Mark W Olson: Perspectives on the development of a unified national
payments system in the United States
Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve
System,at the First EU/US Retail Banking Forum Conference, Brussels, 15 November 2005.
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Introduction
Good morning. I would like to thank the World Savings Banks Institute, as well as the European
Savings Banks Group, for the invitation to address this distinguished audience. I appreciate the
opportunity to share some thoughts on the development of a unified national payments system in the
United States. I am looking forward to Ms. Tumpel-Gugerell's remarks on the euro system's
perspective, and I anticipate a lively panel discussion will follow.
The European Union and the United States have had very different experiences with the origin and
evolution of their payments systems. There is a great deal to learn by studying both systems and their
ongoing changes. This morning, I would like to discuss the development of a unified national
payments system, or single payments area, in the United States. I will sketch the foundations of the
contemporary US payments system and remark on the history of US banking. I think you will
recognize some parallels with, but also important differences from, the European Union experience. I
will then discuss some of the challenges in the US experience, as well as some thoughts on the future
of the US payments system. The overarching theme of my remarks is that the United States has
evolved toward an increasingly unified national payments system, through both market-driven
development and some specific public-sector actions.
A brief history of the US banking and payments system
From the late 1700s through the mid-1800s, the development of the US banking system was
dominated by roles played by individual states. Generally, commercial banks were not chartered by
the federal government; rather, they were chartered, regulated, and supervised by the states and
operated under different state legal and regulatory frameworks. The explicit delegation of bank
supervision to the states reflected the strong preference for decentralized authority and resulted in the
first brief efforts to establish a national bank. In 1791, the federal government chartered the First Bank
of the United States with a twenty-year charter, its first attempt to establish a central bank. After that
charter lapsed in 1811, the federal government in 1816 made a second attempt to form a central bank,
by establishing the Second Bank of the United States. That twenty-year charter was also allowed to
lapse amid the economic and political controversies of that time.
In ensuing years, the banking system was highly decentralized with individual state-chartered
commercial banks issuing their own bank notes. Although there has been an academic debate about
the success of this period of competitive, private-bank note issuance, the federal government
ultimately acted to address significant problems posed by this banking structure. In the payments
system, for example, state bank notes were subject to devaluation in response to credit risk and to
counterfeiting, creating a significant burden on local and interstate commerce. In 1863 and 1865, the
National Bank Acts permitted the federal government to charter national banks and allowed these
banks to issue national bank notes backed by federal bonds. The collateralization of national bank
notes with US government bonds, along with a 10 percent tax on state notes, expedited the
acceptance of national bank notes and quickly eliminated state notes from circulation. In addition, the
United States Treasury also began directly issuing notes backed by gold in the 1870s. These
developments were important first steps in unifying the national payments system.
In retrospect, the overall fragmentation of the US banking system helped produce a fragmented
national retail payments system, including a fragmented check-clearing system. Checks, which were
traditionally cleared through local private clearing houses or correspondent banks, were the
predominant alternative to making payments with bank notes or gold. However, checks were not paid
at par. That is, checks cleared between banks in different states or locales were discounted based on
the costs of transportation needed to collect the checks, the risk profiles of the banks on which the
checks were drawn, and the need to earn a return on clearing activities. Neither the consumer nor the
merchant knew how much of the value of a check would ultimately be delivered to the intended
beneficiary, so it was difficult to determine the value of a check needed to pay a bill. As the level of
interstate commerce grew, the costs associated with this inefficient practice became quite
burdensome. Also, collecting a check could take a long time. Because a check could be forwarded to
numerous correspondent banks before ultimately being presented for payment, some public officials
charged that banks deliberately engaged in the "circuitous routing" of checks to exploit the
inefficiencies of the payments system.
The risks and inefficiencies in the fragmented banking system also resulted in bank panics, which
were relatively common, and made it difficult to transfer liquidity from one region of the country to
another. In 1913, the US Congress established the Federal Reserve System, not only to provide
greater financial stability and to improve banking supervision, but also to provide an elastic currency
and a national check-clearing system. The Federal Reserve began issuing currency in 1914.
Moreover, checks that were cleared through the Federal Reserve and that were drawn on
Federal Reserve member banks were exchanged at par value.
In the early days, the Federal Reserve's national check-clearing service was provided free of charge to
nationally chartered banks that were required to join the system and state-chartered banks that joined
voluntarily. Despite some early difficulties with achieving widespread par clearing, the
Federal Reserve's check collection services ultimately provided the nation with a much more unified
payments system.
During this period, checks or drafts were also used as a means of settling interbank payment
obligations. To improve the safety and efficiency of the interbank settlement process, in 1918 the
Federal Reserve developed and implemented Fedwire, the first real-time gross settlement system.
The key feature of the Fedwire system was the ability to transfer account balances held at the central
bank through telegraphic messages using a secure communications network. Although Fedwire was
intended to improve the large-value payment system, and quickly accomplished that goal, it was also
used for some urgent large-value commercial and retail payments, and continues to be used that way
today.
The payments operations of state and federally chartered private banks, private clearing houses, and
the operations of the new central bank, provided the foundation for the private- and public-sector
payments infrastructure that exists in the United States today. Yet for many years, policies that
deterred interstate banking shaped the design and operation of the retail payments system. The US
banking and payments system has also been shaped by other important state and federal laws.
Starting in the late 1800s, states attempted to develop a more-uniform set of commercial laws
codifying existing laws and common business practices. They eventually adopted the Uniform
Commercial Code, or UCC, which states generally enacted. At the federal level, a number of laws
influenced the development of the banking system.
Laws such as the McFadden Act and the Douglas Amendment to the Bank Holding Company Act
were passed to restrict either bank ownership or bank branching across state lines. Over the years,
legislation enacted by the various states, and ultimately at the federal level, eliminated the barriers to
banks operating across state lines, at least with respect to interstate bank acquisitions. In 1994, the
Riegle-Neal Act, which repealed most of the federal prohibitions on interstate banking, set the
foundation for establishing efficient, national retail banking and payment arrangements.
If the US banking structure is the foundation of the retail payments system, the cornerstone is the
competitive market model for payment system operators. The Monetary Control Act of 1980, or MCA,
codified the use of the competitive market model for the US payments system with the central bank as
a provider of services. Prior to that Act, only Federal Reserve member banks were permitted to use
the Federal Reserve's (free) payment services. Nonmembers typically cleared checks through a
network of upstream correspondent banks that were Federal Reserve members. The MCA confirmed
the Federal Reserve's role as a key provider of services and required the Federal Reserve to provide
payment services to both member and nonmember banks. Most importantly, the MCA required the
Federal Reserve to price its payment services and to fully recover the costs of providing those
services, including imputed taxes and profits. The purpose of this requirement was to avoid having the
central bank underprice payment services in a way that would undercut the existence and growth of
private-sector alternatives. The ultimate goal was to stimulate efficiency and innovation by
encouraging competition between service providers and payment system operators, including the
central bank.
The legal framework governing payment systems has continued to evolve. In its role as catalyst for
payments system improvements, the Federal Reserve has worked with the private sector to identify
and address barriers to improvements in payments system efficiency. It then developed legislative
recommendations that eventually became the Check Clearing for the 21st Century Act, known as
Check 21. Check 21, which became effective in 2004, eliminated legal impediments to the use of
electronic technologies to collect checks. Under Check 21, banks no longer need to physically move
original paper checks from the bank where the checks are deposited to the bank that pays them. The
law created a new negotiable instrument called a substitute check, which permitted banks to truncate
original checks, to send digital check images across the country, and to deliver paper substitute
checks to banks that wanted to continue receiving paper checks. As a result, checks will ultimately be
collected faster and at lower cost through an electronic national clearing structure.
Consumer behavior and market response in the future US payments system
The development and adoption of new payments instruments is largely being influenced by
consumers, merchants, and their banks and service providers interacting in a market setting. Until very
recently, checks have been the dominant form of noncash payment in the US payments system as
measured by the annual number of payments. However, the 1990s saw a marked shift in consumers'
behavior. Federal Reserve research has revealed a steady decline in check usage since the
mid-1990s. By 2003, electronic noncash retail payments exceeded check payments for the first time.
Debit cards, used primarily by consumers for everyday purchases, have represented the fastest
growing segment of the retail payments system. They have been a natural bridge from cash and
checks to electronics. Historically, automated teller machine and debit card networks, much like the
early check-clearing network in the US, were generally regionally based. Banks issued debit cards that
could be used only on certain networks, which had limited reach across state lines. This meant that,
although early debit cards were a convenient new way to make noncash payments, the scope of their
use was limited. Some networks developed interchange agreements to expand the acceptance of their
debit cards. In addition, as debit cards evolved, the major credit card companies and their banks
began to issue a new type of debit card that operated through the existing national credit card
networks. The use of these so-called signature-based debit cards has been growing rapidly for several
years.
Another payment mechanism that was developed jointly by the private sector and the Federal Reserve
was the automated clearinghouse, or ACH, system. The ACH system is a batch electronic payment
system that has traditionally been used to process recurring credit and debit transactions, such as
payroll payments, mortgage and utility payments, and government benefits. In its infancy, the ACH
system was a segmented regional system that has since evolved into a nationwide payments system.
More recently, banks have used the ACH system in innovative ways to make nonrecurring payments,
such as payments over the telephone or Internet, which were typically made by credit or debit card. In
addition, businesses that receive large numbers of checks from customers are obtaining their
customers' permission to convert the checks into ACH payments. As a result, the ACH has exhibited
significant growth in recent years and is contributing to the decline in the number of payments being
processed as checks.
It remains to be seen how significant an effect recently emerging instruments such as payroll cards,
stored-value cards, or electronic benefits transfer instruments will have on the payments landscape.
Whether or not these instruments are broadly accepted will depend largely on consumer and business
preferences, and on how much of an improvement these instruments are over competing payment
instruments. It is difficult to foresee how quickly and in what forms alternative payments will evolve in
the US economy. It is likely, however, that the evolution will continue to be market-driven.
In conclusion, I want to emphasize that the national payments system of the United States has
evolved through both private- and public-sector contributions. Both sectors have been involved in
technological innovation and the development of payments infrastructure. In addition, the public sector
has responded by addressing legal and other barriers that adversely affect the banking system.
Together, private and public sectors have contributed to a more-efficient national payments system
that facilitates greater commerce and innovation. Looking forward, market needs will ultimately shape
the US payments system and its direction. If the past is a guide, geography will continue to decline as
an important factor in the national payments system just as it has in other areas of economic activity.
Thank you.