines 

appear to reduce some of the Reserve Banks’ competitive advantages in 

providing ACH services; however, the PSOs said that the proposed pricing 

structure would continue to give the Reserve Banks a competitive 

advantage. As previously stated, the Reserve Banks process almost 85 

percent of commercial interbank ACH transactions; the three PSOs (EPN, 

VisaNet, and American Clearing House) process the remaining 15 percent. 

The PSOs believe that the Reserve Banks’ ACH pricing and deposit 

deadlines are the primary reason for the Reserve Banks’ continuing 

dominance in the ACH market. These policies affect the PSOs’ ability to 

compete because they often use the Reserve Banks’ ACH network for 

interoperator ACH transactions in which either the originating bank or 

receiving bank is not a PSO customer. Although the PSOs agree with the 

Board’s proposed changes to the policies on ACH deposit deadlines and 

eligibility, they contend that the modifications to the Reserve Banks’ 

pricing policies would still provide the Reserve Banks with a competitive 

advantage over the PSOs. 

In interviews with us and in comment letters to the Board, the PSOs have 

said that the current Reserve Bank ACH pricing policies provide the 

Reserve Banks with a competitive advantage over the PSOs. The Reserve 

Banks charge a per-file fee for each ACH file they receive, per-item fees for 

each transaction they process, and assess monthly servicing fees to each 

institution whose ACH transactions they process. Conversely, the PSOs 

cannot charge the Reserve Banks or their customers when the PSOs 

process Reserve Banks’ transactions because the Reserve Banks have 

previously been unwilling pay such charges and can refuse to do so 
Page 20 GAO-01-160 Federal Reserve System

because of their dominant market position. The PSOs said that the pricing 

structure is a major competitive advantage for the Reserve Banks because 

any bank that uses a PSO must pay the Reserve Banks’ fees in addition to 

the fees charged by the PSOs. The Reserve Banks’ pricing structure 

provides an incentive for banks to choose Reserve Banks directly because 

depository institutions’ total ACH fees would be higher if they sent 

transactions to the Reserve Banks through PSOs and paid fees to both the 

Reserve Banks and PSOs. PSOs said they were presented with a dilemma: if 

they want to maintain their customer base, they must either charge at a 

discounted rate and absorb the Reserve Banks’ fees or charge a higher 

price, and risk losing customers. 

On May 23, 2000, the Board proposed modifications to the pricing and 

deposit and delivery policies on ACH interoperator transactions, stating 

that the modifications would enhance competition. Under the Board’s 

proposal, the Reserve Banks would be allowed to charge a monthly 

network access fee to PSOs to access depository institutions on the 

Reserve Banks’ ACH network, per-item fees to PSOs for transactions they 

send through the Reserve Banks’ ACH network, and a monthly settlement 

fee to depository institutions that send and receive all ACH transactions 

through PSOs and use the Reserve Banks’ ACH service to settle some 

transactions. In addition, the Board proposed that Reserve Banks would be 

required to pay PSOs for transactions they send to banks through those 

PSOs, but—concerned about potential high charges—requested comments 

on how the fees that operators charge each other (including Reserve 

Banks) might be restrained.

The PSOs believe that the Board’s proposed changes to the Reserve Banks’ 

pricing policies will not significantly reduce the Reserve Banks’ price 

advantage and may actually increase it. They are particularly concerned 

with the proposed monthly network access fee and the settlement fee. The 

PSOs believed that the proposed structure would not correct the current 

competitive inequities and could possibly harm competition. They 

suggested that the proposed price structure would permit the Reserve 

Banks to continue to dominate the market for ACH operator services. They 

also believed that the proposal’s heavy reliance on volume threatened the 

viability of PSOs and would result in PSO customers subsidizing Reserve 

Bank customers. The Federal Reserve said that Reserve Banks incur costs 

when they accept ACH transactions from PSOs and that the Reserve Banks 

should be reimbursed for these costs. Moreover, the Board proposed that 

the Reserve Banks should charge PSOs a monthly network fee because, 

when an operator provides other operators’ customers with access to its 
Page 21 GAO-01-160 Federal Reserve System

network, it provides value to those customers and the operators that serve 

them. In explaining the settlement fee, which would be paid by the 

respective banks, the Board said that Reserve Banks should be permitted 

to charge a settlement fee because the Reserve Banks are providing a 

service not provided by other operators when the Reserve Banks settle 

interoperator transactions for a depository institution that chooses to send 

or receive all its ACH transactions through a PSO, some of which are 

processed and settled through the Reserve Banks. In contrast, the PSOs 

believe that the Reserve Banks are subsidizing the ACH services they offer 

by charging fees, like the network access fee, to the PSOs and their 

customers that the Reserve Banks do not charge to their customers. They 

contend that the Board’s analysis for the network access fee is flawed 

because it bases the value of the Federal Reserve ACH network on the 

number of routing numbers included in its network, not on the ACH 

transaction volume destined to a particular routing number. 

Notwithstanding the differences over the pricing modifications, the Board 

and the PSOs generally agree on the Board’s modifications to the Reserve 

Banks’ policies on ACH deposit deadlines and eligibility. Because the 

Reserve Banks currently impose the same deposit deadlines on PSOs as 

they do on banks, the PSOs must set an earlier deposit deadline on their 

customers. The Board proposed that the Reserve Banks work 

collaboratively with the PSOs to establish specific interoperator deposit 

deadlines by which Reserve Banks and the PSOs would exchange 

interoperator transactions. The PSOs support this proposal, including the 

Reserve Banks’ preliminary recommendation for the deposit deadlines.16

On the issue of PSOs’ eligibility, the Board and the PSOs agree that the 

Reserve Banks’ deposit deadline and the pricing structure modifications 

should be limited to any intermediary that is defined as an operator under 

the operating rules of NACHA.17 Accordingly, this proposal would exclude 

third-party processors or some larger private sector competitors from the 

modifications unless they comply with the NACHA standards for operators. 

The Board released its new fees and deadlines October 31, 2000.

16 The Reserve Banks’ preliminary recommendation is that one interoperator deposit 

deadline be established at 2:30 p.m. Eastern time for an immediate settlement item and that 

another interoperator deposit deadline for next-day settlement item be established at 3:00 

a.m. Eastern time. Currently, the PSOs must deposit their items for immediate settlement at 

3:00 p.m. Eastern time. 
Page 22 GAO-01-160 Federal Reserve System

Questions About the 

PSAF and Pension Cost 

Credits Have Raised 

Concerns About the 

Federal Reserve’s 

Pricing 

MCA delineated several broad pricing principles for the Federal Reserve. In 

addition, the Federal Reserve issued pricing principles to further govern 

how it sets prices. These statutory and additional principles give the 

Federal Reserve considerable latitude in pricing its services by allowing it 

to recover the costs of its priced services over the long run. One 

requirement of MCA is that the Federal Reserve is to recover all direct, 

indirect, and imputed costs for priced services. Imputed costs are 

calculated to approximate costs that would have been incurred by private 

businesses in providing similar services to ensure some level of pricing 

parity. Because the PSAF is a proxy and is based on the Federal Reserve’s 

interpretation within the broad parameters set by MCA, certain aspects of 

the methodology have been criticized. In addition, the impact of the 

Federal Reserve’s use of pension cost credits on price setting has been 

criticized. 

Federal Reserve Pricing 

Practices Comply with MCA 

Requirements

To meet MCA’s full cost recovery requirement, the Federal Reserve 

developed an annual pricing process. This multistep process includes the 

Federal Reserve’s annual budgeting process, which involves the review of 

Reserve Bank and Board expenses, including all direct and indirect costs 

related to priced services, and the annual compilation of data used to 

calculate the PSAF. This process is discussed in greater detail in appendix 

III. The Federal Reserve’s prices are based on estimated direct and indirect 

costs as well as the PSAF. The Federal Reserve determines compliance 

with MCA over a 10-year period on the basis of the amount of revenues 

generated from each service line, such as check collection and ACH, 

compared to costs allocated to that service line. Over the 10-year period 

1990 through 1999, the Federal Reserve calculated that the Reserve Banks 

recovered 101.1 percent of their total costs for providing services, including 

17 To qualify as a private sector ACH operator, an entity must execute an agreement with 

NACHA to comply with or perform all of the following: adhere to NACHA operating rules 

and other applicable laws and regulations; execute agreements with a minimum of 20 

independent depository institutions that bind the depository institutions to NACHA 

operating rules and the private sector ACH operator’s rules; provide clearing, delivery, and 

settlement services for intraoperator transactions; exchange interoperator transactions with 

other ACH operators; process and edit files according to the requirements of NACHA 

operating rules; evaluate the creditworthiness of and apply risk control measures to their 

customers; adhere to the Federal Reserve’s Policy Statement on Privately Operated 

Multilateral Settlement Systems; and adhere to any NACHA performance standards for ACH 

operators.
Page 23 GAO-01-160 Federal Reserve System

imputed expenses, special project costs targeted for recovery, and targeted 

return on equity. 

Board policies require that fees for priced services be set to match 

revenues for each service line with its estimated costs. However, the 

Federal Reserve may not always fully recover costs for each product within 

a service line and has discretion in allocating certain costs across products 

within service lines. For example, within the check collection service line, 

the Federal Reserve may recover more transportation costs from “Check 

Product A” than “Check Product B,” even though the transportation costs 

may be similar. Federal Reserve officials also confirmed that they engage in 

“market-based” pricing within service lines, which allows it to consider 

such factors as elasticity of demand.18 Therefore, the Federal Reserve has 

discretion to set prices above costs for products that have little private 

sector competition and set prices to recover marginal costs for products 

that have greater private sector competition. For example, within the check 

collection service line, prices for return-item cash letters,19 for which the 

Federal Reserve has limited competition, the highest fee increased 75 

percent between 1995 and 2000. Conversely, for forward-processed cash 

letters, for which the Federal Reserve faces greater competition, the 

highest fee increased 16 percent over the same period.20

Although it is the Federal Reserve’s policy to recover costs for each service 

line over the long run, circumstances may arise that hinder its ability to 

fully recover costs in a particular service. These circumstances may 

include changes in technology or banking structure, more efficient 

operations, or aggressive pricing by other service providers. In determining 

whether to continue to provide the service, the Federal Reserve may 

consider the other objectives of MCA, such as continuing to provide 

equitable access and an adequate level of services nationwide and giving 

due regard to competitive factors. In such a case, it is the Federal Reserve’s 

policy that a decision to continue to provide a service that could not 

reasonably be expected to meet its long-run cost-recovery objective would 

18 Elasticity of demand measures the change in demand for a service on the basis of a change 

in the price.

19 A cash letter contains a listing of individual checks and the packaged checks.

20 Federal Reserve check collection prices are reported as ranges from low to high, because 

the specific price for each product varies depending on which Reserve Bank provides the 

service, among other factors.
Page 24 GAO-01-160 Federal Reserve System

be made only where there was a clear public benefit and would be publicly 

announced. The Federal Reserve applied this policy in the early 1980s 

when it subsidized the costs of ACH to encourage movement away from 

checks to promote a more efficient payment mechanism.

The PSAF Is Important 

Because it Affects Federal 

Reserve Prices

The PSAF is important because it affects the Federal Reserve’s prices. The 

PSAF is considered a component of expenses when the Federal Reserve 

sets prices; the higher the PSAF is, the higher the Federal Reserve’s prices 

for check collection, ACH, and other prices have to be to cover expenses 

and achieve the targeted return on equity. The act requires the Federal 

Reserve to calculate the PSAF to simulate costs that are not incurred by 

Reserve Banks in their operations to reduce pricing disparities between 

Reserve Banks and private sector entities providing similar services. The 

PSAF consists of imputed income taxes and a targeted return on equity as 

well as the imputed costs of interest on short- and long-term debt, sales 

taxes, and assessments for Federal Deposit Insurance Corporation deposit 

insurance. Once the PSAF value is calculated, it is allocated to the various 

service lines, such as check collection and ACH. The process the Federal 

Reserve uses to determine the PSAF and its incorporation into the annual 

pricing process is discussed in greater detail in appendix III. 

Developing the PSAF methodology has always been a challenge because 

there are no directly equivalent private sector providers to the Reserve 

Banks and no set of firms whose mix of services is the same as that 

provided by the Reserve Banks. However, bank holding company data are 

used as a proxy. Private sector competitors we interviewed most frequently 

questioned the targeted return on equity portion of the calculation. The 

Federal Reserve’s targeted return on equity represents an imputed after-tax 

profit that the Federal Reserve would expect to earn if it was a private firm. 

The Federal Reserve bases the targeted return on equity on the returns of 

equity of the 50 largest bank holding companies (by asset size) for each of 

the last 5 years. Therefore, the data used to calculate the targeted return on 

equity include returns from all bank activities, not only those associated 

with correspondent banking activities. The implementation of the GrammLeach-Bliley Act of 1999 may make bank holding company data even less 

comparable because it allows holding companies with more diversified 

firms to become bank holding companies.21

Some of the correspondent bank officials we interviewed said that on the 

basis of returns generated by their correspondent banking activities, the 

targeted return on equity was generally too high. However, others said that 
Page 25 GAO-01-160 Federal Reserve System

it was too low. All agreed that the returns they attributed to correspondent 

banking activities could vary depending on the cost accounting systems 

and methodologies implemented at individual banks. Federal Reserve 

officials said that although the PSAF methodology may be imperfect, they 

have been unable to develop a more accurate methodology because of the 

lack of publicly available information on profitability, which is most 

relevant to the priced services Reserve Banks provide. 

The Federal Reserve has done periodic reviews of the PSAF methodology 

since the methodology was established in 1981. However, Federal Reserve 

officials said that the PSAF methodology has not been changed 

significantly since 1989, when the Federal Reserve revised certain aspects 

of the PSAF methodology. However, in 2000, the Federal Reserve began to 

recognize certain assets and liabilities when calculating imputed financing 

costs and returns on equity in the PSAF. We discuss this change in detail 

later in this report. 

In April 2000, the Federal Reserve began one of its periodic reviews of the 

PSAF methodology. The group tasked to review the PSAF methodology 

includes Reserve Bank and Board staff members. Although the Federal 

Reserve has historically published substantial changes to the PSAF 

methodology in the Federal Register for comment, it has not historically 

solicited input from the private sector or academics in developing 

proposals that are issued for public comment. Expanding participation in 

the review to private sector firms and academics could result in new and 

innovative thinking about how to best revamp the PSAF methodology and 

possible data alternatives, given the changes in the market. 

Competitors Question 

Federal Reserve Use of 

Pension Cost Credits

Some of the Federal Reserve’s competitors have questioned its practice of 

allocating a portion of its pension cost credit as part of the expenses 

considered when setting prices. The pension cost credits result from the 

Federal Reserve’s over-funded pension plan and the earnings generated by 

its pension plan assets. The Federal Reserve uses generally accepted 

accounting principles (GAAP) to account for its pension credits. However, 

the practice has drawn criticism from some of its competitors because of 

21 The Gramm-Leach-Bliley Act enables bank holding companies to opt to become financial 

holding companies. A financial holding company is a bank holding company that meets 

certain eligibility requirements. As of September 1, 2000, over half of the 50 largest U.S. bank 

holding companies (1999 data) had opted to become financial holding companies.
Page 26 GAO-01-160 Federal Reserve System

concerns that the pension cost credit reduces the Federal Reserve’s 

expenses, which has allowed it to offer lower prices for its services. 

Although the Federal Reserve started allocating the pension cost credit for 

price-setting purposes only in 1993, the pension cost credit in the Reserve 

Bank’s financial statements resulted from a new accounting standard 

implemented in 1987 that changed the way employers account for 

pensions.22 Without the pension cost credit and assuming that the Federal 

Reserve made no other adjustments to prices or expenses, it would not 

have achieved its targeted return on equity for any of the years from 1993 to 

1999 and would have operated at a loss in 1993 and 1994. 

FAS 87 requires employers, including other private sector service 

providers, to (1) determine the fair market value of their pension plan 

assets, less estimated future obligations as of a given date; and (2) 

gradually recognize the resulting assets (or obligations) in their financial 

statements over time. As of January 1, 1987, the Federal Reserve 

determined that its pension plan assets exceeded its estimated future 

obligation for pension benefits, which resulted in an unrecognized pension 

asset of $681 million. In accordance with accounting rules, the Federal 

Reserve amortized this unrecognized pension asset over a 15-year period 

and began recognizing it in its financial statements in 1987. The portion 

allocated to priced services resulted in approximately $10 million after-tax 

in credits to (reductions in) expenses each year. However, the Federal 

Reserve did not use this portion of the pension credit to offset costs when 

setting annual fees for priced services until 2000. 

FAS 87 also required that annual pension plan costs be included in financial 

statements to properly reflect the costs of a pension plan. The annual cost 

figure consists of several components, including the estimated cost of 

future retirement benefits being earned by employees during the year 

netted against the annual return on pension plan assets and the amortized 

unrecognized pension assets (credit) previously discussed. The Federal 

Reserve recorded a net pension cost credit in its financial statements in 

every year from 1987 through 1999 due to the high returns its pension 

assets were earning.23

22 Financial Accounting Standard No. 87, Employers Accounting for Pensions. 

23 Because the Federal Reserve’s pension assets continue to earn favorable returns and the 

pension fund remains over-funded, it has made only one contribution to its retirement plan 

since 1987. In 1998, the Banks contributed over $80 million to reimburse the plan for 

administrative expense and accumulated earnings. 
Page 27 GAO-01-160 Federal Reserve System

Since 1987, the Federal Reserve has allocated a portion of this annual 

pension cost credit to priced services to determine recovery for MCA 

compliance. That is, the pension cost credit enabled the Federal Reserve to 

reduce the cost recovery amount and still comply with MCA.24 However, 

the Federal Reserve did not reduce costs for priced services by the pension 

cost credit when setting annual fees for priced services until 1993, when a 

new accounting standard was issued that required employers to record 

postretirement expenses in a manner similar to pension costs.25 The 

Federal Reserve has traditionally considered the pension cost credits and 

postretirement benefits expenses to be related types of expenses that 

generally offset one another. For that reason, the Federal Reserve did not 

include the pension cost credits when setting fees for priced services until 

it implemented the accounting standards for postretirement benefits in 

1993.26 In 1995, the Federal Reserve implemented a similar accounting 

standard for postemployment benefits.27

In 1995, the Federal Reserve allocated about $24 million, after tax, in 

pension cost credits to priced services and about $16 million, after tax, in 

postretirement and postemployment benefits expenses. However, since the 

pension plan continued to achieve returns and grow in size, the pension 

cost credit grew in relation to the related postretirement and 

postemployment benefits expenses. By 1999, pension cost credits allocated 

to priced services were about $72 million, after tax; and the cost of 

postretirement and postemployment benefits was about $16 million, after 

tax. 

The large disparity between the amount of the Federal Reserve’s pension 

cost credits and other related postretirement and postemployment benefits 

24 The Federal Reserve determines cost recovery on the basis of revenues divided by costs 

over a 10-year period, which should equal 100 percent. 

25 Financial Accounting Standard No. 106, Employers’ Accounting for Post Retirement 

Benefits Other Than Pensions (FAS 106). The purpose of FAS 106 was to improve the 

reporting of postretirement benefits expenses and to change the prevailing practice at the 

time, which was to account for postretirement benefits on a pay-as-you-go or cash basis.

26 Between 1987 and 1992, neither the amortized unrecognized pension asset (credit) nor 

annual pension cost credit were included in pricing decisions. 

27 The Federal Reserve implemented Financial Accounting Standard No. 112 Employers 

Accounting for Postemployment Benefits on January 1, 1995. These benefits include 

medical and dental insurance, survivor income, disability income, and workers’ 

compensation expenses self-insured by individual Reserve Banks.
Page 28 GAO-01-160 Federal Reserve System

expenses resulted in a net credit to the Federal Reserve’s expenses 

allocated to priced services. This net credit served to reduce the total 

expenses allocated to priced services, while at the same time increasing the 

net income from priced services. If the pension cost credit had not been 

used to offset costs allocated to priced services, the Reserve Banks would 

likely have set their fees higher to recover costs. Otherwise, the Federal 

Reserve would not have reached its targeted return on equity in any year 

between 1993 and 1999. The amounts annually returned to the U.S. 

Department of the Treasury could have been more or less than the amounts 

actually returned depending on the effect higher fees would have had on 

the amount of Federal Reserve payment services purchased by its 

customers and the market.28

Changes in PSAF 

Methodology Related to 

Prepaid Pension Assets 

Result in Higher Costs for 

Price-Setting Purposes

In 2000, the Federal Reserve began allocating a portion of its prepaid 

pension asset and postretirement and postemployment benefit liabilities29

in the asset and equity figures it used for calculating imputed financing 

costs and returns on equity in the PSAF. According to Federal Reserve 

documents, the reason for this change was largely twofold. First, the value 

of the prepaid pension assets began to increase significantly due to large 

returns generated from its substantial investments. Second, the effects of 

prepaid pension assets are already included in the balance sheets of the 

bank holding companies, which are used to compute financing rates and 

return on equity applied to the Reserve Banks’ assets to be financed for the 

2000 PSAF calculation. This change resulted in an additional $60.5 million 

of pretax imputed costs in the 2000 PSAF, which increased the amount to 

be recovered.

Prior to 2000, the prepaid pension asset and postretirement and 

postemployment benefits were not included in the PSAF calculation 

because the Federal Reserve considered the pension asset to be selffinanced through income generated from pension plan investments. If the 

imputed costs associated with the effect of including pension assets and 

postretirement and postemployment benefit liabilities had been included 

beginning in 1997, when the assets started to became large, imputed pre-tax 

PSAF costs would have increased by approximately $18.2 million, $30.9 

28 The Federal Reserve returns profits generated by priced services to the Treasury. 

29 A prepaid pension asset represents the excess of the cumulative funding level of the 

pension plan over the accrued pension obligation. 
Page 29 GAO-01-160 Federal Reserve System

million, and $45.7 million in years 1997, 1998, and 1999, respectively. If the 

costs the Federal Reserve had to recover had been increased by these 

amounts, Reserve Banks would likely have had to raise prices or take some 

other action to ensure compliance with MCA

The Federal Reserve 

Has Promoted the Use 

of its Products 

Through New Product 

Development and 

Marketing

The Reserve Banks have strategically developed new products and 

marketed them in such a way as to actively compete for payments 

business. However, the manner in which the Reserve Banks have done this 

has sometimes been criticized by their competitors. Criticisms have 

focused on specific products developed by the Reserve Banks and their 

techniques for marketing them. We found that the way in which the Federal 

Reserve has developed and approved new products has changed over time, 

resulting in confusion among its competitors about its process for bringing 

new products to the market. In our interviews with Federal Reserve staff 

and private sector competitors in the payments system, we found 

misunderstandings about what the Reserve Banks do and basic 

disagreements about the appropriate Reserve Bank approach in competing 

for payments business, including its product development and marketing. 

The Federal Reserve Has 

Developed Products to 

Respond to Perceived 

Market Needs

Reserve Bank staff, in competing for payments business, have developed 

products and services that are designed to respond to perceived market 

needs. Private sector competitors have complained that some of the 

Reserve Banks’ products are predatory in nature, fall outside the payments 

system, or work to diminish incentives for innovation in the payments 

system. However, these views were expressed by competitors to the 

Reserve Banks and do not represent the views of all banks we interviewed, 

many of whom expressed satisfaction with the Federal Reserve’s products 

and the role it plays in the payments system. In prior years, the Reserve 

Banks’ product offerings in check collection were locally based and varied 

by Reserve Bank. In recent years, the Reserve Banks have been working to 

make their product offerings and prices more nationally based. Because 

the Federal Reserve is in the midst of a transition from a locally based to a 

nationally based system, some of its products are available from some 

Reserve Banks but not others; other products are available nationally. 

Certain Reserve Bank payment products, three of which are described 

below, have caused concern from the Reserve Banks’ private sector 

competitors. Their concerns have generally focused on such issues as the 

products’ pricing or the appropriateness of the Reserve Banks offering the 

product. Such questions of appropriateness often stem from a different 
Page 30 GAO-01-160 Federal Reserve System

understanding of the Federal Reserve’s role in the payments system than 

that of Federal Reserve staff we interviewed. Private sector competitors of 

the Reserve Banks often stated that the Federal Reserve should promote 

the efficiency of the payments system by providing service where there are 

gaps in service, rather than competing aggressively for markets that are 

already served by others. Federal Reserve staff said that MCA is based on 

the premise that competition will promote the efficiency of the payments 

system. They believe that by actively competing for payments business, the 

Federal Reserve is promoting the efficiency of the payments system. This 

lack of consensus among payment system participants was exhibited 

during forums held by the Federal Reserve’s Committee on the Federal 

Reserve in the Payments Mechanism. During the forums, held in May and 

June of 1997, the committee and the Reserve Banks met with 

representatives from 450 payment system participants, including banks of 

all sizes, clearing houses and other third-party service providers, 

consumers, retailers, and academics. Federal Reserve staff said that 

although a few large banks and clearing houses thought the Federal 

Reserve should exit the check collection and ACH business, the 

overwhelming majority of forum participants opposed Federal Reserve 

withdrawal, primarily because of concern about payments system 

disruptions. The question of whether, and to what degree, the central bank 

should be involved in the payments system may never be resolved to 

everyone’s satisfaction. Views on these questions evolve over time and are 

therefore likely to remain open to debate.

Nationwide City Sort Private sector competitors have criticized the Federal Reserve’s 

Nationwide City Sort product as being inappropriate because it was 

developed to serve a market that was already served by private check 

processors. In March 1996, the Reserve Banks began offering the 

Nationwide City Sort product. This is a check-sorting product that is 

designed to allow a bank to deposit all of its items destined for a specific 

set of major cities with its local Federal Reserve check processing office. 

All Reserve Banks offer a uniform fee structure for the service. Prior to the 

introduction of this product on a nationwide basis, it was available on a 

limited basis in some Reserve Banks. 

Some payment system participants who compete with the Federal Reserve 

charge that the development of the Nationwide City Sort product was an 

inappropriate response on the part of the Federal Reserve to the success 

private sector competitors were having with similar products. They also 

suggested that the Federal Reserve’s prices for this product were too low 

and could not be covering costs as required by MCA. Federal Reserve 
Page 31 GAO-01-160 Federal Reserve System

documentation from the product development process notes the presence 

of other providers in this market and the lack of a comparable Federal 

Reserve product. Reserve Bank staff acknowledged that they actively seek 

to identify market needs and develop products for which there is a market. 

They see no prohibition, implied or otherwise, on developing any product 

to serve the market, and they said that the Nationwide City Sort product 

complies with their own pricing guidelines and MCA.

Explicit Float Pricing Option The Federal Reserve’s Explicit Float Pricing Option product has been 

criticized by private sector competitors as being a credit product rather 

than a payment product and representing an overly aggressive approach to 

competition in the payments system. The Federal Reserve’s Explicit Float 

Pricing Option product provides banks with availability, or credit, for all of 

the checks they deposit with Reserve Bank offices located in the eighth and 

tenth Federal Reserve districts on the day that the Reserve Banks process 

them. Otherwise, some of the items would receive deferred availability 

because of the time it would take to collect the funds for the checks. 

Deferred availability results in the respondent bank having to make 

multiple bookkeeping entries as various checks are credited to the bank’s 

reserve account, rather than a single entry. The credit is provided for funds 

that are not yet available and is referred to as “float.” The respondent bank 

pays interest on the funds credited. 

The Federal Reserve’ s competitors have suggested that this product is a 

loan rather than a payment service and that it is therefore inappropriate for 

the Federal Reserve to provide it under these circumstances. Federal 

Reserve staff respond that this is a valuable service to banks because it 

simplifies their account reconciliation processes. They further note that 

“float” is listed explicitly as a product in MCA, and therefore it is not 

inappropriate for the Federal Reserve to price float. Federal Reserve staff 

explained that the float that occurs with most Federal Reserve products is 

generally not explicitly priced; it is considered in the development of the 

price for the product.

Check Imaging/Archiving Another service that has drawn criticism from the Federal Reserve’s 

competitors is its image archiving service, which is offered as part of 

several different products. This service, which supplements the Federal 

Reserve’s electronic check presentment services, involves the capture and 

storage of a check image by the Federal Reserve. Competitors’ criticism of 

this product focuses on two issues. First, they point out that this service 

makes technology available to banks that have not invested in its 

development without requiring them to pay a premium for a new innovative 
Page 32 GAO-01-160 Federal Reserve System

service. This penalizes those banks that made substantial capital 

investments in developing such technologies because they cannot recover 

enough to make future investments worthwhile. Second, competitors 

suggest that one element of this product, storing the image of a check for 

up to 7 years, takes this service out of the realm of a payment service and 

into that of a back-office recordkeeping service. 

Federal Reserve officials respond that this product is necessary to support 

electronic check presentment30 because, in the event of a problem with a 

given check, it is necessary to have an image of the check if the check itself 

is not available. They believe that the Federal Reserve’s involvement in 

making this technology available is consistent with its stated intent to serve 

as a catalyst to move the payments system to more electronic media. 

Federal Reserve staff said that image archiving is not simply a back-office 

record-keeping product because of the necessity of the image for electronic 

check presentment. They also point out that the Federal Reserve has been 

providing other products similar to image archiving in which the Reserve 

Banks provide paying banks with the information from checks several 

hours before presenting the checks to allow the paying bank to anticipate 

its needs for funds.

The Federal Reserve’s role in developing image archiving technology has 

raised the question of the appropriate role the Federal Reserve should play 

in innovation in the payments system. Competitors and other critics of the 

Federal Reserve suggest that the Federal Reserve’s involvement in the 

development of imaging technology has penalized other banks that 

invested in this technology because it made the technology available to 

banks that did not make an initial investment, without requiring that they 

pay a premium to those that did. This means banks that did invest in the 

technology lose the opportunity to make sufficient profit from their 

investment. Competitors argue that the Federal Reserve has removed 

incentives for future innovation because banks that might be inclined to 

invest in new, untested technologies will decline to do so in anticipation of 

the Federal Reserve investing in and spreading the benefits of the 

technology. According to critics, this approach removes an important 

benefit of competition in the payments system. 

30 With electronic check presentment, the checks are presented electronically to the paying 

bank by the transmission of the magnetic ink character recognition (MICR) line data at the 

bottom of the checks rather than the paying banks’ receipt of the paper checks. The paper 

checks may be sent to the paying bank at a later time or may be “truncated.” When checks 

are truncated, the check writers do not receive the cancelled checks. 
Page 33 GAO-01-160 Federal Reserve System

Federal Reserve staff responded to this suggestion by stating that their 

involvement in developing technologies such as imaging is often critical to 

the development of these technologies. They said that they began their 

initial efforts to develop imaging technology 14 years before its 

implementation. At that time, according to Federal Reserve staff, no banks 

were investing in the technology. Federal Reserve staff suggested that if the 

Federal Reserve had not made its initial investment in the technology, no 

one else would have because the expected payoff from the technology was 

too far in the future. They said that most private sector firms might not 

make major capital investments in technologies that are unproven and may 

not be ready for 14 years. They further note that Reserve Bank customers 

pay for the services they receive, including the costs of making and 

financing the capital investments and of research and development. 

Federal Reserve staff point to their involvement in the successful 

development of the ACH system as an example of the role that they can 

play in innovation. They said that prior to their involvement, private sector 

firms had the opportunity to invest in the technology but did not. The 

Federal Reserve made the investment and developed the system. The 

Federal Reserve has clearly played a role in basic research and innovation 

in areas in which the private sector is hesitant to invest either because of 

uncertainty or expected length of time before payoff. However, once 

certain approaches appear feasible, the private sector can be much more 

flexible and responsive than the Federal Reserve if the private sector is not 

constrained by market conditions that have been altered by the Federal 

Reserve’s dominant presence or if the benefits are not lowered by the 

Federal Reserve spreading the benefits of a technology faster than the 

market otherwise would.

The Federal Reserve 

Coordinates District-Based 

Sales Staffs to Maintain and 

Expand Customer Base

Each Reserve Bank maintains a business development staff that includes 

account representatives who work directly with banks to promote Federal 

Reserve payments products. Federal Reserve staff explained that the 

Federal Reserve’s marketing staff has a dual structure. It is Federal Reserve 

district-based, with a national overlay. The Business Development Office 

located in the Federal Reserve Bank of Chicago coordinates the Federal 

Reserve System’s marketing efforts. This office provides a national 

coordinating function for the marketing staffs located in each of the 

Reserve Banks. Each Reserve Bank marketing staff is expected to develop 

and maintain business relationships with banks that use Federal Reserve 

payments services. This maintenance of customer relationships includes 

occasional visits to ensure that the Federal Reserve is fulfilling its customer 
Page 34 GAO-01-160 Federal Reserve System

needs or to follow up on any problems that may arise. Federal Reserve staff 

explained that much of the discussion between sales staff and commercial 

banks surrounds the solving of problems that may arise in providing 

payment services rather than aggressively promoting the use of Federal 

Reserve services. However, proposed solutions will generally include use 

of Federal Reserve products.

The Federal Reserve’s sales staff numbers 279 staff nationwide. However, 

many of these staff have other responsibilities in addition to their sales 

responsibilities. Reserve Bank staff said that the ratio of customers to sales 

staff is such that most banks receive visits from Federal Reserve sales staff 

only every 2 or 3 years. Although it is not a systemwide practice, two of the 

Reserve Banks and two Reserve Bank offices maintain a bonus system that 

rewards sales staff on the basis of set goals. However, Federal Reserve 

officials said that the sizes of the bonuses are relatively modest, generally 

no more than 5 percent of salary; and the goals are generally based on 

strategic initiatives, such as the number of new electronic check 

presentment customers that a member of the sales staff may have gained. 

Federal Reserve Products 

Receive Differing Levels of 

Review on the Basis of Their 

Expected Impact

Federal Reserve policies provide for varying levels of review and approval 

for their retail payment products depending on the expected competitive 

impact of the product or the extent to which the product is considered to 

represent a new service line. A routine proposal would be expected to 

result in minimal reaction from users and other service providers, pertain 

to a change that does not have policy or significant competitive 

implications, and enable the changed product to recover incremental costs. 

It would not be expected to substantially change budgeted service 

revenues in the first year of introduction. A nonroutine service or product 

would represent a new service line, a new product within an existing 

service line that would significantly modify the service line, or a new fee 

structure for an existing service line. 

Nonroutine proposals require approval by either the Board or the director 

of DRBOPS. The Financial Services Policy Committee31 has the authority to 

approve routine proposals but can delegate this authority to the 

appropriate Reserve Bank product director. In recent years, the Federal 

31 The Financial Services Policy Committee was created in late 1994 to coordinate 

management and strategic planning for the provision of financial services by the 12 Reserve 

Banks and has oversight for ensuring quality control for Reserve Bank products.
Page 35 GAO-01-160 Federal Reserve System

Reserve has been attempting to minimize the bureaucratic review 

associated with approving routine products. In some cases, products are 

treated as accelerated products, which are routine products that can be 

approved by Reserve Bank product directors because they are considered 

to be very similar to already existing products. Of the 119 check products 

approved in 1999, 2 were treated as nonroutine, 92 were treated as routine, 

and 25 were accelerated. Two new ACH products were approved in 1999, 

and both were treated as nonroutine. Federal Reserve staff said that very 

few of the 119 proposals were for new products. Rather, most of the routine 

proposals were for small changes in fees or deposit deadlines or to offer 

existing products at offices that did not previously offer a particular 

product.

In some instances, the Board will conduct a competitive impact analysis 

when considering an operational or legal change, such as a change to a 

price or service if that change would have a direct and material adverse 

effect on the ability of other service providers to compete effectively with 

the Federal Reserve in providing similar services due to differing legal 

powers or constraints or due to a dominant market position the Federal 

Reserve has derived from such legal differences. Board policy states that 

all operational or legal changes having a substantial effect on payments 

system participants will be subject to a competitive impact analysis, even if 

competitive effects are not apparent on the face of the proposal. Under 

similar circumstances, the Board may request comment on matters related 

to Reserve Bank priced services, including new products or services. 

The Federal Reserve maintains policies to guide its decisions with regard to 

the level of review that products should receive and whether to conduct a 

competitive impact analysis or issue matters for comment. However, Board 

staff said that the decision is ultimately judgmental. Federal Reserve staff 

said that over time, the Federal Reserve has delegated more of the 

authority to approve new products and product enhancements in an effort 

to make the process more efficient. They conceded that products that may 

have once been considered nonroutine may now be considered routine. 

They said that it is possible that a product that may have once been the 

subject of a request for public comment might not be today. The Board’s 

pricing principles, which were adopted following public comment, provide 

that the Board will request public comment “. . . when changes in fees and 

service arrangements are proposed that would have significant longer-run 

effects on the nation’s payments system.” 
Page 36 GAO-01-160 Federal Reserve System

Some competitors to the Federal Reserve we interviewed said that they 

were unsure of how the Federal Reserve develops and announces new 

products and services. Staff at one correspondent bank said that they did 

not know a specific Reserve Bank was offering a particular check product 

until they discovered it on the Reserve Bank’s Web site or in pricing 

circulars. Other competitors said that certain products, such as the 

Nationwide City Sort, should have been issued for public comment before 

being introduced. Competitors also complained that the Board did not do 

competitive impact analyses when it should have. Although Board policies 

concerning these issues are available, they are generally not published in a 

manner that makes them easily available to the public. 

Our interviews with Federal Reserve staff and their private sector 

competitors revealed very different understandings of the Federal 

Reserve’s policies with regard to the appropriate level of review certain 

products should have received prior to their introduction. Generally, these 

different understandings resulted in the Federal Reserve’s private sector 

competitors believing that the Federal Reserve had not followed its own 

policies. Meanwhile, Federal Reserve officials stated that the routine 

nature of these products made such review unnecessary. The Federal 

Reserve’s change in philosophy over the appropriate level of review for 

some products seems to have further contributed to these differing 

understandings of Federal Reserve policies and procedures. Although the 

policies themselves have not changed over time, the Federal Reserve’s 

judgements in implementing them appear to have changed, with increased 

authority delegated to the Reserve Banks. This has resulted in very 

different understandings of the appropriateness of the Federal Reserve’s 

actions in competing for check clearing and ACH business.

Conclusions The Federal Reserve plays multiple roles in the payments system by virtue 

of its status as central bank, banking industry regulator, and payments 

service provider. Where these roles overlap, conflict, or potentially 

complement one another inappropriately, the Federal Reserve is faced with 

the challenge of managing or separating them in such a way as to ensure 

that it is fulfilling each role without exerting undue influence or giving itself 

an advantage at the expense of the banking industry or its private sector 

competitors in providing payment services. In doing our work, we found no 

evidence to suggest that the Federal Reserve has not adequately separated 

its multiple roles.
Page 37 GAO-01-160 Federal Reserve System

As a central bank and banking industry regulator, the Federal Reserve is 

inherently different from a correspondent bank, private clearing house, or 

PSO. Many of the competitive disparities resulting from these differences 

cannot be removed without changing the structure or nature of the various 

institutions. In many cases, where it has been possible for the Federal 

Reserve to remove competitive disparities between itself and its private 

sector competitors, it has done so to a degree. However, some competitive 

disparities that the Federal Reserve could remove or decrease persist, for 

varying reasons. 

The Federal Reserve, through MCA and its pricing principles, has broad 

latitude in setting prices for its services. The Federal Reserve generally 

uses this latitude to help ensure that its prices are competitive. Although 

the PSAF is supposed to ensure that the Federal Reserve’s prices allow for 

equitable competition with the private sector, the PSAF methodology has 

been criticized as flawed. For example, some contend that the targeted 

return on equity is too low, and therefore the PSAF is too low. Others said 

the PSAF is too high. Federal Reserve officials acknowledge that the 

methodology used to simulate the costs and profits that would have to be 

incurred by a private sector competitor is problematic. In addition, they 

prefer to use publicly available data that can be disclosed to help ensure 

the transparency of the PSAF methodology. However, this information 

includes bank holding company data that are not limited to the 

correspondent banking activity that is most closely related to Reserve Bank 

payment activities. The Federal Reserve’s current review of its PSAF 

methodology is well under way. However, in future reviews, the Federal 

Reserve could benefit from including a wider variety of participants in the 

effort, including some from outside of the Federal Reserve. 

The Federal Reserve’s use of pension cost credits to offset the cost of 

priced services has also been criticized. Initially, these pension cost credits 

were small and generally offset associated postretirement and 

postemployment expenses. However, as the pension cost credit continued 

to increase, the associated expenses generally remained unchanged, which 

resulted in a large increase in the amount of pension cost credit in excess 

of the expenses. The Federal Reserve is free to allocate these credits to 

offset costs for priced services, but in doing so it has opened itself to 

criticism about how it prices its services and whether such a practice is 

beneficial from a public policy perspective. The credits have offset 

operating expenses for priced services and have allowed the Federal 

Reserve to meet its targeted return on equity, as required by MCA, without 

having to raise prices and/or cut costs. However, in 2000, the PSAF 
Page 38 GAO-01-160 Federal Reserve System

increased substantially because of the recognition of certain prepaid 

pension assets and postretirement and postemployment liabilities in its 

asset and equity figures. This will serve to offset some of the benefit 

associated with the pension cost credit.

The Federal Reserve has developed and marketed products in such a way 

as to compete actively for banks’ payment business. We found no evidence 

that its actions in this regard have been in violation of MCA. However, the 

Federal Reserve’s policies for developing and marketing products is not 

well understood by its private sector competitors. Although the Federal 

Reserve established its policies in this area some time ago, its judgements 

with regard to their appropriate implementation have changed over time. 

For example, new products that formerly may have been subject to 

approval by the Board are now more likely to be approved through 

delegated authorities at the Reserve Bank level. The Board has also been 

less inclined to use the public comment process than in the past. This has 

resulted in misunderstandings among private sector competitors about the 

propriety of some of the Federal Reserve’s actions in developing and 

marketing their products. These misunderstandings are exacerbated by 

continuing disagreements about whether, and to what degree, the Central 

Bank should be involved in the payments system.

Recommendations Although it may be too late in the current review of its PSAF methodology 

for the Federal Reserve to include participants from outside the Federal 

Reserve throughout the review process, we recommend that in future 

reviews the Board solicit input from individuals from outside the Federal 

Reserve, including academics and industry officials, at an earlier stage in 

reviews of the PSAF methodology and allow them to participate 

throughout the review process, perhaps including the evaluation of 

comments on any proposed PSAF revision, to determine if there are better 

ways to structure the PSAF.

We also recommend that the Federal Reserve clarify policies and 

procedures for introducing new products and product enhancements to the 

payments industry and make those policies more readily available to its 

private sector competitors.

Agency Comments We received written comments on a draft of this report from the Board that 

are reprinted in appendix IV. The Board generally agreed with our 
Page 39 GAO-01-160 Federal Reserve System

conclusions and indicated its intention to assess the role academics and 

industry officials could play in subsequent reviews of its PSAF 

methodology. The Board also said that it will clarify its priced service 

policies and practices and make them more accessible to interested 

parties. The Board provided technical comments that we incorporated 

where appropriate.

We are sending copies of this report to requesting congressional 

committees. We are also sending copies of this report to the Honorable 

Alan Greenspan, Chairman of the Board of Governors of the Federal 

Reserve System. We will make copies available to others on request.

Please contact me or Orice Williams, Assistant Director, at (202) 512-8678 if 

you or your staff have any questions concerning this letter. Key 

contributors to this report are acknowledged in appendix VI

Thomas J. McCool

Managing Director, Financial Markets and

Community Investment
Page 40 GAO-01-160 Federal Reserve System

LIST OF CONGRESSIONAL REQUESTERS

The Honorable Phil Gramm 

Chairman

Senator Paul S. Sarbanes 

Ranking Minority Member 

Committee on Banking, Housing and Urban Affairs 

United States Senate

The Honorable James A. Leach 

Chairman 

Representative John J. LaFalce

Ranking Minority Member 

Committee on Banking and Financial Services 

House of Representatives 

The Honorable Carolyn Maloney

Committee on Banking and Financial Services

House of Representatives
Page 41 GAO-01-160 Federal Reserve System
Page 42 GAO-01-160 Federal Reserve System

Appendix I

Objectives, Scope, and Methodology ApApenednxidexiIs

To review the Federal Reserve’s role in the payments system, our objectives 

were to (1) identify organizational relationships and differing goals within 

the Federal Reserve that could present a conflict of interest and identify 

Federal Reserve Policies for managing or avoiding any conflicts; (2) 

identify any competitive advantages enjoyed by the Federal Reserve 

compared to its private sector competitors and evaluate the extent to 

which the Federal Reserve, through changes to its regulations and 

operating policies, has or has not removed them; (3) review how the 

Federal Reserve has priced its services; and (4) review Federal Reserve 

policies for developing and marketing its services.

We focused our work on the retail payments services provided by the 

Reserve Banks, check collection and the automated clearinghouse (ACH), 

because these services account for over 90 percent of the Federal Reserve’s 

revenue from payments services. Moreover, it is in the retail payments 

services that the Federal Reserve has received the most private sector 

competition and has received the most public criticism of how it has 

competed.

To fulfill our objectives, we interviewed

• staff from the Federal Reserve Board’s Division of Reserve Bank 

Operations and Payment Systems, which is the Board’s Division 

primarily responsible for overseeing the Reserve Bank’s payments 

activities;

• Reserve Bank staff from the Atlanta, Boston, and Chicago Federal 

Reserve districts, because these staff are involved in providing national 

coordinating functions for the Federal Reserve’s payment services;

• staff from various groups representing participants in the payments 

system, including the Independent Community Bankers Association, 

American Bankers Association, National Automated Clearinghouse 

Association, and Association of Bank Couriers;

• staff from various competitors of the Reserve Banks in providing 

payments services, including five large banks involved in the check 

collection business, representatives of two private ACH operators, and 

two check clearing houses; 

• staff from 20 community banks located throughout the United States 

who had assembled in Washington, D.C. for a conference sponsored by 

the Independent Community Bankers Association, and 

• former officials of the Federal Reserve who were active during their 

tenures with the Federal Reserve in payments issues.
Appendix I

Objectives, Scope, and Methodology

Page 43 GAO-01-160 Federal Reserve System

To identify organizational relationships and differing goals within the 

Federal Reserve that could present a conflict of interest, we reviewed the 

Federal Reserve Act, Monetary Control Act, and the Expedited Funds 

Availability Act. In addition, we reviewed Board policies for managing 

and/or separating its responsibilities and roles in the payments system. 

During our interviews of the staff listed above, we sought any indication or 

evidence of breaches of the Federal Reserve’s policies separating its 

various roles in the payments system. We also followed up on allegations 

raised by others of breaches of the Federal Reserve’s separations. 

To identify any competitive disparities between the Federal Reserve and its 

private sector competitors in check and ACH payment services, and the 

extent to which the Federal Reserve has removed them, we interviewed 

Federal Reserve Board and Reserve Bank officials and private sector 

competitors in check and ACH services. We reviewed the Board’s changes 

to Federal Reserve policies and regulations for check and ACH services 

and previous GAO work on the Federal Reserve System, check collection, 

and other payment mechanisms. For identified check competitive 

disparities, we determined whether the Board addressed these disparities 

by making changes to Regulations CC and J to level the playing field 

between the Reserve Banks and the private competitors. For identified 

ACH disparities, we reviewed the Board’s recent proposals to modify the 

Reserve Banks’ ACH pricing and deposit deadline policies. We interviewed 

affected parties, including Reserve Banks, correspondent banks, and 

private ACH providers, along with major organizations representing 

banking institutions, clearinghouses, and private ACH providers. For each 

of these interviews, we asked similar questions to determine the 

respondents’ views of the competitive balance between the Federal 

Reserve and its private sector competitors in providing payment services. 

We also reviewed comment letters submitted to the Board on its 

rulemaking efforts under Regulation CC and on its proposed modifications 

to the Reserve Banks’ ACH pricing and deposit deadline policies. 

To review how the Federal Reserve has priced its services, we reviewed the 

requirements placed on the Federal Reserve by the Monetary Control Act 

of 1980 (MCA) and the Federal Reserve’s own pricing principles. We also 

reviewed the Federal Reserve’s Private Sector Adjustment Factor (PSAF) 

methodology and its pro forma financial statements and other pricing 

information contained in the Federal Reserve Board’s annual reports, the 

Federal Reserve’s fee schedules for priced services, and the Federal 

Reserve’s Planning and Control System (PACS). In addition, we reviewed 

Financial Accounting Standards Board standards, including Financial 
Appendix I

Objectives, Scope, and Methodology

Page 44 GAO-01-160 Federal Reserve System

Accounting Standard No. 87, Employers Accounting for Pensions; and 

Financial Accounting Standard No. 106, Employers’ Accounting for Post 

Retirement Benefits Other Than Pensions. We reviewed our previous work 

on the Federal Reserve’s pricing for priced services and on the PSAF, the 

Federal Reserve Board Office of Inspector General’s (OIG) report on the 

Board’s compliance with MCA, and OIG’s follow-up work on its 

recommendations. We discussed all of this material with the Federal 

Reserve Board and Reserve Bank staff involved in the pricing process. We 

also interviewed individuals from outside the Federal Reserve who have 

publicly expressed opinions about the Federal Reserve’s pricing practices. 

To review how the Federal Reserve has developed and marketed its check 

and ACH services, we reviewed Board policies on its delegated authorities 

for approving payment products and on soliciting public comments for 

product proposals. We also interviewed Reserve Bank staff to ascertain 

how these policies are implemented. To determine the level of 

understanding of these processes in the private sector, we interviewed 

private sector payments participants. 

We received written comments on a draft of this report from the Board that 

are reprinted in appendix IV. The Board also provided technical comments 

that we incorporated where appropriate.
Page 45 GAO-01-160 Federal Reserve System

Appendix II

Check Relay ApendxiI

The Reserve Banks have contracted with private-sector couriers to provide 

centrally managed air and ground transportation system for checks since 

the mid-1970s. Until 1998, the Reserve Banks’ retail payment management 

and management of the air transportation system, the Interdistrict 

Transportation System (ITS), was located at the Federal Reserve Bank of 

Boston, where questions were raised about its cost recovery and how its 

operations were managed.1

 In 1998, the retail payment function, including 

ITS, was moved to the Federal Reserve Bank of Atlanta, and ITS was 

renamed Check Relay. However, controversy persists about how the 

Federal Reserve recovers costs associated with the transportation of 

checks. Although Check Relay is very similar to its predecessor system, 

Reserve bank officials said they reevaluated the check transportation 

system at the time it was moved to Atlanta and will continue to evaluate its 

purpose and function. Recent changes have included allowing their 

contracted air couriers to carry non-Federal Reserve freight, called 

conjunctive work, and increasing the number of commercial vendors it 

used for certain routes. 

Background In 1985, we issued a report that addressed concerns raised about the 

Federal Reserve’s pricing of check clearing activities.2

 This report included 

a discussion of the Reserve Banks’ air transportation system for checks, 

then called ITS. Several air couriers who competed with ITS complained 

that the Federal Reserve’s method of pricing can impede competition. 

Federal Reserve officials said that their decisions for accounting for 

transportation revenues and costs paralleled those of the private sector. In 

our 1985 report, we reported that the Federal Reserve had established 

interterritory transportation surcharges to help offset the cost of 

transportation and to help equalize check processing prices for all 

institutions using Federal Reserve services, whether the Federal Reserve’s 

transportation was used or whether an institution’s own transportation was 

used. We agreed that the way the Federal Reserve priced its services could 

pose a problem for private sector courier firms that did not have Federal 

1

On January 5, 1996, the Democratic Staff of the Committee on Banking and Financial 

Services, U.S. House of Representatives, released a report entitled Waste and Abuse in the 

Federal Reserve’s Payment System that detailed a number of managerial problems with ITS. 

These problems were further explored in hearings before that same committee’s 

Subcommittee on Domestic and International Monetary Policy held on September 16, 1997.

2 An Examination of Concerns Expressed About the Federal Reserve’s Pricing of Check 

Clearing Activities (GAO/GGD-85-9, Jan. 14, 1985).
Appendix II

Check Relay

Page 46 GAO-01-160 Federal Reserve System

Reserve contracts. However, we recognized that requiring the 

transportation surcharge to exactly cover costs for each market area would 

be difficult to administer, is not required under existing law, and would not 

necessarily be effective. In 1983, we found that transportation surcharges 

did not cover costs. Complaints about ITS pricing practices have persisted 

since the mid-1980s. Problems with ITS were most recently explored in 

hearings before the Committee on Banking and Financial Services, House 

of Representatives, on September 16, 1997.

Structure and 

Operation of Check 

Relay

Check Relay, formerly ITS, is managed by the Federal Reserve Bank of 

Atlanta. Like its predecessor, Check Relay provides routine ground and air 

transportation service to 45 Regional Check Processing Centers (RCPC) or 

check offices throughout the country. Although Check Relay’s seven 

vendors generally provide exclusive air transportation service to the 

Federal Reserve for its specified routes, the network is managed by the 

Federal Reserve.3

 As part of the management function, the Federal Reserve 

establishes flight schedules and routes, transfers cargo from plane to plane 

at the hubs, tracks the cargo, and performs periodic reviews. In addition to 

the seven vendors mentioned previously, several other contract vendors 

provided airfreight forwarding, which was managed by a private sector 

firm under contract with the Reserve Banks.

Check Relay is used to transport checks from one Reserve office to another 

and between Reserve offices and financial institutions. On weekdays, it 

uses a centrally managed hub and spoke network to connect all Federal 

Reserve offices, except those in the Twelfth district. Because of the time 

difference on the West Coast, checks from other districts are sent to the 

Twelfth District via commercial air freight forwarding that ties into Check 

Relay at Cincinnati. Reserve Bank officials said that commercial 

transportation is used to transport checks to and from the Twelfth district 

because time zone differences prevent the Federal Reserve Bank of San 

Francisco from providing same-day availability for out of district banks. 

Therefore, the transportation of the checks is less time critical. These 

officials also said that they use a commercial vendor to provide air freight 

forwarding service for all checks on the weekend instead of a dedicated 

network because these checks have longer time windows between deposit 

and delivery deadlines.

3

 In 1999, the Federal Reserve began a pilot program permitting vendors to carry conjunctive 

work. In addition, one of the vendors was allowed to sublease a route to another air courier.
Appendix II

Check Relay

Page 47 GAO-01-160 Federal Reserve System

How the Federal 

Reserve Recovers 

Transportation Costs

The Federal Reserve’s recovery of transportation costs has been the 

subject of controversy since the passage of the Monetary Control Act of 

1980. Its competitors believe that the Federal Reserve subsidizes the costs 

associated with air transportation. Over the years various legislative 

proposals have been introduced that would have required the Federal 

Reserve to treat transportation as a separate product and recover its costs 

separately from other costs associated with check collection.4

 Federal 

Reserve officials believe that transportation is not a distinct product; 

rather, they see it as one component of check collection. For example, 

Federal Reserve officials said that they consider check transportation 

similar to other components of the check service, such as data processing 

and telecommunications, which are not separate services subject to 

separate cost recovery requirements.

The Federal Reserve’s policy is to match revenue and cost by service line, 

such as check collection, rather than individual categories of costs, such as 

transportation. This means that check transportation costs are recovered 

within the check service line, not per individual check product. Federal 

Reserve officials said that they do not view check transportation costs as a 

direct component of each product; instead, they are allocated and 

recovered by service line. Federal Reserve officials said that Check Relay’s 

goal is to contribute to the recovery of total costs for the check service line. 

Air couriers who provide transportation services to collecting banks point 

out that the Federal Reserve’s method of pricing can make a difference in 

their efforts to compete with Check Relay. For example, some complain 

that the Federal Reserve’s transportation costs must be higher than those 

reflected in its prices, which makes it difficult for air couriers to compete. 

Aside from Check Relay, only one air courier offers nationwide service 

carrying checks. As of September 2000, it carried about three times as 

much volume as Check Relay on any given night. Reserve Bank officials 

estimate that they transport about 15 to 20 percent of nonlocal checks.

Check Relay costs allocated to priced services are recovered by fees for 

those services. Reserve Bank officials said that its transportation costs are 

4

These legislative proposals have included, among others, H.R. 1442, “The Federal Reserve 

Free Enterprise Act,” introduced in 1997, which would have included the transportation of 

paper checks as a separately priced service; and H.R. 2119, “the Efficient Check Clearing Act 

of 1997,” which would require cost-revenue matching for specific Federal Reserve-provided 

services, including check transportation.
Appendix II

Check Relay

Page 48 GAO-01-160 Federal Reserve System

recovered through a surcharge on certain products and included as a flat 

rate for others. Check Relay officials estimated that air and ground 

transportation costs represent about 3 to 4 percent of the Reserve Banks’ 

cost of check collection. The Federal Reserve generally does not price 

according to distance but instead uses the average cost of providing 

transportation nationwide. According to some of the correspondent bank 

officials we spoke with, average costing is consistent with the 

transportation costing methodology used by correspondent banks. In 1999, 

improved information systems demonstrated that Check Relay 

transportation components in check product prices independently covered 

the service line’s national transportation costs. 

Federal Reserve 

Decision to Allow 

Conjunctive Work

In December 1999, at the urging of correspondent banks and Federal 

Reserve air vendors, the Federal Reserve instituted a pilot program that 

would allow its air transportation vendors to carry non-Federal Reserve 

cargo, known as conjunctive work, on Federal Reserve routes. This type of 

arrangement is not new to the Federal Reserve; conjunctive work was once 

allowed on Federal Reserve air routes, and it has always been allowed on 

its ground routes. However, for decades prior to December 1999, the 

Federal Reserve required its air transportation vendors to carry Federal 

Reserve cargo exclusively. In the 1990s, the Federal Reserve solicited 

comments on a proposal to allow Federal Reserve vendors to carry 

conjunctive work once again. On the basis of comments received, the 

Federal Reserve decided not to permit conjunctive work at that time. 

In the late 1990s conjunctive work became an issue once again as the 

Federal Reserve looked for ways to lower its operating expenses. At the 

prompting of its vendors and at least one large correspondent bank, the 

Reserve Banks implemented a pilot program in 1999 that would allow 

conjunctive work. Reserve Bank officials also estimated that most of its 

vendors fly with 75 percent excess capacity. As part of its 1998 request for 

bid process, the Federal Reserve published an amended request for bids, 

following its bidding conference, which included the option to submit 

alternative proposals based on conjunctive work. Although respondents 

were required to submit proposals that did not include conjunctive work, 

they were invited to submit alternative proposals that included conjunctive 

work. Reserve Bank officials said that they received three proposals with 

the alternative included.5

 Officials said that the pilot program became 

permanent in the Spring of 2000. As of June 2000, only one air 

transportation vendor routinely carried conjunctive work. 
Appendix II

Check Relay

Page 49 GAO-01-160 Federal Reserve System

Reserve Bank officials said that a portion of fees generated by vendors for 

conjunctive work will be used to offset the contract costs of transportation 

incurred by the Reserve Banks. For example, if the current rate used to 

calculate the fee is $1.25 per pound of conjunctive work carried, and a 

vendor carries 400,000 pounds of conjunctive work annually, and the 

Federal Reserve contract cost is $2 million, the contract costs after the 

adjustment for the conjunctive work would be $2 million minus $500,000, 

or $1.5 million. According to officials, the vendor that carried conjunctive 

work as of June 2000 carried an average of 2,000 pounds of conjunctive 

work daily (compared to 50,000 pounds carried overall). 

Reserve Bank officials said that its current system is well suited to manage 

this program and that it has various mechanisms in place to monitor its 

usage. For example, Federal Reserve cargo is to remain the vendor’s first 

priority, and the Federal Reserve plans to monitor conjunctive work 

through the Federal Reserve’s weight tracking system and by the fact that 

cargoes are transferred from plane to plane by Reserve Bank personnel. 

The vendors also have to disclose what non-Federal Reserve cargo they are 

carrying.

Federal Reserve 

Extends Existing 

Contracts 

As mentioned previously, the Federal Reserve Bank of Atlanta plans to 

continuously reevaluate the current transportation system in search of 

more cost-effective alternatives. The movement toward conjunctive work 

was identified as one way to cut costs. Reserve Bank officials said that they 

also plan to thoroughly reevaluate the system over the next several years to 

measure the benefits of the system versus the costs. These officials also 

said that as electronic payments continue to grow, the need for air 

transportation to move paper checks will likely decrease over time. As part 

of the Federal Reserve Bank of Atlanta’s planned efforts to review Check 

Relay, Reserve Bank officials said that they opted to extend the expiration 

dates of existing contracts so that all the contracts expire at the same time. 

These officials said that they felt that 2003 would be sufficient time for 

them to review various alternatives to the existing transportation structure. 

However, at least one air courier has criticized the Reserve Bank’s decision 

to extend the existing contracts rather than requesting new bids for all 

contracts in light of the new policy concerning conjunctive work.

5

Although three alternative bids were submitted, officials said that none were selected on 

the basis of the alternative proposal for various reasons.
Appendix II

Check Relay

Page 50 GAO-01-160 Federal Reserve System

In addition to allowing conjunctive work, the Reserve Bank has taken other 

steps to lower its transportation costs. In June 2000, it approved a sublease 

arrangement between one of its vendors and another air courier to cover 

one of its routes because both the Reserve Bank vendor and the other air 

courier were flying the same route with excess capacity of over 75 percent. 

Reserve Bank officials said that they are open to similar arrangements, 

provided the arrangement would lower costs without hampering service. 

Further, they said that all options would be considered over the next few 

years, including abandoning Check Relay. However, these officials 

cautioned that any alternative system would have to enable the Reserve 

Banks to provide service to all depository institutions on an equitable basis. 

Reserve Bank officials said that their biggest concern with the Reserve 

Banks not having their own network is that commercial air couriers can 

exit the market or drop a service at any time, and there is only one 

commercial national air courier currently dedicated to check collection. 

They also said that one air courier had recently stopped providing a 

service, which resulted in Check Relay having to fill the void. 
Page 51 GAO-01-160 Federal Reserve System

Appendix III

The Federal Reserve’s Pricing Process ApendxiI

Since the implementation of the Monetary Control Act of 1980 (MCA), the 

Federal Reserve has charged fees for providing payment services. The act 

required the Federal Reserve to charge fees to cover the costs of those 

services it provides to depository institutions. In setting prices, the Federal 

Reserve is bound by several broad pricing principles. To ensure some level 

of price parity, the act requires that the Federal Reserve recover its total 

direct, indirect, and imputed costs for priced services, including check 

collection and ACH, over the long run.1

 These imputed costs represent the 

private sector adjustment factor (PSAF). Although the act requires the 

Federal Reserve to recover all implicit and explicit costs over the long run, 

it also gives the Federal Reserve the flexibility to consider other factors 

when setting its prices, such as market efficiency, equity, and competitive 

impact. 

Pricing Principles In setting its prices, the Federal Reserve considers several broad principles, 

including explicitly pricing services and recovering cost “over the long 

run.” The Federal Reserve explicitly prices and annually publishes its fees 

for priced services in the Federal Register. It has also defined the long run 

as 10 years. MCA requires that the Federal Reserve follow certain 

principles when pricing its products. These broad statutory principles 

include the following: 

• All Reserve Bank services covered by the fee schedule shall be priced 

explicitly.

• All Reserve Banks services covered by the fee shall be available to 

nonmember depository institutions, and such services shall be priced at 

the same fee schedule applicable to member banks, except that 

nonmembers shall be subject to any other terms, including a 

requirement of balances sufficient for clearing purposes, that the Board 

may determine are applicable to member banks.

• Over the long run, fees shall be established on the basis of direct and 

indirect costs actually incurred in providing priced services, including 

1

 The act also lists the following services: currency and coin services, wire transfer services, 

settlement services, securities safekeeping services, Federal Reserve float, and any new 

services that the Federal Reserve offers.
Appendix III

The Federal Reserve’s Pricing Process

Page 52 GAO-01-160 Federal Reserve System

interest on items credited prior to actual collection, overhead, and an 

allocation of imputed costs (PSAF), which is to include taxes that would 

have been paid and the return on capital that would have been earned 

had the services been provided by a private business firm. However, the 

pricing principles shall give due regard to the provision of an adequate 

level of services nationwide as well as competitive factors when setting 

prices.

• Interest on items credited prior to collection shall be charged at the 

current rate applicable in the market for federal funds.

In addition to the statutory principles delineated in MCA, the Federal 

Reserve adopted additional pricing principles it is to follow when setting 

pricing. These broad principles are:

• Fees are to be set so that revenues for major service lines match explicit 

and imputed costs. If, in the interest of providing an adequate level of 

services nationwide, the Board determines to authorize a fee schedule 

below cost, it will announce its decision.

• Service arrangements and related fee schedules shall be responsive to 

the changing needs for services in particular markets. Users and 

providers of similar services will be given advance notice for changes in 

fees and significant changes in service arrangements to permit orderly 

adjustments.

• The structure of fees and service arrangements may be designed to both 

improve the efficient utilization of Federal Reserve services and to 

reflect desirable longer run improvements in the nation’s payments 

system. Public comment will be requested when changes in fees and 

service arrangements are proposed that would have significant longer 

run effects on the nation’s payments system.

In 1984, the Federal Reserve also implemented a policy regarding the 

treatment of surpluses and shortfalls that may arise in providing priced 

services. This policy states that the Federal Reserve sets fees to recover 

projected costs for the calendar year rather than to offset prior years’ 

surpluses or shortfalls.
Appendix III

The Federal Reserve’s Pricing Process

Page 53 GAO-01-160 Federal Reserve System

Private Sector 

Adjustment Factor 

Based on Bank Holding 

Company Model

As previously mentioned, MCA requires the Federal Reserve to calculate 

certain implicit costs that are incurred by private sector service providers 

but not the Reserve Banks. The purpose is to ensure that the Federal 

Reserve does not enjoy a price advantage based on its quasi-governmental 

status. The PSAF includes costs associated with taxes, Federal Deposit 

Insurance Corporation (FDIC) premiums, financing costs, and imputed 

profit. The PSAF is calculated annually by the Federal Reserve from 

information provided by the Reserve Banks. The calculation process starts 

as part of the Federal Reserve’s annual budget process and the final PSAF 

amount is usually announced in November. The year 2000 PSAF allocated 

to priced services was $192.6 million, an increase of 66 percent, or $76.8 

over the 1999 amount. According to Federal Reserve documents, the large 

increase was mainly attributed to the identification of additional costs 

related to certain pension assets and benefits.

The first step in the methodology for calculating the PSAF involves 

determining the average book value of Federal Reserve assets that will be 

used in providing priced services during the coming year. Second, shortterm assets are assumed to be financed with short-term liabilities; longterm assets are assumed to be financed with a combination of long-term 

debt and equity derived from the average of the largest 50 bank holding 

companies (BHC). Third, imputed costs are determined by applying related 

interest rates and rates of return on equity from the BHC model. The longterm debt and equity rates are based on BHCs in the model for the last 5 

years. Because short-term debt, by definition, matures within 1 year, only 

data for the most recent year are used for computing the short-term rate. In 

addition to these capital costs, the PSAF comprises imputed sales taxes, 

expenses of the Board related to priced services, and an imputed FDIC 

insurance assessment on clearing balances held with the Reserve Banks to 

settle transactions.

The BHC model used to derive the ratios used in the PSAF includes 

financial data obtained from the annual reports and Securities and 

Exchange Commission filings of the 50 largest BHCs from each of the last 5 

years. The Federal Reserve derives the long-term debt and equity rates 

based on the average of the last 5 years’ bank holding company data; the 

short-term debt rates are based on the most recent year’s data used. 

Federal Reserve officials indicated that BHC information used for the PSAF 

calculation contains a 2-year lag due to the timing of information 

availability. 
Appendix III

The Federal Reserve’s Pricing Process

Page 54 GAO-01-160 Federal Reserve System

The Federal Reserve Bank of Kansas City develops the PSAF 

recommendation that is then reviewed and approved by the Financial 

Services Policy Committee (FSPC) and Board along with the fee schedules. 

To determine full cost recovery, the PSAF is allocated across priced 

services. 

Federal Reserve 

Pricing Process

The Federal Reserve’s pricing process begins in June as part of its annual 

budgeting process. Each Reserve Bank produces estimated costs and pro 

forma revenue statements. Board staff provide the initial estimates of 

pension cost credit, and the Federal Reserve Bank of Kansas City staff and 

FSPC staff provide the estimates of the PSAF. Fees are set to match 

revenues for major service lines with their costs. However, the Federal 

Reserve does not always fully recover costs by product line and has 

discretion in allocating certain costs across products within a service line. 

The Federal Reserve gathers expense data using PACS, a centralized, 

uniform cost accounting system used by all Federal Reserve Banks. The 

pro forma statement of priced service performance uses PACS data to 

report operating expenses by priced service.

If a depository institution or other payments system participant believes 

that the Federal Reserve’s priced services policies or practices are not in 

accord with the competitive analysis or other criteria described above, 

Federal Reserve policy instructs it to communicate its concerns to the first 

vice president of the local Reserve Bank. If the institution wishes to pursue 

the complaint, it may address the concern to the designated Board member.

Federal Reserve Uses 

Full-Cost Recovery to 

Price its Services

When setting prices for its services, the Federal Reserve uses full-cost 

recovery, which means it accumulates all direct and indirect costs, 

including the PSAF for the services identified in MCA. Indirect costs 

include support and overhead,2

 which cannot be directly attributed to 

priced services. Indirect costs are allocated to priced services in total and 

to other Reserve Banks activities on the basis of their proportion of total 

Reserve Bank costs.

2

 These costs include total Federal Reserve administrative functions, central mail 

operations, legal, budget preparation and control, expense accounting, records management 

and contingency planning, motor vehicles, and audit.
Appendix III

The Federal Reserve’s Pricing Process

Page 55 GAO-01-160 Federal Reserve System

The Federal Reserve’s pricing principles require that revenues for each 

service line, such as check collection and ACH, match total costs for that 

service line over a 10-year period. Federal Reserve policy is to set prices to 

recover its costs by service line. However, under certain circumstances, it 

may set prices below costs to encourage use of a service or in response to a 

temporary situation that could be corrected. For example, during the early 

1980s, the Federal Reserve set prices below costs for ACH to encourage its 

development and use.
Page 56 GAO-01-160 Federal Reserve System

Appendix IV

Comments From the Federal Reserve System ApendxiIV

Note: GAO comments 

supplementing those in the 

text appear at the end of 

the appendix.

See GAO comment.
Appendix IV

Comments From the Federal Reserve System

Page 57 GAO-01-160 Federal Reserve System

Note: We did not reproduce 

the technical comments.
Appendix IV

Comments From the Federal Reserve System

Page 58 GAO-01-160 Federal Reserve System

The following is GAO’s comment on the Federal Reserve System’s letter 

dated October 19, 2000.

GAO Comment The report is now titled Federal Reserve System: Mandated Report on 

Potential Conflicts of Interest.
Page 59 GAO-01-160 Federal Reserve System

Appendix V

GAO Contacts and Staff Acknowledgments ApendxiV

GAO Contacts Thomas J. McCool, (202) 512-8678

Orice Williams, (202) 512-5837

Acknowledgments In addition to those named above, Toayoa Aldridge, Thomas L. Conahan, 

Nancy Eibeck, Jeanette M. Franzel, Rosemary Healy, Robert Pollard, John 

H. Treanor, and Paul Thompson made key contributions to this report.

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