Mr. Ferguson remarks on the Federal Reserve's Role in the payments system  (Central Bank Articles and Speeches, 4 Apr 98)
Central bank: fed | Type: speech | Date: 1998-04-04

Mr. Ferguson remarks on the Federal Reserve's Role in the payments system Address by Mr. Roger W.

Ferguson, Jr., a member of the Board Governors of the US Fed Reserve System, before the Bankers' Roundtable held in Phoenix, Arizona on 4/4/98.Thank you for inviting me to speak with you today.

I am pleased to have opportunity to discuss the Federal Reserve's role in the payments system with you reasons.

The Bankers' Roundtable includes many of the major participants in the U.S. p system.

Also, our role in the payments system has received considerable attention re only by the Federal Reserve itself but also by Congress, the GAO, and the banking i including the Bankers' Roundtable.As a central bank, the Federal Reserve needs to ensure that the payments s of the United States (1) supports economic growth, which can best be done by ensurin access, (2) manages risk well, (3) is resilient in the face of crisis, and (4) continu keep pace with the needs of an evolving economy.

To achieve these goals, we serve payments provider and regulator.Today, I would like to focus on how the Federal Reserve influences the le competition in the market for payment services and how we hope, through competition, to continuing improvements in the payments system.

## Current Role of Federal Reserve as Service ProviderAs

you know, the Federal Reserve Banks provide a range of payment-relat services.

Some of these services are generally viewed as critical to the execution o Reserve's core central bank responsibilities.

For example, the Federal Reserve's cas are integral to one the Fed's primary responsibilities -- to provide for an elastic c Fedwire funds transfer system facilitates final settlement of interbank payments in ce money and provides liquidity to the financial markets to support a growing economy. settlement service facilitates the final settlement in central bank funds of payments outside the Federal Reserve.For retail payments, however, the appropriate role of the Federal Reserve i obvious.

Historically, we can understand why the Federal Reserve began to process ch ACH payments.

In an era of rudimentary communications and a fragmented banking system the early part of this century, the Reserve Banks' involvement in check collection improve the workings of the national economy, spur trade, and overcome some of the str impediments that had contributed to the financial panics in the late 1800s and early that time, checks were used far differently than they are today, and represented a pri of making interbank wholesale transfers.

Sixty years later, in the 1970s, the Feder early participation in and subsidization of the automated clearing house system pro impetus to launch that new nationwide electronic payment mechanism.I believe that fostering a competitive environment is critically importan portions of the retail payments system, including those in which the Federal Rese participant.

Indeed, the effectiveness of the U.S. retail payments systems can be cred to the competitive marketplace in which payments are provided.

The Federal Reserve pr a competitive marketplace in part through innovations that enhance the cost effective quality of our services.

An example of current initiatives we have underway that I t great potential is the use of web browser software to enable banks to communicate w Federal Reserve to send and retrieve information.

This technology will make it much einstance, for banks to order cash, retrieve images of checks, and submit the financial that we ask banks to provide regularly.

It will also significantly improve our abilit quickly to the evolving needs of our customers.The Federal Reserve is also working to streamline the check collection pr through the use of electronics and image processing.

Last year, more than 2.2 billion or about 14 percent of all checks collected by the Reserve Banks -- were pr electronically.

In addition to the growing array of image services provided by th Banks, the Fed is also leading efforts to develop industry standards for the exchange images.

Another example of current Fed innovation is in the ACH arena.

The Federal R will soon provide financial EDI translation capability available to all banks that r transactions through our Fedline software.

This capability will support the Treasury initiative and help facilitate end-to-end electronic payments.In 1980, in part to promote competition among the Federal Reserve a private-sector service providers, Congress enacted the Monetary Control Act.

MCA requi Federal Reserve to price its payment services to recover all costs of providing the se the long run, including imputed costs that would have been incurred and imputed prof would have been earned had the services been provided by a private firm.

The Federal has fully met this requirement, and I believe MCA has enhanced the competitive envir for the provision of payment services and has improved payments system efficiency.We must recognize, however, that the competitive market envisioned by Congr in the Monetary Control Act may not be fully realized due to several fundamental dif between the Federal Reserve and private firms.First, the Federal Reserve is immune to insolvency or default.

Therefo customers do not need to concern themselves with credit risk associated with using th Reserve as an intermediary bank in payment services.Second, the Reserve Banks continue to have some legal advantages over ot providers of check services, even though the Federal Reserve Board has taken steps t these advantages through its Regulation CC same-day settlement rule.Third, the Federal Reserve has a different risk-taking profile than do th firms with which it competes.

As you know all too well, many innovations that appear great promise fail in the marketplace, while others succeed.

The public nature of t Reserve, along with its self-imposed objective of achieving industry average profit m each service line, virtually dictates a more conservative approach in the marketp contrast, a private firm may be more willing to risk the funds of its shareholders in of achieving significantly higher profit margins.Finally, Federal Reserve Banks lack the flexibility afforded their privat competitors to be selective in the customers to which they will provide payment servic their pricing of those payment services.

We are also subject to far greater public disclosure than our competitors.You can see from these examples that the Federal Reserve has some mater advantages as a competitor, but also some impediments to being an effective competitor the advantages and the impediments should be kept in mind.

## Rivlin Committee StudyBecause

of these competitive inequities, it is all the more important Federal Reserve periodically reassess the need to continue to provide check and ACH ser market structure, technology, and competitive conditions evolve.

We last did so in 1997 after Chairman Greenspan established the Committee on the Role of the Federal Rese the Payments System, or the so-called Rivlin Committee.

The Committee examined a rang alternative scenarios under which payments could be provided and sought views from a number of payments system participants.Most participants urged the Federal Reserve to continue to provide check ACH services.

Many expressed concern as to whether private-sector service providers adequately meet the needs of all depository institutions, especially small institutions remote locations, if the Federal Reserve were to exit these services.

In particular, t the Federal Reserve serves certain market segments that may not yet have demonst adequate market competition, specifically, providing check and ACH services to low-v banks and providing check services to banks throughout the country that need to collec drawn on small, remote banks.The Rivlin Committee concluded that the Federal Reserve should continue provide check and ACH services, with the objectives of enhancing efficiency, prom integrity, and ensuring access.

Given the Federal Reserve's current dominant market po these services and the risk of disruption if the Federal Reserve were to exit qu conclusion makes sense.

The Committee also concluded that we should play a more active working collaboratively with providers and users of the payments system, to help strategies for moving to the next generation of payment instruments.

## Future Role of the Federal Reserve as Service ProviderFor

the longer term, will the conclusion that the Federal Reserve shoul provider continue to be the correct one?

This question hinges in large part on the exte the Federal Reserve's participation is needed to ensure the smooth functioning of the system that achieves the four goals I outlined earlier and whether there are significan private firms entry into the interbank check and ACH markets.

In other words, we need whether the Federal Reserve's operational involvement in retail payment services woul or impede competition and progress as the market for these payment services evolves.There has been much debate regarding the extent to which check markets 'contestable,' or truly subject to competition, particularly those segments of the mark the Federal Reserve serves.

Are there significant barriers to competition in these mar can they be reduced?

The Federal Reserve's market position in some segments may si indicate that there is insufficient volume to support more than one bank presenting very low-volume endpoints.

If that is the case, does this suggest that a private-sec could fill the gap if the Fed were to exit this service?

If the market will only provider, would potential entrants provide sufficient market discipline on that provide that the terms of its service are reasonable or would regulation be required?

One poss to correspondent banks providing services equivalent to the Federal Reserve's is th limited presentment abilities.

As I will discuss shortly, we are currently evaluatingPrivate-sector entry into ACH appears to face different obstacles.

Toda ACH service exhibits economies of scale over broad volume levels, which suggestsefficiency may be enhanced and unit costs minimized by having few ACH operators.

Thus Federal Reserve may have an advantage because it processes the large bulk of ACH paym We believe that the competitive environment that results from multiple ACH operators w ensure continued efficiency improvements and innovation in this service.

I belie important that the Federal Reserve take appropriate steps to stimulate the com environment in the ACH.

Our planned enhancements to our net settlement service, whic provide significant operational benefits for private-sector ACH operators and othe clearing arrangements, is clearly a step in this direction.As market conditions change, we should reassess the ability of the pr marketplace to foster the efficiency and integrity of, and access to the full ran payment services without the Federal Reserve's operational involvement.In particular, continued geographic expansion by major correspondent ba resulting from interstate branch banking will lessen the Federal Reserve's distinc nationwide service provider.

In addition, continued fast-paced technological advancem likely result in further substantial reductions in the cost of data processing communication services.

These technological improvements may reduce the barriers fac other firms in establishing or expanding the scope of their payment services.

Finally, Reserve's operational role in retail payments will decline inevitably as other type payments not provided by the Federal Reserve grow.

These changes may promote t competitive environment for the provision of retail payment services and may dimini Federal Reserve's dominant market position in the provision of these services.

## Emerging Retail Payment SystemsI know some of us are impatient with the pace of the migration of retail pa to electronic alternatives.

Earlier predictions of a cashless, checkless society clear mark.

Technological advances, however, are providing new opportunities to accelera migration to electronic payments.

New payment methods will likely continue to suppl rather than supplant, existing forms of payment.

Given the track record of previous f will refrain from speculating on the future pace of this shift from paper to electronicThe stakes for banks in making the transition from paper-based retail payme electronic ones are high.

Some industry observers estimate that payments businesses as much as one-third of industry revenues, expenses, and profits.

The risk to ban expenses from the current payments systems stay while significant new investment emerging payment methods are required.

As I see it, banks would be well advised to man transition, leverage their advantage from established customer relationships and inform harness industry-wide energy.Experience has taught us that there are often significant lags betwe introduction of a new payment instrument and its widespread use.

These lags are due t factors, such as the time required for the needed physical infrastructure to emerg required for consumers and businesses to become familiar and comfortable with using payment method, and the time necessary to achieve the critical mass of acceptance payors and payees.

In addition, it often takes a long time for service providers t scale economies that would make the new instrument cost effective compared to existingMoreover, the speed of adoption depends on the distribution of risks, cos benefits of the new payment methods among the end users of the payments as well as resfrom incumbent service providers.

Even if the marginal cost of a new payment techno equivalent to that of an existing payment, incumbents may have advantages over rivals w technologies because they may have already incurred the fixed costs of providing their may have already gained market share and familiarity with consumers.

For exam incumbents may have achieved the benefits from a large network of users, referre network externalities by economists.Adoption of new technologies may also be slowed if they require consider amounts of coordination.

A technological leader can try to establish the de facto sta developers can try to negotiate common standards, which is a time-consuming process th constrain technological innovation, but spreads risk while permitting competition for The result is a natural tension between maintaining an adequate level of competit achieving a level of cooperation that enhances efficiency and consumer welfare.I do not believe that the market for new retail electronic payment services the existence of market failures that would suggest a need for direct Federal Reserve involvement.

These products, and the markets in which they operate, appear to be e adequately on their own, just as the credit card, debit card, and ATM networks evolved Federal Reserve operational presence.Therefore, with respect to the Federal Reserve as a service provider, I t have a role as provider and enhancer in traditional payment services, check and AC probably will not be a provider of newer retail services.

I have confidence that the p marketplace can provide the combination of new products, services, and service provi meet the needs of consumers and businesses.

Our goal is to determine how we can best process of moving to these new instruments without pre-empting private sector creativ problem solving.

## Federal Reserve as RegulatorI've focused my comments thus far on the Federal Reserve's operational ro the payments system.

In addition to the Reserve Banks' role as provider of payment s the Federal Reserve Board also regulates aspects of the payments system.

While our provider of payment services goes back to the inception of the Federal Reserve, our au regulate the interbank collection or execution of payments not processed by the Federa is only about a decade old.In exercising this regulatory authority, the Board has focused in large improving the competitiveness of the market for interbank check collection.

The Board same-day settlement rule enhanced the ability of correspondent banks to compete wi Federal Reserve Banks in collecting checks.

The Board adopted this rule because it be was in the best interest of the payments system, even though it knew the rule would r Reserve Banks' check volume.

Our goal was competition in the check collection marke preserving Federal Reserve market share.As I mentioned earlier, even with the same-day settlement rule, correspo banks may still have difficulty competing with Federal Reserve Banks in some check col markets due to their more limited presentment abilities.

Several weeks ago, the Board advanced notice of proposed rulemaking designed to assess market experience under the day settlement rule.

The comments we receive will be helpful in assessing whether reductions in the legal disparities between the Federal Reserve Banks and private-secwould further enhance competition and the overall efficiencies that could result competition.This analysis is a complex one.

I believe that in principle reduction disparities between the Federal Reserve and private-sector banks will enhance competition.

The benefits of regulatory change, however, have to be balanced with a increase in costs to paying banks and their check-writing customers.

In other words, continue to look for ways to reduce legal disparities between the Federal Reserve and sector banks, but some of these changes may not reduce costs for all participants in thThe Federal Reserve's role should also include identifying and redu regulatory burdens that unreasonably inhibit innovations that improve the efficiency, and convenience of payment methods.

Regulation may reduce uncertainty for some, but i also discourage investment in new products or technologies by others.

This is particul the product is relatively new and demand for it is relatively uncertain, as is curre with a number of emerging electronic payment methods, such as stored-value cards. government should avoid regulatory actions that may inhibit the evolution of emerging p products and services or prevent the effective operation of competitive market forces. clear whether, or what type of, regulation will be needed for many new products a important to avoid jumping to the conclusion that such regulations are inevitable over term.

Often the best regulation is that which addresses specific abuses or public poli Regulation that anticipates potential future problems runs the risk of resulting in ov that unduly stifles innovation.

## ConclusionI'd like to conclude by re-emphasizing the role of competitive markets in f continued

efficiency and innovation in the U.S.

payments system.

The Federal Rese striving to foster the competitive environment for those retail payment services in wh an operational role as well as those services in which it does not.

For those servi the Reserve Banks have an operational role, they strive to provide them in a cost-effec quality manner and take advantage of technological advances.

We also plan to enhan efficiency and help to foster improvements in the services in which we have an operati I believe the Federal Reserve has an obligation as a public entity to periodically ass have just done -- the extent to which it needs to continue to provide interbank reta services in competition with private firms.For newer payments mechanisms, we do not strive to become an active provid However, we can encourage private-sector initiatives and remove regulatory hurdl experimentation, where appropriate.

We can also help, in collaboration with the priva to overcome barriers and market imperfections.

Ultimately, however, the marketplac decide which payment products and services will best meet the needs of household businesses for reliable, secure, and efficient payments.No matter whether we are discussing existing services, possible new produc regulatory actions, the Federal Reserve seeks to foster efficiency, integrity, and bro the payments system.

Our attention to this area reflects our recognition that functioning payments system is critical to the smooth functioning of the nation's econo