For years, with increasingly regularity, banks have been relying on the Federal Reserve to whisk away their excess cash, weed out the worn bills, return the money to them when they need it - and, oh yes, pay them interest on it.
And the Fed, chafing more and more under the weight of these tasks, has given banks the firm message that it can't, and won't, tolerate the situation much longer. It has told banks that they must reduce the amount of currency they "cross-ship," and will, starting next year, have to pay a fee for each bundle of bills that exceeds a certain volume limit.
Now, the Fed is turning to software as a way to keep the cash from even getting on a truck in the first place. Starting this week, under a program known as custodial inventory, a handful of volunteer banks will keep their vault cash on their premises rather than shipping it to the Fed for recirculation.
The banks, which will keep the cash in a designated area of their vault, will still get to transfer the cash to the Fed's books and earn the interest, but they will have to handle the "fitness sorting" on their own, dispatching with the bills that aren't good enough to circulate.
The Fed hopes the program will solve a big problem - the fact that banks have gotten in the habit of sending large volumes of small-denomination notes (specifically $5s, $10s, and $20s) to their local Federal Reserve Bank for processing and recirculation, and then reordering the same amount of currency to be delivered back to them days later. This, the Fed says, has become too great a financial burden for the central bank.
At the same time, the Fed hopes the custodial inventory program will defuse controversy over a fee that it intends to impose, of at least $5 a bundle (of 1,000 notes), on banks that impose too heavily on the Fed's responsibility to cross-ship cash.
The exact fee hasn't been set, and it won't be until next spring, by which time the Fed hopes to have had a good road test of the custodial inventory experiment as well as a chance to educate banks about how much vault cash they are cross-shipping and how they can reduce that amount. Many smaller banks would be exempt from the fee because they don't cross-ship that much.
Starting this week and continuing through the end of September, the Fed will begin live pilots of custodial inventory with 14 banks, which will hold on to some portion of vault cash that they normally would have shipped to the Fed. The program will be managed through a software program that the Fed developed in-house, which is based on software that the New York Fed uses for a similar custodial inventory program for financial institutions that stock U.S. bank notes overseas.
The Fed hopes to test the domestic custodial inventory program for six months, then to issue final policy guidelines on the recirculation issue in March or April, said Mark L. Mullinix, executive vice president and product manager of the Fed's cash product office in Los Angeles. In the meantime, in an effort to blunt the sharp criticisms banks made during the comment period on this issue last winter, the Fed is giving any bank that wants it a monthly
"The grand sweep of things is that we want to have a successful field program for custodial inventory," said Mr. Mullinix - who himself works from the San Francisco Fed - in a phone interview this week. "Next year we want to expand the CI program nationwide, so that before we even cross the threshold of charging a fee for cross-shipping, we've got a financial institution that's got about a year of this custodial program under their belt."
Barbara A. Bennett, the director of policy and product development for the Fed's cash product office, is leading the custodial inventory project. She said the first pilot bank will get set up this week, with the other participants to follow. The Fed is keeping the banks' names to itself for now, but says that clearly this issue is more important to larger banks, which ship larger volumes of currency.
During the trial, the bank "will have access to a Web-based application that actually tracks deposits into and withdrawals from the custodial inventory, so that the bank receives credits and debits from its Fed account as if it had made a physical deposit to the Fed," Ms. Bennett said. "Instead, they're moving the cash into the designated area of their vault that is the custodial inventory. We have a manual of procedures that we expect each of the custodial inventory sites to follow."
The bank will have to designate a container, or caged-off area, in its vault where it can lock up and seal the custodial inventory currency. After a deposit is recorded, the bank can fitness-sort it when convenient (day or night), and withdraw it between 7 a.m. and 4 p.m. local Fed time.
On the one hand, "What is saved is the round-trip transportation to the Fed," Ms. Bennett said. On the other hand, "It does not completely offset the processing cost that they have avoided by sending the currency in to the Fed." Many banks already do have the equipment needed to handle fitness sorting, she said.
In conjunction with the program, the Fed in July issued a revised version of its fitness standards for banknotes, which were first published in December and were subject to comments in January. The standards - which cover such issues as soil level, ink wear, holes, tears, corners, and tape - are meant to help banks plan for a future when they will be sorting bills not just for counterfeit but for fitness, and to help manufacturers of cash-sorting equipment calibrate their machinery.
The major change between the December version of the standards and the newer one is that graffiti - defined as extraneous marks on the notes - has been removed from the standard. The vendor community was having trouble with the graffiti standard, and the Fed concluded that it was covered under the general soiling rubric and didn't need its own separate category, said Roland Costa, the vice president and chief technology officer of the Fed's currency technology office, who is based in the Richmond, Va., Fed. The new rules say that "they no longer have to consider graffiti in their sorting decisions," he said.
Until now, "We have never published standards, and, quite frankly, central banks around the world are having issues with publishing standards, and how to make it generic enough," Mr. Costa said. The standards the Fed published "basically just say how we sort our notes - they don't mandate any specific sorting by banks."
It remains to be seen whether the Fed can reduce banks' dander through its various efforts to make the new cross-shipping policy more acceptable. Among the 25 letters it received during its comment period (which are listed at the Fed's Web site, along with reams of other information about the custodial inventory program and related matters) were several that warned of many dire consequences from the proposal - from more expenses to banks to less service for customers. Among the most contentious issues are the cross-shipping fee and the proposal that banks keep no more than 25% of their vault cash in the custodial inventory program, which the banks say is too little.
"Our concern was just what costs might be associated with participating" in custodial inventory, "because of the security requirements that the board might impose that were different from what the bank might think was necessary," said John C. Rasmus, a senior federal counsel at the American Bankers Association, in an interview Thursday. "There was some concern that there might be additional costs associated with that type of program, and the Fed never identified what those might be."
He said he hoped there would be additional room for banks to shape the policy as the Fed moves forward.
Mr. Mullinix of the Fed said the pilot period is absolutely meant for learning and collaboration. "There are a couple of things we want to understand," he said. "Do we, in fact, see recirculation occurring? Are we able to see some improvements in [depository institutions'] cross-shipping performance so there's less coming into the Fed?" Once those results are established, he said, it will be easier to figure out what an appropriate cap figure will be for custodial inventory currency.
Fed officials say that the cross-shipping situation has gotten so out of control that something simply has to give, whether banks complain or not. At odds are the Fed's responsibility to cull unfit notes from circulation, and the convenience and benefits banks have discovered they get when they ship large volumes of cash to the Fed and order it back when they need it.
"The typical situation is that they receive deposits of cash in from merchant customers on Monday and Tuesday, and don't need that extra cash until the end of the week when they're stocking the ATMs and paying merchants out for the weekend," Ms. Bennett said. "So there's this period of time when they're holding it on their books and there's this increased cost there.
We're hoping that the custodial inventory will allow them to offset those costs."
Mr. Mullinix said the situation has evolved over time, with the Fed shouldering more work that the banks used to do themselves. Even if banks started paying the proposed cross-shipping fees without changing their behavior, he said, the work would soon reach untenable levels for the Fed.
"This process really began in the mid-1990s and has accelerated since then, and we're returning to our more traditional and historic role," Mr. Mullinix said. "They say, 'You're shifting the cost to us,' and we say, 'We're actually shifting the cost back to you.' "
