Randall S Kroszner: The future of payments - challenges and opportunities
Remarks by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal Reserve
System, at the 2007 Payments Conference titled "Competitive Forces Shaping the Payments
Environment: What's Next?", Federal Reserve Bank of Chicago, Chicago, Illinois, 10 May 2007.
* * *
I am pleased to have the opportunity to speak at this conference on competitive forces shaping the
payments environment.1 Spurred by a period of rapid innovation, we are at a crucial juncture in the
evolution of the U.S. payments system. The long-predicted decline of the paper check is materializing
as consumers and businesses continue to embrace alternative ways of making and clearing
payments. A 2004 Federal Reserve study of retail payments revealed that electronic payments have
now surpassed the use of checks as the preferred means of making noncash payments.2 The use of
debit cards has grown strongly, and the number of checks being converted into ACH payments has
grown to nearly 3 billion annually. Electronic check clearing has begun to grow exponentially in
response to changes in check law.
As a consequence of the accelerating pace of change, we participants in the payments system cannot
help but challenge our fundamental assumptions about payment operations, which were based on
long-standing processes for clearing paper. And adjustments are being made. The Federal Reserve
Banks, for example, have cut the number of offices at which they process checks in half since 2003,
and more consolidations are planned for later this year. Check transportation networks, particularly air
transportation networks, are also beginning to shrink.
Our conference organizers are to be applauded for bringing together industry participants, regulators,
and academics at this crucial juncture to consider "what's next" for the payments system. After briefly
describing the evolution of the payments system, I will discuss how recent regulatory changes and
technological innovation have interacted to affect the payments system - that is, how regulatory
changes have affected the use of technology in the payments system and how technological
innovations have affected how the payments system is regulated. I will then discuss some key
characteristics of successful payments innovations and highlight some challenges and tradeoffs, such
as the tradeoff between convenience and security, that need to be considered as the payments
system continues to evolve. Finally, I will discuss the future of electronic check clearing and the
important and complementary roles the Federal Reserve and the private sector will need to play in the
continued evolution of the payments system.
Evolution in the structure of the payments system
The different forces now shaping the evolution of the payments system have been gathering for
decades. From a legal and regulatory perspective, a series of fundamental changes in U.S. banking
laws, especially the laws governing interstate banking, have facilitated a long-term consolidation of
banking across geographic boundaries in this country.3 Banking consolidation, in turn, has fostered
the ongoing consolidation of payments infrastructure both within banks and among the
clearinghouses, networks, and other financial utilities that serve the banking industry. From a
technological perspective, decades of investment by the financial industry, businesses, and more
recently households have broadened and deepened the infrastructure for supplying and accessing
electronic payments. Payment cards and other access devices have proliferated, and the demand for
electronic payments has grown apace. As a result, the use of electronic payments has doubled over
the first half of this decade.
From a historical perspective, it is clear that the Federal Reserve has an important role to play in the
evolution of the payments system. Indeed, the Federal Reserve was founded, in part, to address
significant problems in the payments system, such as nonpar check collection and financial stability
issues that existed in the nineteenth and early twentieth centuries.
Regulation and technology
Turning now to regulation and technology, technological change can create the need for regulatory
change. And regulatory change can stimulate new applications of technology that foster greater
efficiency and growth. At times, there is a complex interplay between changing technology and
regulation. In the payments arena, regulators and rulemakers need to be aware of how technology is
changing the industry and, when appropriate, remove artificial barriers to innovation.
Let me highlight several important examples of recent adjustments to rules and regulations that have
changed the way payments are initiated and processed. Beginning in the late 1990s, the National
Automated Clearing House Association (NACHA) changed its rules to permit the so-called conversion
of checks to electronic fund transfers via the ACH system; subsequently, the Board modified its staff
commentary to clarify the application of Regulation E to these transactions.4 Today, businesses can
use the information on eligible checks they receive over the counter and at lockbox locations to create
ACH debit transactions. Partly as a result of the private sector's expanding use of check conversion,
the total volume of checks collected by Federal Reserve Banks has in recent years fallen faster than
the estimated decline in the number of checks being written.
In 2003, Congress passed the Check Clearing for the 21st Century Act (Check 21).5 Broadly
speaking, Check 21 was designed to foster market-based improvements in the check collection and
return system, mainly by authorizing - but not requiring - banks to truncate or stop the flow of original
paper checks and to create legally equivalent substitute checks for presentment to the paying bank.6
In 2004, the Board published regulatory changes to implement Check 21. The legal and regulatory
changes associated with Check 21 are encouraging the banking industry to use new technologies to
create and process digital images of checks and to print substitute checks only when necessary to
meet legal presentment or customer requirements. In a recent report to Congress on Check 21, the
Board noted that the adoption of new clearing techniques was slow at first but has accelerated
significantly in the past year.7 For example, between March 2006 and January 2007, the banking
industry's use of substitute checks increased three-fold and its use of electronic check images
increased five-fold. This pattern of adoption is consistent with early conjecture from the banking
industry that the scale and scope of required changes to individual bank technology systems and
operations would take time to implement. In addition, Check 21 has started to alleviate the check
system's dependence on large-scale air transportation to move checks around the country, a
vulnerability that was highlighted when planes were grounded following the events of September 11.
To address a barrier to the use of electronic payments, the Federal Reserve has recently proposed
modifications to Regulation E that would eliminate the requirement for paper receipts on small-dollar
payments.8 The Federal Reserve must, however, also be mindful of how changing payment practices
can affect risk in the payments system and take regulatory action, when appropriate. For example, the
Federal Reserve recently modified Regulation CC to reallocate the liability for unauthorized remotely
created checks among depository institutions, shifting liability to institutions that are better positioned
to understand and mitigate those risks.9
Clearly, both regulators and the private sector have a role to play in the continuing evolution of the
payments system. Regulators must continue to evaluate and adjust their rules in light of new realities
in the marketplace. At the same time, the private sector must put forward sound and prudent
innovations that address the needs of the marketplace, including the need to control risk.
Characteristics of successful innovation
Our conference organizers have challenged us to think about "what's next." One tool to help
understand the future is to analyze why certain innovations have been successful in the past.
Infrastructure changes have been one source of successful innovation. Much of the innovation in the
early days of electronic payments involved building new electronic processing systems for ACH and
card systems, and then gradually expanding electronic access to these core systems. The goal of
these infrastructure changes was typically to speed up payments and reduce the societal costs of
dependence on paper.
Following the implementation of Check 21, the banking industry and the Reserve Banks are again
making major infrastructure changes. The expansion of access to this infrastructure and the
development of tools for using it may well follow the path of earlier innovation and foster additional
change over the next few years. Experience in the late 1990s, however, gives us reason for caution.
At that time, there were attempts to introduce whole new payments systems for card and Internet
payments. A few of these attempts succeeded, but most failed. Thus, the introduction of new
technology alone is not sufficient for successful innovation; innovations must also meet important
market demands.
A key characteristic of successful innovation is that it generally reduces cost or increases the
convenience of making one or more types of payments. Examples include the introduction of ATM
transactions many years ago, as well as new methods for making payments over the Internet. Both of
convenience
these examples highlight the importance payment system end-users place on the of
making their payments, specifically the time and location of their transactions. In the case of ATMs,
banking customers shifted their payment activity from inside a bank branch to a more convenient time
and location. ATMs also provided banks with a lower-cost way to serve their customers. In the case of
Internet and telephone payments, the use of credit cards, new person-to-person systems, and new
ACH payment types allowed payments to be made more rapidly at any time of the day, even when the
parties to the transaction were thousands of miles apart.
The information linked to a payment has also emerged as an important component of end-users'
demand for payment innovations. This point challenges us to think of payments as more than simple
instructions to debit and credit bank accounts when we attempt to predict the needs of consumers and
businesses for innovative payment products.
In business-to-business remittance payments, for example, firms need to link traditional payment
information to information about the bills being paid in order to post and reconcile their accounts. Over
the years, businesses have made significant investments to automate their internal accounting
processes for check payments. As a result, checks are still very heavily used for corporate
remittances. After years of industry discussion, it is now clear that linking billing information to
electronic payment instructions is a key to the greater automation of business payments.10 Payments
system operators, banks, and businesses must continue to cooperate on standards and encourage
the necessary software changes to enable the broad-based automation of business payments. This is
no simple task, as there are competing standards both domestically and internationally. Nonetheless,
business users of the payments system continue to call for change, and we all need to press forward
on this issue.
Challenges to innovation
Although improving convenience has been an important force behind successful innovation,
consumers and businesses have increasingly demanded greater security in their electronic payments,
particularly as more information is linked to these payments. In general, there is often a basic tradeoff
between security and convenience: the easier a system is to use and access, the less secure it tends
to be. Striking the appropriate balance between convenience and security is a key challenge. How can
we manage fraud and operational risks, along with credit and other risks, without unduly interfering
with the ease of using a particular system? As I noted earlier, technological change can help stimulate
successful innovations and make it more convenient for businesses and consumers to make and
receive payments and link information to those payments. But technological change can also generate
new methods of perpetrating fraud and disrupting payments systems - and thus require us to develop
new responses to these challenges and risks.
Check fraud has long been an important issue for the banking system and has been increasing
recently, as described in the Board's Check 21 report. In the electronic sphere, card systems have
also had to deal with fraud since their inception. Naturally, cost-benefit calculations guide the pace of
innovation to address fraud. These costs typically include technology and labor costs, as well as the
time and other requirements needed to authenticate and authorize transactions. Benefits typically
include the monetary losses, customer problems, and legal costs that are avoided. Important but more
difficult-to-quantify benefits include the avoidance of reputational damage to payments system
participants, as well as sustained public confidence in the payments system. In the context of this
costbenefit framework, we can anticipate that when the costs of prevention fall or fraud begins to increase,
banks, businesses, and consumers, will react by implementing or demanding changes in policies,
business processes, and technology to address risk. This dynamic balancing process is part of the
ongoing development of the payments system.
In the past, the banking industry has taken steps to address its own security concerns, as well as
those of its customers. The experience with card systems and the ACH are instructive. In the 1970s,
major credit card companies began to deploy electronic authorization systems for transactions. This
step was strongly influenced by the desire of banks and merchants to control fraud. The more recent
development of intelligent detection systems represents yet a further step in combating fraud. Other
new technologies are beginning to be deployed, such as cards that have computer chips, to further
reduce fraud and to introduce new services to the market.
In the ACH system, the original risk design relied heavily on trusted, long-term relationships among
known counterparties. Key participants were supervised depository institutions that originated and
received the electronic payments. The primary types of commercial payments were electronic payroll
deposits and recurring payments for utility bills. Fraud concerns did not justify establishing centralized
controls at the system level. The risk model, however, has been changing as parties have begun to
use the ACH to make one-time payments over the telephone and Internet, payments that are not
necessarily based on long-term, trusted relationships. As the ACH network has grown and become
more complex, layers of nonbank service providers may now be involved in originating certain types of
payments, which further attenuates the trust relationships on which the network was founded.
To address these emerging risks, ACH operators and NACHA have been working cooperatively with
the industry to control new occurrences and types of fraud and other closely related risks. ACH
operators are now providing their customers with innovative risk-management services, and NACHA
has initiated a risk-monitoring program to better identify problems. NACHA is also developing
programs to better monitor and control the ACH originations of depository institution customers. While
the ultimate success of these efforts cannot yet be assessed, they represent important steps in the
right direction. As the banking industry develops new payments solutions, it must be proactive in
balancing convenience and risks, as well as cost, to ensure continued customer confidence in the
payments system.
The future of electronic check clearing
Perhaps the greatest current opportunity in the retail payments system is for the banking industry to
move rapidly to the electronic clearing of checks. As envisioned by Congress, Check 21 has created a
strategic vision for moving the U.S. check clearing system into the new century. The historic
infrastructure for paper check clearing is consolidating rapidly. Banks are changing their internal
systems so they can accept deposits and collect checks electronically and are increasingly accepting
their check presentments electronically. Bank technology vendors are playing an important role in
facilitating change. And the Reserve Banks are working to implement the vision of Check 21, both by
enhancing their electronic check infrastructure and by working closely with other payments system
operators and the industry.
In this environment of changing rules, infrastructure, and, yes, costs, it is imperative for banks and
their customers to look closely at their own payment policies, operations, and technologies. Banks will
need to develop broad and thoughtful payment strategies to navigate the changing environment and
work constructively within the industry. Inevitably, banks will also need to change their operations.
The role of the Federal Reserve
The Federal Reserve will continue to play an important role in fostering a smoothly functioning
payments system that is safe, efficient, and accessible. We also need to be flexible in carrying out our
traditional payments system functions - provider of payment services, regulator, and catalyst for
change - in the rapidly changing payments landscape.
Since its inception, the Federal Reserve's broad role in the payments system has been to improve
efficiency and foster financial stability. When the Federal Reserve was formed almost one hundred
years ago, the U.S. banking system was highly fragmented and checks were not cleared at par. To
address this situation, the Federal Reserve began providing a national check-clearing service to banks
that joined the Federal Reserve System. This service and other Federal Reserve policies helped guide
the nation toward a more unified payments system.
In its role as service provider, the Federal Reserve will continue to promote the efficiency and stability
of the nation's payments system. The Reserve Banks are now pricing their check services to
encourage greater use of electronic check clearing. The Reserve Banks are also leaders in providing
Check 21 services that encourage depository institutions to shift to a greater use of electronics in
check processing and are working collaboratively with the industry on electronic check standards and
other technical issues. Most importantly, the Reserve Banks will continue to compete as payment
services providers on a fair and equitable basis by pricing their services to recover their costs,
including imputed profits and taxes, over the long run, as required by the Monetary Control Act of
1980.
In its role as a regulator, the Federal Reserve will need to be alert to the application of regulations in
changing circumstances. As I have already noted, the Federal Reserve has, in recent years, modified
its regulations to facilitate the greater use of electronics in the payments system and to address
emerging risks. When considering potential regulatory changes, the Federal Reserve must also
ensure that any proposed changes are consistent with the changing technological environment and
adequately protect consumers.
Finally, in its role as a catalyst for change, the Federal Reserve continues to work with the private
sector to identify and, when appropriate, address barriers to payments system innovation. This past
March, I participated in a roundtable in Minneapolis on retail payments fraud that was sponsored by
the Payments System Policy Advisory Committee. The roundtable promoted dialogue on key fraud
issues with a wide range of participants in the retail payments systems. It is our objective to continue
to sponsor different types of forums over time as an important part of our public outreach activities. We
believe that through its payments system roles, the Federal Reserve is well positioned to encourage
both future payments system evolution and the appropriate balancing of efficiency and risk as new
products and services are developed.
Conclusion
We are living in a period of rapid innovation and transition in the payments system. Powerful forces
have been converging to reshape the retail payments system. Yet the United States continues to
enjoy safe, efficient, and reliable systems for making payments. As innovations occur, market forces
will ultimately sort out which of these will best serve the needs of consumers and businesses. Both the
private and public sectors have contributed to the evolution of the national payment system of the
United States; clearly, both will have an important role to play in the future. As we ask each other
"what's next" during this time of transition, I believe that dialogue among payments system participants
and users is critically important. Information and different points of view will help us all identify and
address issues of innovation, risk, and efficiency in a balanced and thoughtful manner. This
conference is a welcome and constructive element in this important dialogue.