For release on delivery
12:00 p.m. EST
February 27, 2020
Direction of Supervision: Impact of Payment System Innovation on Community Banks
Remarks by
Michelle W. Bowman
Member
Board of Governors of the Federal Reserve System
at
"Age of Advancement: The Intricacies of a Digital World"
2020 Banking Outlook Conference sponsored by
the Federal Reserve Bank of Atlanta
Atlanta, Georgia
February 27, 2020
It is a pleasure to be here today. I appreciate the invitation to speak to you as part
of this year's Banking Outlook Conference at the Federal Reserve Bank of Atlanta.1 I
think this year's theme, Age of Advancement: The Intricacies of a Digital World, captures
the dynamic and evolving landscape of our country's financial system well. Advances in
technology are occurring at a rapid pace and present the opportunity to make our
financial system safer and more efficient for more Americans.
From faster payments to artificial intelligence, technological advancements touch
nearly every aspect of our financial system and affect institutions of every type. As the
first Federal Reserve governor to serve in the role designated by Congress for someone
with community banking experience, I am especially interested in the impact these kinds
of advancements may have on community banks. I am also committed to ensuring that as
policymakers and supervisors navigate the intricacies of today's digital world, we do so
in a way that considers the important role of community banks in cities and towns and
rural communities across the country, and our nation's financial system more broadly.
To that end, I believe the Federal Reserve is well positioned to support innovation and the
future of banking in a way that ensures our nation's evolving financial system works for
community banks and the customers they serve. So I would like to spend my time with
you today focusing on how the Federal Reserve can achieve this objective in one specific
area, that of our nation's payment system.
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Importance of Community Banks and the Payment System
As many of you may know, before joining the Federal Reserve, I was a
community banker and more recently had the privilege to serve as the Kansas State Bank
Commissioner. I have seen firsthand the vital role that our nation's community banks
play in the financial industry and in the economy more broadly.
Through the services they provide, community banks help support strong cities,
towns, and rural communities across the country, which are central to a vibrant economy.
For example, small business lending is an essential part of community bank portfolios.
Many community banks often specialize in serving small businesses, which account for
the majority of new job creation in the country.2 In fact, community banks hold 48
percent of all loans to small businesses and farms in the United States.3
Community banks are also often seen by their customers as an important source
of financial advice and a source of civic leadership.4 Community banks have a deep
understanding of their local areas. They also have close relationships with those living in
the communities they serve and the organizations that serve those communities. In many
instances, community banks are also serving markets that tend to be neglected by larger
banks. These connections allow community banks to focus on specific local needs to
provide a variety of services, which often include tailored and innovative products.
Payment services in particular are a key component of these relationships and are
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essential to the role of banks in their communities. Community banks help ensure that
consumers and businesses can safely and efficiently access and move their money. By
doing so, the payment services they provide act as the foundation for economic activities
that help cities, towns, and rural communities grow and thrive, which in turn is essential
to a strong and stable financial system.
A strong and stable financial system also depends on the smooth functioning of
the nation's payment system. Today, many Americans take the ability to move money
across the country safely and efficiently for granted, but history shows that payment
system disruptions can affect the economy more broadly.5 In the past, our nation's
payment system was fragmented and inefficient, creating costs for consumers, merchants,
banks, and, ultimately, the U.S. economy. For example, before the Federal Reserve was
established, check clearing fees and banks' efforts to avoid them often led to circuitous
check routing, with recipients facing long, unpredictable delays in receiving their money.
When they did eventually receive their money, fees had often consumed a considerable
portion of what they were expecting. In extreme instances, this led to checks moving
from city to city before eventually ending up at their destination. One often-cited
example described a check that started in Rochester, New York, and traveled to
Jacksonville, Florida, then to Philadelphia, Baltimore, and Cincinnati before it finally
reached its final destination in Birmingham, Alabama.6 To put that in terms of miles
traveled, if the check had gone directly from New York to Alabama, it would have
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traveled about 1,000 miles. Instead, it traveled 3,000 miles up and down the east coast,
likely for days, before it finally reached its destination. The distance from Atlanta to Los
Angeles is shorter than the route that check took.
These kinds of inefficiencies were so significant that one of Congress's
motivations in creating the Federal Reserve was ensuring a safe and efficient nationwide
payment infrastructure. Shortly after they opened for business, the Reserve Banks began
providing a nationwide check collection service. This service helped speed up payments
by reducing circuitous routing. It also facilitated access to more-efficient payment
services for banks across the nation. Since then, the Federal Reserve has continued to
support ongoing efficiency improvements in the nation's payment system, including the
development of the Fedwire funds transfer system and the implementation of the
automated clearinghouse, or ACH system, in partnership with the private sector.
This operational role has allowed the Federal Reserve to support the goal of a safe
and efficient payment system throughout its history. It has also contributed to widespread
public confidence in the nation's payment infrastructure. At times, the Federal Reserve
has taken extraordinary steps to ensure the payment system can function reliably. After
planes were grounded on September 11, 2001, in the aftermath of the terrorist attacks in
New York and Washington, D.C., the Federal Reserve arranged alternative transportation
for millions of checks that normally would have moved across the country by plane. The
Federal Reserve also started giving immediate credit for all checks that it received. This
provided a key source of liquidity for the payment system and temporarily caused the
daily float held by the Federal Reserve to increase over 6,000 percent.7 After September
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11, the Federal Reserve also took steps to improve the future efficiency of the nation's
check collection system by working with Congress on the passage of the Check 21 Act in
2002.
A safe and efficient payment system also needs to be accessible, because payment
services are most valuable when you can pay anyone regardless of where balances are
held. The ultimate success of any effort to modernize the U.S. payment system depends
on adoption across the entire banking industry. Therefore, in considering the Federal
Reserve's provision of payment services, Congress took steps to try to ensure access to
services across the country. As a result, Congress specifically tasked the Federal Reserve
with taking into account an adequate level of services nationwide when providing and
setting fees for payment services.8 The United States has a highly complex banking
system with more than 10,000 depository institutions spread over wide areas with
differing payment needs.9 Over 4,800 of those are community banks.10 In many areas,
particularly rural areas, community banks may be the primary providers of banking
services for individuals and small businesses. Community banks are, therefore, essential
in ensuring access to safe and efficient payment services in towns, cities, and rural
communities nationwide so that payments can move across the country regardless of
geography-from here in the South, to the Midwest, and coast to coast.
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Community Banks and Payment System Innovation
A diverse banking system where institutions of all sizes are able to innovate and
meet evolving customer needs is essential to ensure access to safe, efficient, and modern
payment services for communities across the nation. At the Federal Reserve, we support
the responsible use of technology and innovation to transform the financial system and
reduce frictions and delays, while preserving consumer protections, data privacy and
security, and financial stability. But as technology continues to advance, the intricacies
of our digital world become more complex, and I believe we can help ensure that banks
are well positioned to take advantage of these technology advancements and innovations.
Like the rest of the financial industry, community banks are investing in new
technologies and innovations to meet the growing expectations of their customers. With
their considerable understanding of local needs, community banks are able to put these
kinds of innovations to use in meeting the specific needs of their communities. At the
Federal Reserve, we are actively engaging with the banking industry to encourage
responsible innovation in the community-banking sector.
But I also firmly believe that we cannot just say community banks need to engage
in responsible innovation, we need to empower community banks to do just that, and I
am committed to working with my colleagues to realize this objective. I believe it is our
responsibility as a payment service provider and supervisor to ensure that our nation's
evolving financial system works for community banks. Because by empowering them to
provide modern and innovative services to their customers, we also ensure that
Americans across the country can make payments safely and efficiently.
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First, as a provider of payment services, the Federal Reserve has a long history of
supporting community banks. We have long-standing relationships with, and the
nationwide infrastructure to provide services to, thousands of community banks across
the country. While the existing payment infrastructure provided by the Federal Reserve
has generally served community banks and the nation's economy well, advances in
technology have also created opportunities to modernize these payment services.
Collectively, these efforts will create a modern payment infrastructure that provides
community banks the ability to meet customer expectations in offering innovative
services with the same effectiveness and efficiency as other providers. This in turn will
provide consumers the ability to better manage their financial lives by accessing accounts
when and where they choose and providing more flexibility to manage money and make
time-sensitive payments.
To start, the Board has supported changes to existing Federal Reserve services.
For example, at the end of last year, the Board announced changes to support adoption of
an additional same-day ACH window available later in the day. When it was adopted in
2015, same-day ACH allowed for faster processing and return of recurring, low-cost
payments such as payroll and bill payments. This additional window will help to make
the benefits of same-day ACH more broadly accessible. More specifically, it will allow
banks and their customers, particularly those located outside the eastern time zone, to use
same-day ACH services during a greater portion of the business day.
Our modernization efforts do not stop with existing services, though. The
FedNowSM Service, announced last August, will create a new payment infrastructure for
institutions of all sizes to offer innovative faster payment services. Community banks in
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particular were strong supporters of developing the FedNow Service. Many of them
emphasized that the Federal Reserve's long-standing policy commitment to promoting
nationwide access would result in a service that is accessible to banks of all sizes. They
felt that this in turn would ultimately increase the long-term likelihood of being able to
offer faster payment services in their communities. Community banks continued to voice
strong support in response to our most recent request for comment on the design of the
FedNow Service. At the same time, they raised a number of important issues, including
interoperability, time to market, and use of volume-based pricing. These issues are
important to community banks, and as such, they are important to me. I intend to work
with my colleagues so that the FedNow Service meets the needs of community banks and
their customers. I hope that you will continue to engage with us, continue to provide
your feedback, and continue to be patient as we undertake this effort to develop the
FedNow Service. Because with your input, I believe the Federal Reserve can continue its
long history-which started with bank notes and checks, then continued with ACH-of
providing infrastructure that supports the independence and success of community banks
for the long term.
It is also important to understand that technology advancements affect more than
just the payment infrastructure behind-the-scenes. Innovations in consumer and other
end-user experiences, such as those facilitated by fintech firms, can also transform the
way that consumers interact with their financial institutions, offering community banks
additional opportunities to serve their customers in the future. For instance, I have
previously discussed how working with fintech firms may offer community banks
potential partnerships that leverage the latest technology to provide customer-first,
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community-focused financial services and provide customers with efficiencies, such as
easy-to-use online applications or rapid loan decisionmaking. These kinds of strategic
partnerships harness the indispensable knowledge and trust that community banks have
built with retail customers and local small businesses. For example, we have seen
community banks experience significant growth after partnering with fintech companies
to offer checking accounts for online investors, personal loans, and debit cards. We have
also seen such partnerships increase efficiency in service offerings, such as significantly
reducing loan approval processing time. We expect that the efforts to modernize our
payment infrastructure that I outlined earlier, such as FedNow, will serve as a foundation
for this kind of innovation to flourish, and will support new opportunities for community
banks and the communities they serve.
Of course, new technology is also subject to many of the traditional risks banks
have managed in the past with more-traditional consumer services, and implementation
of new technology should be driven by banks' business strategies and customer needs.
Ultimately, banks remain responsible for conducting due diligence and understanding the
risks faced by their organization. But technology advances quickly, and new
developments inevitably raise new questions. That is why I believe that the Federal
Reserve also needs to take steps as a supervisor to ensure our nation's evolving financial
system works for community banks.
First and foremost, it is essential we continue to meaningfully engage with
stakeholders on these issues. For example, we recently launched an innovation web page
(www.federalreserve.gov/innovate) that will serve as an accessible central hub for
stakeholders interested in learning about and engaging with the Federal Reserve on
innovation-related matters.11 The web page can serve as a starting point for members of
the industry to engage with Federal Reserve specialists, submit questions, and request in-
person meetings. We also announced a series of "fintech innovation office hours" across
the country. The first of these was held just yesterday here in Atlanta, and some of you
may have even had the opportunity to participate. These are also an important
opportunity for us to learn, and I encourage you to provide your feedback. For
community banks and their potential fintech partners, I hope that these sessions will serve
as a resource to meet one-on-one with Federal Reserve staff members with relevant
expertise, discuss fintech developments, share specific projects, and ask questions. They
also provide us an opportunity to hear directly from banks and fintech companies about
challenges to innovation.
Another important area of focus for me is community banks' relationships with
their vendors and third-party service providers. As a former community banker, I am
acutely aware that community banks are often reliant on outside service providers and
vendors to access new technologies and provide payment services. I also know that
supervisory expectations in these areas can be challenging, and I have experienced it
myself. There are several things I believe we can do to help provide clarity and
transparency, reduce confusion, and simplify and remove some of the burden community
banks face in this area.
First, in order to give community banks a better picture of what success in due
diligence of third-party providers looks like, and where it begins and ends, I believe that
we should release more information on its necessary elements. This change would
provide clarity and assist community banks in completing their work. In particular, I
believe that regulators can provide more clarity on the types of questions that should be
asked of a prospective third-party provider and our view of a satisfactory answer. I also
believe our guidance should explain what due diligence looks like for a potential fintech
partner, because the standards applied to other third parties may not be universally
applicable. Potential partnerships are not one-size-fits-all. Every bank has different
objectives, and guidance should reflect some supervisory flexibility so that we do not
impede prudent, strategic partnerships between community banks and potential partners.
Regulators should especially support partnerships that combine the strengths of
community banks and fintech companies, which have a track record of success. I also
believe the Federal Reserve should allow banks to conduct shared due diligence on
potential partners. If several banks use the same third-party service provider and are
open to collaborating, they should be allowed to pool resources instead of duplicating one
another's work. These approaches would not only have the benefit of increasing clarity
and transparency for community banks, but could also be beneficial for fintech
companies that hope to become third-party providers.
Second, clear and transparent guidance is most helpful when it is consistent. I
have previously discussed my view that guidance on third-party relationships should be
consistent across banking agencies. No one benefits when banks and their potential
partners or other vendors have to navigate unnecessary differences in guidance between
agencies. To that end, the Federal Reserve is in the process of working with the other
banking agencies to update our third-party guidance. As part of this process, I believe
that the banking agencies should all have consistent expectations for third-party
relationships, and that the Federal Reserve should, as a starting point, move toward
adopting the Office of the Comptroller of the Currency's guidance.
Third, I believe we can improve transparency with regard to our supervision of
third parties. Through our service provider supervision program, we regularly conduct
exams of many third-party service providers. While we make the outcomes available to
banks that are clients of a supervised service provider, I believe we can go a step further
to increase transparency by also making information that may be useful about our
supervision of key service providers available to banks. This could take a number of
forms, such as being more transparent about who and what we evaluate. Of course,
moving forward in these areas requires careful consideration and interagency
collaboration, and I have asked our staff to work with other agencies to develop and
propose workable options for giving banks the benefit of the knowledge that supervisors
have about their potential providers in an appropriate manner.
Finally, I believe regulators and supervisors have a role to play in ensuring that
regulatory burden is tailored to bank size, risk, complexity, and capacity. Knowing the
burden that third-party monitoring in particular can present to employees of the smallest
banks, I have also encouraged Federal Reserve staff to consider options for further
tailoring our expectations for community banks with assets under $1 billion in this area.
Collectively, I view these as important steps to improve the ability of community
banks to manage their third-party relationships effectively. By doing so, I believe we will
be able to better support the ability of community banks to access innovative new
technology and offer modern services to customers.
Looking Ahead
The kinds of advances in technology we are discussing here today present
challenges and opportunities for banks of all sizes, including community banks.
Investments in new technology are likely to create implementation costs, and payment
system innovations are no exception. Testing new technology, upgrading software and
processing systems, and integrating new systems with existing systems will require banks
to incur costs and dedicate resources to implementation. Community banks in particular
may incur additional costs, for example to extend operating hours in order to facilitate
payments during nonstandard business hours.
However, technological advances also present opportunities for community banks
to continue serving their neighbors, and payment services are a key component of this.
Since I joined the Federal Reserve, I have been on the road a lot, visiting Federal Reserve
Districts and talking to bankers, consumers, and community groups. I have been struck
in particular by stories I have heard about younger generations of Americans moving
back to rural areas. These individuals may be returning to their hometown or moving out
of urban centers, but they still have the same expectations for services like those that may
be offered by larger banks with nationwide footprints. Technological developments, like
the payment system modernization efforts we have discussed today, allow banks across
the country to meet these customer expectations and provide payment services on a
competitive basis.
I believe the Federal Reserve is uniquely positioned as a provider of payment
services and as a supervisor of banks to ensure that our nation's evolving financial system
works for community banks. As a provider of payment services, our efforts to modernize
the nation's payment system through services like FedNow and same-day ACH will
ensure community banks and their customers have access to today's financial technology
nationwide. As a supervisor of banks, we can support responsible innovation by reducing
regulatory burden where we can, clarifying expectations, and improving the ability of
community banks to manage their relationships effectively. Collectively, I believe these
efforts will help support a community banking sector that is well positioned to thrive and
offer modern, innovative services to their customers. By providing such services,
community banks can help ensure all Americans can make payments safely and
efficiently regardless of their location and that families across the country have access to
financial services that are so important to their success and the success of our
communities in today's age of advancement.