Payment Services: Federal Reserve's Competition with Other Providers Benefits Customers, but Additional Reviews Could Increase Assurance of Cost Accuracy
Published: 2016-08-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Federal Reserve Banks compete with private-sector entities to provide services while Federal Reserve Board staff also supervise the Reserve Banks and other service providers and financial institution users of these services. The Monetary Control Act requires the Federal Reserve to establish fees for its services on the basis of costs, including certain imputed private-sector costs. GAO was asked to review issues regarding the Federal Reserve's role in providing payment services. Among other objectives, GAO examined (1) how well the Federal Reserve calculates and recovers its costs, (2) the effect of the Federal Reserve on competition in the market, and (3) market participant views on the Federal Reserve's role in the payments system.
GAO analyzed cost and price data trends; reviewed laws, regulations, and guidance related to Federal Reserve oversight and provision of payment services; and interviewed Federal Reserve officials, relevant trade associations, randomly selected payment service providers, customer financial institutions, and other market participants.
section_title: What GAO Found
paragraphs: The Federal Reserve Banks are authorized to provide payment services—such as check clearing and wire transfers—to ensure continuous and equitable access to all institutions. The Depository Institutions Deregulation and Monetary Control Act of 1980 (Monetary Control Act) requires the Federal Reserve to establish prices for its payment services on the basis of the costs incurred in providing the services and give due regard to competitive factors and the provision of an adequate level of services nationwide. GAO found the Federal Reserve had a detailed cost accounting system for capturing these costs that generally aligned with federal cost accounting standards. Although this system was evaluated and found effective by a public accounting firm in the 1980s, it has not undergone a detailed independent evaluation since then. In addition to the actual costs it incurs in providing services, the Federal Reserve also must include an allocation of imputed costs which takes into account the taxes that would have been paid and the return on capital that would have been provided if the services had been furnished by a private firm. Although its processes for simulating the imputed costs generally were reasonable, the Federal Reserve did not impute certain compliance costs private-sector firms can face—such as for planning for recovery and orderly wind down after financial or other difficulties. Including additional simulated costs competitors can incur and obtaining periodic external evaluations of its cost accounting practices would provide greater assurance that the Federal Reserve fully includes appropriate costs when pricing its services.
Since the mid-2000s, the effects of Federal Reserve participation in the payment services market have included lower prices for many customers; overall market share for competitors also increased. Although some competitors raised concerns about some Federal Reserve pricing practices, customers GAO interviewed generally were satisfied with its services and prices. The Federal Reserve also has a process for assessing its pricing and products to help ensure it is not unfairly leveraging any legal advantages. Since 2005, the Federal Reserve lowered prices for checks and smaller electronic payments while increasing prices for wire transfers. During this time, private-sector competitors' market share expanded overall. But the Federal Reserve's only competitor in small electronic payments and wire transfers told GAO that increased regulatory costs and competitive pressure from the Federal Reserve creates difficulties for the long-term viability of private-sector operators.
Most market participants GAO interviewed were satisfied with how the Federal Reserve performed various regulatory and service provider roles in the payments system. Most of the 24 participants GAO interviewed had no concerns over how the Federal Reserve separated its supervisory activities from its payment services activities. The Federal Reserve also has begun collaborating with market participants to pursue improvements to the safety, speed, and efficiency of the payment system. Although some competitors said the Federal Reserve should reduce its payment services role, many participants supported having the Federal Reserve remain an active provider. Federal Reserve staff indicated that these activities provide the Federal Reserve with sufficient revenue to enable it to provide ubiquitous access at affordable prices.
section_title: What GAO Recommends
paragraphs: GAO recommends that the Federal Reserve consider ways to incorporate, where appropriate, additional costs faced by private-sector competitors in its simulated cost recoveries and periodically obtain an external audit that tests the accuracy of the methods it uses to capture and simulate its costs. The Federal Reserve noted steps they will take to address GAO's recommendations.

section_title: Letter
paragraphs: With the value of checks and electronic payment transfers exceeding a  quadrillion dollars in 2015, a reliable and efficient payments system is  essential for the economic stability of the United States. The Board of  Governors (Board) and the 12 Federal Reserve Banks of the Federal  Reserve System (Federal Reserve) play multiple roles in the payments  system, including functioning as the nation’s central bank, supervising  financial institutions, and providing payment services to market  participants. The Reserve Banks offer a range of payment services to  depository institutions and the federal government, including collecting  checks; electronically transferring funds; issuing, transferring, and  redeeming U.S. government securities; distributing and receiving  currency and coin; and maintaining accounts for reserve and clearing  balances. The Board oversees the operations of the Reserve Banks and  serves as a regulator of certain aspects of payment services in the United  States. As part of its oversight, the Board issues regulations that apply to  the payment services activities of the Reserve Banks and the private- sector entities that compete with them. Where these roles potentially  overlap or conflict, the Federal Reserve faces the challenge of managing  or separating the roles in ways that help ensure it fulfills each role without  exerting undue influence or giving itself an advantage at the expense of  the banking industry or its private-sector competitors in providing payment  services.
In 2000, we reviewed the potential conflicts of interest posed by the  Federal Reserve’s operation of a payment system that competes with  private-sector systems operated and owned by institutions that the  Federal Reserve also supervises. We found no evidence to suggest that  the Federal Reserve had not adequately separated its multiple roles in  the payments system. However, the overall U.S. payments system has  evolved since our 2000 report. Technology has dramatically changed  many aspects of the payments process, notably in the transition from the  use and settlement of paper checks to electronic payments. In addition,  the Federal Reserve has begun publicly exploring how the United States  can develop a near real-time payment system to facilitate payments  between individuals and businesses as several other countries are  moving to. When Congress mandated that the Reserve Banks offer  payment services to nonmember depository institutions on terms  comparable to those for member banks, it also required that the Banks  publish prices for these services that were established over the long run  on the basis of all the direct and indirect costs actually incurred in  providing the services, including certain imputed costs that would have  been incurred if the services had been furnished by a private firm.
You asked us to update our 2000 report and in particular, review the  Federal Reserve’s management of its potential conflicts of interest in the  U.S. payments system, including issues relating to the costs and pricing  of its services. This report examines (1) how effectively the Federal  Reserve captures and recovers its payment services costs; (2) the effect  of the Federal Reserve’s practices on competition in the payment  services market; (3) how the Federal Reserve mitigates the inherent  conflicts posed by its various roles in the payments system; and (4)  market participant viewpoints on the future role of the Federal Reserve in  the payments system. This report focuses on three payment system  products offered by the Federal Reserve—check clearing, electronic  payments known as Automated Clearing House (ACH) payments, and  wire transfer payments—because these are the services in which the  Federal Reserve primarily competes with private-sector entities.
To address these objectives, we analyzed data on the reported costs and  revenues of Federal Reserve payment services from 1996 to 2015 and  how pricing and fee structures for the services had changed over this  period. We took steps to assess the reliability of these data and  determined they were sufficiently reliable for our analysis. Although we  analyzed the processes by which the Federal Reserve accounts for its  reported costs and revenues, we did not include detailed testing of the  Federal Reserve’s cost accounting controls related to its priced services  activities. We reviewed relevant legislation and Federal Reserve policies,  regulations, and guidance relevant to payment services activities. We  reviewed audits that external and internal audit organizations performed  of Federal Reserve payment system costs and activities. We also  reviewed the Federal Reserve’s policies that outline the criteria it would  consider before offering a new payment service. We interviewed Board  and Reserve Bank staff and 34 market participants, including financial  trade associations whose members participate in payment systems and  issue rules governing payment system activities; payment services  providers, including those that compete with the Federal Reserve; and  banks and credit unions that were end users of payments systems  services from other private-sector providers and the Federal Reserve.  The sample of banks and the sample of credit unions we interviewed  were both composed of a nonprobability stratified sample based on tiers  by asset size, including interviewing the five largest banks and randomly  selecting a number of banks from the large, mid-sized, and smaller tiered  banks. For credit unions we randomly selected institutions from larger and  from smaller credit unions. We also interviewed both financial institution  and nonbank entities that provided competing payments services  randomly selected within type of institution. We also interviewed staff from  the Department of Justice about competition issues. For more information  on our methodology, see appendix I.
We conducted this performance audit from November 2014 to August  2016 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: The Federal Reserve has long had a role in the U.S. payments system.  One of the major impetuses for the creation of the Federal Reserve was  to reduce the potential for disruptions in payments that periodically  occurred in the United States. During a financial crisis in 1907 stemming  from losses arising from the San Francisco fire and the failure of the  Knickerbocker Trust in New York City, payments were largely suspended  throughout the country because many banks and clearinghouses, which  served as centralized locations for banks to exchange checks for clearing,  refused to clear checks drawn on certain banks. These refusals led to  liquidity problems in the banking sector and the failure of otherwise  solvent banks, which exacerbated the impact of the crisis on businesses  and individuals.
With the passage of the Federal Reserve Act, Congress established the  Federal Reserve in 1913 in part as a response to these events. The  Federal Reserve Act also directed the Federal Reserve to supply  currency in the quantities demanded by the public and gave it the  authority to establish a national check-clearing system. Previously, some  paying banks (on which checks had been drawn) had refused to pay the  full amount of checks (nonpar collection) and some had been charging  other fees to the banks presenting checks to be paid. To avoid paying  these presentment fees, many presenting banks routed checks to banks  that were not charged presentment fees by paying banks. This circuitous  routing resulted in extensive delays and inefficiencies in the check- collection system. In 1917, Congress amended the Federal Reserve Act  to prohibit banks from charging the Reserve Banks presentment fees and  to authorize nonmember banks as well as member banks to collect  checks through the Federal Reserve System.
As the nation’s central bank, the Federal Reserve manages U.S.  monetary policy, supervises certain participants in the banking system,  and serves as the lender of last resort. The Federal Reserve System  consists of the Board of Governors in Washington, D.C., and 12 Reserve  Banks with 24 branches located in 12 districts across the nation. The  Board is a federal agency, and the Reserve Banks are federally chartered  and organized like private corporations each with a board of directors and  with their shares owned by their member banks. The Board is responsible  for maintaining the stability of financial markets, supervising banks that  are members of the Federal Reserve and bank and savings and loan  holding companies, and overseeing the operations of the Reserve Banks.
The Board has delegated some of these responsibilities to the Reserve  Banks, which also provide payment services to depository institutions and  government agencies. As a result, the Federal Reserve has dual roles as  both payment systems operator and as a regulator of payment system  participants.
The role of the Federal Reserve Banks as a provider of several payment  services in the United States contrasts with that of the central banks of  other countries. According to a study by the Bank for International  Settlements, which provides services to other central banks, of the 13  foreign jurisdictions examined, central banks in 11 operated large value  payment transfer systems—as the Reserve Banks do—but only 2 central  banks (those in Belgium and Germany)—also operated check-clearing  and electronic retail payment networks.
To improve the functioning of check services, Congress instituted a par- value (face value) check collection service to simplify the check-clearing  process in the Federal Reserve Act, and gave the Federal Reserve  operational (through the Reserve Banks) and regulatory (through the  Board) roles in check collection. Interbank checks are cleared and settled  through a check-collection process that includes presentment and final  settlement. Presentment occurs when checks are delivered by the bank  that received them—which currently almost exclusively involves  transmission of electronic images—to paying banks for payment. The  checks may be sent either directly to the paying bank or through another  entity—either another bank, a check clearinghouse, or a correspondent  bank—that would ultimately deliver them to the paying banks (see fig. 1).  The paying banks then decide to honor or return the checks. Settlement  ultimately occurs when collecting banks are credited and paying banks  debited, usually through accounts held at a Reserve Bank or at  correspondent banks that provide check clearing and other services for  other institutions. As part of its role in regulating check collection, the  Federal Reserve Board promulgated regulations that govern various  aspects of these processes, including Regulation CC (which covers how  quickly banks must make funds from checks and other deposits available  for withdrawal and governs aspects of interbank check collection and  return), and Regulation J (which covers how institutions can collect and  return checks and other items through the Reserve Banks).
To facilitate electronic check processing, some banks can create an  electronic image of a paper check at their branches, while others  transport the paper to centralized locations where the paper is imaged.  After imaging, an image cash letter is assembled and sent directly to a  paying bank, an intermediary bank, or to a collecting bank (such as a  Reserve Bank or a correspondent bank) or to an image exchange  processor for eventual presentment to the paying bank. The Reserve  Banks offer imaged check products—FedForward, FedReceipt, and  FedReturn—for a fee to banks that use its check collection services to  present checks for payment at other institutions. Similarly, other entities  that offer check-clearing services charge fees or use other mechanisms  to obtain compensation for such services, or institutions may not charge  each other when directly exchanging images.
The Fedwire Funds Service (Fedwire), the Federal Reserve’s wire  payments service, began in 1918 as a funds transfer service and initially  used Western Union’s telegraph lines to transmit payments. The current  Fedwire network provides a real-time gross settlement system in which  about 6,000 participants can initiate electronic funds transfers that are  immediate, final, and irrevocable. Depository institutions and others that  maintain an account with a Reserve Bank can use the service to send  payments directly to, or receive payments from, other participants.  Depository institutions also can use a correspondent relationship with a  Fedwire participant to make or receive transfers indirectly through the  system. Participants use Fedwire to handle time-critical payments (such  as settlement of interbank purchases, sales of federal funds, securities  transactions, real estate transactions, or disbursement or repayment of  large loans). The U.S. Department of the Treasury, other federal  agencies, and government-sponsored enterprises also use Fedwire to  disburse and collect funds. A private-sector entity, The Clearing House  Payments Company L.L.C. (TCH), operates a competing wire transfer  service—the Clearing House Interbank Payment System (CHIPS)—that is  used for similar purposes as Fedwire. Figure 2 shows how a typical wire  transfer payment occurs.
In response to concerns over high volumes of paper checks in the  payments system, the Federal Reserve worked with the private sector in  the 1970s to develop an electronic system to exchange payments known  as Automated Clearing House (ACH). These payments are often used for  small or recurring transactions, such as direct deposit of payrolls or  payment of utility, mortgage, or other bills. The Reserve Banks’ Retail  Payments Office operates an ACH payment network (called FedACH). By  agreement (in the form of an operating circular), ACH transactions are  conducted under rules and operating guidelines developed by a nonprofit  banking trade association, NACHA (formerly the National Automated  Clearing House Association). With limited exceptions, Federal Reserve  staff indicated that the Reserve Banks incorporate the association’s rules  by reference in their ACH operating circulars, which represents the  agreement between a Reserve Bank and its customers on the terms and  conditions of the FedACH services. TCH also operates its own ACH  network—the Electronic Payments Network—through which its members  can transmit and receive ACH payments to or from the customers of their  institutions. The Federal Reserve and TCH exchange ACH payments  originated by their customer institutions that are bound for institutions  using the other’s ACH network. Both the sending and the receiving  institutions typically are charged fees for ACH transactions. Figure 3  illustrates a typical ACH payment.
In 1980, Congress enacted changes that expanded the role of the  Federal Reserve in the payments system. The Monetary Control Act of  1980 (Monetary Control Act) extended the Federal Reserve’s reserve  requirements to all depository institutions, not just member banks of the  Federal Reserve. The act also allowed the Reserve Banks to offer  payment services to all depository institutions that had previously been  available at no cost to their members. Part of the legislative history of the  Monetary Control Act indicates that since the act required nonmember  institutions to meet reserve requirements, it was reasonable to also  provide such institutions with access to Reserve Bank payment  services. At this time, the act required the Federal Reserve to begin  charging all institutions for such services.
Because this change placed the Reserve Banks and private-sector  providers of payment services in competition with each other, the act  included certain requirements to encourage competition between the  Reserve Banks and private-sector providers to ensure provision of  payment services at an adequate level nationwide. The Monetary Control  Act required the Board to establish a fee schedule for Reserve Bank  payment services, under which all services are required to be priced  explicitly. The act also required that over the long run, fees be established  on the basis of all direct and indirect costs actually incurred in providing  the priced services, including imputed costs that would have been  incurred by a private-sector provider, giving due regard to competitive  factors and the provision of an adequate level of such services  nationwide. In describing the policies adopted to implement the  requirements of the Monetary Control Act, the Board stated that the act’s  legislative history indicated Congress sought to encourage competition to  ensure that these services would be adequately available nationwide and  at the lowest cost to society. According to these Board policies, the  Reserve Banks provide payment services to promote the integrity and  efficiency of the payments mechanism and ensure that payment services  are provided to all depository institutions on an equitable basis and in an  environment of competitive fairness.
In participating in the payments system, the Federal Reserve has taken  various actions to make the system more efficient. For example, in the  1950s the Federal Reserve contributed to the adoption of magnetic ink  character recognition, which allowed routing and other processing  information to be printed in machine-readable ink on the bottom of the  check’s face, which helped automate check processing. As discussed  earlier, the Federal Reserve worked with the private sector to develop the  ACH system in the 1970s. Initially, ACH volumes were low with most  volume growth attributed to government-initiated transactions, because  high startup costs made private-sector banks reluctant to invest in and  use the network. For a few years following the implementation of the  Monetary Control Act, the Federal Reserve subsidized the ACH network,  which helped the network obtain sufficient volume to become successful.  To improve the clearing of checks, Congress passed the Check Clearing  for the 21st Century Act (Check 21), which became effective October 28,  2004, which was legislation supported by the Federal Reserve. Check  21 facilitates check truncation, which is the substitution of the original  physical check with a legal equivalent (called a substitute check).  According to the trade association that establishes rules for exchanging  check images, checks are generally processed as images.
In 1998, a committee of senior Federal Reserve executives examined  whether the Federal Reserve’s participation in the payments system  remained justified in light of changes occurring in the financial services  and technology sectors at the time. This committee’s report addressed  the results of its review of the role the Federal Reserve played in the use  of checks and ACH payments in the retail payments system, including  considering whether any changes in its role could affect the integrity,  efficiency, and accessibility of this system. After examining check- clearing activities, the committee concluded that Reserve Banks’  withdrawal from the check collection market would disrupt the system in  the short-run, with little promise of substantial benefit over the longer run.  The committee noted that withdrawing from check clearing could increase  check collection prices to small and remote depository institutions and  could disrupt the migration from paper to electronic payments. Similarly,  the report concluded that having the Reserve Banks remain in the ACH  market would be more conducive to the future efficiency and migration to  electronic payments, including joint efforts with industry participants to  spur innovation in products and increase ACH usage.
subsections: section_title: Other Entities Involved in the Payments System
paragraphs: In addition to the Reserve Banks, other entities offer payment system  services to financial institutions. To process check payments, financial  institutions can set up direct, individual connections with other financial  institutions with which they can exchange check images for clearing of  checks drawn on the accounts of their respective customers. Institutions  also can submit their checks to clearinghouses that process and transmit  check image files for clearing to the respective clearinghouse members  on which the checks are drawn. For example, in addition to operating the  only other ACH and wire transfer networks that compete with the offerings  of the Federal Reserve, TCH also acts as a clearinghouse for check  images. Other competitors that provide checking services include  correspondent banks, bankers’ banks, and corporate credit unions. The  financial institution customers of these entities will send or receive their  checks, ACH payments, or wire transfers using these entities’ systems,  which may pass them to other entities, including individual institutions,  TCH, or the Reserve Banks, for processing. Some financial institutions  also use nonfinancial third-party data processors that aggregate  payments for these services and route them to other entities, including  the Reserve Banks or their competitors, for processing.
section_title: Check Volumes Decline as Use of Other Payment Types Rises
paragraphs: From 2000 through 2012, total noncash payments grew, and check  volumes declined, as the use of other payments types increased.  According to data the Federal Reserve reported in 2013, noncash  payments—including those made with debit cards, credit cards, ACH, and  prepaid cards (but excluding wire transfers)—grew almost 69 percent  from 2000 to 2012. The fastest growing payment method was debit  cards, whose use grew by more than 466 percent over this period. The  number of ACH payments also grew by more than 255 percent, while the  number of check payments declined by more than 56 percent. Figure 4  shows how the use of payment types changed in this period.
The changes in the relative use of the various payment methods largely  reflect consumers switching from check use to card-based or other  payment methods. According to the Federal Reserve’s analysis,  consumers wrote about 8 billion fewer checks to businesses in 2012 than  they had in 2006, and businesses wrote 4 billion fewer checks in 2012 to  consumers or other businesses than they had in 2006. Federal Reserve  staff noted that although check volumes have declined, the dollar value of  payments made by checks—estimated by the checking industry  association to exceed $20 trillion in 2013—indicates that checks are still  an important payment method in the United States because businesses  continue to use them to make payments to other businesses.
The growth in ACH payments encompassed its increased use for making  various types of payments, including for payroll deposits and automatic  bill payments, as well as increased use by consumers to make one-time  payments over the Internet. Although it had not obtained the volume of  wire transfers as part of past triennial reports, the Federal Reserve  analysis estimated that more than 287 million wire transfers occurred in  2012, with a combined value of about $1,116 trillion. Consumer senders  accounted for just 6 percent of total wire transfers in 2012.
section_title: Federal Reserve Has Processes in Place to Comply with Cost Recovery Requirements
paragraphs: The Federal Reserve Banks incur various costs as part of their provision  of payment services. To fully account for these costs, the Federal  Reserve uses a detailed accounting system for accumulating and  reporting cost, revenue, and volume data for the payment and other  services Reserve Banks conduct. The Federal Reserve’s cost-accounting  practices generally align with those used in the private sector and with  cost-accounting standards for federal entities. As part of setting fees for  its payment services, the Federal Reserve is required to also impute  some additional costs that it would have incurred if it were a private entity.  Although various options could be used to calculate these imputed costs,  each with their own trade-offs or methodological challenges, the current  methodology the Federal Reserve uses appears reasonable. However,  the Federal Reserve is not currently including certain costs that its  private-sector competitors may incur, including costs related to integrated  planning for recovery and orderly wind down of operations. According to  Federal Reserve data from 1996 through 2015, the Federal Reserve  Banks generally recovered the identified costs of providing payment  services, as required by the act. Although the Federal Reserve has  various internal controls to help ensure it accurately captures its payment  services costs, it has not obtained a detailed, independent evaluation of  the reliability of these processes in over three decades.
subsections: section_title: Federal Reserve Uses a Detailed System for Accounting for the Full Costs Associated with Its Payment Services
paragraphs: The Federal Reserve Banks use a detailed cost accounting system that  helps them meet several requirements relating to how to set the fees  charged for payment services and account for and recover the costs  incurred in providing them. The Monetary Control Act requires that over  the long run the Federal Reserve’s fees be established on the basis of all  direct and indirect costs incurred in providing payment services, and an  allocation of imputed costs that would have been incurred by a private- sector provider. Because the Board must set fees based on the total of  these costs, failure to account for all of its actual costs could result in the  Federal Reserve underpricing its services and competing unfairly with  private-sector providers.
According to data provided to us by the Federal Reserve, the Federal  Reserve Banks incurred over $410 million in actual costs as part of  providing payment services in 2014. These costs include personnel costs,  such as salaries and benefits of employees who perform payment  services activities, as well as those associated with equipment, materials,  supplies, shipping, and other costs for payment services activities.  Additionally, costs associated with overhead and support services  (activities benefitting multiple Reserve Banks, but performed under a  centralized function) are allocated to the payment services. For example,  expenses associated with functions such as sales and accounting are  categories of support costs for payment services activities. The majority  of the actual costs the Federal Reserve incurs in providing payment  services—78 percent in 2014—are support costs related to activities such  as developing software applications, implementing information security,  and providing help desk services.
The Planning and Control System (PACS) Manual for the Federal  Reserve Banks establishes cost-accounting policies and provides a  uniform reporting structure for accumulating and reporting cost, revenue,  and volume data for the payment and other services conducted by the  Reserve Banks. This system establishes a set of rules and procedures  used to determine the full cost of these services. Costs are accounted for  at the individual Reserve Bank level and subsequently aggregated to  reflect costs for all payment services throughout the Federal Reserve  System.
section_title: Federal Reserve Banks’ Cost Accounting Practices Align with Private-Sector Practices and Federal Standards
paragraphs: Federal Reserve staff told us that the cost-accounting practices in the  PACS manual generally align with practices used in the private sector.  Additionally, based on our analysis, these practices align with cost- accounting standards developed for federal entities. While generally  accepted accounting standards exist for the preparation of financial  statements, no single set of authoritative or uniform standards have been  developed that apply to the cost accounting practices used in the private  sector. In the private sector, systems like PACS typically are used to  provide management with internal information for making decisions on  cost efficiency and capability.
Although no single or uniform set of standards apply to cost accounting  practices in the private sector, Federal Reserve staff acknowledged that  information from PACS helps them manage their operations similar to the  way in which other organizations use cost accounting information.
However, they noted that their cost accounting system is detailed and  granular to ensure that they account for all costs when pricing their  payment services as required. The Board engaged an independent public  accounting firm to conduct an evaluation of its payment services pricing  methodology in 1984. This accounting firm’s evaluation included testing  whether costs incurred by the Reserve Banks were adequately captured  and whether support and overhead costs were appropriately allocated.  This auditor’s report concluded that the Federal Reserve’s accounting  and reporting systems that captured its payment services revenues and  costs were operating effectively. In addition, the accounting firm noted  that its testing confirmed that PACS had adequate controls that were  being followed and ensured that costs were being accurately captured.
Furthermore, representatives of the independent public accounting firm  that conducted the 2014 financial audit of the financial statements of the  Federal Reserve System told us that the Reserve Banks have thorough  and redundant internal controls for financial reporting even in comparison  to many commercial organizations. The representatives of this firm told us  that their audits of the expense categories that appear in the Federal  Reserve’s financial statements had not identified significant problems.  They noted that this likely reflected the Federal Reserve’s thorough  system of controls. However, the representatives of this firm told us that  they had not audited the expenses allocated to the payment services  specifically.
In addition, our analysis indicated that the Federal Reserve’s cost  accounting practices aligned with broad cost accounting standards for  federal entities. The Federal Accounting Standards Advisory Board  developed the Statement of Federal Financial Accounting Standards 4:  Managerial Cost Accounting Standards and Concepts (SFFAS 4) to help  federal entities provide reliable and timely information on the full cost of  federal programs. Reserve Banks are not required to comply with these  accounting standards because they are not a government agency but  rather federally chartered corporations. However, to provide one measure  of the quality of the Federal Reserve’s practices, we compared PACS  with the requirements of the cost accounting standard for federal entities.  SFFAS 4 directs government entities to meet five standards for their cost  accounting, and our analysis indicated that the Federal Reserve’s PACS  addressed each of these. For example, as prescribed in SFFAS 4,  PACS defines specific responsibility segments and provides the Reserve  Bank a process for accounting for the full costs of their services. Based  on this analysis, we concluded that the design of the Federal Reserve’s  system generally aligned with the elements recommended by the  standard. See appendix II for further details on the Reserve Banks’ cost  accounting practices.
section_title: Federal Reserve’s Current Process for Simulating Private-Sector Costs Appears Reasonable, but Does Not Currently Account for Certain Costs
paragraphs: Based on our analysis and discussions with market participants and  financial experts, the methodology the Federal Reserve uses to calculate  imputed payment services costs appears reasonable, but some market  participants noted that alternate methodologies might be more  appropriate. As previously discussed, the Monetary Control Act requires  the Federal Reserve to establish fees on the basis of direct and indirect  costs, including an allocation of imputed costs which takes into account  the taxes that would have been paid and the return on capital that would  have been provided if a private firm had provided the services. The total  of the imputed costs and return on capital is referred to as the private- sector adjustment factor (PSAF). The Board approves the PSAF annually  as part of its annual process for approving fees for the Reserve Banks’  priced services. The PSAF methodology calculates four additional costs  that a typical private-sector payment services provider would incur: debt  financing costs, equity financing costs (or return on equity), taxes, and  payment services’ share of Federal Reserve Board expenses. See  appendix III for further details on the PSAF methodology.
Over the years, the PSAF has declined significantly, following similar  trends in declining transactions, revenues, and assets associated with the  Federal Reserve Banks’ payment service activities. Following declining  payment services revenues and assets, as well as changes in practices  among payment services customers, the total imputed costs arising from  the Federal Reserve’s PSAF calculations declined from $150 million in  2002 (or an inflation-adjusted basis of nearly $194 million using 2015  dollars) to $13 million in 2016. However, as a percentage of total payment  services assets, the PSAF increased slightly from 1.3 percent to 1.5  percent during this period. Federal Reserve staff said that they use  publicly available information to calculate the imputed elements of their  PSAF methodology and publish the methodology and its results annually  in the Federal Register. Additionally, all proposed and finalized changes  to the PSAF methodology, as well as a summary of the public comments  on these changes, are published in the Federal Register and posted to  the Federal Reserve’s website. Federal Reserve staff indicated that they  follow this approach to help ensure that the PSAF methodology is  transparent and that its results can be more easily verified by the private  sector.
As part of its attempts to improve its accuracy and conform the PSAF to  changes in the payment system market, Federal Reserve staff noted that  the Board has made numerous changes to the methodology over the  years. The Federal Reserve staff said that they consider changes to the  PSAF methodology when conditions in the marketplace or industry  suggest that practices in the markets or other changes have occurred that  should be considered in the methodology for imputing costs. They said  that in those situations they evaluate different options to improve the  methodology and request public comments on the strongest options  before adopting a new approach. We reviewed the changes made  between 1980 and 2014 and found that the Federal Reserve had publicly  sought comment on significant changes to its PSAF methodology 10  times during this period. These include changes to how the return on  equity is calculated and to the peer group used to approximate the levels  of debt and equity in the model. See appendix III for further details on  changes to the PSAF methodology over time.
subsections: section_title: Concerns over Whether All Relevant Costs Are Included in the PSAF
paragraphs: Private-sector market participants have criticized the Federal Reserve for  not accounting for or imputing into the PSAF certain regulatory  compliance costs that private-sector providers incur. These costs include  those associated with federal antimoney-laundering requirements,  increased audit and risk management, overseeing the risks posed by  service vendors, and integrated planning for recovery and wind down of  operations. The Federal Reserve has said that it accounts for some of  these costs as actual expenses incurred by the Reserve Banks, and that  it has been considering how the other costs might be incorporated into  the PSAF.
In May 2015, the Electronic Check Clearing House Organization  (ECCHO) submitted a letter to the Board expressing concerns over the  Federal Reserve’s failure to account for certain costs being borne by  private-sector check services providers and urged it to conduct a  complete (de novo) competitive impact analysis of the Reserve Banks’  check image services. ECCHO specifically noted that many of its  members that provide check processing services to other institutions  incur costs associated with compliance with federal antimoney-laundering  requirements. In a written response sent in December 2015, the Chair of  the Federal Reserve Board’s Committee on Federal Reserve Bank Affairs  said that if private-sector banks incur material antimoney-laundering  compliance costs related to their check collection services that the  Reserve Banks do not, it might be appropriate for Reserve Banks to  impute such costs as part of the PSAF. However, Federal Reserve staff  said that correspondent banks have informed them that determining the  proportion of antimoney-laundering costs that relate to check services  specifically would be difficult, because they do not allocate compliance  costs directly to this service. Federal Reserve officials said in their  response to ECCHO that, while they did not see the need for the  complete competitive impact analysis that ECCHO requested, they  continue to consider how they could identify ways to incorporate these  costs into the PSAF methodology if they are material. However, until the  Federal Reserve determines and implements such costs into the PSAF,  the imputed costs will not reflect these actual expenses incurred by many  of the Federal Reserve’s competitors.
Additionally, enhanced regulatory standards, including those that apply to  entities designated as systemically important financial market utilities,  have raised regulatory compliance costs for the Federal Reserve’s key  competitor. Under the Dodd-Frank Wall Street Reform and Consumer  Protection Act, entities engaged in payment, clearing, or settlement  activity must be designated as systemically important by the Financial  Stability Oversight Council if the Council determines that the failure of or a  disruption to the functioning of the entity could create, or increase, the risk  of significant liquidity or credit problems spreading among financial  institutions or markets and thereby threaten the stability of the U.S.  financial system. Such entities then become subject to heightened  prudential and supervisory provisions intended to promote robust risk  management and safety and soundness. The act required the Federal  Reserve to issue rules to prescribe risk-management standards for those  financial market utilities designated as systemically significant for which  the Board is the supervisory agency. In November 2014, the Board  issued amendments to Regulation HH, based on the international risk- management standards for payment services that are systemically  important developed by the Committee on Payment and Settlement  Systems (CPSS) and the Technical Committee of the International  Organization of Securities Commissions (IOSCO). Regulation HH  requires designated financial market utilities to implement rules,  procedures, or operations designed to ensure that the financial market  utility meets or exceeds various standards, including, among others,  those relating to its governance, risk management and credit risk. For  example, the entity must have an integrated plan for its recovery and  orderly wind down, maintain unencumbered liquid financial assets  sufficient to cover the greater of the cost to implement its recovery and  orderly wind-down plans and 6 months of current operating expenses,  and hold equity greater than or equal to the amount of unencumbered  liquid financial assets required.
Representatives from TCH told us that complying with these standards  has increased their regulatory compliance costs and that they question  the extent to which the Federal Reserve has appropriately incorporated  these costs into the PSAF. TCH estimated that their efforts to comply  with these requirements have increased their operating costs by 10  percent, including additional costs associated with their Risk Office that  conducts activities related to information technology security, risk  management, liquidity risk and orderly recovery and wind-down planning,  among other things. They also said that they incur greater costs  associated with responding to their customers’ due diligence reviews  regarding vendor management, an element of the federal bank  examination process in which federal bank examiners evaluate a financial  institution’s third-party relationships as a component of their overall risk- management processes.
The Federal Reserve has incorporated some, but not all, of these  expenses into the imputed costs it calculates as part of the PSAF.  Federal Reserve staff have said that although the Reserve Banks’  payment services are not always subject to the same regulatory regime  as similar services provided by the private sector, the Reserve Banks are  subject to Board supervision and that these oversight costs are already  included in the PSAF as Board expenses and are being recovered  through revenue from the services. Additionally, Federal Reserve staff  told us that the Reserve Banks have devoted increased resources to  audit and risk management functions and that costs associated with these  functions—including additional personnel—are captured in PACS as  internal audit costs at the product line level. Federal Reserve staff said  that the amount of these costs had increased in recent years as they  hired additional staff to perform expanded oversight activities.  Additionally, in order to foster competition with private-sector financial  market utilities that are required to hold liquid net assets funded by equity  to manage general business risk, the Federal Reserve Board requires the  Fedwire Funds service to impute equity held as liquid financial assets  equal to 6 months of estimated current operating expenses. To meet this  requirement the Fedwire Funds service imputed an additional $2.7 million  in equity above the $51.1 million it imputed to meet other capital  requirements. This additional imputed equity, at the equity financing rate  in the 2016 PSAF, resulted in the Federal Reserve having to recover  additional imputed financing costs of $265,000. Federal Reserve staff  also clarified that, as a service provider of last resort, the Fedwire Funds  Service is subject to unique requirements that do not apply to CHIPS. For  example, the staff noted, Reserve Banks have incurred (and continue to  incur) substantial expenses in recent years to develop, implement, and  test manual procedures for settling systemically important transactions in  the unlikely event that the Fedwire Funds Service automated systems are  not available. Additionally, Federal Reserve staff told us that they also  receive inquiries from customers conducting vendor management due  diligence. Federal bank examiners told us that they have not noticed any  differences in how either the Reserve Banks or TCH respond to questions  from financial institutions on their vendor relationship and that in the  course of an examination they would look at an institution’s relationship  with the Federal Reserve the same way as they would view an  institution’s relationship with TCH.
However, the Federal Reserve has not incurred or imputed costs related  to a plan for recovery and orderly wind down that is required of CHIPS. In  a 2014 request for comment on revisions to its Policy on Payment System  Risk, the Board noted that Fedwire services do not face business risk that  would cause the service to wind down in a disorderly manner and disrupt  the stability of the financial system because the Federal Reserve, as the  central bank, would support a recovery or orderly wind down of the  service, as appropriate, to meet public policy objectives. As a result,  Federal Reserve staff said, the Board currently does not require the  Fedwire service to develop recovery or orderly wind-down plans or to  estimate or impute the costs of developing those plans. However,  estimating what these costs would be for its own operations if it were a  private firm and including them in its PSAF methodology would enable the  Federal Reserve to more completely impute costs that it would have  incurred as a private firm in order to meet its cost recovery goals.
section_title: Reasonableness of Methodology
paragraphs: As previously noted, the Monetary Control Act states that the Federal  Reserve must impute certain costs for its payment services that would  have been incurred if a private firm had provided them. Additionally, the  act states that the Federal Reserve’s pricing principles shall give due  regard to competitive factors and the provision of an adequate level of  services nationwide. However, the act does not specify exactly how the  Federal Reserve should impute these costs and various ways could  reasonably exist to do so. The Federal Reserve has stated that there is  no perfect private-sector proxy for imputing these costs and that the  PSAF methodology represents a reasonable approximation of the costs,  though some market participants have criticized the methodology.
Nevertheless, some market participants have questioned the  appropriateness of the Federal Reserve’s current PSAF methodology.  Representatives from TCH said that the PSAF should be calculated using  a peer group comprising payments-processing companies. They noted  that in 2015 their company’s equity capital was materially larger than the  imputed equity levels calculated by the Federal Reserve. However,  neither the Board’s rule on risk management standards for systemically  important financial market utilities that it regulates nor the international  framework for addressing risks of financial market utilities on which it was  based dictates any specific equity requirements other than to hold at least  6 months of current operating expenses funded by equity for liquidity  reasons and equity greater than or equal to the amount of liquid net  assets required.
Some have argued that the Federal Reserve’s current approach for  imputing debt and equity into the PSAF—in which it uses financial data  from all U.S. publicly traded firms in Standard and Poor’s Compustat  database—does not sufficiently reflect the financial activities that its  payment services represent. Furthermore, the U.S. publicly traded firm  market includes many firms that are engaged in industries outside of  payment services that may be even less similar to the Federal Reserve  than is TCH. However, Federal Reserve staff said that basing the imputed  debt and equity levels on a peer group consisting of firms providing  payment services, such as large bank holding companies, is not optimal  because such firms engage in many different lines of business and have  risk profiles dissimilar to the payment services provided by the Reserve  Banks. Additionally, the Federal Reserve has noted that a methodology  based on all publicly traded firms decreases the risk of price volatility that  could result from changes in the characteristics or financial results of a  limited peer group. If the Federal Reserve’s product pricing had to vary  widely each year because of large variability in the PSAF, such volatility  could be disruptive to its customers and the payment systems market.
Furthermore, the PSAF methodology uses data in the public domain to  help ensure that the PSAF calculation is replicable and transparent.  Federal Reserve staff noted that the Monetary Control Act states that all  Reserve Bank services shall be priced explicitly, which the Board  interprets as being fully transparent in their pricing. Many private-sector  payment services providers, including TCH, are not publicly traded and  do not provide publicly available financial information, which, if used to  calculate the PSAF, could hamper the Federal Reserve’s goal of  maintaining the transparency and replicability of its methodology.  Transparency can be an important goal, and our 2000 report included  recommendations that the Federal Reserve implemented to increase the  transparency and involvement of market participants in its pricing  activities.
As noted, the Federal Reserve has attempted to use different  methodologies for calculating the PSAF, including previously using the  financial data from a peer group of bank holding companies to calculate  the PSAF’s target return on equity. Although the Federal Reserve no  longer bases the PSAF methodology’s peer group on the top 50 bank  holding companies, the resulting equity financing rates have remained  similar. We reviewed the return on equities for the top 50 bank holding  companies from 2006 through 2015, and found that the average pre-tax  return on equity was 10.5 percent for these bank holding companies,  which is similar to the 10.1 percent pre-tax return on equity used in the  Federal Reserve’s 2015 PSAF calculation.
Because the PSAF is a proxy for private-sector costs and profit  dependent on a range of variables, and because of the Reserve Banks’  unique structure and operation and the lack of perfectly comparable  private-sector competitors, the calculation of the PSAF amount involves  trade-offs and assumptions that could be reasonably debated. For  example, assumptions on how to impute the return on equity in the  methodology can dramatically affect the overall figure. However, as  previously noted, changing the way the equity is imputed to include  nonpublic financial information might come at the cost of transparency  and replicability of the methodology.
While the Federal Reserve’s approach seems reasonable, any single  PSAF figure calculation could be reasonably criticized based on the  assumptions made and trade-offs chosen. Likewise, different trade-offs  and assumptions could result in higher or lower PSAF figures. We asked  three finance experts to review the Federal Reserve’s PSAF  methodology. All three experts said that the methodology and the  assumptions used to make the calculations seemed reasonable. One  finance professor said that specific assumptions on rates that the Federal  Reserve uses were standard assumptions to use, though there may be  some disagreement within each one, which could be expected. Another  finance professor said that the Federal Reserve’s approach appears to be  reasonable without being unnecessarily complex, and added that any  alternative models might add more complexity for little benefit.
We also reviewed the methodology and the changes made from 2005  through 2014 and determined that many of the assumptions used rely on  professional judgments and involve trade-offs between precision and  ease of calculation. For example, the Federal Reserve simplified its  calculation for computing the methodology’s equity financing rate in 2005.  Previously, the methodology averaged the results of three separate  financing models based on (1) the return on equity investors would  demand based on the risk in the market, (2) the average 5-year ratio of  net income-to-book value of equity among a peer group of bank holding  companies, and (3) a forward-looking approach estimating the discounted  present value of all future cash flows. Ultimately, the Board changed the  methodology to use only the model based on the expected rate of return  on equity that investors would demand based on the risk in the market,  because they considered this approach to be a well-known, generally  accepted, and theoretically sound model that is simpler and more  transparent than other approaches. In 2005, this change reduced the  PSAF from the $161 million it would have been under the three-model  approach, to $90.8 million under the simplified one-model approach.  However, annual fluctuations in peer group earnings or in projected cash  flows could have made the PSAF lower under the three-model approach  than under the one-model approach in a given year.
section_title: Federal Reserve Generally Has Achieved Its Cost Recovery Goals
paragraphs: According to Federal Reserve reporting on cost recovery rates from 1996  through 2015, the Reserve Banks have recovered or come close to  recovering all actual and imputed costs for all of their payment services.  As noted previously, the Monetary Control Act requires fees to be  established, over the long run, on the basis of the costs actually incurred,  and an allocation of the imputed costs that would have been incurred by a  private-sector provider. To meet this mandate, the Board has developed  an internal goal of recovering 100 percent of its costs for all its explicitly  priced payment services over a 10-year period. Federal Reserve staff told  us that the Monetary Control Act did not provide a specific definition of  “over the long run,” but they used 10 years for their targeted recovery  time frame.
The Federal Reserve annually reports how well it has met its 100 percent  recovery goal over 10-year periods. As shown in figure 5, in the rolling 10- year periods that cover 1996-2015, the Federal Reserve achieved at least  a 97.9 percent recovery for every 10-year period during this span.  However, a relatively low-cost recovery rate of 85.1 percent in 2003  lowered the 10-year rates for eight of the periods. In 2003, the Federal  Reserve’s check services had a net loss of more than $65 million that the  Federal Reserve attributed to significant one-time costs related to  consolidation activities, a decline in volumes, and greater use of products  with lower margins. The significant loss in that one year resulted in the  Federal Reserve falling short in achieving its 100-percent cost recovery  goal in each of the ten periods that included 2003 in the calculations. The  Federal Reserve’s cost recovery rates in the three most recent periods— none of which include the 2003 cost recovery figures—exceeded 100  percent.
Although the Federal Reserve Banks generally have come close to  recovering all of their actual and imputed costs for their payment services  in aggregate, the extent to which individual payment services recovered  their costs varied more widely from year to year (see table 1). Cost  recovery variations between products in a given year may be due to  circumstances specific to those products. For example, in 2014, the  Federal Reserve Banks’ ACH service recovered 86.7 percent of its costs.  The lower rate was due to a nearly $32 million charge incurred that year  associated with a multiyear technology initiative that was to have  modernized a processing platform but had been suspended that year. In  contrast, in the same year, greater-than-expected check volume resulted  in cost recoveries of more than 115 percent for that product line, which  helped the Federal Reserve Banks achieve their overall cost recovery  goals for that year and in the 10-year periods that included 2013 and  2014.
From 2005 to 2014, annual revenues and expenses across the Federal  Reserve Banks’ payment service products varied. Since 2005, the total  revenue the Federal Reserve Banks earned from providing check, ACH,  and wire transfer services declined by nearly 54 percent, from about $881  million in 2005 to $409 million in 2014 (a decline of nearly $1.1 billion to  $414 million, almost 61 percent in 2015 dollars). This decline was largely  due to a steep reduction in the expenses and imputed costs related to the  Federal Reserve Banks’ check services, which corresponded with the  transition to digital check images and the decline in commercial check  transactions. From 2005 to 2014, the number of checks the Federal  Reserve Banks processed fell from 12.2 billion to 5.7 billion. The decline  in expenses correspondingly reduced the need for the Federal Reserve  Banks to obtain as much revenue from this product line (that is, to  achieve cost recovery). Check service revenue fell from over $740 million  in 2005 to almost $175 million in 2014, which was a decline from $888  million to nearly $177 million in 2015 dollars (see fig. 6). In contrast, total  revenues for ACH and Fedwire increased from a combined total of about  $140 million in 2005 to over $234 million in 2014. In inflation-adjusted  2015 dollars, this equals an increase of almost $69 million.
Federal Reserve staff said that the cost structures for each of the check,  ACH, and wire payment services have significant differences. For  example, check clearing is more labor-intensive than the other services  and consequently incurs more personnel costs as a share of its  expenses. In 2015, personnel costs for check services represented more  than 15 percent of that service’s operational costs, while personnel costs  represented less than 3 percent of operational costs for Fedwire. Federal  Reserve staff identified personnel, information technology services, and  software application development as key cost drivers for the payment  services.
section_title: Federal Reserve’s Process for Capturing Its Payment Services Costs Has Not Been Externally Reviewed in Decades
paragraphs: Although the Federal Reserve appears to have a sound system for  capturing its payment services costs, it has not obtained an independent  review involving detailed testing of the accuracy of its cost accounting  process in more than 30 years. As previously noted, in 1984, shortly after  it was mandated to capture and recover these costs, the Board had an  external review by an independent public accounting firm of its pricing  methodology, including evaluations of its cost accounting PACS process  and the PSAF. At that time, the accounting firm’s report concluded that  the processes the Federal Reserve had implemented to capture its costs  were sound and that the overall PSAF methodology was logical and  complied with the Monetary Control Act.
The Federal Reserve obtains some assurance that cost accounting  practices for its payment services continue to be adequate from a unit  within the staff of the Board that conducts rotating reviews of the Reserve  Banks’ operations. Federal Reserve staff said that this unit reviews all the  Reserve Banks on a triennial basis (4 of the 12 banks each year) to  evaluate each bank’s effectiveness in producing reliable expense  information in compliance with PACS manual requirements. These  reviews examine the processes and controls relating to the cost-allocation  processes (including how expenses related to centrally provided  information technology activities are allocated) and internal support  charges. In these reviews, this internal unit identifies deficiencies and  control weaknesses and makes recommendations for improvement. In  addition, we reviewed the reviews the internal unit performed of the 12  Reserve Banks and of the Federal Reserve Information Technology  group between 2012 and 2015. Although some of these reviews noted  deficiencies with how the Reserve Banks were complying with the cost  accounting practices prescribed in the PACS manual, these issues were  characterized as “minor” or “less-significant” by the reviewers and,  according to Federal Reserve staff, did not result in any material cost  distortion. In addition, we reviewed a sample of nine audits that Reserve  Banks’ internal auditors had completed since 2011. Of these nine audits,  eight included reviews of controls relating to cost accounting practices. All  of the reviews concluded that overall management controls were  “effective” and one which provided a “generally effective” assessment.
External audits of the financial statements of the Federal Reserve System  overall and of the individual Reserve Banks are conducted annually.  However, these audits do not include detailed testing of the accuracy of  the processes used to capture or allocate costs associated with the  payment services, and thus the Federal Reserve does not obtain specific  assurance about the accuracy of these practices. Although staff from the  independent public accounting firm that conducted the Federal Reserve’s  financial audit in 2014 told us that the Federal Reserve Banks have  thorough processes, their audits did not include steps to review payment  services costs and revenues because these costs were not in the scope  of the audit.
The Committee of Sponsoring Organizations of the Treadway  Commission’s (COSO) Internal Control-Integrated Framework—a leading  framework for designing, implementing, and conducting internal control  and assessing the effectiveness of internal control—states that  compliance with applicable laws and regulations is a key objective for an  organization establishing internal controls. Under this framework, a key  means of providing such assurance can be the performance of monitoring  activities, which includes the use of an independent third party to perform  specific evaluations of whether aspects of an organization’s internal  controls are present and functioning. The annual financial audit does not  address the Federal Reserve’s payment services, representatives from  the accounting firm told us, because they do not meet the materiality  threshold. However, the Federal Reserve Banks must accurately capture  their costs to ensure the Board is meeting the mandate in the Monetary  Control Act for the Board to set fees on the basis of all direct and indirect  costs.
The Federal Reserve believes that the internal controls of the Reserve  Banks, internal audits by the Reserve Bank audit departments, and the  review process and examinations by the Board of Governors staff are  adequate for reasonably ensuring the accuracy of its accounting of costs  associated with payment services. Although we analyzed the processes  by which the Federal Reserve accounts for actual and imputed costs, we  did not include detailed testing of the Federal Reserve’s calculations or  cost accounting controls related to its priced services activities. By  obtaining periodic independent reviews to determine if the practices used  to capture all costs directly incurred by payment service activities and the  methods used to identify costs arising in other areas that should be  allocated to payment services are sound and that staff are adequately  complying with these practices, the Federal Reserve could attain greater  assurance that it is complying with its requirements under the Monetary  Control Act to set fees on the basis of all direct and indirect costs.
section_title: While Some Competitors Expressed Concerns about Some Federal Reserve Payment Service Practices, Users Appeared to Benefit
paragraphs: The Reserve Banks have added new services and fee structures  (including volume-based pricing) for customers to help ensure that they  retain adequate revenues to maintain their presence in the market.  Financial institution customers we interviewed generally were satisfied  with the Reserve Banks’ services and fees; however, some competitors  questioned the fairness of some Reserve Bank pricing practices such as  bundling discounts and volume-based pricing. To help ensure that the  Reserve Banks compete fairly, the Board has established pricing policies  and processes for assessing the competitive effects of changes to the  Reserve Banks’ payment fees and services. Although the Reserve Banks’  actions may be affecting some competitors’ profitability, our analysis of  the Reserve Banks’ fee and volume trends suggests that their actions to  compete appear to have reduced payments services costs for some  users to date.
subsections: section_title: As Product Markets Changed, the Federal Reserve Added New Services and Price Tiers for Some Customers to Ensure It Earns Sufficient Revenue
paragraphs: In response to changes in the product market for payments, and in an  effort to generate sufficient revenues to achieve full cost recovery, the  Federal Reserve has added new products and pricing structures.  According to Federal Reserve documents, the Reserve Banks have  introduced new services and pricing structures to retain existing  customers and attract volume from both existing and new customers. As  noted earlier, the Reserve Banks provide payment services both to  promote the efficiency of the payments mechanism and to ensure that  payment services are provided to all depository institutions on an  equitable basis. To achieve this, the Reserve Banks expanded the use of  pricing structures that provide discounts to customers that send them  higher volumes of transactions to process. In 1993, the Board approved  volume-based fees for the Reserve Banks’ noncash collection service  and several check products. One of the objectives of adopting volume- based fees at that time was to encourage more efficient use of payment  services (by addressing differences in demand through fees). In  approving these fees, the Board asked its staff to recommend guidelines  on the use of volume-based fees, which were then adopted in 1997 and  published in the Federal Register. At that time the Board also approved  specific volume-based fees for the ACH origination service. In 2010, the  Reserve Banks expanded this practice by introducing several volume- based pricing tiers for customers receiving ACH transactions. The new  pricing tiers charge customers lower per-item fees as transaction volumes  with the Federal Reserve increase.
The Reserve Banks also introduced fixed monthly fees to retain or  increase their payment services revenues. In 2009, the Board approved a  new monthly participation fee for the Reserve Banks’ Fedwire service in  addition to the per-item charges. Originally set at $60 per month, by 2014  this fee had increased to $90. For the ACH service, the Board approved a  new monthly minimum fee in 2010, which was $25 for customers that  originated payments and $15 for customers that received payments. By  2015, these fees had risen to $35 and $25, respectively. Because fixed  expenses constitute much of the costs of providing these services,  Federal Reserve staff said that adding fixed fees was their way of better  matching pricing structures to corresponding cost structures.
In addition to pricing changes, the Reserve Banks have introduced  discounts to benefit customers that use them to process transactions for  multiple payment products. For example, customers that transact at least  90 percent of their ACH payments a month through the Reserve Banks  and enable electronic receipt of checks from the Reserve Banks for all of  their routing numbers can receive a per-item fee discount on certain  check-clearing transactions. According to Federal Reserve staff, this  allows them to reward customers that use multiple services with a  discount in one of those services, which increases the likelihood that  these customers will continue to use the Federal Reserve.
section_title: Customers Generally Were Satisfied with Federal Reserve Services, but Some Competitors Questioned the Fairness of Some Practices
paragraphs: Reserve Bank customers with whom we spoke generally were satisfied  with the services and pricing they received, but some competitors raised  concerns about the fairness of a number of pricing practices.  Representatives of Reserve Bank customers—12 banks and credit  unions that were selected, in part, using random selection across three  asset size groupings—with whom we spoke generally were satisfied with  the Reserve Banks’ service offerings and prices.
Representatives of seven institutions said that they thought the  Reserve Banks’ pricing of payment services was reasonable and  competitive. For example, representatives from one large credit union  said that the Federal Reserve’s prices are low and that they also  provided a good service.
Representatives from two other institutions said that they valued the  Reserve Banks above private-sector providers for other reasons. For  example, the representative of one small community bank said that,  while private-sector payment service pricing generally may be lower  or even significantly cheaper, the bank will continue to use the  Reserve Banks’ services because doing so allows it to remain  independent and provide top-quality service to its customers without  depending on a private-sector provider. A representative of a large  credit union said that, while the credit union might be able to get more  favorable pricing from private-sector providers, the difference would  not be enough to warrant switching from the Reserve Banks. The  representative added that the credit union had confidence in the  Reserve Banks’ services and felt that the Reserve Banks were looking  out for its interests.
For the remaining three institutions, representatives from two said  that, while they did not have much insight into the pricing of providers  they do not use, they generally believe that pricing was comparable or  competitive between the Federal Reserve and the private sector. A  representative of one of the three institutions told us that the institution  switched to the Federal Reserve in 2007 because of unhappiness with  the fees and service of its private-sector provider. Representatives  from one institution said that the Federal Reserve and private-sector  pricing was similar for checks and wire payments, but not for ACH  payments, where they said the Federal Reserve had better prices.
However, some private-sector competitors with whom we met expressed  concerns with the fairness of some of the Federal Reserve’s pricing  practices, specifically in the following areas: bundling discounts, volume- based pricing, the competitive environment for check clearing, the ACH  interoperator fee, cost effectiveness, and the Federal Reserve’s ability to  innovate.
subsections: section_title: Bundling Discounts
paragraphs: TCH—the Reserve Banks’ largest competitor in general and their sole  competitor in ACH and wire payment services—stated that a bundling  discount offered by Reserve Banks to customers that use multiple  payment services unfairly take advantage of the Federal Reserve’s  unique market position. Specifically, TCH staff said that the Federal  Reserve’s Retail Payments Premium Receiver product, which rewards  banks that transact a higher volume of ACH transactions with the  Reserve Banks by offering a discount for certain check forward payments,  represents an unfair bundling of services. According to TCH  representatives, this discount represents a cross-subsidy between  services, which they allege violates the intent of the Monetary Control Act.  Federal Reserve staff noted that this product offers attractive pricing  discounts to smaller financial institutions, unlike many of its other  discounts that focus on larger financial institutions, and is intended to  serve as a customer retention tool. Specifically, they said that the lower  price allowed them to retain customer volume, which is needed to achieve  economies of scale. According to its policy on the provision of financial  services, the Federal Reserve maintains an operational presence in the  payment system to contribute to economic efficiency. Additionally, the  Federal Reserve has said that the Retail Payments Premium Receiver  product is consistent with the letter and spirit of the Monetary Control Act  and the Board’s pricing principles, noting that revenues from either check  or ACH services do not contribute toward recovering costs for the other  service and therefore do not represent a cross-subsidy. Furthermore, staff  said that the Reserve Banks are not in a unique position in relation to  providing “relationship pricing,” as private-sector institutions also use such  pricing structures. Officials at the Department of Justice told us that  product bundling is not necessarily anticompetitive and is practiced in a  wide range of industries.
section_title: Volume-Based Pricing
paragraphs: Some private-sector competitors expressed concerns that the Reserve  Banks charged customers more in markets in which the Reserve Banks  face less competition to enable lower pricing in markets in which they  face more competition. Competitor concerns included the following:
One large bank provider with large corporate customers explained  that, because the Reserve Banks have access to some smaller or  more remote financial institutions, they charge other institutions a  higher rate to collect checks drawn on these smaller institutions,  taking advantage of their access and relatively exclusive relationships.  The price for sending a check to another institution is determined, in  part, by the pricing tier in which that institution is included.
TCH staff said that the Reserve Banks offer steep discounts to large  financial institutions in markets where they compete for business and  offset these discounts by charging higher fees to smaller financial  institutions that have no alternatives to the Federal Reserve. They  considered this to be an anticompetitive pricing practice. They noted  that TCH faces difficulty obtaining smaller financial institutions as  customers because the costs in switching providers may outweigh the  pricing benefits for these institutions.
Federal Reserve staff said that volume-based pricing is a common  practice they believe helps maintain the efficiency of payment services.  Federal Reserve staff said that they follow volume-based pricing  principles when establishing pricing tiers and do not price their services  below marginal cost. They added that they assign items drawn on a  financial institution to a tier based on the number of checks the Reserve  Banks present to that financial institution, with those institutions with more  volume assigned to a lower-priced tier. They also noted that the private  sector similarly establishes tiers based on volume. Because private- sector competitors have similar price structures, and because any higher  prices paid by lower-volume customers likely do not increase their overall  costs significantly (as discussed later), this practice also appears to  benefit the payment services market overall.
section_title: Competitive Environment for Check Clearing
paragraphs: Some private-sector competitors raised concerns that certain protections  that helped ensure fair competition for processing paper checks have not  been carried over into the electronic environment. The Federal Reserve  has been examining this issue. Staff from TCH and ECCHO noted that,  until a regulatory change in 1994, the Reserve Banks had a statutory  advantage over private-sector competitors when presenting paper checks  to paying banks. According to the Federal Reserve Act and Federal  Reserve regulations, the Federal Reserve can obtain a same-day  payment from a paying bank by debiting the paying bank’s account at a  Reserve Bank without being charged a presentment fee. To address this  advantage the Board adopted Regulation CC’s same-day settlement rule  in 1992, effective beginning in 1994. The same-day settlement rule  allowed any bank to present paper checks to any other bank by 8:00 a.m.  for settlement that same day without presentment fees. According to  Federal Reserve staff, this regulatory change reduced the Federal  Reserve’s competitive advantage and allowed banks to compete more  effectively.
However, according to ECCHO staff, the transition to the exchange of  check images has removed the effect of the competition-enhancing  change because Regulation CC does not apply to electronic images.  They explained that check image exchange, unlike the presentment of  paper checks, requires institutions to have legal agreements for and  electronic connections between both parties, both of which can be costly  to establish. The Board attempted to address this advantage by twice  requesting comment, in 2011 and in 2014, on whether to modify  Regulation CC to include similar presentment provisions for the exchange  of check images. Although the Board has not yet taken final action on  these proposals, they did not receive significant support from  commenters, with payments trade groups noting both policy and  operational issues. Additionally, commenters did not provide any  alternative approaches that could be used to address the perceived  competitive disadvantage. In a December 2015 letter (in response to a  May 2015 letter from ECCHO raising these issues), the Chair of the  Federal Reserve’s Committee on Federal Reserve Bank Affairs said that  Federal Reserve staff have been asked to review certain pricing practices  related to electronic checks to determine whether any changes to Federal  Reserve policies, procedures, products, or fee structures were warranted.  This letter states that the Federal Reserve will continue to engage in  dialogue with ECCHO and industry stakeholders on steps to improve the  competition and efficiency of the check system, and Federal Reserve staff  told us in that they continue to consider ways to address these concerns.
section_title: ACH Interoperator Fee
paragraphs: TCH, as the only private-sector operator of ACH payments, told us that it  is concerned that the Reserve Banks have been taking advantage of their  market position to charge an artificially high fee for processing  transactions that TCH sends to them. Representatives of TCH explained  that, for ACH payments, both institutions involved have to process a  transaction, regardless of which one originates or receives the payment.  ACH payments generated by customers of TCH or the Federal Reserve  but bound for customers of the other provider must pass between both  operators, thus creating an interoperator transaction. In such cases, the  party that receives the item charges the other party “interoperator fees.”  However, TCH sends more items to the Reserve Banks because its large  bank customers typically generate large volumes of payments on behalf  of their business customers—many of which are sent to institutions that  use the Reserve Banks for ACH receipt. As a result, according to TCH  representatives, the interoperator fee benefits the Reserve Banks at the  expense of TCH. TCH representatives believe no costs exist that would  justify charging any price for these transactions.
However, Federal Reserve staff said that the Reserve Banks incur the  same costs when processing ACH files from a depository institution or  private-sector operator. If the Federal Reserve and TCH lowered or  eliminated the interoperator fee, the Federal Reserve likely would have to  increase prices for ACH payments made entirely within its network to  recover the lost revenue. This could effectively raise prices for its  customers while lowering them for TCH’s customers. Federal Reserve  staff said they established the interoperator fee below the average 2013  per-transaction cost to originate a FedACH item, not including electronic  connection costs. This average origination cost is based on operating  costs and imputed costs and has been fairly stable since the  determination of the fee.
section_title: Cost Effectiveness
paragraphs: While differences exist in cost structures between the Federal Reserve  and the private sector, these differences largely reflect differences in  customer bases. For example, TCH staff raised concerns over the cost- effectiveness of the services provided by the Federal Reserve, noting that  they operate much more cost effectively on a per-item basis than the  Reserve Banks. Specifically, TCH said that its average cost per  transaction for check, ACH, and wire items was approximately 16 percent  to 29 percent of the average cost per transaction for the three products  offered by the Reserve Banks. However, TCH told us that they primarily  serve large financial institutions. The other competitors of the Reserve  Banks, including large commercial banks, a bankers’ bank, corporate  credit unions, and a nonbank service provider, also tended to serve  narrower ranges of customers. For example, representatives of some  large banks with whom we spoke said that they tended to provide  payment services mostly to larger entities. Staff from a large bank told us  that they mainly provide check processing services targeted to smaller  institutions in areas where their bank has support staff.
In contrast, our analysis of Federal Reserve data indicated that the  Reserve Banks provide payment services to thousands of institutions  across a range of asset sizes, including large numbers of smaller  institutions. For example, about 86 percent of the Reserve Banks’ 3,665  forward check customers and about 94 percent of their ACH receipt  customers had less than $1 billion in assets. Federal Reserve staff told us  that providing payment services to many of these customers is more  costly because low-volume users are the largest users of customer  support services, resulting in higher per-item costs for these customers.  The account setup and maintenance costs also result in higher per-item  costs for low-volume customers. The Federal Reserve staff also noted  that they incur other expenses not borne by their private-sector  competitors, such as those related to processing transactions manually in  the event of a disruption. If TCH had a similar customer base and costs  as the Reserve Banks, its costs would likely be higher on a per item basis  and would be more similar to that of the Reserve Banks. Similarly, if the  Reserve Banks left the market for payment services, and TCH and the  other providers took on these customers, their costs per transaction  would likely increase due to the higher costs of serving the customers  currently served by the Reserve Banks, thus reducing or eliminating any  cost-effectiveness advantage. Correspondingly, if the Reserve Banks  provided services only to the larger customers that process larger  volumes, their costs per item would similarly be lower and their cost  effectiveness would appear higher.
The Federal Reserve noted that some of the differences in cost structures  provide competitive advantages to competitors of the Reserve Banks.  However, these cost differences may not be significant enough incentive  for current Federal Reserve customers to turn to other providers. For  example, staff from TCH said they have difficulty encouraging smaller  institutions to use TCH for payment services because many of these  institutions have payment volumes that are too low to produce savings  significant enough to justify a switch from the Federal Reserve.
section_title: Ability to Remain Profitable and Innovate
paragraphs: TCH representatives expressed concerns that the Federal Reserve’s  pricing and other behaviors have limited competitors’ ability to promote  innovation in the payments system. Representatives from TCH said that  the Federal Reserve’s pricing strategies have left little room for  profitability in providing payment services, leading to an overall reduction  in investment in research and development necessary for continued  innovation in the payments industry. They also added that any  innovations developed by TCH need to be accepted by the Federal  Reserve, which can present a challenge. For example, TCH  representatives said that they developed a universal payments identifier  to increase privacy protections and reduce fraud in electronic payments,  but the Federal Reserve did not adopt this innovation. Representatives  from the Federal Reserve noted that they partnered with TCH to deploy  this capability so that TCH customers wishing to use these identifiers for  ACH payments could do so without concern that such payments would be  rejected if they were routed across ACH networks. However, the Reserve  Banks said that there was little market demand for this capability by their  customers and determined not to offer the service directly.
In contrast, Federal Reserve staff said that the Federal Reserve’s  involvement in the payments market has contributed to the development  of new products and more efficient processes over time. Federal Reserve  staff and some market participants cited the Federal Reserve’s role in  multiple market innovations. For example, Federal Reserve staff indicated  that the remote capture of check deposits using smartphones and online  service access were an outcome of the check image improvements that  grew out of the Check 21 Act, which the Board helped to develop and the  Reserve Banks helped to implement. In addition, a representative from a  payment service provider said that the Federal Reserve was essential in  transitioning the check-clearing industry to image exchange after Check  21 became effective in 2004. The representative added that the Federal  Reserve has been helping to facilitate international ACH payments by  creating connections to other countries. Other market participants said  that the Federal Reserve has been leading the way on faster payment  initiatives such as same-day ACH (payments can clear and settle on the  same day they are submitted). The Reserve Banks began offering an opt- in same-day ACH settlement service for certain debit transactions in  2010, and expanded this service to include support for credit transactions  in 2013. Federal Reserve staff said that their push toward instituting a  same-day ACH service, along with NACHA’s rule amendment in 2015  allowing for same-day ACH payments, will help their customers develop  new products, such as direct deposit for hourly payroll, which benefits  users as well. With customers increasingly demanding faster, ubiquitous,  safe, and inexpensive payment solutions, at least 18 other countries have  developed real-time retail payments systems, according to a 2015 white  paper from an international payments network.
Representatives from TCH said that increased regulatory costs along with  what they see as the unfair way that the Federal Reserve is competing in  payment services is creating difficulties for the long-term viability of  private-sector operators. TCH staff said that appropriate competition in  the market for payment services, including higher prices, would facilitate  continued research and development by the private sector, leading to  ongoing private-sector innovation in the payments system.
While the Monetary Control Act requires the Federal Reserve to give due  regard to competitive factors and the provision of an adequate level of  such services nationwide when pricing its payment services, the act does  not address the preferred type or extent of private-sector competition in  the payments industry. Federal Reserve staff said that there are clear  benefits to vigorous competition with the private sector, such as the  additional resilience provided to large bank customers due to the  presence of two wire payment operators. In addition, they said that the  competition between the two is helpful in ensuring both entities are as  responsive as possible to customer needs. However, they also noted that  the overall costs to the market of having two ACH operators are higher  because of the loss of some economies of scale. Federal Reserve staff  added that, while it is not their intent to drive TCH out of business, they  also are not convinced it is necessary to have two operators, as many  other countries only have one provider for such services. Because the  effect of changing any Federal Reserve pricing likely would allow TCH to  raise its own prices, the benefits of such actions for the overall  marketplace and end-users is not clear. Conversely, if the Federal  Reserve withdrew from the market, the costs to the overall payments  system could decrease, but since TCH would likely have to expand its  infrastructure and market reach, its costs would increase, and the effect  on overall prices also would be unclear.
section_title: Federal Reserve Has Processes and Policies to Help Ensure Pricing Fairness
paragraphs: To help ensure that they compete fairly with private-sector payment  services providers and set fair pricing, the Reserve Banks must adhere to  various pricing principles and Board policies. As discussed previously, the  policies include the pricing principles established in the Monetary Control  Act, which required Federal Reserve payment services to be priced at the  same fee schedule for Federal Reserve members and nonmembers and  that such fees be established on the basis of all direct and indirect costs,  giving due regard to competitive factors and the provision of an adequate  level of such services nationwide. The Board has adopted several  additional pricing principles to help ensure that the Reserve Banks  compete fairly.
Generally, the Reserve Banks must set prices for each payment  service so that revenues match costs over the long run. However, the  Board’s pricing principles acknowledge that the Reserve Banks may  set below-cost prices for a service if it is in the interest of providing  adequate service nationwide. But such a decision would require a  Board announcement.
The Reserve Banks also must ensure that their services and pricing  are responsive to the changing needs of particular markets and  provide advance notice for changes in fees and significant changes in  service arrangements to permit orderly adjustments by users and  providers of similar services.
To help ensure that Reserve Bank pricing determinations give adequate  regard to competitive factors, Federal Reserve staff told us that they  follow industry standards and best practices for pricing their services.  They said that the factors they consider are similar to those that other  service providers such as correspondent banks would consider. These  factors include  the costs associated with the service;  the cost structure, such as the extent to which costs are fixed or  variable;  the price sensitivity of customers; and  the extent to which the market for the product or service is  competitive.
They explained that price sensitivity—the extent to which a customer is  likely to react to a pricing change—for a product is particularly important  when determining whether to use volume pricing. For example, they said  that higher-volume customers are fairly price sensitive; that is, they are  more likely to send more or less business to the Reserve Banks  depending on the prices charged. With the cost to provide services to  higher-volume customers being lower than for other customers, staff said  that using volume pricing to set lower prices for higher-volume customers  was reasonable. Federal Reserve staff also said that they sometimes use  pricing to influence consumer demand. For example, for a legacy product  such as the access fee for using a dial-up connection to the Reserve  Banks, they might increase the price to discourage its use. The Federal  Reserve considers the various competitive factors for each pricing or  service change proposal (typically during its annual pricing process).  Each pricing or service change proposal during the process must  consider customer, competitive, and policy implications before the  Reserve Banks bring a formal proposal to the Board. At the beginning of  this process, Federal Reserve staff consider market feedback from the  prior year’s pricing changes and analyze market trends and projections as  they develop new pricing proposals.
The Board also has policies to prevent the Reserve Banks from engaging  in anticompetitive or predatory pricing. According to the Department of  Justice, predatory pricing occurs when a firm charges prices that are  temporarily set below its incremental costs in an attempt to harm  competitors. Department of Justice staff involved in antitrust and  anticompetitive legal cases told us that a firm can be deemed to be  competing unfairly if it is engaged in predatory pricing, bundling its  products anticompetitively, or engaged in anticompetitive tying—requiring  the purchase of additional products as part of another purchase. Federal  Reserve staff told us that they used volume-based pricing in accordance  with principles the Board published in the Federal Register in 1997, which  are intended to avoid the risk of predatory pricing. These principles note  that volume-based fees “promote the efficient use of payment services by  allowing Reserve Banks to set variable fees closer to the incremental  costs of providing services.” Federal Reserve staff said that they take  into account competitive factors when establishing volume-based pricing  because the need to attract sufficient revenue from large-volume  customers better ensures that prices charged to low-volume customers  do not get too expensive. However, these principles also state that the  Reserve Banks will not price a particular service below its marginal cost,  or the cost of clearing one more item. According to these principles, this  type of pricing constraint is well established in antitrust law and is  intended to prevent predatory pricing.
In addition to these principles, the Federal Reserve conducts a  competitive impact analysis for all proposed changes to products and  prices and for all new products and prices. The analyses help ensure that  the Reserve Banks are not unfairly leveraging any legal advantages they  have over private-sector competitors—such as differing legal authority or  their dominant market position deriving from such legal differences.  According to a policy statement outlining its practices, the Federal  Reserve will conduct a competitive impact analysis on all proposed  operational or legal changes determined to have a substantial effect on  market participants, even if the competitive effects are not apparent on  the face of the proposal. In practice, Federal Reserve staff noted that  they also conduct competitive impact analyses for routine proposals  (those that only moderately affect existing product offerings). See  appendix IV for more information about how the Board conducts and  reviews competitive impact analyses.
section_title: The Federal Reserve’s Presence Appears to Have Generally Benefitted Payment Service Users
paragraphs: Based on Federal Reserve data and estimates and our analysis and  interviews, the presence of the Reserve Banks in the payments services  market appears to have reduced payments services costs for some  customers to date. For instance, from 2001 through 2013 private-sector  providers increased their market share for check, ACH, and wire  services—an indication that the Reserve Banks have not necessarily  negatively affected competition in these markets (see fig. 7). In 2001, the  Reserve Banks had about 57 percent of the share of the market for check  payments, about 64 percent of the market for wire payments, and more  than 85 percent of the market for ACH transactions. By 2013 (the most  recent data available at the time of this review), the Reserve Banks’  market share had declined in each of these payment services, with the  largest declines occurring in the ACH market. Their share of payments  originated declined from 86 percent to 49 percent and their share of  payments received from 87 percent to 63 percent.
Although the Federal Reserve’s most recent triennial payments study  included market share data through 2013, some more recent data also  exist.
ECCHO staff, using a different methodology, in 2014 and 2015  estimated that the Federal Reserve had between 42 percent and 44  percent of the check-clearing market.
For ACH, the Federal Reserve had around 55 percent of the market  share for ACH originations and about 62 percent of the market for  ACH receipts in 2014 and 2015, according to our analysis of Federal  Reserve and NACHA data provided by the Federal Reserve.
For wire payments, the Federal Reserve had about 55 percent of  market share in 2014 and 51 percent in 2015, according to our  analysis of Federal Reserve and TCH data provided by the Federal  Reserve.
These data suggest that the Reserve Banks’ market share for both check  and wire payments has continued to decline since 2013, although their  share of the ACH market has stabilized in the last few years.
The effect of the Reserve Banks’ competition in the markets for payment  services can vary across customers, but generally has resulted in lower  prices for payment transactions, according to Federal Reserve and TCH  staff. Federal Reserve staff told us that by competing actively to gain  more volume and new customers through their pricing and product  offerings, they have exerted downward pressure on prices for payment  services. TCH staff told us that the prices they charge their customers are  largely based on the cost of providing those services, taking into account  the prices set by their competitors in the marketplace.
The competition with the Reserve Banks often lowered prices for  competitors’ customers as well. Private-sector payment service providers  told us that the Reserve Banks’ published prices act as a baseline for the  industry. For example, TCH primarily serves large banks in a network  that, with few exceptions, offers the same pricing to all its members.  Representatives of TCH told us that they price their services based  largely on the cost of providing those services, taking into consideration  the price set by the marketplace, which includes the pricing offered by the  Reserve Banks and other private-sector entities. One nonbank service  provider that performed check processing said that most large banks try  to keep their prices about 10 percent lower than the Reserve Banks’. The  bankers’ bank and corporate credit unions we interviewed generally serve  smaller institutions in distinct geographical areas, such as a particular  state. Staff from the bankers’ bank said that the Reserve Banks’ fee  schedules serve as the pricing starting point for the industry.
Some of these competitors told us that they often offer additional services  to attract customers, similar to the Reserve Banks, and one also offers  discounts for customers that use multiple products and services. Another  servicer said that although they used to set prices directly off of the  Reserve Banks, they now use a model that can generate a range of  prices that allows them to maintain profitability. Although staff from one  bankers’ bank said that they were unable to offer prices as low as the  Reserve Banks’, they competed by offering more personalized customer  service than other competitors.
Our analysis of the Reserve Banks’ revenue and volume data shows that  many customers generally appear to have benefitted from lower prices in  recent years. We examined volume and revenue data for each of the  Reserve Banks’ check, ACH, and wire services and determined that, in  general, while price ranges have expanded as previously noted, average  costs for financial institution customers generally decreased in recent  years.
For all check items, the Reserve Banks earned average revenue per  item of $0.0249 in 2014, down 82 percent from $0.160 in 2007.  Federal Reserve staff noted that the primary driver of this cost decline  has been the transition from exchanging paper checks to check  images.
One of the most used check processing product types the Reserve  Banks offer involves processing files containing check images. From  2004 to 2011 the most used product of this type was for files  submitted by 8:00 p.m. (in 2012, the deadline was changed to 9:00  p.m.). The average cost per file processed went from $0.054 in 2007  to $0.020 in 2015—a decline of almost 63 percent.
Similarly, many customers paid less for their ACH origination and receipt  transactions over time as the Reserve Banks’ average per-item ACH  revenues declined, although some customers benefited more than others.  Specifically, the average revenues per item for ACH items decreased  from $0.0046 in 2005 to $0.0044 in 2014, or about 5 percent. For both  ACH origination and receipt services, the Reserve Banks saw the  proportion of revenue, and the total revenue earned from their largest  customers, decline while revenues increased from all other customers,  despite the number of institutions in these categories remaining stable.  For example, the share of ACH revenue earned from institutions with  more than $1 billion in assets declined from 60 percent in 2005 to 56  percent in 2014, although total revenues from these customers grew from  $35.6 million to $46.4 million, or from $42.7 million to $46.9 million in  2015 dollars. Because these larger institutions likely serve many other  end-user business and retail customers, these lower costs likely benefited  such end-users. The tendency of other providers to match or attempt to  set lower prices than the Reserve Banks also would extend the benefits  of lower Reserve Banks prices to the end-users that use other payment  service providers.
For its Fedwire service the Reserve Banks increased their revenues from  larger and midsize customers as their revenues declined from their  largest customers.
Overall, Reserve Bank customers paid 76 percent more for wire  transfers from 2005 to 2014—which reflects the costs of system  upgrades that occurred during this time.
From 2005 to 2014, the share of Fedwire revenues earned from the  largest institutions (more than $1 billion in assets) declined from 78.1  percent in 2005 to 64.9 percent in 2014, although total revenues from  these customers grew from almost $36 million to almost $50 million  (or from about $43.2 million to $50.5 million in 2015 dollars) in that  span.
Revenues from the next largest institutions ($200 million to $1 billion  in assets) increased from 8.5 percent to 13 percent.
In contrast, the revenues from the smallest institutions (less than $50  million in assets) remained under 1 percent.
Although smaller customers faced price increases, their actual costs are  smaller than those incurred by larger institutions. For example, small  credit union customers paid the Reserve Banks an average of $1,672  annually to receive ACH payments and small banks paid $1,772 in 2014.  In contrast, banks with more than $1 billion in assets paid an average of  almost $78,000 annually to send and receive FedACH payments that  year. We compared these average ACH expenses to the noninterest  expense amounts for all banks and credit unions with more than $1 billion  in assets and found that these ACH expenses would represent from  about 0.12 percent to 0.18 percent of the median institution’s total  noninterest expenses, but for the small institutions (those with less than  $50 million in assets), these ACH expenses would represent from about  0.05 percent to 0.48 percent of the median institution’s total noninterest  expenses.
Smaller institutions received far fewer Fedwire payments than larger  institutions, on average. The average small credit union received between  100 and 224 Fedwire payments annually from 2005 through 2014, and  small banks similarly received between 115 and 188. In contrast, the  average Reserve Bank customer with more than $1 billion in assets  received between 188,000 and 210,000 Fedwire payments annually in  the same period. As a result, the average amount spent on Fedwire  originations and receipts by smaller institutions was far lower than for  larger institutions. From 2005 to 2014 (the last year full data were  available), the average small credit union spent between $244 and  $1,838 annually to send and receive Fedwire transactions, or $914 on  average. Similarly, small banks spent between $396 and $1,442 on  Fedwire transactions, or $1,058 on average. In contrast, the largest  Federal Reserve customer banks spent between $48,000 and $77,000  annually, or almost $62,000 on average.
section_title: Market Participants Generally Viewed the Federal Reserve as Managing Potential Payment Services Conflicts
paragraphs: The Federal Reserve performs various roles, including managing  monetary policy, supervising bank holding companies and certain banks,  and acting as a lender of last resort, which create potential conflicts of  interest with the Reserve Banks’ role as provider of payment services. To  prevent Reserve Bank staff from inappropriately using any knowledge  gained from other activities (such as bank examinations) to increase the  competitiveness of their payment services, the Board has established  various policies and processes. In 1984, the Board issued various  standards to minimize the potential that the various roles of the Federal  Reserve could provide advantages for its payment services activities.  These include organizing the Reserve Banks’ operations so that the  duties of staff responsible for the Reserve Banks’ nonpayment services  activities do not overlap with those of the staff who conduct payment  services. Under this structure, Reserve Bank personnel with responsibility  for payment services (unless acting in the capacity of president or first  vice president) are prohibited from being responsible for monetary policy,  bank supervision, or lending.
Similarly, payment services personnel are prohibited from making policy  decisions affecting monetary policy, bank supervision, or lending matters.  Reserve Bank personnel involved in monetary policy, bank supervision,  or lending are permitted to provide to Reserve Bank payment services  personnel certain confidential information obtained in the course of their  duties. However, sharing the information would have to fulfill an important  supervisory objective, preserve the integrity of the payment mechanism,  or protect the assets of the Reserve Banks. In such cases, information is  to be provided on a need-to-know basis and only with the approval of  senior management.
To prevent payment services staff from obtaining information that could  be used for competitive advantage from the Federal Reserve’s  supervisory activities, Federal Reserve staff told us they have restrictions  on access to the databases that store examination information and other  confidential supervisory information. Board staff noted that the Reserve  Banks have groups that monitor credit risks to the Reserve Bank to  protect the assets of the Reserve Bank as well as to protect the payment  system generally. The staff in these groups have access to confidential  supervisory information to perform this activity, and sometimes must  share information with the payment services staff when implementing risk  controls on particular institutions’ accounts. The guidance that Federal  Reserve staff provided to us addressing credit risk monitoring activities  includes a section reminding Reserve Bank staff to share information on a  need-to-know basis only. A Board review conducted in 2005 that  surveyed the Reserve Banks on their information-sharing practices found  that staff were sharing information only when appropriate.
To limit potential for conflicts, Federal Reserve staff also have limited the  extent to which the information technology systems that financial  institutions use to access payment systems activities integrate with  functions related to other Federal Reserve activities. For instance, the  Reserve Banks offer a system known as Fedline, which provides the  ability to conduct transactions across various payment system services. A  July 2015 memorandum to staff responsible for statistics and deposit  reserves activities noted that staff responsible for payment services sales  had suggested that the applications for other business lines be more fully  integrated into Fedline to allow more seamless movement among these  activities. However, the memorandum reminds these staff that the  applications for the other business line functions were purposefully  segregated from the payment system applications in Fedline to better  ensure that staff adhered to conflict-of-interest standards for payment  services.
The Federal Reserve also includes information in training to help ensure  that relevant staff are aware of restrictions intended to prevent payment  services activities from benefiting from information obtained from other  Federal Reserve activities. Federal Reserve Board staff explained that  conflict-of-interest issues are not covered in a separate training course  but instead are addressed as part of other training. The 1984 standards  note that Reserve Bank staff are expected to provide full and accurate  information on Federal Reserve services (including features, quality,  prices, and operating requirements) to enable depository institutions to  make informed decisions, and that comparisons of Federal Reserve  services with those of other providers should be fair and objective. During  initial training, employees who work in the sales and marketing areas are  made aware of these policies to help ensure that their sales interactions  with banks avoid any inappropriate discussions. The staff noted that the  credit risk management staff developed some training modules and an  online training course that was shared among the 12 Reserve Banks that  includes information on the Board’s guidance on information sharing.
In addition to the Board’s policies, the individual Reserve Banks whose  staff conduct payment service activities also have policies that restricted  information sharing and other activities that could create potential  conflicts. We reviewed the policies of five of the Reserve Banks that  conduct payment services activities to determine if they addressed  behavior that could create conflicts of interest among supervisory,  payment services, and other activities. Each of the five Reserve Banks  have policies that restrict the sharing of information between payment  services staff and supervisory or other Reserve Bank staff. In addition,  four of the banks specifically restrict supervisory staff from discussing  payment services issues with financial institutions. Three of the banks’  policies also note that payment services staff should not disclose to other  Reserve Bank staff whether a financial institution was a payment services  customer. In addition, three of the banks’ policies note that decisions on  whether to take supervisory actions against a financial institution should  not be based on whether or not the institution was a payment services  customer. The Reserve Bank policies generally note that sharing of  information between payment services and staff with other responsibilities  could occur if such sharing served a specific supervisory purpose or if the  information was otherwise publicly available.
To determine compliance with the policies to prevent staff from sharing  information or exerting influence to advantage its payment services  activities, the Board also conducts periodic reviews to evaluate the  Reserve Banks’ application of the policies. The Division of Reserve Bank  Operations and Payment Systems within the Board is responsible for  conducting operations reviews of the Reserve Banks. As previously  discussed, Board staff told us that they review operations at four Reserve  Banks each year. As part of these reviews, Board staff discuss the  Reserve Banks’ information sharing practices for staff and provide  feedback to the banks about any concerns with the management of  confidential supervisory information.
The Federal Reserve also indicated that oversight by other auditors also  helps provide assurance that it is taking adequate steps to minimize  conflicts between its payment system activities and its other roles. The  Board’s Inspector General conducts reviews that sometimes address the  Board’s oversight of Reserve Bank payment systems activities. For  example, in September 2014 the Inspector General reported on the  extent and effectiveness of oversight (by the Division of Reserve Bank  Operations and Payment Systems) of the Reserve Banks’ Fedwire and  other wholesale financial services activities. The Inspector General’s  review stated that it had not identified any deficiencies regarding the  efficiency and effectiveness of the Board staff’s oversight, and that the  staff employed off-site monitoring, ongoing communication, on-site  reviews, and assistance from the general auditors at the Reserve Banks  to provide oversight of the Reserve Banks’ wholesale financial services.  The Board’s 1984 policy that sets out standards for the Reserve Banks’  payment services activities notes that an additional level of external  review comes from providing the public with the ability to comment on  significant Board proposals on Reserve Bank payment services activities.
The Federal Reserve also has a process for addressing complaints about  its payment system activities. Federal Reserve staff told us that they have  sometimes received questions from market participants on these  operations. If the issue is not resolved to the participant’s satisfaction,  they can escalate the matter to the chair of the Board’s Committee on  Federal Reserve Bank Affairs. This person is responsible for investigating  and responding to complaints concerning actions of Reserve Bank  personnel who are alleged to be inconsistent with the standards related to  conflicts arising from its payment systems’ activities.
Discussions with Federal Reserve staff and market participants suggest  that the Reserve Banks comply with the policies intended to prevent them  from using their other roles to benefit their payment services activities.  When we last reported on the potential conflicts between the Reserve  Bank’s payment services activities and the other roles of the Federal  Reserve in 2000, we found no evidence to suggest that the Reserve  Banks had not adequately separated their multiple roles. Since then,  Board staff told us that they have rarely received complaints relating to  conflicting roles in the payments system. For example, in the last 5 years,  staff recalled one instance in which they received a complaint from a  competing payment clearing organization. The complaint related to an  alleged incident in which a Reserve Bank payment systems sales  employee purportedly told a financial institution that use of Reserve Bank  payment services would help them comply with any regulatory  requirements. Board staff pursued the complaint, but were unable to  address the specific allegation due to lack of details regarding the  incident. However, Board staff held discussions with Reserve Bank staff  responsible for payment services sales to reinforce policies concerning  conflicts of interest. According to the Federal Reserve staff, Board staff  advised the competing payment clearing organization of the steps that  were taken in response to its complaint, and the organization did not  pursue its concern with the chair of the Board’s Committee on Federal  Reserve Bank Affairs.
Most market participants we interviewed also indicated that they did not  have concerns that the Reserve Banks were inappropriately using their  various roles to benefit their payment services activities. To help assess  how well the Reserve Banks were managing potential conflicts among  their different roles, we interviewed 24 providers and users of payment  services (including the top 5 largest banks and a randomly selected group  of service providers and end users). These entities included:
12 financial institutions and nonbank entities that compete with the  Reserve Banks to provide payment services; and
12 banks and credit unions that were end-user customers of private- sector providers, the Reserve Banks, or both (including 6 also  supervised by the Federal Reserve).
Of the 12 entities we interviewed that were end-user customers of  payment services, most (10 of 12) did not express concerns with the  Federal Reserve’s multiple roles. For example, staff at one large bank  said the Federal Reserve managed any potential conflicts of interest  between its payments side and its regulatory side well and that they had  not seen evidence of conflicts. They noted that their discussions with  Federal Reserve examination staff focused on safety and soundness, and  conversations with the Federal Reserve payments services staff were  similar to those they would have with a private-sector vendor. Of the  entities with concerns, one was a credit union not supervised by the  Federal Reserve whose representatives said that they were unsure of the  need for the Federal Reserve to function as both a regulator and provider  in the payment system. The other was a large bank, whose staff noted  that although they were not aware of any situation where a Federal  Reserve examiner raised concerns with their bank’s use of private-sector  providers, they did note that concerns existed over whether the Federal  Reserve is fully recovering its costs or whether it uses its advantages  over private-sector competitors.
Similarly, of the 12 entities we interviewed that competed with the  Reserve Banks, representatives of 9 of these entities did not express any  concerns over the Federal Reserve’s management of its multiple roles.
Representatives of the 3 remaining entities did express some concerns.  For example, staff at one payment services provider told us that some  banks have been told by Federal Reserve staff that if they did not process  sufficient volumes on both of the competing ACH networks—those  operated by The Clearing House and by the Reserve Banks—it could be  seen as a supervisory issue. Representatives of another institution told us  that when they moved their check-clearing business from the Federal  Reserve to a competing provider more than 3 years ago, Federal Reserve  payment services employees allegedly made comments suggesting  negative implications for the institution. But since then, the Federal  Reserve has been this entity’s primary supervisor and the representatives  said that the Federal Reserve has not taken any inappropriate actions.  The third entity that expressed concerns was a large bank that is  supervised by the Federal Reserve and offers payment services to  others. Representatives of this bank noted their Federal Reserve  examiners had not exercised any pressure on their institution to use the  Federal Reserve’s payment services but questioned the appropriateness  of the Federal Reserve offering comments on pricing on the ACH  payment association’s proposal to implement same-day ACH  transactions. Federal Reserve staff noted that these concerns related to  the establishment, calculation, and future management of an interbank  fee (in the nature of an interchange fee) for the ACH system’s same-day  settlement transactions that would be processed by the Reserve Banks  as an ACH operator under the proposed rules of NACHA for this service.
section_title: Market Participants Generally Support a Continued Role for the Federal Reserve in the Payments System
paragraphs: Market participants we interviewed generally support the Reserve Banks’  role as providers of payment services. Many of the 34 market participants  we interviewed—bank and credit union users of payment services and  private-sector providers of payment services (both direct competitors and  others involved in payment services activities)—said that the Federal  Reserve has an important role in the payment system. Several market  participants, including those that compete with the Reserve Banks in  providing payment services, said that the Federal Reserve successfully  promotes ubiquitous access to payment services and should continue to  do so.
Representatives of all 12 financial institutions that we interviewed that  used the Reserve Banks’ payment services generally expressed positive  views about the Federal Reserve’s roles in the payment system, including  comments about the Federal Reserve providing stability, promoting  competition, ensuring access to all institutions, and promoting innovation  in the payments industry. Representatives of one large bank said that the  Reserve Banks have strengthened competition in the market and put  pressure on private-sector providers, which has benefitted all parties.  Representatives of a community bank said that they think the Reserve  Banks provide a valuable service, especially to community banks.  Representatives from 2 of the 12 financial institutions had concerns about  the Federal Reserve’s roles in payment services. Representatives from  one large federal credit union said that the Reserve Banks’ prices were  low and their service very good, but worried that the Reserve Banks’  actions to lower prices might weaken competition in this market. In  contrast, representatives of several smaller financial institutions with  whom we met said that they appreciated the Reserve Banks’ services in  the payments system and preferred to use their services over a private- sector competitor. One bank official from a smaller institution said that  although the Reserve Banks’ prices were not necessarily lower than the  prices of private-sector providers, the official preferred the quality of  service in the provision of services.
Similarly, in our interviews all three payment service providers that do not  compete directly with the Reserve Banks said that they generally thought  the Reserve Banks’ provision of payment services has helped the  payment services industry. One provider said that the Federal Reserve  actively promoted innovation in the payments industry, citing the Federal  Reserve’s involvement in transitioning the check industry to digital  imaging, despite the resulting decrease in its own market share in that  payment service. Representatives from another provider said that they  believed that the Federal Reserve has always played the role of an  “industry helper” and cited the Federal Reserve’s roles in guiding the  industry toward adopting innovations in the coming years.
However, representatives from some competing payment service  providers said that they would prefer the Reserve Banks to compete less  actively in the payment services market. At least 6 of 12 competing  payment service providers and one trade association with members that  are competing providers said that they thought the Reserve Banks should  compete less actively in the payment services market, and several  suggested that the Federal Reserve instead become more of a payment  service “provider of last resort,” as illustrated in the following examples.
Representatives from one large bank said that for years they  considered the Reserve Banks as providing a critical function through  their connections to many institutions. But they noted that the Reserve  Banks recently made price and product changes to attract more  business and that undermined market competition. The staff said that  they would prefer the Reserve Banks to become providers of last  resort.
Some private-sector providers suggested that the Federal Reserve  stop providing payment services and instead focus more on ensuring  ubiquitous access to all financial institutions or simply act as a  regulator by creating and overseeing rules for the private-sector  providers. Staff from one medium-sized bank said that they thought  the Reserve Banks should instead focus on setting the rules as a  regulator of the payments system, while staff from a corporate credit  union said the Reserve Banks should instead focus on settlement,  and not clearing of payments. However, Federal Reserve staff told us  that cost recovery requirements dictate that the Reserve Banks  remain an active service provider, because being a “provider of last  resort” would require them to make transactions too expensive. They  said that larger-volume customers likely would use other providers,  leaving revenue from the lower-volume customers that remained to  recover costs. Moreover, they indicated that, if the Reserve Banks  were providers of last resort, the Federal Reserve would likely not be  able to meet its statutory cost-recovery requirement and would not  further its mission to foster the efficiency of the payments system or  ensure ubiquitous access.
Representatives of two payment service providers said that the  Federal Reserve could be more transparent in its payment service  pricing and compliance with the Monetary Control Act’s cost recovery  requirements. The pricing principles the Board developed in response  to the Monetary Control Act require the Reserve Banks to publish their  prices and to solicit public comments when proposing pricing or  product changes that are expected to have significant longer-term  effects on the payments system.
Representatives of TCH said that, while TCH welcomes competition from  the Federal Reserve, they believe that such competition should be strictly  in compliance with the Monetary Control Act, and that the Federal  Reserve should be transparent about such compliance.
subsections: section_title: The Federal Reserve Has Been Engaging Stakeholders to Improve the Payments System
paragraphs: In acknowledgment of the need to ensure that the United States keeps  pace with advancements in the payments system, the Federal Reserve  has been convening groups of stakeholders to explore ways to improve  the payments system, including bringing about faster and more secure  payments. The Federal Reserve cited the rapid changes to the payments  process brought on by high-speed data networks and other technology,  as well as the escalating security threats towards existing payment  systems, as evidence of the need for all stakeholders to join to improve  the payment system. (Payment system stakeholders include large and  small businesses, emerging payments firms, card networks, payment  processors, consumers, financial institutions, and government agencies.)  Furthermore, consumers and businesses have begun to desire fast,  convenient, ubiquitous, safe, and inexpensive payment options, according  to an international payments network. While other countries have  developed real-time or near real-time retail payments systems, the U.S.  payments system does not have a ubiquitous, convenient, and cost- effective way for consumers and businesses to make real-time or near  real-time payments. According to a 2015 white paper from the same  international payments network, 18 countries have real-time retail  payments systems, an additional 12 countries have been either exploring  or developing them, and another 17 have been considering developing a  system that would span multiple countries. In one example, Australia  has been making the transition to its New Payments Platform, which is  designed to enable future payments to be processed and settled in real  time with finality, even outside of normal banking hours.
To help begin the process and explore and solicit input on concepts and  criteria for a new system for the United States, the Federal Reserve  published a public consultation paper on improving the payments system  in September 2013. This paper provided perspectives on the key gaps  in the current U.S. payment system and identified desired outcomes to  address the gaps. Specifically, the Federal Reserve identified eight gaps  and opportunities for improvement in the current payment environment,  which included end users’ increased demand for real-time transactions  and timely notifications; the lack of ubiquity in currently operating  electronic payment services (as compared with legacy systems such as  checks); and the challenges associated with cross-border payments. The  paper also identified five desired outcomes to be achieved within 10 years  to address these gaps and opportunities. These desired outcomes  included having payment participants collectively identify and embrace  key improvements, implementing process improvements that reduce  costs and increase innovations over the long run, and having a system  that offers consumers and businesses greater choice and security.
The Federal Reserve obtained nearly 200 written responses from industry  stakeholders on the consultation paper, and published these responses  and the Federal Reserve staff summary of the responses on its website.  According to the summary document, about 75 percent of the written  responses agreed with the gaps, opportunities, and desired outcomes the  paper had identified. Commenters also suggested additional areas for  focus, particularly related to ensuring comparable regulation for payment  providers and addressing the needs of the unbanked or underbanked.  For example, according to the Federal Reserve’s summary document,  depository institutions broadly argued that they are held to higher  regulatory and risk-management standards than nonbank payment  providers, and merchants expressed desire for a payment system  governance structure that allows them to have more influence. According  to the summary document, many respondents opined that a 10-year plan  to improve the payments system was not aggressive enough, and that  more action should be taken in the near term.
To advance this effort, in January of 2015 the Federal Reserve issued  Strategies for Improving the U.S. Payment System, a document that sets  forth its strategies for bringing together all stakeholders to improve the  payment system. In this document, the Federal Reserve refined and  finalized the five desired outcomes into the following categories: speed,  security, efficiency, international, and collaboration. In addition, the  Federal Reserve identified five strategies to improve the payment system  in the United States: actively engage with stakeholders on initiatives designed to improve  the U.S. payment system;  identify effective approaches for implementing a safe, ubiquitous,  faster payments capability in the United States; work to reduce fraud risk and advance the safety, security, and  resiliency of the payment system; achieve greater end-to-end efficiency for domestic and cross-border enhance Reserve Bank payments, settlement, and risk-management  services.
Since then, the Federal Reserve has been forming task forces of industry  stakeholders, with one task force focused on evaluating effective  approaches of a faster payments system, and the other focused on  promoting payment security. These task forces have developed  effectiveness criteria for assessing alternative solutions for faster  payments and the Federal Reserve has also appointed key staff to  support and guide these efforts.
Although some market participants expressed concerns to us about the  Federal Reserve’s process for moving toward a faster payments solution,  Federal Reserve staff told us that these concerns appeared to reflect  misunderstandings of the process. For example, representatives from a  payment service trade association with whom we spoke said that the  Federal Reserve was making edits and inserting criteria in documents  containing stakeholder perspectives to emphasize its own service  offerings. Specifically, they said that the Federal Reserve inserted a  criterion that suggested that all faster payments positions should settle  with the Reserve Banks. However, Federal Reserve staff noted that the  criterion in question states “The solution should either enable settlement  in central bank money, or minimize and strictly control the credit and  liquidity risk arising from the use of commercial bank money for the inter- provider settlement process.” They added that settlement in central bank  money does not mean that the Reserve Banks would operate the faster  payments solution, as evident in TCH’s ACH service that settles using  central bank money. Federal Reserve staff also told us that the drafting of  the criteria documents for the Faster Payments Initiative took place during  meetings of the Faster Payments Task Force and Steering Committee,  and that this was a transparent and rigorous process.
Representatives from a large bank also said that they were concerned  about an intellectual property requirement contained in the participation  agreement for stakeholders involved in the faster payments planning  process. They said that the Federal Reserve required participants to sign  an agreement that included language noting anything coming out of the  discussion would be the intellectual property of the Federal Reserve.  Because of these terms, the bank decided not to participate, and they  said that they knew of other financial institutions that felt similarly.  However, Federal Reserve staff said that the characterization of the  participation agreement language is not correct and that the agreement  does not limit a participant’s use of its own intellectual property. Instead,  they said that the agreement includes terms for fair, reasonable, and  nondiscriminatory licensing of intellectual property. In addition, there is an  opt-out provision in the agreement that allows participants to identify any  intellectual property present in a final report before it is published and  decline to grant the license for it. Furthermore, based on feedback from  the industry related to the intellectual property provisions, the Federal  Reserve revised the participation agreement in March 2016 to reduce the  scope and legal burdens for the participant in licensing its intellectual  property. Federal Reserve staff said that the vast majority of current  members have signed this agreement and additional industry participants  have also joined their effort after these revisions were made.
section_title: Conclusions
paragraphs: The presence and activities of the Federal Reserve in the payments  system generally have been beneficial, including by helping to lower the  cost of processing payments for many end-users. Market participants also  generally supported having the Federal Reserve continue to play multiple  roles in the payment system. The Federal Reserve also continues to  support innovation and process improvements for the payments in the  United States.
To help ensure that it competes fairly with the private sector, the Federal  Reserve uses a cost accounting system for capturing its payment system  costs that is detailed and generally in alignment with comparable federal  standards. It also uses a reasonable approach to impute the costs that it  would bear if it was a private entity and includes these in the costs that it  recovers with its payment services revenues. However, the Federal  Reserve has not included in its imputed costs some costs that its  competitors incur. These include those related to developing plans for  recovery and orderly wind down, which are costs that its primary  competitor in wire transfers has had to incur to comply with new  requirements for resolution planning for systemically important payment  system entities. Also, the Federal Reserve has not included costs borne  by private-sector providers related to complying with antimoney- laundering requirements. By including these costs, the Federal Reserve  would more completely impute and recover costs that it would have  incurred as a private firm.
In addition, although it also conducts internal reviews to help ensure that  it captures the required costs accurately, the cost accounting system has  not been specifically reviewed by an external auditor in more than 30  years. Internal control standards state that compliance with applicable  laws and regulations is a key internal control objective, and a key means  of providing such assurance can be the performance of monitoring  activities, which can include external reviews, to ensure that such  compliance is occurring. Having its cost accounting practices periodically  subject to independent testing would provide greater assurance that the  Federal Reserve is complying with the Monetary Control Act.
section_title: Recommendations for Executive Action
paragraphs: To provide greater assurance that the Federal Reserve is complying with  the Monetary Control Act’s requirement to establish fees on the basis of  costs actually incurred and an allocation of imputed private-sector costs,  the Chair of the Federal Reserve Board of Governors of the Federal  Reserve System should:
Consider ways to incorporate the costs related to integrated planning  for recovery and wind down and compliance with antimoney- laundering requirements, to the extent practicable, in its imputed  private-sector cost methodology.
Periodically obtain independent testing of the methods the Federal  Reserve uses to capture its actual costs and simulate those of the  private sector.
section_title: Agency Comments, Third-Party Views, and Our Evaluation
paragraphs: We provided a draft of this report to the Federal Reserve and to The  Clearing House for review and comment. The Federal Reserve provided  written comments that we reprinted in appendix V. The Federal Reserve  and The Clearing House also provided technical comments that we  incorporated, as appropriate.
In written comments, the Federal Reserve stated that it is planning to take  steps in response to both recommendations. In response to our  recommendation that it consider ways to incorporate costs related to  integrated planning for recovery and wind down and compliance with  antimoney-laundering requirements in its imputed private-sector cost  methodology, the Federal Reserve’s letter stated that it will consider ways  to incorporate these costs. The Federal Reserve noted that, in some  cases, these costs are difficult to measure, given the challenges in  obtaining financial information from private-sector payment service  providers. In other cases, the Federal Reserve noted that it already bears  costs that its competitors do not. In response to our recommendation that  the methods the Federal Reserve uses to capture its actual costs and  simulate those of the private sector be independently tested periodically,  the Federal Reserve stated that it will procure an independent review of  the methods used for capturing actual and imputed costs related to its  payment services. We acknowledge this step and note that having such  reviews performed periodically will provide greater assurance to all  payment services market participants of the Federal Reserve’s  compliance with the Monetary Control Act.
Along with its technical comments, The Clearing House noted an  appreciation of our recommendations that the Federal Reserve consider  ways to incorporate certain costs borne by the private sector in providing  payment services and obtain periodic independent cost-capturing system  testing. However, The Clearing House also stated that it was  disappointed in our other findings, which did not appear to reflect the data  provided to us on a variety of issues. We believe we incorporated the  information provided by The Clearing House to the extent possible as  appropriate.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Federal Reserve and  other interested parties as appropriate. In addition, the report will be  available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or evansl@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made key contributions to this report  are listed in appendix v.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report focuses on three payment system services offered by the  Federal Reserve—check clearing, electronic payments known as  Automated Clearing House (ACH) payments, and wire transfer  payments—because these are the services in which the Federal Reserve  competes with private-sector entities. This report examined (1) how  effectively the Federal Reserve captures and recovers its payment  services costs; (2) the effect of the Federal Reserve’s practices on  competition in the payment services market; (3) how the Federal Reserve  mitigates the inherent conflicts posed by its various roles in the payments  system; and (4) market participant viewpoints on the future role of the  Federal Reserve in the payments system.
To examine how effectively the Federal Reserve has recovered the costs  of providing these payment services, we analyzed data on overall  reported revenues and expenses associated with the three payment  services from 1996 through 2015. We also analyzed data on the specific  expenses associated with the payment services from 2001 through 2014  to identify relevant trends and cost structures. We assessed the reliability  of these data by interviewing relevant Federal Reserve officials about the  controls and quality assurance practices they used to compile these data,  and determined the data were reliable for these purposes. We  interviewed Federal Reserve staff about the processes used for capturing  these costs and reviewed the Federal Reserve’s Planning and Control  System (PACS) Manual for Federal Reserve Banks, which establishes  cost accounting policies for the payment services at all Federal Reserve  Banks, whose staff conduct the payment services activities. We obtained  expert opinions on the soundness of the policies and practices detailed in  the PACS manual, including consulting internally with a cost accounting  expert within GAO, as well as with representatives from the auditing firm  that had conducted the 2014 audit of the Federal Reserve’s financial  statements. We analyzed 12 reviews conducted by an internal Board staff  between 2012 and 2015 and a judgmental selection of 9 audits conducted  by the internal audit staff of the Reserve Banks to determine the extent of  their findings related to cost accounting practices. We also reviewed the  only external audit that had examined the cost accounting practices at the  Federal Reserve Banks that had been conducted in 1984. No private- sector cost accounting standards existed to compare to the cost  accounting practices followed by the Reserve Banks, which are federally  chartered but organized as private corporations. As a result, we  compared the design of PACS to the elements that federal managerial  cost accounting standards—Statement of Federal Financial Accounting  Standards 4—recommend be included in federal agency cost accounting  systems to determine how the Federal Reserve’s practices aligned with a  comparable standard.
To determine how the Federal Reserve was imputing and recovering  costs that would have been incurred had its payment services been  provided by a private firm, in accordance with the Monetary Control Act,  we examined data and documentation relating to the Federal Reserve’s  methodology for computing this “private sector adjustment factor” (PSAF).  Based on our assessment of the controls and quality assurance practices  the Federal Reserve used to compile these data, we determined the data  were reliable for this purpose. We consulted with an internal GAO  financial markets expert, a financial analyst who monitors payment  service market participants, and three academic financial experts on the  reasonableness of the methodology’s assumptions. We reviewed notices  in the Federal Register from 2005 through 2014 that detailed proposed  and final changes to the methodology over this period. For further  explanation of these issues we spoke with Federal Reserve staff who  oversee payment services activities. We also interviewed a financial trade  association that issues rules governing payment system activities and  whose members participate in the payments industry, as well as  representatives of a major payment services provider to get their opinions  on the Federal Reserve’s PSAF methodology. We also reviewed industry  documentation on criticisms of the Federal Reserve’s PSAF methodology.
To examine how the Federal Reserve prices its payment services and  assesses the impact of its competition in this market, we analyzed volume  and pricing data for the Federal Reserve’s check, wire, and ACH payment  services from 2004 to 2014, including publicly available fee schedules.  We also analyzed Federal Reserve pricing and revenue data for each of  these services, including examining trends in service prices over time. To  ensure that these data were sufficiently reliable for our purposes, we  verified that we had obtained complete data on the revenue by type of  customer by comparing them to the annual revenue totals reported  publicly by the Federal Reserve. Based on this comparison and our  assessment of the controls and quality assurance practices the Federal  Reserve used to compile these data, we determined the data were  reliable for this purpose. We also reviewed Federal Reserve  documentation on pricing its services and on competitive impact  analyses, including policies, guidance, and Federal Register notices. We  interviewed Federal Reserve staff for information on how they price their  services and compete in the payments market. We also interviewed staff  from the Department of Justice to better understand what practices can  be considered anticompetitive.
For the perspectives of market participants on the Federal Reserve’s  pricing and competitive impact in the payments industry, we interviewed  34 market participants, including:
7 financial trade associations whose members participate in payment  systems and/or issue rules governing payment system activities  (NACHA and the Electronic Check Clearing House Organization).
12 entities that provide payment services that compete with the
3 nonfinancial institution service providers,
6 correspondent banks that provide payment services to other  institutions but also offer banking services to individual corporate  and retail customers,
2 corporate credit unions and 1 bankers’ bank that conduct  payment services and other activities for other institutions.
3 nonfinancial institution payment services providers that did not  compete with the Federal Reserve.
12 financial institutions that were end users of payment services from  other private-sector providers and/or the Federal Reserve, including
8 banks (including 6 that were regulated by the Federal Reserve),
4 credit unions.
We selected the financial institutions that used the Federal Reserve or  private-sector providers in two ways. First, we interviewed the 5 largest  bank holding companies by total assets in the United States. Some of  these institutions are both providers of payment services and users of the   Federal Reserve’s services. Second, we interviewed an additional 11  banks and credit unions that were chosen by random selection within the  following tiers based on total assets:
Banks (7) >$50 billion (3 large) $10-$50 billion (2 midsized) <$10 billion (2 small)
Credit Unions (4) >$5 billion (3 large) <$5 billion (1 small)
The entities we interviewed that provide payment services were those  selected randomly from a larger sample of institutions identified by a  payments industry association and those identified in other interviews as  service providers with valuable knowledge of the industry.
We also analyzed data from the Federal Reserve that included the  revenues it earned from various customer categories that it tracked  internally. These categories included various ones for customer  institutions of various asset sizes and for other entities, such as bankers’  banks or foreign banks. We used these data to identify the extent to  which the Federal Reserve’s revenues had changed over time and how  the amounts paid by different customer groups had changed. Because of  circumstances in the check market—including the industry’s transition to  images—we determined that the data for check were only sufficiently  comparable from the period between 2007 and 2014, which was the last  year that we obtained complete transaction volume data from the Federal  Reserve. Data for ACH and wire transfers appeared to be sufficiently  comparable from 2005 to 2014. Based on our assessment of the controls  and quality assurance practices the Federal Reserve used to compile  these data, we determined the data were reliable for this purpose.
To examine how the Federal Reserve mitigates the inherent conflicts  posed by its various roles in the payments system, we reviewed the  Federal Reserve’s policies related to its payment services organizational  structure and the requirements related to the conduct of its staff in the  Monetary Control Act and relevant Federal Reserve policies. We also  reviewed additional guidance the Federal Reserve provided to its staff on  the conduct of its payment services activities. We also reviewed training  materials the Federal Reserve used to inform its staff about requirements  relating to its payment services activities. In addition, we reviewed audits  or other reviews done by the Board’s Inspector General or other bodies  related to the conduct of its payment services activities. We interviewed  the Federal Reserve Board staff who oversee payment services activities,  including about the extent to which they received complaints from market  participants and about the conduct of the Federal Reserve’s payment  services activities. In addition, we interviewed representatives of the 34  market participants to obtain their perspectives on the conflicts in the  Federal Reserve’s roles in the U.S. payments system.
To examine market participant viewpoints on the future role of the Federal  Reserve in the payments system, we interviewed representatives of the  34 market participants, including bank and credit union users of payment  services and private-sector providers of payment services (both direct  competitors and others involved in payment system activities). We also  reviewed the Federal Reserve’s policies that outline the criteria it would  consider before offering a new payment service, including comment  letters publicly posted by industry stakeholders in response to the Federal  Reserve’s public consultation paper. We also obtained views of Federal  Reserve staff about their payments improvement initiative.
We conducted this performance audit from November 2014 to August  2016 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Federal Reserve Payment Services Cost Accounting
paragraphs: The Monetary Control Act requires that over the long run the Federal  Reserve’s fees be established on the basis of all direct and indirect costs  actually incurred in providing payment services, and an allocation of  imputed costs that would have been incurred by a private-sector provider.  The Federal Reserve Banks use a detailed cost accounting system that  helps them meet their requirements relating to how to set fees and  account for and recover costs incurred as part of providing payment  services.
subsections: section_title: Federal Reserve Payment Services Costs
paragraphs: According to data provided to us by the Federal Reserve, The Federal  Reserve Banks incurred more than $410 million in costs as part of  providing payment services in 2014 (see table 2). Of these, personnel  costs represented about 7 percent of total payment services costs.  Support costs represented the large majority of the costs of payment  services activities. Nearly 78 percent of the overall costs of providing  payment services arose from almost $320 million of expenses allocated  to those services by the Federal Reserve’s National Support Services.  These costs included the expenses arising from developing software  applications, implementing information security, providing help-desk  services, business development activities, accounting, and other support  functions. The Federal Reserve Banks’ payment services were also  allocated more than $28 million in local support services costs that  include Reserve Bank information, technology services, audit expenses,  and general administrative services. More than $22 million in various  overhead costs—representing about 5 percent of overall payment  services costs—were also allocated to payment services activities, and  these included, Federal Reserve staff told us, expenses associated with  overall corporate-wide functions such as bank administration, accounting,  and contingency planning.
section_title: Reserve Banks’ Cost Accounting System
paragraphs: According to the Planning and Control System (PACS) Manual for the  Federal Reserve Banks, every dollar expended (or received) by the  Reserve Banks is recorded into three cost categories: account,  department, and activity. Federal Reserve staff described how a Reserve  Bank’s expense related to a $10,000 contribution to the employees’  retirement thrift plan account would be recorded in the following way.
Initially, costs are recorded at the account level. In this example, these  contributions are recorded in a “Retirement and other benefits – Thrift  Plan” expense account.
Because the contributions were made for employees who work in  different departments, the Federal Reserve would allocate these  expenses to departments using various allocation methods. For  example, the Retail Electronic Payments Department at a given  Reserve Bank would be allocated some of the retirement expenses.  The allocation would be calculated based on a “salary dollar ratio  distribution,” equal to the salary expense of the department divided by  the total salary expense of the Reserve Bank. Therefore, if the  salaries in the department represented 1 percent of the salaries of the  Reserve Bank, 1 percent of the retirement plan contribution ($100)  would be allocated to the Retail Electronic Payments Department.
Subsequently, the Federal Reserve would further allocate this  departmental expense among the various activities that the  department tracks. For example, if 70 percent of the department’s  operations were devoted to automated clearing house (ACH) activities  and 30 percent were associated with check processing, $70 of the  department’s allocated retirement expense would be recorded under  ACH activity and $30 under check activity.
Similarly, the Federal Reserve Banks’ payment services would be  allocated support and overhead expenses using the methods and  procedures prescribed in the PACS manual, such as using a fixed  percentage of some other factor or on a dollar-ratio basis. For example,  maintenance expenses incurred at one Reserve Bank may be allocated  to payment services activities on the basis of the amount of space their  operations occupy in the bank’s buildings.
section_title: Appendix III: Private Sector Adjustment Factor (PSAF) Methodology
paragraphs: As it is required under the Monetary Control Act to calculate imputed  private-sector costs and return on capital, the Board of Governors of the  Federal Reserve System (Board) has developed a PSAF methodology  that allows it to calculate four costs that they do not incur, but that a  typical private-sector payment services provider would incur: debt  financing costs, equity financing costs (or return on equity), taxes, and  payment services’ share of Federal Reserve Board expenses. A private  firm providing payment services would need to raise capital to obtain the  funds to invest in the necessary facilities, equipment, and other assets  needed to conduct these activities. To determine the financing costs  associated with this debt and equity capital, the Federal Reserve  compiles the values of the actual assets it uses to conduct payment  services activities. In addition to its premises, furniture, and equipment,  these values may include an asset corresponding to the Federal  Reserve’s net pension plan obligations. The PSAF methodology assumes  that any short-term assets—such as supplies—are to be financed with  short-term debt and that long-term assets—such as facilities and  equipment—would be financed with long-term liabilities and a  combination of imputed long-term debt and equity. The methodology also  assumes that the Federal Reserve would use the same percentage mix of  long-term debt and equity that it derives from the U.S. publicly traded firm  index to finance its long-term assets not offset by long-term liabilities.
Once it has identified the imputed amount of debt and equity it would  need to fund its capital structure, the Federal Reserve calculates the rates  for debt and equity financing. Using publicly available, market-based  interest rates, it calculates a total amount of interest that it would have to  pay for the year on the mix of short- and long-term debt amounts that  were identified based on its asset structure. In 2016, the Federal  Reserve’s PSAF methodology determined that it would have paid a rate  of 0.3 percent on $19 million of short-term debt. The long-term debt  financing rate was 4.2 percent.
To determine the cost of the equity it would have to use to finance its  payment services activities’ assets, the Federal Reserve uses a generally  accepted financial formula for calculating the expected rate of return on  equity that investors would demand based on its risk relative to the  market as a whole. In 2016, the PSAF model calculated a pre-tax return  on equity of about 9.8 percent, which represented additional imputed  financing costs of $5.3 million.
After these total imputed financing costs of debt and return on equity are  calculated, the Federal Reserve’s PSAF methodology imputes two  additional costs that a private-sector firm likely would incur. The first of  these additional costs is an amount equivalent to the sales taxes that the  Federal Reserve Banks would have incurred based on budgeted outlays  for materials, supplies, and capital. These costs must be included as part  of the allocation of imputed costs under the criteria listed in the Monetary  Control Act. Furthermore, these costs are imputed rather than actual  because the Federal Reserve Banks are exempt from paying sales taxes  under the Federal Reserve Act. Then payment services’ share of Federal  Reserve Board expenses, which Federal Reserve staff said are costs  associated with the Board’s supervision of the payment services  operations conducted by the Reserve Banks, are included in the PSAF,  because, Federal Reserve staff told us, these costs are not captured by  the PACS (which captures the actual costs Reserve Banks incur). In  2016, the expenses related to Board supervision and to imputed sales  taxes were calculated to be $5.0 million and $2.8 million, respectively.
Using its PSAF methodology, in 2016 the Federal Reserve calculated a  total PSAF cost of $13.1 million that would have been incurred if the  Reserve Banks were a private-sector provider, down from $18.0 million in  2015, as shown in table 3. This amount was allocated to each payment  service based on the percentage of the projected operating expenses of  the Federal Reserve Banks’ payment services that each service  represented.
subsections: section_title: PSAF Methodology Changes Over Time
paragraphs: As part of the Federal Reserve’s attempts to improve the PSAF’s  accuracy and conform it to changes in the payment system market,  Federal Reserve staff noted that the Board has made numerous changes  to the methodology over the years.
These changes included a change made in 2000 to begin allocating a  portion of the Federal Reserve’s prepaid pension asset and  postretirement and postemployment benefit liabilities into the asset and  equity amounts the PSAF used for calculating imputed financing costs  and returns on equity. This change was made because the value of the  prepaid pension assets began to increase significantly due to large  returns generated from its investments and because the effects of prepaid  pension assets were being included in the balance sheets of the bank  holding companies the Federal Reserve was using as its peer group to  compute the PSAF’s financing rates and return on equity. This change  resulted in an additional $60.5 million of pretax imputed costs being  included in the 2000 PSAF amount. In 2005, the Federal Reserve  simplified its methodology for calculating the PSAF’s equity financing rate  by shifting from an average of three separate financing models to a single  calculation based on the return on equity investors would demand based  on the risk in the market.
In the past, the Federal Reserve used financial information from large  U.S. bank holding companies to calculate elements of the PSAF. For  example, from 1981 to 2001, the Federal Reserve had been using the  average debt and equity proportions used by the top bank holding  companies in the United States, before setting the equity imputed into the  PSAF to meet the FDIC definition of a well-capitalized institution.  Additionally, the financial information from large bank holding companies  was used to calculate the PSAF’s return on equity until 2006 and imputed  taxes until 2013. In 2012, the Board adopted a policy of basing the  imputed capital structure, debt and ROE rates, and tax rates on data for  the U.S. publicly traded firm market. Federal Reserve staff noted that over  time bank holding companies were engaged in different businesses and  had risk profiles that were beyond those represented by the payment  services of the Reserve Banks, many of which are now provided by  nonbank entities. In 2012, the Federal Reserve amended Regulation D,  governing reserve requirements, to eliminate the clearing balance  program, which was largely modeled after similar programs offered by  correspondent banks, wherein banks maintain balances with their  correspondents. The level of clearing balances held at the Reserve Banks  had declined after the Federal Reserve began paying interest on deposit  balances held at Reserve Banks. Federal Reserve staff noted that the  elimination of the clearing balance program significantly changed the size  and nature of the assets and liabilities associated with the payment  services to such an extent that the Federal Reserve determined that the  use of bank holding companies as the peer group was no longer  appropriate for the PSAF methodology.
section_title: Appendix IV: Competitive Impact Assessment Process
paragraphs: To ensure that it is not unfairly leveraging a possible legal advantage to  benefit its payment service activities, the Board of Governors of the  Federal Reserve System (Board) formally analyzes the potential  competitive impact of any significant changes in the Reserve Banks’  payment services pricing or product offerings. The process it uses for  conducting competitive impact analyses involves determining if a  proposed change would harm other providers due to legal differences,  and then weighing the potential harm of the change to competitors  against the potential benefits to the overall payments system. For each  price or service change proposal, the Board first considers whether the  change would have a direct and material adverse effect on the ability of  other service providers to compete with the Reserve Banks. According to  its policy, if the Board identifies such an effect, staff then determine  whether the effect was due to differing legal powers or the Reserve  Banks’ dominant market position deriving from such legal differences.  According to the Federal Reserve, existing legal disparities between the  Reserve Banks and the private sector include differences in the rules for  same-day settlement of paper checks, check presentment deadlines and  locations, the ability of the paying bank to impose reasonable delivery  requirements, and the control and timing of settlement. For example,  according to the Federal Reserve Act and Federal Reserve regulations,  every paying bank must accept paper checks from the Reserve Banks,  and the Reserve Banks can obtain a same-day payment from a paying  bank by debiting the paying bank’s account at a Reserve Bank without  being charged a presentment fee. While the Board addressed this  advantage through the adoption of Regulation CC in 1992 (effective in  1994), some market participants we interviewed noted that Regulation CC  applied to paper check clearing only, and does not address the Reserve  Banks’ advantage in the exchange of check images. In 1998 the Board  proposed limiting or eliminating this and all remaining legal disparities  between it and the private-sector competitors, but based on the public  comments they received, the Board concluded that the significant costs  associated with reducing the remaining legal disparities would outweigh  any efficiency gains to the payment services industry, and could result in  a reduction in efficiency to the payments system. For example, they said  that providing for a later settlement of Reserve Bank presentments would  delay the ability of the Reserve Banks to post credits for check deposits,  making intraday account management more difficult for many banks and  potentially increasing their daylight overdraft charges.
Federal Reserve staff told us that a competitive impact analysis could  indicate that a proposed change might have an adverse effect on private- sector competitors, but still not be considered unfair as long as it was  determined that the Reserve Banks would not be leveraging their legal  advantages. For example, the use of volume-based pricing and the  bundling of services that has concerned some private-sector competitors  did not raise objections in the Board’s competitive impact analysis  process because these changes were not deemed to rely on a legal  advantage.
If the analysis of a proposed new product or pricing change determines  that the Reserve Banks would obtain a competitive advantage stemming  from their legal advantages, Federal Reserve staff then must continue to  evaluate the proposed change to determine if the change furthers any  overarching Board objectives, such as increasing the efficiency of the  payments system or ensuring ubiquitous access. Staff must also consider  whether the objective of the proposed change could be met in another  way that would less adversely affect competing private-sector service  providers. Finally, the Board may decide to modify the proposed change  to lessen any adverse effects, or decide that the benefits to customers  are significant enough to adopt the proposed change despite the potential  for adverse effects on other competing market participants.
To help ensure that it is complying with its pricing policies and effectively  assessing its competitive impact, the Federal Reserve conducts various  internal reviews. Federal Reserve staff said that all product and pricing  changes must first be documented in a proposal by the relevant Reserve  Bank product office. These proposals are to include customer and market  competitive impact analyses. During proposal development, product office  staff sometimes also consult with industry work groups to solicit their  feedback. Once senior leadership in the product office achieve consensus  on the proposals, staff may then send the proposals to the Reserve  Banks’ Financial Services Policy Committee for its review and approval.  The proposals—including the associated competitive impact analyses— then are sent to the Board, although Federal Reserve staff said that they  often have ongoing and iterative discussions with Board staff prior to its  receipt of the proposals. Board staff then conduct their own independent  analysis of the proposals, and the Board will occasionally solicit additional  public comments if it anticipates any significant long-term effects  associated with the proposal. Nonroutine changes to pricing and product  offerings are subject to approval by the Board or the director of its  Division of Reserve Bank Operations and Payment Systems.
The Federal Reserve estimated that staff have completed 32 competitive  impact analyses for nonroutine proposals since 2000, in addition to the  analyses conducted for routine proposals and for the Board’s public  rulemaking process, as necessary. Nonroutine proposals are those that  create a new service, create a new product line within an existing service,  introduce new pricing structures, or are expected to generate significant  comment from market participants. The Board’s annual repricing exercise  is considered as a single, nonroutine analysis. A routine proposal,  alternatively, is a new product or proposed change that only moderately  affects existing products or is expected to result in minimal action from  market participants. Federal Reserve staff estimated that they performed  an average of 2–3 nonroutine analyses and 8–9 total analyses each year.
After a new product introduction created controversy in 2013, the Federal  Reserve added additional controls to better ensure that any subsequent  changes would not result in unfair competition with the private sector. For  their 2013 fee schedule, the Reserve Banks introduced a new check- clearing product known as “Choice Receiver,” which offered preferential  prices to customers for using a Reserve Bank as the presentment bank.  The Choice Receiver product was initially approved by the Board but later  challenged by private-sector competitors as unfair. After reviewing more  complete information about the product, Board staff said that they  concluded that its approval had been inappropriate because the product  office had not provided sufficient information to allow the Board to  evaluate whether the product relied on the Federal Reserve’s legal  advantages. Once all the relevant information had been considered, the  Board rescinded the product later that year because it was deemed to  have a direct and material adverse effect on the ability of other service  providers to compete effectively with the Federal Reserve due to legal  differences.
As a result of this experience, Federal Reserve staff told us they modified  their internal processes for analysis and review of proposed price and  service changes. For example, they created a competitive impact analysis  template that serves as a training tool for staff (staff respond to a series of  questions evaluating the potential adverse effect of proposed changes).  Reserve Banks also implemented a concept evaluation process, which  provides a high-level overview of planned changes to products or prices  in advance of formal proposals, and an enhanced postimplementation  review process, which compares the actual performance of a product or  service to the estimated changes in the original proposal. Federal  Reserve staff said that these processes together have helped provide  clarity to internal stakeholders on products in development; improved the  transparency and collaboration between product offices and Board staff;  and provided validation for prices and products after they have been  implemented.
section_title: Appendix V: Comments from the Federal Reserve
section_title: Appendix VI: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgements
paragraphs: In addition to the individual named above, Cody Goebel (Assistant  Director), Nathan Gottfried (Analyst-in-Charge), William R. Chatlos, A.  Nicole Clowers, Giselle Cubillos-Moraga, Robert Dacey, Simin Ho, John  Karikari, Paul Kinney, Risto Laboski, Marc Molino, Patricia Moye, Barbara  Roesmann, and Jason Wildhagen made major contributions to this report.