Donald L Kohn: Evolution of retail payments and the role of the Federal
Reserve
Remarks by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal Reserve
System, at the Western Payments Alliance 2006 Payments Symposium, Las Vegas, Nevada,
11 September 2006.
* * *
I am pleased to have the opportunity to speak at this symposium examining the continuing
convergence of paper and electronic payments. Today marks the fifth anniversary of the September
11th terrorist attacks on the United States. On that day, as our nation came to grips with the terrible
events it had just witnessed, the Federal Reserve remained open and operating, in part to help ensure
that the nation's payments system continued to function. In the aftermath of the attacks, the financial
industry has taken many steps to strengthen the resilience of our nation's critical payments
infrastructures. For the retail payments system, the September 11th attacks highlighted the banking
industry's extensive reliance on air transportation as planes came to a standstill and the collection of
checks slowed dramatically. This prompted a heightened focus on how electronic processing
technologies could be applied to the check-collection system to reduce the reliance on air
transportation and improve check-processing efficiency more generally.
My remarks today, which reflect my own thoughts and not necessarily those of the other members of
the Federal Reserve Board, will focus on the future of the check-collection system and the future role
of the Federal Reserve in retail payments services.1
A period of transition in the retail payments system
Today, shifts in consumer behavior and rapid industry innovation, along with legal and regulatory
change, are dramatically reshaping our retail payments system. Because of the increasing availability
and declining cost of convenient electronic payment alternatives, many payments that were until
recently being made in paper form are today being made electronically. In addition, new electronic
technologies are now being harnessed to improve the processing of checks.
The 2003 Federal Reserve study on the use of retail payment instruments revealed dramatic changes
in consumer behavior. It found that, for the first time ever, the number of electronic payments in the
United States - such as credit card, debit card, and automated clearinghouse (ACH) payments -
exceeded check payments. A range of data indicates that electronic payments have continued to
increase and that check payments have continued to decline. Debit cards, primarily used by
consumers for everyday purchases, are the fastest growing segment of the retail payments system.
Consumers seem to view debit cards as a natural progression from cash and checks because they are
a convenient electronic means of making payments without incurring the additional debt often
associated with credit card use. In fact, on at least one major network, debit card payments are
reported to have surpassed credit card payments.
This shift in payment behavior can be attributed in part to changes in the rules and regulations
governing the ACH network, which have facilitated the use of this network for one-time, nonrecurring
payments. As you know, in the past the ACH was used mainly for recurring payments, such as payroll
and mortgage payments. Today, consumer purchases at stores, over the telephone, and on the
Internet can be completed using the ACH. Regulatory and rule changes have also facilitated the use
of the ACH to convert checks that consumers mail to businesses or provide at the point of sale into
electronic payments. These new uses of the ACH for one-time payments have driven the continuing
double-digit growth rates of ACH transaction volume. Given these dynamic changes in the payments
system, the Federal Reserve is planning to repeat its triennial survey of retail payments use next year
to take another snapshot of the nation's retail payments system.
The Federal Reserve's experience with Check 21
Not only are more payments being made electronically, but more check payments are also being
processed electronically, in part because of the Check Clearing for the 21st Century Act, or Check
21.2 Clearly, Check 21 has begun to diminish the importance of geography and physical transportation
in check processing, and banks have started to reengineer their backroom processes to accommodate
end-to-end electronic check clearing.
Since October 28, 2004, the date Check 21 took effect, the Reserve Banks' Check 21 volume has
grown rapidly, reflecting a trend that will lead to the widespread electronic processing of checks in the
not-too-distant future. Private-sector service providers that offer Check 21 services are also
experiencing rapid growth in volume as the banking industry becomes more interested in and capable
of using Check 21 authority to clear checks. Today, about 17 percent of the checks deposited with the
Federal Reserve Banks, or slightly over 6 million checks a day valued at about $20 billion, are
deposited using the Reserve Banks' Check 21 product suite. As expected, depository institutions have
been somewhat slower in agreeing to accept their check presentments electronically because of the
complexity of integrating such presentments into back-office processing and risk-management
systems. As a result, the use of substitute checks is widespread. Nevertheless, in July 2006 almost 4
percent of the Reserve Banks' daily volume, or about one and a half million checks, was presented to
paying banks in electronic Check 21 files, and this volume is growing rapidly.
Thus, banks are starting to realize many of the benefits of the end-to-end electronic check processing
that were envisioned when Check 21 was enacted, including efficiency gains and cost savings. In
addition, they are beginning to offer their customers new and better services. For example, some
banks are offering their business customers the ability to truncate checks and deposit them
electronically. Also, banks are now able to set a later-in-the-day cutoff hour for check deposits
because they can transmit checks electronically from their branches to their central processing
facilities for collection. As a result, banks should be able to provide customers with improved funds
availability, more efficient cash management services, and better access to services for their
geographically remote customers.
The evolution of electronic check collection
How will electronic check collection evolve in the years to come? The industry is discussing several
possible models. In the first, check images are transmitted to the paying bank along with the MICR-line
payment information.3 In the second, the MICR information is transmitted to the paying bank while the
check images are stored in remote archives that can be accessed on demand. Both models are
already being used to some extent and each has its advantages and disadvantages. I suspect that, as
the industry gains greater experience with electronic check collection, the superiority of one of the
models may become clearer.
Those who favor the first model believe that it allows paying banks to better manage their risks and
customer relationships. Paying banks would not have to rely on multiple image archive providers, with
whom they may have no direct contractual relationship, to obtain check images for customer online
banking services and backroom operations. Others believe that a small number of centralized
checkimage archives, as envisioned in the second model, would be more cost-effective and would not
appreciably increase risk or degrade customer service. In this model, the MICR information on a check
could be transmitted over a dedicated network or, as recently suggested by some bankers, the ACH.
The ACH is seen as a potentially attractive option because it is an electronic system that reaches all
depository institutions and could eliminate the need to print substitute checks.
The flow of check information over the ACH system raises the legal question of whether the payments
should be characterized as checks or electronic fund transfers. If the payments were characterized as
checks, under current check law banks can choose whether to receive presentments electronically or
permitting
in paper form. A key principle underlying Check 21 was to maintain this choice by banks to
participate in electronic check processing when their business case justified doing so. Requiring banks
to accept electronic check presentment simply because they participate in the ACH system and have
agreed to abide by NACHA rules might be viewed as contrary to this principle. Alternatively, if the
payments were characterized as electronic funds transfers, then how would banks obtain the
authorizations required under Regulation E to convert the transactions into ACH payments? When
evaluating the relative benefits of using the ACH network for these payments, we must consider these
threshold legal questions.
A perspective on the future U.S. check system
The checkless society has been predicted for decades; however, as we near 2007, we know that even
though checks are used less frequently, they are still used widely. Industry experts are understandably
wary of predicting what lies ahead for the U.S. check system. However, as we engage in strategic
discussions on the future of checks and contemplate investments in check-processing infrastructure,
we need to consider how the check system might evolve. Let me take a first step and offer one
perspective.
The decline in check use has already caused the Reserve Banks to reduce by half the number of
offices at which they process paper checks. In 2003, the Reserve Banks had forty-five
checkprocessing offices nationwide, versus the twenty-two they have today and the eighteen that they will
have by early 2008. Further consolidations are likely as check volumes continue to decline and as
checks are increasingly processed electronically. Ultimately, perhaps sometime late in the next
decade, the Reserve Banks might process checks at only a single office nationwide. These changes in
the Federal Reserve's check-processing infrastructure will benefit bank customers by entitling them to
earlier funds availability on their check deposits, because all checks will eventually become local
checks, which are generally subject to a maximum permissible hold period of two business days. This
will present risk-management challenges for banks because a bank seldom learns that a local check is
unpaid before it must make the funds available to the customer for withdrawal.
Moreover, while some checks are being collected faster as a result of electronic processing, in the
future other checks might be collected more slowly. We have already seen some banks decide to
process large- and small-dollar checks differently. Specifically, many banks are expediting the
collection of larger-dollar checks by taking advantage of the Check 21 authority. On the other hand,
banks are continuing to collect smaller-dollar checks in paper form, using physical transportation
networks, because the value of collecting these smaller-dollar checks faster does not justify the cost of
doing so.
As larger-dollar checks are increasingly cleared electronically, the use of relatively expensive
dedicated check-transportation networks to clear the aggregate value of the remaining checks will be
harder and harder to justify economically. As a result, it is quite possible that it will take longer to
collect smaller-dollar checks as dedicated, high-cost check-transportation networks are scaled back or
eliminated and these checks are transported using slower, less costly means.
The Federal Reserve is now studying whether overall improvements in the check-collection system
would be sufficient in the near term to justify the Board's use of its authority under the Expedited
Funds Availability Act to reduce maximum hold periods.4 The likely slowing of the collection of
smallervalue checks could make any change problematic in the near term. Nonetheless, as I have already
noted, recent and future consolidations of Federal Reserve check-processing regions have benefited,
and will continue to benefit, bank customers as many nonlocal checks become local and therefore
subject to shorter maximum holds.
If the payments system evolves as I have just outlined, then it is possible that in the next ten to twenty
years the Reserve Banks will accept only checks that are deposited electronically and that can be
presented electronically; any remaining paper checks may have to be cleared through other channels.
In this scenario, the current paper-check infrastructure of the Federal Reserve that is heavily reliant on
physical transportation will be replaced by an electronic-processing infrastructure with a production
data center and a few backup sites, not unlike today's ACH network.
The role of the Reserve Banks in the provision of retail payments services
The changes I have just described could very well have implications for the role of the Federal
Reserve in the payments system. From its inception in 1913, the Federal Reserve has not only been
closely involved in overseeing the nation's payments system but has also been an important
operational component of that system. This latter role has involved competing with the private sector
to provide certain retail payments. Congress originally wanted the Federal Reserve to play this
operational role to reduce inefficiencies in the payments arena. This role has changed considerably
over the past century, with some changes resulting from the enactment of statutes such as the
Monetary Control Act, or the MCA.
The MCA went a long way toward establishing a relatively level playing field on which the Reserve
Banks and private-sector payments providers have competed over the past quarter century. However,
because of the inherent differences between the central bank and private-sector service providers, a
truly level playing field will never be entirely possible. The Reserve Banks enjoy certain advantages,
such as an unsurpassed credit rating, that makes them an attractive service provider in times of
financial stress. On the other hand, the Reserve Banks do not have the flexibility enjoyed by their
competitors to negotiate fees and other service terms with individual customers. Because of these
differences, it is incumbent on us from time to time to reexamine our operational role in the payments
system.
These assessments have focused in the past, and should continue to focus in the future, on the
Federal Reserve's role as a provider of retail payment services. Large-value payments systems, such
as Fedwire, are typically viewed as core, systemically important services, and they are commonly
provided by other central banks around the globe. A rationale for the participation of a
governmentrelated entity, such as the Federal Reserve, in the retail payments system is harder to formulate. The
most recent assessment of this operational role was conducted in the late 1990s, by the Committee on
the Federal Reserve in the Payments Mechanism, better known as the Rivlin Committee, and it
focused on the Federal Reserve's role in the check and ACH systems. Ultimately, the committee
concluded that the Federal Reserve should remain a provider of both check-collection and ACH
services and should play a more active role in helping the banking industry become more efficient. The
committee determined that the Federal Reserve played an important role in providing both check and
ACH services to small and remote institutions and that, if the Federal Reserve stopped providing these
services, it could disrupt the market in the short run, resulting in higher prices and more regulation,
with little promise of substantial benefits over the long run. In recent years, we have actively pursued a
strategy of engaging the industry in discussions on payments system issues and offering services
designed to encourage the increased use of electronics.
As we move into a more steady-state electronic check environment, the Federal Reserve may find it
appropriate once again to review its longer-term operational role in the retail payments system.
Clearly, at that time, the Federal Reserve's national reach will no longer be a compelling reason for its
operational role. As the Federal Reserve assesses its role in providing retail payment services, it will
be important to consider how the circumstances that have provided the rationale for the Federal
Reserve's continuing involvement in retail payments services may have changed. The review would
have to address, among other things, the following questions: If the Reserve Banks were to withdraw
from check and ACH services, would these services continue to be provided competitively and
costeffectively? Would depository institutions continue to have equitable access to these services? In the
event of an unanticipated shock, would the payments system be sufficiently resilient?
Conclusion
In conclusion, the retail payments system will continue to become increasingly electronic even though
the exact nature of that system is not yet clear. What is clear, however, is that the Federal Reserve will
continue to foster a safe and efficient payments system. This shift away from paper and toward the
electronic processing of payments has significant operational and legal implications that all of us need
to ponder. I believe that an ongoing dialogue among payments system participants will help us
address, in a balanced and thoughtful manner, these important issues that affect the long-term
strategic direction of the U.S. financial system. This symposium is a welcome and constructive part of
that dialogue.