The final report of the Committee on the Federal Reserve in the Payments Mechanism-the Rivlin committee-makes an eloquent case for Fed leadership in the evolution of the U.S. payment system. This especially applies to the transitional period between our current, largely paper-based environment and the eventual emergence of a universal, reliable, and cost- effective electronic alternative.
In considering and rejecting scenarios that have the Fed exiting payment markets through liquidation or privatization, the committee concluded, for all intents and purposes, that leadership is the central bank's only prudent option. This recommendation is welcome, if overdue. It is especially welcome for its realistic assessment of the "checkless society" as a phenomenon not exactly just around the corner.
The payment system has been rudderless for as long as anyone can remember. We rely on platitudes and a variety of fragmented innovation initiatives to fill the leadership void in an arena that generates, directly and indirectly, over $120 billion in annual revenue and touches the lives of every citizen and business.
The Fed committee's work deserves more attention than it has received. It also deserves support in the form of a public commitment to its recommendations through immediate and vigorous endorsement by the Federal Reserve Board and Chairman Alan Greenspan.
This should take the form of a call for aggressive action within the Fed - and within the banking industry generally - for comprehensive legislation aimed at removing legal impediments to electronification and for systemwide infrastructure standards that preserve, and hopefully enhance, the ease, convenience, and acceptance of current paper processes.
These efforts should be coupled with education of consumers, businesses, and financial institutions about the benefits and risks associated with an increasingly electronic payment infrastructure.
As important, perhaps more so, is the need for aggressive product development in the Fed to cement its leadership position and encourage evolution of a more electronic infrastructure, especially in the area of high-volume, low-dollar "retail" transactions. Such initiatives should include:
Creation of a national check image archive in conjunction with truncation of low-dollar items deposited with the Fed for clearance.
Automatic conversion of truncated items to automated clearing house debits for presentation to payer banks.
Flexible payer-bank access to archived images through the Internet (or secure Internet technology) for signature verification and other research purposes.
Automated processing of check returns through the ACH.
Service-level commitments and pricing policies that encourage use of the new mechanism for interbank collections.
Notwithstanding inevitable complaints of private-sector operators about its unfair competitive advantages, the Fed is the only logical provider of such services and the only logical source of leadership in reshaping the payment system.
The Fed is ultimately responsible for maintaining the integrity of the payment system, assuring accessibility of the system to all depositories, and managing overall efficiency. With a 35% share of the market and a majority share in more than half the country, it is the major, if not dominant, provider of interbank collection services. The Fed has much of the technology infrastructure in place for a first major step toward electronification, and it already bears the fixed-cost burden of running the ACH system.
If these are insufficient reasons for the Fed's taking leadership, consider where the private sector has taken electronification in the last 20 years and also the current state of private-sector interbank collections.
Since its inception in the late 1970s, electronic data interchange has generated far more smoke than fire. Its successes have largely been outside payment areas, and even today fewer than 100 banks claim full EDI capabilities; only about 10% of banks can even receive EDI payments directly-hardly evidence of leadership on anyone's part.
The ACH, though much more successful overall, has also failed to realize its initial promise. Payroll and Social Security direct deposits, various other federal government transactions, and cash concentration debits are the most significant components of ACH volume-not the recurring consumer payments for which it was conceived.
Almost 65% of payments generated by today's automated bill payment systems never enter the ACH. Rather, they are included in printed reports that are mailed to payees, along with paper checks. Again, where is the leadership?
Commercial banks have always claimed leadership in the area of interbank check collections, and indeed the private sector's share of this market has increased since the implementation of the Monetary Control Act of 1980.
Granted, revenues are unevenly distributed across the processor universe, but the banking industry's interbank collections revenue amounts to only about $2 billion a year and profit margins average a slender 3% or 4%. By comparison, demand deposit sweep accounts generate about 30% more revenue than interbank collections and more than triple the profits.
Sweeps also generate profit without expensive technology investments, and by reducing balance sheet assets they improve virtually every measure of bank performance. And sweeps represent just one of many attractive opportunities open to commercial banks for strengthening customer relationships, improving profitability, and preserving what remains of the industry's historical business.
One might argue on this basis that surrendering leadership to the Fed, or abandoning large segments of the check market while concentrating on higher-margin objectives like sweeps, is not only logical but also the prudent choice of bank senior managers sincerely committed to improving shareholder value.
Does that mean commercial banks and other providers should abandon the check processing business? Of course not. It does not even mean they should completely retreat from the interbank market.
Roughly a third of the 64 billion checks Americans write each year are on-us-they never leave the bank of first deposit. Obviously, their processing will continue, with individual banks making decisions about archiving, truncation, and eventual electronification.
Clearing houses handle about 25% of all checks, around 15 billion items a year, and their processing will probably continue, possibly with electronification functions added. There will also be significant volumes of checks, wholesale lockbox payments, and other large-dollar items that will demand special handling. These could be possibly one or two billion items a year, or 3% of total volume.
This leaves 27 billion to 28 billion items a year, 20 billion of which are already handled by the Fed system.
No single bank nor consortium of banks has resources sufficient to tackle the mystifyingly complex tangle of laws, regulations, and customs that govern payment system operations.
As the planet's most profitable bank and as an institution enjoying universal, if sometimes grudging, respect for its integrity, the Fed can muster resources to effect dramatic systemic change and is uniquely positioned to work with the Congress and other legislative bodies in shaping a unified body of law befitting the computer age.
The Fed's academically oriented staff is likewise positioned to educate, and the Federal Reserve has already invested heavily-some say as much as half a billion dollars-in the image technology infrastructure needed for a next major step toward electronification.
Granted, significant additional investments will be needed. Mass-storage requirements for a national check archive alone have been estimated at 5,000 to 7,500 terabytes a year. That is a number with a lot of zeros, but given the rapid decline in storage costs per megabyte it is hardly a daunting challenge.
In any event, concrete steps toward more electronic check processing, even modest steps like those suggested in this article, strengthen the payment system.
They speed the process of presentment and clearance, reducing risks and opportunities for fraud, especially when coupled with automated returns. By dramatically reducing transportation costs associated with check processing, they effectively self-fund portions of the investment required for their own implementation.
They also condition the payment environment for more substantive changes in the future, such as intra-day or even virtual real-time presentment, eliminating inconveniences like the complex messaging requirements of current electronic check presentment processes.
Do benefits of this magnitude justify a broader Fed role in payment system operations? That question goes beyond the scope of this article. My point is that the payment system needs stronger leadership than has been evidenced from either public or private sectors if significant electronification is to occur.
The Rivlin committee presented a compelling case for the central bank's leadership. Its case is strengthened by the diminishing role of certain payment system processes in major banking strategies and by the relatively modest success thus far of private sector electronic payment initiatives.
The committee's recommendations deserve endorsement and advocacy within the Fed system. Debate on a national scale should follow. A continued leadership void will only lead to further fragmentation of efforts and to eventual weakening of the payment system as a whole.
