Clearing and Settlement of U.S. Dollar Payments: Back to ... · demanded payment in gold coin, bank-notes or greenbacks.4 Banks located out-side the major ﬁnancial centers maintained

1 For convenience, depositoryinstitutions are called banks.

FEDERAL RESERVE BANK OF ST. LOUIS

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SEPTEMBER/OCTOBER 1996

Clearing andSettlement ofU.S. DollarPayments: Backto the Future?

Bruce J. Summers and R. Alton Gilbert

The Federal Reserve System wasformed in 1914. Wide dissatisfaction withroutinely expensive and slow settlement ofinterregional payments, as well as occa-sional disruptions of the payments systemcaused by banking panics, are among thefactors that led to its creation. Accordingly,an important purpose for creating the Fed-eral Reserve to serve as the nation’s centralbank was to enhance the efficiency andimprove the stability of the nation’s pay-ments system.

At the time of the formation of theFederal Reserve, the paper check was theprinciple means of making payment. TheFederal Reserve attempted to fulfill itsmandate for improving the check-collec-tion system by providing banks with anational check-collection service.1 Since it was the only institution with a nation-wide network of banking offices andsettlement accounts for banks, it had anadvantage in interregional check collec-tion. Over time, the Reserve Banks addednew payment services to exploit the ad-vantages of new technology: wire transferof reserves, a book-entry service for safe-keeping and electronically transferringownership of government securities, andthe automated clearinghouse, designed asan electronic alternative to checks.

The share of U.S. dollar payments pro-cessed through the Federal Reserve Banks

began declining in 1980, when the ReserveBanks began charging for payment ser-vices, as required by the Monetary ControlAct. This declining share, for both small-and large-dollar payments, appears to rep-resent a major shift in the operation of theU.S. dollar payments system. Our paperexamines the implications of this shift forthe Federal Reserve’s ability to fulfill itsmandate to safeguard the stability and efficiency of the payments system. In particular, we examine whether the prob-lems that existed in the payments systemprior to 1914 will at some time reappear asthe Fed’s operational role declines. It isimportant to consider whether the nation’spayments system has changed in ways thatmake Reserve Bank services less essentialfor dealing with the problems that havebeset it in times past, and what the futurerole of the Federal Reserve Banks shouldbe as payment processing systems con-tinue to evolve.

The following section examines theoperation of the payments system prior to the formation of the Federal Reserve,focusing on aspects of the system thatwere considered defects by advocates of acentral bank. Subsequent sections estab-lish a conceptual framework for our anal-ysis and describe the payment servicesoffered by the Reserve Banks and trendsin their share of the total volume andvalue of U.S. dollar payments processedeach year. The article then discusses rea-sons for the declining Reserve Bank shareof payment processing and the implica-tions of these trends for the paymentssystem.

PROBLEMS WITH THE PAYMENTS SYSTEM PRIORTO THE FORMATION OF THE FEDERAL RESERVE

An analysis of the importance ofReserve Bank payment services for thebanking industry in the United States

Bruce J. Summers is a senior vice president and chief financial officer at the Federal Reserve Bank of Richmond. R. Alton Gilbert is a vice president and banking advisor at the Federal Reserve Bank of St. Louis. Mary C. Lohmann provided research assistance.


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2 The discussion of the check-collection system prior to 1914and changes made by theFederal Reserve is based onSpahr (1926), chapters IV, VI,and VII; Watkins (1929), chapter VI; and White (1983),chapter 2.


requires a review of some banking history.2

By the mid-1850s, the dollar value of U.S.bank deposits exceeded that of banknotes,and the value of transactions settled bycheck exceeded the value of transactionssettled by banknote. This growth in check transactions required a system forclearing a large number of checks amongbanks. Before the introduction of FederalReserve services, commercial bankscleared checks drawn upon other localbanks by channeling them through localclearinghouses or delivering them directlyto the local banks for payment. Typically,local checks could be collected quicklyand at par.

Collecting checks drawn on banksoutside a given community involved moretime and expense. When checks were pre-sented directly to paying banks at theirplace of business, the banks were requiredby law to pay the face value of the checks.Banking law did, however, permit banks topay less than the face amount of checkssubmitted for collection by indirect means,such as through the mail. The rationale for this deduction from the face amount,called an exchange charge, was that remit-ting payment could involve certain costs,including the cost of transporting coin orbank notes from the paying bank to thecollecting bank. Delays were anotherexpense to collecting banks, in addition to exchange charges. Under banking law, a bank that received checks through themail became the collecting agent for thebank that had sent them and was thereforeresponsible for obtaining payment fromitself. As a result, paying banks oftenremitted funds to collecting banks severaldays after receiving checks through themail.

Despite the rationale for exchangecharges, many bankers considered them a basic defect in the operation of the pay-ments system. Prior to the formation of theFederal Reserve System, there were severalmajor proposals and attempts by bankersto eliminate exchange charges. Oppositionto exchange charges was most commonamong bankers in the larger cities, wherebanks generally paid for checks drawn

on accounts of their depositors at par,through local clearinghouses. The banksthat imposed exchange charges generallywere relatively small and located in moreisolated areas.

Collecting banks attempted to avoidthese delays and exchange charges byusing the services of correspondent banks.Often depository banks (the banks of first deposit) sent checks drawn on banksoutside their communities to their cor-respondent banks. The correspondentswould then send the checks to other bankswith offices near the paying banks, which,in turn, would present the checks to thepaying banks over the counter. In thissystem of collection through correspond-ents, depository banks might receive lessthan the face amount of the checks, butmore than if the checks were sent directlyto paying banks. The correspondentswould split the collection fee (the differ-ence between the face value of the checksand the amount credited to the demandaccounts of the depository banks) with theother banks that had assisted them in get-ting the checks to the paying banks. Insome arrangements, the correspondentswould credit the demand accounts ofdepository banks for the full amount of thechecks being collected but would requirethe depository banks to hold large demandbalances as a form of compensation forthis service. Under either arrangement, it was competition among correspondentbanks that tended to reduce the costs ofcollecting interregional checks.

The process of collecting checksthrough correspondents as a means ofavoiding exchange charges led to somenotorious cases of checks passing throughthe offices of many banks and travelingover very long distances, relative to theactual distance between the depositorybank and the paying bank. Many of theresulting delays and operating expensescould have been avoided through moredirect collection channels. Competitionamong correspondent banks, however, led to substantially reduced levels ofexchange charges over time (Spahr, 1926,pp. 102–3).


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3 Under the Federal Reserve’sRegulation J, which governs thecollection of checks and otheritems by Reserve Banks, an“item” does not include acheck that cannot be collectedat par. Further, the ReserveBanks are required to acceptcash and other items at par.

4 After passage of federal bank-ing legislation in the 1860s,the paper currency in circulationcomprised notes issued bynational banks and greenbacks(fiat currency issued by theUnited States Treasury).Because national banks wererequired to back their noteswith U.S. Treasury securitiesdeposited with the TreasuryDepartment, the public consid-ered national bank notes assafe as gold coins, even duringbanking panics.

5 Some have criticized thenational banks in New York Cityfor suspending currency pay-ments when they still had largeamounts of gold and currencyin their vaults. These criticsmaintain that the banks weretoo concerned about meetingtheir legal reserve require-ment—vault cash (gold andcurrency) that equalled orexceeded 25 percent of theirdeposits—rather than using allof the cash in their vaults tomeet demands of their deposi-tors (Dewald, 1972).


Although exchange charges declinedsubstantially over time, many bankers continued to view them as a fundamentaldefect in the operation of the nation’s pay-ments system. Congress responded to callsfor reform by giving the Federal Reserve amandate to improve the efficiency of thepayments system, and the Federal Reserveresponded by establishing a national net-work of offices for collecting checks. Be-cause the Federal Reserve Act forbids theReserve Banks from paying exchangecharges to banks, the Reserve Banks estab-lished the practice of accepting for depositonly those checks drawn upon banks thathad agreed to pay the Reserve Banks atpar.3 Although the Federal Reserve was notgranted legal authority over the exchangecharges set by individual banks, its domi-nant operational role in check collectioneventually made collection at par (zeroexchange charges) a national standard forthe banking industry.

Another problem with the operation ofthe payments system prior to the forma-tion of the Federal Reserve in 1914 wasthe occasional disruption of the paymentssystem caused by banking panics. Whenevents caused depositors to lose confi-dence in the safety of their deposits, theydemanded payment in gold coin, bank-notes or greenbacks.4 Banks located out-side the major financial centers maintainedlarge shares of their cash assets in depositswith major banks in the financial centers,particularly New York City, and theytended to respond to depositors’ substan-tial cash withdrawals by drawing downdeposits with these banks. Sprague (1910),in his analysis of banking panics in thenational banking era, emphasized that theconcentration of bankers’ deposits in asmall number of banks in New York Citymade the banking system vulnerable todisruption.

Bankers attempted to cope with panicsthrough cooperative arrangements imple-mented through their local clearinghouses.During normal times, activities of theclearinghouses were limited largely tocheck clearing and settlement: Banksdeposited gold with the clearinghouses

and received certificates that served asclaims on the gold; they cleared checksthrough the clearinghouses and settledtheir net positions with clearinghouse certificates. At times of relatively highdepositor demand for gold and currency(banknotes and greenbacks), the clearing-houses created additional certificates forinterbank settlement, called loan certi-ficates. Banks that borrowed these addi-tional certificates from their clearinghousepledged some of their commercial loans orother securities to the clearinghouse ascollateral. This process of accepting bankloans as collateral and issuing loan certifi-cates had the effect of increasing themonetary base. Members of the clearing-house could use the gold and currency intheir vaults to meet the demand of theirdepositors without concern that theywould have insufficient cash assets tocover net debit positions at the clearing-house.

On several occasions after clearing-houses had created loan certificates fortheir members, clearinghouse membersalso suspended currency payments to theirdepositors. While creation of loan certi-ficates helped banks respond to unusuallylarge demands for currency, the loancertificates were used primarily to settleinterbank positions with the clearing-house. Banks were obligated to pay theirdepositors gold or currency but did notalways do so when their inventories wereinadequate to meet the demand of theirdepositors.5 Instead, during some generalsuspensions of currency payments todepositors, banks paid their depositorssmall-denomination loan certificates,issued by their clearinghouses, whichserved as substitutes for currency in emer-gency situations (Andrew, 1908).

Before the creation of the Fed, whenbanks in major financial centers suspendedcurrency payments to depositors, majordisruptions in the payments system re-sulted. There is evidence that these sus-pensions, each of which lasted only one or two months during the period from the Civil War through 1914, seriously disrupted economic activity, including


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6 See Dwyer and Gilbert (1989)and Roberds (1995). Duringthe 1930s, the Federal Reservewas not effective in dealingwith banking panics. One viewis that banks relied on theFederal Reserve to deal withthe panics, and the Fed did notfulfill its role as the centralbank in the face of bank runs.


interregional and foreign trade, partic-ularly in 1873 (Sprague, 1910, pp. 71–82)and in 1893 (pp. 119–210).

The Federal Reserve System, modeledafter the clearinghouses of the period, wasauthorized to deal with panics by increas-ing bank reserves through discount win-dow loans.6 Its creators assumed that government sanction would lessen theimpact of banking panics, and an experi-ence in 1914, just before the Fed wascreated, may support this assumption. Theoutbreak of war in Europe triggered runson U.S. banks. However, the Aldrich-Vreeland Act of 1908 had authorized clear-inghouses to put into circulation emergencyissues of national banknotes, which hadbeen printed and stored for such an event.Roberds (1995), who finds that the realeconomic impact of the panic of 1914 wassmaller than that of prior panics, arguesthat the difference can be attributed togovernment sanction for the emergencyissuance of national banknotes.

CONCEPTUAL FRAMEWORKThis section describes some concepts

that are fundamental to understanding theoperation of the payments system and therole of the Reserve Banks.

Clearing and SettlementIn describing Reserve Bank services,

it is useful to distinguish between twoprocesses: the clearing of payments andinterbank settlement of payment obliga-tions. Most Reserve Bank services combine the clearing and settlementfunctions, although the Reserve Banksalso offer interbank settlement services,with the clearing of payments among thebanks performed through private chan-nels. The implications for the paymentssystem of declining Reserve Bank opera-tions depend on which function of theFed is affected more: clearing or settle-ment.

Clearing comprises three main steps:processing payment instruments, deliver-ing them to paying banks, and calculatinginterbank payment obligations. Settlement

involves discharging the payment obliga-tions. To illustrate the distinction betweenthese two functions, consider the clearingand settlement of checks among banksthat are members of a clearinghouse.Banks rely on the clearinghouse to performthe clearing function when they exchangechecks drawn on each other. Then theclearinghouse calculates the multilaterallynetted payment obligations due to and duefrom each clearinghouse participant. Banksparticipating in the clearinghouse havevarious options for settling these obliga-tions. Members of the clearinghouse canagree to settle using cash or more likely thedeposit liabilities of a private bank, whichmight also be a member of the clearing-house, or through another institution.Alternatively, settlement could be accom-plished through the transfer of reservesmaintained at the Reserve Banks. UsingFederal Reserve Bank liabilities to achieveinterbank settlement is important from apublic policy perspective for at least tworeasons: First, reliance on Reserve Bankliabilities contributes to the robustness ofsettlement arrangements and reduces themoral hazard that might result if all pro-viders of payment services relied upon asmall number of large commercial banks assettlement intermediaries. Second, it is byoffering Fedwire and net settlement servicesto clearinghouses that the Federal Reserveis able to exert an indirect form of supervi-sory influence on the safety and soundnessof private clearing arrangements, since theFederal Reserve lacks statutory authorityover the operations of clearinghouses. (SeeJuncker, Summers, and Young, 1991.)

Network EffectsAccording to the literature on indus-

trial organization, an industry has networkeffects if the value of a service to a cus-tomer depends on the number of othercustomers using the service. These net-work effects have important implicationsfor industry structure and competitivebehavior (see Economides and White,1994; Katz and Shapiro, 1994).

Because the payments system hassome of the characteristics of a network


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industry, it is also important to considerthe role of network effects in its operation.To illustrate, consider the value of mem-bership in a check clearinghouse to bankswith offices in a community where severalbanks conduct business. Initially, eachbank sends payment instruments to eachof the other banks demanding payment incurrency for checks that are presented.Then, two of the banks in the communitydecide that they can reduce their operatingcosts—and the risk of having currency lostor stolen—by arranging for their messen-gers to meet at an intermediate point andexchange checks. The two banks agree tosettle among themselves by debiting andcrediting balances they hold with eachother, rather than moving currency aboutthe community.

This clearing and settlement arrange-ment would be even more efficient if thesetwo banks were to get a third bank to jointhem, clearing checks among the threebanks under rules they agree to adopt as aclearinghouse. In the same way, this clear-inghouse would be even more valuable forits members if additional banks joined. Ifthese network effects are strong enough,there will be one check clearinghouse inthe community, and all banks with officesthere will be members.

In an industry with network effects,the first entity to develop a network has an advantage over later entrants. To besuccessful in developing a rival network,the new entity must convince many partic-ipants to switch to its network simul-taneously, since the value of a network toeach participant depends on the number of other participants using the network.Many years ago, the Reserve Banks devel-oped a dominant network for interregionalcheck clearing, which gave the FederalReserve leverage over the operation of the payments system. Even if some banksdid not like the rules under which theReserve Banks offered payment services or the process innovations favored by theFed, those with a lot of interregionalchecks to clear found it advantageous touse the Fed’s clearing and settlementnetwork.

One alternative, of course, to using the Fed’s network is to develop a privatenetwork for interregional check clearing.Developing such an alternative would havebeen especially difficult prior to 1980,however, when the Reserve Banks pro-vided payment services to member banksonly, free of explicit charge. Prior to pas-sage of the Monetary Control Act of 1980,which required the Reserve Banks tocharge for their services, almost all of thebanks that cleared a high volume of inter-regional checks were members of theFederal Reserve System. A rival to the Fedfor interregional check clearing wouldhave had to convince banks to pay a posi-tive charge per check (compared to a zerocharge per item in the Fed’s system) orwithdraw from Fed membership and rely on the new private system. Once theReserve Banks began assessing check-clearing charges and requiring all banks to maintain reserves, the private systemsfor check clearing became more viablealternatives to the clearinghouse servicesof the Reserve Banks.

Industries with strong network effectsalso tend to be highly concentrated. If pri-vate payments networks were to supplantthe role of the Reserve Banks, this develop-ment would raise antitrust issues withrespect to access to the payments system.Thus, the declining role of the ReserveBanks in processing payments and thedevelopment of private systems for checkclearing compel us to examine the issuesof competition and monopolies in thenation’s payments system.

FEDERAL RESERVE BANKSERVICES

This section reviews the laws and Federal Reserve policies that govern theactivities of Reserve Banks as providers ofpayment services. It also describes theprincipal payment and payment-relatedservices provided by the Reserve Banks.The appendix describes the paymentservices of the Reserve Banks in moredetail and discusses major changes in theservices over the years.



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7 Operating circulars are detailedinstructions concerning particu-lar banking services, includingaccount services, payment ser-vices, and the discount window.Some apply uniformly to all 12Reserve Banks, while othersapply to the services of individ-ual Reserve Banks.

8 For an analysis of the value of“free” Reserve Bank paymentservices to member banks rela-tive to the opportunity cost oftheir required reserves, seeGilbert (1977).


BackgroundThe Reserve Banks function as bank-

ers’ banks: Banks that use the Fed’s pay-ment services maintain reserve balances at the Reserve Banks and have access tocredit from the Fed. All transactions clearedthrough the Reserve Banks are settled on agross basis; that is, the value of each trans-action is settled through a debit or creditto a bank’s reserve account. Occasionally,debits and credits resulting from use of theFed’s payment services can cause a bank to miss its target for reserves, or they cancause a negative reserve balance. ReserveBanks lend reserves to banks that are tem-porarily short of funds, including bothintraday credit (daylight overdrafts) andovernight credit (discount window loansor overnight overdrafts). The ReserveBanks also serve as fiscal agents to the fed-eral government by providing paymentservices to the United States Treasury andto various other government agencies.

Reserve Banks have special privilegesand powers as suppliers of payment services.For example, they have legal authority topresent checks for same-day settlementlater in the day than do private banks.

Further, Reserve Banks have access to priv-ileged supervisory information concerningthe condition of banks, which they mayuse to protect themselves from losses inproviding payment services and relatedcredit. In addition, they can create reservesto meet the liquidity needs of banks.

Law and Policy Governing ReserveBank Services

The Reserve Banks provide paymentservices under the authority of the FederalReserve Act, as amended over the years.The terms and conditions under whichthey provide services are governed by regulations of the Board of Governors and implemented through Reserve Bankoperating circulars.7

The Monetary Control Act of 1980(MCA) was a watershed for the ReserveBanks as providers of payment services.Prior to passage of the MCA, the memberbanks in the Federal Reserve shouldered arequired reserve burden which they couldsatisfy through only two forms of non-earning assets: deposits held in accountswith the Reserve Banks and vault cash.Banks that were not members of the Fedsystem were not burdened by this require-ment. Provision of “free” payment servicesby the Reserve Banks was viewed as anoffset to the reserve requirement burden.8

But the MCA changed all that:

1. It extended the reserve require-ments of the Federal Reserve to alldepository institutions.

2. It granted all depository institu-tions access to the discount windowand to Reserve Bank services.

3. It required the Reserve Banks tocharge explicit fees for their services.

Under the MCA, the Reserve Banks’revenue from fees on their paymentservices must, over the long run, equal orexceed the cost of providing the servicesplus a markup to reflect the tax rates andprofit rates of private-sector firms (seeshaded box on MCA guidelines). Thus, the MCA subjects the Reserve Banks to

MCA GUIDELINES FOR PRICINGBANK SERVICES

The following section of the Monetary Control Act(MCA) specified guidelines for the pricing of ReserveBank services:

“Over the long run, fees shall be established on thebasis of all direct and indirect costs actually incurred inproviding the Federal Reserve services priced, includ-ing interest on items credited prior to actual collection,overhead, and an allocation of imputed costs whichtakes into account the taxes that would have been paidand the return on capital that would have been provid-ed had the services been furnished by a private busi-ness firm, except that the pricing principles shall givedue regard to competitive factors and the provision ofan adequate level of such services nationwide.”

Thus, the basis for the Federal Reserve’s setting theprices of its payment services below levels as specifiedin this section of the MCA is inadequate competition inmarkets for payment services or an inadequate level ofservices in at least some regions of the nation.


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market discipline similar to that faced bycommercial firms: Reserve Banks mustprovide services efficiently, price themcompetitively, and meet the market’s stan-dards for quality services. Further, theymust be careful to gauge the profitability of new service offerings.

Since passage of the MCA, the FederalReserve Board has also issued guidelinesthat specify in more detail the conditionsunder which Reserve Banks may providepayment services. The guidelines issued inJune 1981, state that “the System shouldbe prepared to remove itself from the pro-vision of those services that can be sup-plied more efficiently by the private sector,unless there are overriding public interestconsiderations for maintenance of an operational presence by the System” (Fed-eral Reserve Regulatory Service 7–191).Further, the Board of Governors’ May 1990policy statement on the role of the FederalReserve in the payments system sets ad-ditional conditions to be met before theReserve Banks may offer new payment ser-vices: “the service should be one thatother providers alone cannot be expectedto provide with reasonable effectiveness,scope, and equity” (Federal Reserve Regu-latory Service 7–145.1). Thus, the MCA,together with Federal Reserve Board poli-cies, establishes market-oriented criteriafor determining whether and how theReserve Banks are to provide services.

While these formal and explicit condi-tions under which Reserve Banks maycontinue to offer existing services or enternew payment markets were developed afterpassage of the MCA, earlier decisions by theBoard of Governors suggest somethingabout the Federal Reserve’s philosophy inproviding services. In particular, there is evi-dence that, well before the MCA, the Boardwished to proscribe Reserve Bank involve-ment in the processing of new types ofpayment instruments. In the second half ofthe 1960s, for example, the Federal Reservecame under some pressure from bankers toadapt its check-clearing services to handlethe processing of credit card sales slips. Fora variety of reasons, including concern overthe public sector’s shouldering significant

new costs for handling a quasi-paymentinstrument, the Board decided to deny thecredit card industry access to the checkclearing infrastructure of the Reserve Banks(Brimmer, 1967). Accordingly, the ReserveBanks play no role in processing credit cardtransactions. Instead, a private-sector infra-structure has grown up to support thisimportant component of the paymentssystem.

In contrast to this decision on pro-cessing credit card slips, the Board agreed,at approximately the same time, to requestsfrom bankers that the Reserve Banks pro-vide operational support for the nascentautomated clearinghouse (ACH) as amethod of processing payments. The ACHrepresented a desirable alternative to checksthat would require new automation sys-tems and significant start-up costs. Be-cause these start-up costs would have beendifficult for the private sector to absorb,the Board permitted the Reserve Banks totake on this new operational responsibility.

Payment Services of the Reserve Banks

Cash Services. The Reserve Banks providecoin and currency to banks on demandand receive excess coin and currency frombanks; the banks’ reserve accounts are debited and credited for the value of thesetransactions. However, Reserve Banks donot charge banks for cash services, sincethe Board has determined that cashservices are a central bank function.

Check Clearing. The offices of Reserve Banksthroughout the nation receive checks frombanks for collection, and the proceeds fromthe collection of these checks are credited tothe reserve accounts of the depositing banks.The timing of credits reflects the length oftime required for the Reserve Banks to presentthe checks to the banks on which they aredrawn (paying banks) and to receive pay-ment, which is made by debiting the reserveaccounts of the paying banks. To facilitate thisprocess, the Reserve Banks operate a nationalsystem for transporting checks to the payingbanks. Reserve Bank check-collection servicesinclude both the clearing function (receiving


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CALCULATING THE FED’S SHAREThe calculations in Tables 1–3 are based on three categories of checks processed

by Federal Reserve Banks: those issued by the federal government, U.S. postal moneyorders, and all other checks (referred to as “commercial checks”). Commercial checksprocessed in the United States include “on-us” checks—checks drawn on the bankswhere they were first deposited. Since “on-us” checks do not have to be clearedbetween banks, in all three tables we have subtracted them from the totals for inter-bank checks processed in the United States.

For example, the figures for 1980 in Table 1 were calculated in this manner:Annual Reports of the Board of Governors include the numbers of checks processedby the Reserve Banks each year. The Annual Report for 1980 indicates that theReserve Banks processed 15,721 million commercial checks, 705 million governmentchecks, and 117 million postal money orders. The number for commercial checks,however, reflects double counting: Checks received by one Reserve Bank that weresent to another Reserve Bank for collection were counted as checks processed by eachbank. Beginning in 1982, the Annual Reports eliminated this double counting of com-mercial checks. The numbers for 1982 are available with and without the doublecounting: The number of commercial checks processed without double counting is94 percent of the number with double counting. Applying this 94 percent adjustmentto the data for 1980 yields an estimate of 14,777.7 million commercial checks, and15,599.7 million for total checks, including government checks and postal moneyorders.

The total number of commercial checks in the nation in 1980 is estimated as 42percent of the number of commercial checks processed by the Reserve Banks. Wedivided the

number of checks the Fed processed by the percentage of checks that itprocessed to arrive at the total number of commercial checks issued in the UnitedStates in 1980:

14,777.7m/.42 = 35,185 million.

Of these 35,185 million checks, approximately 29.6 percent, or 10,414.8 million,were “on-us” checks. We subtracted the “on-us” checks from the commercial checks,then added the federal government checks and the U.S. Postal orders to arrive at thetotal number of interbank payment items processed in 1980:

35,185m – 10,414.8m + 705m + 117m = 25,592.2 million.

In Table 2, the average estimated value of a check in 1980 was $792, and the aver-age estimated value of an “on-us” check was $867. Average check values in thesetables are based on the values in the 1979 Atlanta Fed Check Study, adjusted for infla-tion and other factors. The values for checks processed by the Federal Reserve areactual, except that 1980 data have been adjusted for the double counting that wasused in Federal Reserve reporting systems at that time. We multiplied the number ofcommercial checks by the average value per check (35,185 million

3 $792) to arriveat a total value of $27.9 trillion for checks processed in the United States in 1980. Wethen subtracted the estimated value of “on-us” checks (10,414 million 3 $867 = $9.0trillion) and added the value of federal government checks ($599 billion) and postalmoney orders ($6 billion) to arrive at a total value of $19.4 trillion.

In Table 3, we divided the number of payment items that the Federal ReserveBanks processed by the total number of interbank payment items processed in theUnited States (as calculated in paragraph 3, above) to arrive at the Federal Reserve’sshare of payment-items processing for 1980:

15,599.7 million / 25,592.2 million = .61, or 61 percent.


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checks and presenting them to paying banks)and the settlement function (debiting andcrediting reserve accounts).

Automated Clearinghouse. Banks that usethe Federal Reserve’s ACH service instructReserve Banks to pay other banks (ACHcredit entries) or to receive payment fromother banks (ACH debit entries). Theseentries are processed through the computerfacilities of the Reserve Banks (clearing func-tion), and entries are posted to the reserveaccounts on the settlement dates designatedby the banks (settlement function).

Safekeeping of Definitive Securities andNoncash Collection. Reserve Banks acceptdefinitive securities (securities in paperform) for safekeeping. This service, how-ever, is now largely limited to securitiesused to collateralize government depositsand discount window loans. The ReserveBanks collect interest coupons andmatured securities and credit the proceedsto the reserve accounts of banks that ownthe securities.

Wire Transfer of Funds. Banks with re-serve accounts at Reserve Banks may initiatetransfers of their reserves to other banksthrough the Fedwire funds transfer service.Fedwire is a real-time gross settlementsystem. Fedwire funds transfers are pro-cessed electronically and are final whenaccepted for processing by the ReserveBanks. A final payment is one which isunconditional and irrevocable. Clearing and settlement is virtually simultaneous.Fedwire is described as a large-value fundstransfer service because it is designed tofacilitate interbank funds transfers (Horiiand Summers, 1994).

Wire Transfers of Securities. Ownershipof United States government securities andsome agency securities is recorded in thesecurities accounts held by the Reserve Banks.Banks can transfer ownership of these se-curities via the Fedwire securities transferservice, and each transfer is final when ac-cepted by the Reserve Banks for processing.

Fiscal Agency. The Reserve Banks provideaccount, custodial, and payment services tothe U.S. Treasury and to a variety of other

government agencies. These services in-clude issuing and redeeming U.S. Treasurysecurities as well as securities of other U.S.agencies.

Net Settlement. Banks that are membersof private clearing organizations maydecide to settle their mutual obligationsthrough multilateral netting. If a privateclearing service uses the net settlementservices of the Reserve Banks, the net debitand credit positions of the private banksare settled through entries to their reserveaccounts at the Reserve Banks.

TRENDS IN CLEARING ANDSETTLEMENT

The Reserve Banks’ share of total inter-bank payments has declined since 1980 forat least three of the four principal types ofpayment instruments: checks, large-valuefunds transfers, and large-value securitiestransfers. Tables 1, 2 and 3 show the de-clining Reserve Bank components for boththe volume and the value of interbank pay-ment transactions. We have not been ableto develop a time series on the share of thevolume and value of ACH paymentsprocessed by the Reserve Banks.

Check Clearing Table 3 indicates a significant decline in

the Reserve Banks’ share of interbank checkclearing, in terms of both volume andvalue.9 Between 1980 and 1994, the ReserveBank’s component of interbank check-clearing volume declined by about one-third, from an estimated 61.0 percent to39.3 percent, while its check-value compo-nent declined from an estimated 48.5 per-cent to 24.9 percent. These declines areconsistent with a conventional interpreta-tion of major changes in the interbank checkclearing market, including (1) the introduc-tion of Reserve Bank pricing for services,mandated by the MCA, (2) a fairly rapiddevelopment of alternative private-sectorchannels for check clearing, and (3) adop-tion by the Board of Governors of same-daysettlement amendments to Regulation CC.

These amendments to Regulation CC,effective January 1, 1994, changed the

9 Interbank check clearings areso-called “transit items,” forwhich the payor (check writer)and payee have accounts at dif-ferent banks. These are in con-trast to “on-us” checks, forwhich the payor and payeehave accounts at the samebank.


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rules under which banks pay each otherfor checks. Before implementation of thesame-day settlement provisions, a bankpresented with checks directly by anotherprivate bank could either pay the collect-ing bank the following business day orcharge the bank a fee for payment thesame day. Reserve Banks, in contrast, deb-ited the reserve accounts of paying banksthe same day they delivered the checks tothe banks, and the Reserve Banks did notpay fees for this privilege. When privatecorrespondents complained that theserules gave the Reserve Banks an unfairadvantage, the Fed adopted the same-daysettlement regulation, which says that if acollecting bank presents checks to theplace of business of a paying bank before 8 a.m. local time, the paying bank must

return the checks or pay the collectingbank through a Fedwire funds transfer bythe close of business the same day. Thepaying bank is not allowed to charge thecollecting bank a fee for same-day settle-ment. Banks may waive these rules for thetiming of check presentment and means of payment if they wish (Fitzgerald andMacoy, 1993; Crockett, 1994b). ReserveBank check collection volume throughSeptember 1994 was 12 percent below thevolume for the same period in 1993. Thisdecline is attributed largely to same-daysettlement (Marjanovic, 1994b).

Automated Clearing House (ACH) The Reserve Banks are the dominant

processors of ACH payments. They handleall government-related transactions and a

Volume of Interbank Non-Cash Transactions(in millions of transactions)

1980 1985 1990 1994Type of Payment FR Total FR Total FR Total FR Total

Check1 15,599.7 25,592.2 16,687.0 33,489.8 19,304.0 39,670.0 17,149.0 43,637.4ACH2 227.0 –– 585.0 –– 1,435.0 –– 2,379.0 2,521.8Large-Value 25.8 39.0 45.0 69.9 62.6 99.9 72.0 117.5Funds Transfer 3

Securities Transfer4 –– –– 7.7 7.7 10.9 12.9 12.6 19.1Card N/A –– N/A –– N/A 10,478.1 N/A 13,681.0

Sources: Annual Reports of the Board of Governors of the Federal Reserve System and the Bank for InternationalSettlements.

1 See Shaded Box, page 10.

2 Total ACH volume represents Federal Reserve commercial and government items plus items processed exclusively by private-sectorarrangements. The figures for Federal Reserve volumes are taken from actual, recorded data. The source of the estimate for the pri-vate-sector volume is the National Automated Clearing House Association. The private ACH processors active in 1994 included theArizona ACH, Hawaii ACH, New York ACH, and Visa ACH. Data for private ACH processors for periods before 1994 are either not avail-able or incomplete. Note that the majority of items handled by private ACH processors are also delivered to the Federal Reserve for processing, to gain access to endpoints serviced only by the Federal Reserve. In 1994, for example, the total number of items actuallyoriginated and received by private ACH operators was estimated to be 521 million; of these, only 143 million were also delivered exclusively within the private arrangements.

3 The total volume of large-value funds transfers is the sum of Fedwire funds transfers and Clearing House Interbank Payments System(CHIPS) transfers.

4 Total number of Fedwire securities transfers plus adjusted gross volume estimates for the securities transfers of the GovernmentSecurities Clearing Corporation (GSCC) and the Participants Trust Company (PTC). The GSCC estimates were adjusted downward by sub-tracting the number of end-of-cycle transfers made through Fedwire, to avoid double counting. All securities transfers of theGovernment National Mortgage Association (GNMA) were processed through PTC; they could, however, have been processed by Fedwire,had the Federal Reserve chosen to provide such services to GNMA.

Table 1


13


large share of commercial transactions.However, their present share of the volumeand value of interbank ACH transactions,which exceeds 90 percent, does not appearto be sustainable. In addition to the Re-serve Banks, three private organizationsprocess ACH payments: the ArizonaClearing House Exchange, the New YorkClearing House, and Visa USA. The finan-cial press cites the share of ACH paymentsprocessed by the Reserve Banks at about80 percent, with these three organizationsprocessing the remaining 20 percent (Mar-janovic, 1995a,b). This statistic is based on

the fact that these private organizationsreceive 20 percent of total ACH entries.However, some of the ACH entries these pri-vate organizations receive are routed throughthe Reserve Banks for processing.

In this paper, the volume of ACH pay-ments attributed to the Reserve Banks isthat actually processed by the ReserveBanks, whether the originating institutionsdelivered the information on ACH entriesto the Reserve Banks or to private proces-sors. This method of calculating the com-ponent of ACH payments processed by the Reserve Banks is consistent with the

Value of Interbank Non-Cash Transactions (in trillions of dollars)

1980 1985 1990 1994Type of Payment FR Total FR Total FR Total FR Total

Check1 9.4 19.4 10.1 31.9 13.2 43.5 12.6 50.6ACH2 0.3 –– 2.1 –– 4.7 –– 8.4 9.1Large-Value 47.9 85.0 109.1 187.5 199.1 421.1 211.2 506.6Funds Transfer3

Securities Transfer4 –– –– 74.2 74.5 99.9 108.1 144.7 170.0Card N/A 0.1 N/A 0.2 N/A 0.5 N/A 0.7

Sources: Annual Reports of the Board of Governors of the Federal Reserve System and the Bank for InternationalSettlements.

1 See Shaded Box, p. 10.

2 The value of transactions handled by the Federal Reserve plus the value of transactions handled solely by private ACH processors (seeTable 1, footnote 2). For 1994, the estimated value of ACH transactions processed solely by the private sector was about $700 billion.

3 The sum of the value of Fedwire funds transfers and Clearing House Interbank Payments System (CHIPS) transfers.

4 The sum of the value of Fedwire securities transfers, plus the value of the adjusted gross volume for the Government Securities ClearingCorporation (GSCC) plus the value of Participants Trust Company (PTC) adjusted gross volume. See Table 1, footnote 4, for more details.

Table 2

Federal Reserve Share of Interbank Non-Cash Transactions

Check ACH Large-Value Funds Transfers Securities TransfersYear Volume Value Volume Value Volume Value Volume Value

(percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent)

1980 61.0 48.5 –– –– 66.2 56.4 –– ––1985 49.8 31.7 –– –– 64.4 58.2 100 1001990 48.7 30.3 –– –– 62.7 47.3 84.5 92.41994 39.3 24.9 94.3 92.3 61.3 41.7 66.0 85.1

Table 3

method of calculating the component ofchecks processed by the Reserve Banks. Forinstance, checks counted as processed bythe Reserve Banks include those depositedby the banks of first deposit, and by banksthat serve as intermediary correspondentsfor the banks of first deposit.

The high Reserve Bank share can beattributed to the unique circumstancessurrounding the development of the ACHpayment mechanism, which was initiallysubsidized by the Reserve Banks. Signifi-cant developments in the market for ACHservices in the last five years, relating tochanges in technology, banking structureand the entry of private providers, willalmost surely combine to reduce the pro-portion of ACH payments processed by the Reserve Banks.

Large-Value Funds TransferThe Reserve Banks guarantee finality

of funds transfers among banks over Fed-wire; private banks that receive fundstransfers over Fedwire do not have to beconcerned that the transfers will be re-versed by the Reserve Banks because of thefailure of the sending banks to fund theirpayments through the Reserve Banks.Casual observers of the market for large-value funds transfer might conclude thatthe Federal Reserve would have a virtualmonopoly on this service. The informationin Tables 1, 2, and 3, however, indicatesthat this conclusion would be incorrect.Large banks that are members of the Clear-ing House Interbank Payments System(CHIPS)—a wholesale wire-transfer net-work owned and operated by the NewYork Clearing House—use that system asan alternative to transfers over Fedwire forlarge-value funds transfers. Members ofCHIPS net their interbank obligationsmultilaterally and settle these obligationsas a group at the end of the day using Fed-wire funds transfers. They use CHIPSlargely for settling the dollar side of for-eign exchange and for other internationaltransactions.

The component of total large-valuefunds transfers (over Fedwire and CHIPS)handled by Fedwire declined from 1980 to

1994. The volume component fell from66.2 percent to 61.3 percent, and the valuecomponent fell from 56.4 percent to 41.7percent. While the reasons for the rise inthe CHIPS component of large-value fundstransfers are complex, they are related inpart to the rapid growth of internationalpayments. The Reserve Banks have notconsidered the settlement of foreignexchange and other international transac-tions to be part of the mission of Fedwire,and, therefore, they have not attempted todesign the Fedwire service to meet the specific funds-transfer needs of that part of the market. They have, however,responded to the market for funds-transfer services, and to new record-keeping requirements resulting fromanti-money-laundering legislation, byadopting a new format for funds transfersover Fedwire that is based on the stand-ards of the Society of Worldwide Inter-bank Finance Telecommunications (SWIFT).Conversion to the new format will be completed by the end of 1997.

Another factor that may have reducedthe Reserve Banks’ share of large-valuefunds transfers is the Federal Reserve’s pay-ments system risk-reduction program,which in recent years has increased theappeal of multilateral netting for banks. Therisk-reduction program, which has placedsignificant emphasis on containing theamount of intraday credit provided by theReserve Banks, has probably stimulated useof alternatives to Fedwire for clearing large-value transactions.10 On the other hand, therisk controls adopted by CHIPS, which haveincreased the cost of funds transfers overthat system, have tended to offset the effectsof the Reserve Bank’s risk-reductionmeasures.

Securities TransferAs with funds transfer, the casual

observer might conclude that the FederalReserve has a virtual lock on the marketfor securities transfers. In fact, however,the Federal Reserve has restricted therange of U.S. Treasury securities andagency securities for which the ReserveBanks serve as depositories and provide

10 For a description of the policyof the Federal Reserve on day-light overdrafts and paymentssystem risk, see Richards(1995).



14

transfer services. As a result, private sys-tems for clearing and settling transactionsinvolving these securities have developed.For example, the Participants Trust Com-pany (PTC) now serves the entire marketfor clearing and settlement of GovernmentNational Mortgage Association (GNMA)securities.

Private-sector arrangements for net-ting securities transactions are also becom-ing more attractive to banks. The Govern-ment Securities Clearing Corporation(GSCC) has developed a multilateral net-ting service for future-dated U.S. govern-ment securities transactions, and it is inthe process of testing an enhanced servicethat will support netting for same-daytransactions. Introduction of this serviceby GSCC will likely trigger a significantfurther decline in the Reserve Banks’ shareof government and agency securities trans-fers. Table 3 indicates that Fedwire’s shareof the volume of securities transfers de-clined from 100 percent to 66.0 percentbetween 1985 and 1994. The Reserve Bankshare of the value of securities transfers fellfrom 100 percent to 85.1 percent over thesame period.

Card TransactionsAs we noted earlier, the Reserve Banks

do not clear payments made by cards.Table 1 shows that credit-card transactionshave grown rapidly in recent years and by1994 accounted for about 18 percent ofthe number of payments made by creditcard, check and ACH. If payments basedon other types of cards, such as debit cards and stored-value cards, grow rapid-ly relative to older types of paymentsinstruments, the percentage of all retailpayments processed by the Reserve Banks can be expected to continue declining.

In summary, the Reserve Banks’components of both the volume and thevalue of interbank payments have declinedfor small-value retail and large-valuewholesale funds and securities transactionssince about 1980. Prospective develop-ments, including introduction by GSCC of multilateral netting for same-day gov-

ernment securities transfers, can beexpected to cause significant furtherreductions in the Reserve Bank componentof large-value securities transfers. In addi-tion, continued increases in the use of newtypes of retail (small-value) paymentsinstruments, in which the Reserve Banksare not active, could erode further theirrole in the processing of retail paymentsgenerally.

REASONS FOR THERESERVE BANKS’ DECLINING SHARE OFINTERBANK PAYMENTS

Tables 1, 2 and 3 indicate that theReserve Banks’ historically important rolein providing clearing services has beendeclining, although it is still significant.Changes in technology and in bankingstructure have reduced the Reserve Banks’advantages in providing the dominant net-work for clearing and settlement of pay-ments. In addition, the policies of theBoard of Governors have stimulated agreater role for the private sector inclearing interbank payments.

TechnologyNew technology is perhaps the single

most important force leading to new ini-tiatives for processing payments in the private sector. Within the last decade orso, the costs of both computer processingand data communications have fallen dramatically. As a result, automated pro-cessing systems are now within the finan-cial reach of individual institutions as wellas private clearinghouses. At one time,ACH processing required large mainframecomputer systems. Now, very powerful,small, and relatively inexpensive micro-processors are able to handle largevolumes of transactions. Moreover, value-added networks offer a wealth of nationaland even international data communica-tions pathways, including networks withsufficient control and security features tohandle electronic payment transactions.Thus, dramatic reductions in costs havefacilitated the development of alternativenetworks for payment processing func-



15

11 Berger and Humphrey (1988)conclude that nationwide inter-state banking would reduce theresources used in check collec-tion. In addition, they estimatethat it would reduce the shareof total checks processed byReserve Banks by between 43and 60 percent over a 10-yearperiod.



16

tions that were once the primary domainof the Reserve Banks.

Banking StructureRegional interstate banking has also

reduced the advantages of the FederalReserve in interregional check clearing.Banking concentration resulting from therise in interstate banking has increased theproportion of transactions handled bybanks as “on-us” transactions, which by-pass interbank clearing and settlementchannels. Further, bank holding companies have been able to organize payments clear-ing among their affiliated banks on a re-gional basis, often by establishing regionalprocessing centers. Today, the country isexperiencing a major new interstate bank-ing movement as a result of the Riegle-NealInterstate Banking and Branching EfficiencyAct of 1994. More and more, interstatebanking extends network efficiencies to pri-vate institutions throughout the country,thus eroding the Fed’s interregional check-clearing advantage.11

The last 10 or 15 years have seen theformation of national clearinghouses forboth paper and electronic transactions. Forexample, in 1991, Visa USA began offering anational ACH processing service. Further,the New York Clearing House has expressedinterest in expanding the geographic scopeof its ACH service and connecting its pro-cessing network to other private sectorproviders, such as Visa (Marjanovic,1995a,b). With respect to check clearing,the National Clearing House Association,formed in 1992, arranged the clearing of anestimated 2 million checks per day in 1994(Marjanovic, 1994a). Similarly, the Elec-tronic Check Clearing House Organization(ECCHO) which was introduced in 1990,was clearing an estimated 1 million checksper day by 1994, on the basis of electroniccash letters (Crockett, 1994a). Banks arealso active in establishing consortia toexchange retail transactions in ATM andpoint-of-sale networks. Formation of theseprivate networks for clearing paymentsreflects, to some extent, the increased con-centration of banking in recent years. A fewlarge banking organizations now can ex-

change large volumes of checks and otherpayment instruments directly, withoutrelying on a processing intermediary.

Federal Reserve PolicyThe Federal Reserve has strongly

embraced market techniques that promotemore efficient payment operations. Expli-cit pricing of Federal Reserve paymentservices, introduced by the MCA, has elim-inated subsidies to banks that use ReserveBank services. In addition, explicit pricingof intraday, reserve-account overdrafts hasincreased the costs of using Reserve Bankservices for banks with relatively largeintra-day overdrafts (Richards, 1995).Finally, the Federal Reserve Board’s actionin January 1994 requiring same-day checksettlement helped to reduce the barriers tocheck clearing between private parties.Accordingly, within the last 15 years, theexplicit cost of using Federal Reserve pay-ment-processing services has been put onmore comparable terms with private-sectoralternatives, and artificial legal barriers toprivate clearing have been removed.

Federal Reserve Board policy has alsolimited the involvement of the ReserveBanks in the payments system by restrict-ing the scope of their services. For in-stance, the Federal Reserve declined to pro-vide services for clearing and settling creditcard sales slips and book-entry transfers ofGNMA securities. The limitations on thescope of Reserve Bank payment serviceshave facilitated the development of privatesystems for clearing and settling payments.

Outlook for Fed Payment ServicesTechnology, banking structure, and

Federal Reserve policy will likely continueto influence payments processing, certain-ly for the foreseeable future. The outcomeis likely to be a continuation of the trendsshown in Table 3—declines in the com-ponents of various types of interbankpayments processed by the Reserve Banks.Indeed, because virtually all the factorsdiscussed in this paper have emerged rela-tively recently, the trends in Table 3 couldaccelerate, at least for small-value pay-ments such as checks and ACH.

SOME IMPLICATIONS OFREDUCTIONS IN RESERVEBANK SERVICES

Trends in the processing of paymentsby Reserve Banks have implications for theefficiency of the payments system and forthe risk of disruptions in the operation ofthe payments system.

Implications for EfficiencySubsidy for use of Reserve Bank Services.Prior to 1980, the Reserve Banks did notcharge member banks explicit fees for useof their payment services. In the 1970s, the Reserve Banks may have compoundedthe inefficient use of resources in the pay-ments system by subsidizing the collectionof local checks through the establishmentof Regional Check Processing Centers(RCPCs). Because RCPCs provided same-day check crediting to the reserve accountsof collecting banks for checks drawn uponbanks located in the same area, many localcheck clearinghouses could not competeand closed down (Frodin, 1984). While the establishment of RCPCs may have accel-erated the speed of collection, it createdadditional incentives for banks to use theFed for check clearing rather than con-tinuing direct exchanges of checks amongnearby banks.12 Recent declines in the use ofFed payment services reflect more efficientuse of resources resulting from the elimina-tion of the subsidy provided by “free”Reserve Bank services.

Implications of Interstate Banking. Ineffi-ciency in the check-collection system priorto 1914 reflected, to a large extent, the lackof nationwide banking organizations. Highexchange charges and lengthy delays incheck collection that resulted from arrange-ments to avoid exchange charges wouldhave been reduced or eliminated by nation-wide banking.13 The spread of nationwideinterstate banking reduces the chances thatthe declining role of the Reserve Banks inpayment processing will produce a returnto the kind of payments system ineffi-ciency that existed prior to the formationof the Federal Reserve. Interstate banking,

however, might also lead to distortions inthe pricing of payment services that would result from collusive behavior by a few large, nationwide branching organi-zations.

Federal Reserve as Payments System RuleMaker. The success of innovations inimproving the efficiency of the paymentssystem requires cooperation amongproviders of payment services. For in-stance, the Fed and the banking industryagreed many years ago to encode checkswith magnetic characters (the MICR line)that make it possible for banks to sortchecks by machine. This innovation wouldhave been of little value if it had beenadopted by only a few banks. Another ex-ample involves the truncation of checks inthe collection process: To maximize thebenefits of truncation (in which the actualpaper check is taken out of circulation),the first bank that handles a check wouldconvert the paper instrument into an elec-tronic instrument and send the paymentinformation on the check through the col-lection system electronically. Such an in-novation would require the cooperation ofvirtually all banks.

Prior to 1914, the payments system ofthe United States functioned without amechanism by which banks could co-operate in adopting innovations to makeinterregional check collection more effi-cient. Clearinghouses played such a role intheir local communities. There was, how-ever, no national clearinghouse to coor-dinate change for the national paymentssystem. Banks collected checks drawn onbanks located in distant cities through acorrespondent banking system that oftenrouted checks to paying banks indirectly,to avoid the exchange charges of payingbanks. Indirect routing of checks increasedthe expense and length of time in checkcollection. Since its formation, the Federal Reserve has functioned as the de facto national coordinator of thepayments system. The role of ReserveBanks as major providers of payment ser-vices has been important in facilitating anumber of improvements in the efficiency

12 For a description of RCPCs andanalysis of their implications forthe efficiency of the paymentssystem, see Morris (1974,1975a,b); White andTorgerson (1974); andViswanathan and Mayo(1975).

13 Jessup (1967) reports thatnonpar banks (those imposingexchange charges) tended tobe located in unit bankingstates. This observation sup-ports the claim that nationwidebranch banking would havereduced or eliminated exchangecharges.



17

of the payments system, including the fol-lowing:

1. Elimination of nonpar banking.14

2. Addition of the MICR line tochecks, making them readable bycheck-sorting machines.

3. Creation of the automated clearing-house.

4. Expedited processing of returnitems after passage of the ExpeditedFunds Availability Act.

5. General promotion of check imag-ing and electronic presentment(Marjanovic, 1996).

Will the benefits of this leadership andinnovation be lost if the Reserve Bankshave a substantially smaller role in theprocessing of payments in the future? Not necessarily. Even with a smaller opera-

tional role for the Reserve Banks, the Federal Reserve Board, with its broad regu-latory power, can continue to promotepayments system efficiency. An importantexample of the Board’s use of this regula-tory authority to promote efficiency in the check-collection system is its recentintroduction of same-day settlement forchecks, which took effect in January 1994.The Fed’s same-day settlement regulationsets the rules under which collectingbanks present checks and receive paymentthe same day without paying fees to payingbanks. The authority for this action of theBoard is derived from the Expedited FundsAvailability Act of 1987, which granted theBoard regulatory authority over interbankpayment relationships for purposes of pro-moting efficiency of the payments system.Implementation of the change did not re-quire a large operational role for the Re-serve Banks; in fact, it has caused a declinein the check collection volumes of theReserve Banks (Marjanovic, 1994b).

Increased concentration of the bank-ing industry through interstate bankingcan facilitate innovation through coopera-tion among the banks themselves, inde-pendent of the Fed’s efforts. The evidencesuggests that, in the past, there were toomany banks for effective cooperation.Associations of relatively small numbers oflarge banks, however, can work out agree-ments on innovations that benefit a major-ity of their members. For instance, thebanks that formed ECCHO agreed to ac-cept electronic transmission of informationabout checks as legal presentment. InMarch 1995, the New York Clearing Houseannounced that its members had reachedsimilar agreement (Marjanovic, 1995c).These examples illustrate innovation inthe payments system through voluntaryassociation.

Large numbers of banks are able tocoordinate the clearing and settlement ofpayment instruments other than checks,and to adopt innovations. For example,Visa and Mastercard coordinate their pay-ment operations for thousands of theirmember banks. The growth of regionalATM networks indicates that many

14 Some authors challenge theidea that actions of the ReserveBanks to eliminate nonparbanking improved the operationof the payments system. SeeBaxter (1983). The literatureon exhange charges providesconflicting views of this subject.See Frankel (1995); Gilbert(1991); and Salop (1990).For purposes of this section, itis sufficient to argue that, giventhe limited power Congressgranted to the Reserve Banksover the operation of the pay-ments system, the FederalReserve was effective in estab-lishing clearance of checks atpar as the standard for thebanking industry only becauseof the major role of the ReserveBanks in check clearing andsettlement.



18

SAME-DAY SETTLEMENT: RISKREDUCTION FOR COLLECTINGBANKS

Prior to the implementation of the FederalReserve’s same-day settlement regulation, banks thatcollected checks through correspondents generallyreceived payment in the form of credits to their bal-ances at correspondent banks. Under the new regula-tion respondent banks can send checks directly topaying banks and receive payment the same day viawire transfers of funds to their reserve accounts atReserve Banks. Adoption of same-day settlement, there-fore, gives respondent banks more options for limitingtheir exposure during periods of financial distress. Forrelatively small banks, however, the cost of collectingchecks through direct presentment may exceed the riskof collecting through correspondents. The operatingcosts of collecting checks through direct presentmentinclude the costs of sorting checks and arranging forcouriers to present them directly to the paying banks.Even in times of financial stress in the banking indus-try, relatively small banks that rely on correspondentsfor check collection are more likely to continue usingcorrespondent bank services than to switch their check-collection operations to direct presentment.

bankers can work together to provide ATMservices for their customers. The NationalAutomated Clearinghouse Association(NACHA) sets rules and standards forACH, even though it does not itself pro-cess ACH payment items. Finally, there arewell established institutional arrangementsfor setting standards for various aspects ofthe payments system. Thus, past expe-rience with check collection in the UnitedStates may exaggerate somewhat theimportance of the Reserve Banks as pro-viders of payment services in facilitatinginnovation in the payments system.

Access to Payments Systems. When theReserve Banks provided the dominantnationwide system for banks to clear andsettle payments, access to the paymentssystem was determined by legislation andthe operating rules of the Reserve Banks.As private organizations emerge to rivalthe Reserve Bank’s nationwide clearing andsettlement arrangement, access will bedetermined at least in part by these privateorganizations. Various agencies of the gov-ernment and the courts might becomeinvolved in settling disputes on the condi-tions under which private arrangementsfor clearing and settling payments mayexclude some providers of paymentservices.15

Check Clearer of Last Resort. Issuesraised by the role of the Reserve Banks ascheck clearer of last resort have implica-tions for both efficiency and risk. The risein Reserve Bank check clearing during theTexas banking crisis during the secondhalf of the 1980s and early 1990s illus-trates the role of Reserve Banks as checkclearer of last resort (Clair, Kolson andRobinson, 1995). When major banks head-quartered in the Southwest were in seriousfinancial trouble, respondents turned tothe Fed for check collection because theydid not want to suffer disruptions and pos-sible losses resulting from the failure oftheir correspondents (see shaded box,page 18). Given their major role in checkprocessing, the Reserve Banks can absorbadditional check volume when circum-stances disrupt other check-collection channels.

If the Reserve Banks’ check collectionvolumes fall substantially in the future,and their capacity to clear checks is re-duced accordingly, they may no longer beable to fulfill the role of check clearer oflast resort. In periods of financial stress,this situation could put an extra burden ofresponsibility on the banking industry forensuring the safe operation of the paymentssystem. Banks collecting checks wouldneed to be vigilant in managing their riskwhen choosing correspondents and inagreeing to forms of settlement for checkspresented directly to paying institutions.In this context, the Federal Reserve’s Regulation F, “Limitations on InterbankLiabilities,” mandates careful managementof such interbank relationships.

Implications for RiskDoes the declining role of the Reserve

Banks in processing payments increase therisk of payments system disruption? Theanswer depends on the nature of theshocks to the payments system.

Bank Runs. Prior to the formation of theFederal Reserve System, depositor runswere the most important source of risk tobanks. The Fed can deal with threats origi-nating from depositor runs by injectingreserves into the banking system throughopen-market operations and discountwindow loans. In addition, federal depositinsurance limits the vulnerability of banksto depositor runs.

Securities Transfers. Another possibleshock to the payments system would bethe disruption of arrangements for trans-ferring ownership of securities. Is itimportant that the Reserve Banks retain a major role in processing securities transfers in order to minimize the effectsof such shocks on the payments system?Alternatively, are private arrangements for securities transfers sufficiently sound to minimize the chances of suchshocks?

Parties to securities transactions mustbe able to trust their agents to perform as contracted. For instance, individualinvestors in corporate stock must trust

15 See Carlton and Frankel(1995) for analysis of a courtcase involving a dispute overaccess of a bank to Visa forissuing credit cards. Carlton andSalop (1996) discuss the issueof access by firms to joint ven-tures in a variety of cases.



19

their brokers to execute trades accordingto their orders. They must also trust thatthe organizations established to cleartrades and settle obligations among bro-kers will be effective in settling trades. For investors in U.S. Treasury and agencysecurities, banks function as their agentsby holding securities with the ReserveBanks and with private depositories. Whenthe investors decide to sell, the banks useFedwire or a private system to transferownership of the securities and settle thetrades. For investors in securities trans-ferred through privately operated systems,the risk of not receiving the securities they have paid for, and the risk of notreceiving cash for securities they havesold, depends on the reliability of nettingarrangements among members of the systems.

Securities transfers through privatesystems have not created problems for theoperation of financial markets, becausethese systems are well designed. In ad-dition, active oversight by authorities suchas the Federal Reserve has ensured thatsuch private arrangements have the con-trols and guarantees needed to make themreliable. In particular, the guidelines foroperation of delivery vs. payment systemsthat were released by the Federal ReserveBoard on June 15, 1989, refer to variouscontrols, including liquidity safeguards,credit safeguards, and open-settlementaccounting.

As long as the private systems forsecurities transfers are appropriately super-vised and maintain adequate risk controls,the migration of securities transfers fromthe Reserve Banks to private systemswould not appear to create problems forthe operation of financial markets. The fol-lowing sections indicate, however, why theFedwire service for transferring funds andsecurities remains essential for the settle-ment of obligations among members ofthese private systems. These sections alsodiscuss the limited authority of the FederalReserve over the operations of privateclearing organizations which is derivedfrom the role of the Reserve Banks in pro-viding settlement services.

Settlement Using Liabilities of PrivateBanks: Moral Hazard and Systemic Risk.Another source of shock to the U.S. pay-ments system could result from the failureof a major bank used for settlement by asignificant number of other banks. Priorto 1914, banks settled payment obliga-tions among themselves by transferringownership of deposit liabilities at privatebanks, and major disruptions occurredwhen customers lost confidence in thenation’s money center banks. Given thedeclining role of the Reserve Banks in pro-cessing payments, the future might bringincreased public reliance on a few largebanks for settling payment obligations. Ifit does, the government might need toensure the survival of those banks, to pre-vent disruption of the payments system.This reliance on a few large banks at theheart of the payments system couldamplify any moral hazard in bank supervi-sion and regulation. Since the failure ofthe bank would be too disruptive to thepayments system, participants in thefinancial system could assume that therewould be little risk in transactions withthose banks, including the purchase oftheir short-term liabilities.

Multilateral Clearing Arrangements andSystemic Risk. Systems for clearing pay-ments among banks can be designed toavoid the moral hazard outlined above.Consider, for instance, the design ofCHIPS. Federal Reserve policies that applyto the operation of private large-dollarfunds-transfer systems such as CHIPSinclude the requirement that such systemshave means to ensure settlement in theevent of a default by a major participant.Since these arrangements would preventmajor disruptions in the payments systemin the event of the failure of a particularbank, investors in bank equities and liabil-ities cannot assume that any one bank isessential to the operation of the paymentssystem.

We argue that the Reserve Banks mustcontinue to offer Fedwire services to facili-tate access to reserve accounts and espe-cially, to ensure the integrity of net settle-



20

ment arrangements. Banks that use the netsettlement services of Reserve Banks intheir transactions with private payments-clearing systems must have a mechanismlike Fedwire for transferring reserves, tocover their net debit positions. At times,these banks must borrow reserves fromeach other to cover their net debits. Fed-wire enables them to transfer securitieselectronically, both to provide collateral tolenders, and to post collateral with ReserveBanks for discount window borrowing.

Authority of the Federal Reserve overthe operations of private clearing organiza-tions rests principally on the role of theReserve Banks as providers of settlementservices, since the Fed has no statutoryauthority for central bank oversight of pri-vate clearing organizations. As a serviceprovider, the Federal Reserve can makesafe-and-sound operation of clearing orga-nizations a condition to their using itsinterbank settlement services. The Boardstated its standards for the operation ofprivate clearing organizations in Decem-ber 1994, in a policy statement titled“Privately-Operated Large-Dollar Multilat-eral Netting Systems.” The threat ofdiscontinuing its settlement support forsuch clearing organizations, however, is avery blunt supervisory instrument. Forexample, the Fed could disrupt clearing-house operations, and therefore the payments system, by withdrawing itssettlement services. The simple fact thatthe Fed could itself trigger an immediateoperational crisis by withdrawing supportfor settlement calls into question the Federal Reserve’s willingness ever toinvoke such a harsh action.

The trends in the U.S. dollar paymentssystem described in this paper indicate amajor shift toward greater reliance on pri-vate arrangements for clearing both small-dollar and large-dollar payments. Increasedprivatization of the U.S. dollar paymentssystem and a concomitant decline in theoperational role of the Federal ReserveBanks raise questions about the adequacyof the Federal Reserve’s supervisoryauthority to fulfill the original Congres-sional mandate for ensuring the stability of

the nation’s payments system. In fact, theFederal Reserve appears to be somewhatunusual among central banks in that itdoes not have explicit statutory powersrelated to the supervision of clearing orga-nizations. Some of the private clearingorganizations have implemented new riskcontrols to ensure settlement in the eventof default by any of their members. Theseactions indicate some of the Fed’s regula-tory clout under current limitations on itsstatutory authority. It is unclear, however,whether the Fed’s indirect influence onprivate clearing organizations through itsrole as provider of settlement services willbe sufficient to ensure the safety and sound-ness of the payments system in the future.

CONCLUSIONSThe Federal Reserve Banks’ role in

processing payments—in terms of bothvolume and value—has declined since1980, when Congress enacted legislationrequiring the Reserve Banks to charge fortheir payment services. This decline can beexpected to continue or even accelerate inthe future. While the declines in the sharesof payments processed by the Reserve Banksfollowing pricing of the services represent amore efficient use of payments system re-sources, the declining role of the FederalReserve Banks in payments processing hasother important implications for the effi-ciency and stability of the payments system.

One of these implications relates toinnovation. In the past, the actions of theReserve Banks to foster innovation in thepayments system relied on the status of theReserve Banks as major providers of pay-ment services. Will the Reserve Banks’declining role in payments processingeliminate the Fed’s leadership in innova-tion? Not necessarily. The Federal ReserveBoard has broad authority to promote safeand efficient payment methods undertakenbilaterally between depository institutions,especially in the check-collection system.This authority is independent of the Re-serve Banks’ operating role in the pay-ments system. In addition, the growingconcentration of the banking industrythrough interstate banking is facilitating



21

innovation by cooperating groups of banksthat would have been more difficult whenthere were many more separate bankingorganizations.

At the same time, the growth of pri-vate payment networks raises some impor-tant new issues with respect to competi-tion. In the past, access to the paymentssystem was determined largely by law andby Federal Reserve policies; now some ofthe issues involving access to the new pri-vate payments arrangements will be settledin the courts.

Does the declining role of ReserveBanks in processing payments increase therisk of disruption in the operation of thepayments system? The answer depends onhow banks in bilateral and multilateral private clearing arrangements settle theirobligations. Settlement through debits andcredits to accounts at private banks wouldmake the system vulnerable to disruptionin the event of sudden failure by banksthat provide settlement services. Fortunately,the settlement services of the Reserve Bankscan limit this risk—to banks, and to theFederal Reserve in its role as lender of lastresort. To facilitate the use of reserves forinterbank settlement, whether net or gross,Reserve Banks should continue offeringFedwire funds and securities transfer ser-vices and net settlement services. TheFederal Reserve System is able to influencethe practices of clearinghouses primarilyby setting conditions for their use of thesettlement services of the Reserve Banks.The Fed does not have statutory authorityto act as the supervisor of clearing organi-zations. It is not clear at this time whetherthe Fed’s limited influence over clearingorganizations will be adequate to maintainthe safety and soundness of the paymentssystem as the share of payments clearedthrough private channels continues to rise.

REFERENCESAndrew, A. Piatt. “Substitutes for Cash in the Panic of 1907,” Quarterly

Journal of Economics (August 1908). Reprinted in O. M. Sprague,History of Crises under the National Banking System, U.S. NationalMonetary Commission, Senate Document No. 538, 61 Congress, 2ndSession, Government Printing Office, 1910, pp. 434-59.

Baxter, William F. “Bank Interchange of Transactional Paper: Legal andEconomic Perspectives,” Journal of Law and Economics (October1983), pp. 541-88.

Berger, Allen N., and David B. Humphrey. “Interstate Banking and thePayments System,” Journal of Financial Services Research (1988),pp. 131-45.

Blommestein, Hans J., and Bruce J. Summers. “Banking and thePayment System,” in The Payment System: Design, Management,and Supervision, Bruce J. Summers, ed. International Monetary Fund,1994, pp. 15–28.

Brimmer, Andrew F. “Bank Credit Cards and Check-Credit Plans:Development and Implications.” Remarks presented to a JointLuncheon of Commercial Bankers and the Board of Directors of theFederal Reserve Bank of San Francisco, August 3, 1967.

Carlton, Dennis W., and Alan S. Frankel. “Antitrust and PaymentTechnologies,” this Review (November/December 1995), pp. 41-54.

Carlton, Dennis W., and Steven C. Salop. “You Keep on Knocking butYou Can’t Come In: Evaluating Restrictions on Access to Input JointVentures,” Harvard Journal of Law and Technology (Summer 1996),pp. 1-34.

Clair, Robert T., Joanna O. Kolson, and Kenneth J. Robinson. “The TexasBanking Crisis and the Payments System,” Economic Review, FederalReserve Bank of Dallas (First Quarter 1995), pp. 13-21.

Crockett, Barton. “Electronic Bad-Check Notices for CorporationsExpected Soon,” The American Banker (January 6, 1994a), p. 17.

______. “Fast Clearing Off to Slow Start, Poll Finds,” The AmericanBanker (May 12, 1994b), p. 18.

Dewald, William G. “The National Monetary Commission: A LookBack,” Journal of Money, Credit and Banking (November 1972), pp.930-56.

Dwyer, Gerald P., Jr., and R. Alton Gilbert. “Bank Runs and PrivateRemedies,” this Review (May/June 1989), pp. 43-61.

Economides, Nicholas, and Lawrence J. White. “Networks andCompatibility: Implications for Antitrust,” European Economic Review(1994), pp. 651-62.

“Federal Reserve in the Payments System,” 7-145.1. Federal ReserveRegulatory Service, 7•48.

“Federal Reserve System Guidelines for the Provision of FinancialServices,” 7-191. Federal Reserve Regulatory Service, 7•51.

Fitzergerald, Robert M., and Ian W. Macoy. “Check-Processing RuleMeans Efficiency, Competition,” The American Banker (July 7, 1993),p. 17.

Frankel, Alan S. “Monopoly and Competition in the Supply of Moneyand Payment Services.” Memorandum, November 1995.

Frodin, Joanna H. “Fed Pricing and the Check Collection Business: The Private Sector Response,” Business Review, Federal Reserve Bankof Philadelphia (January/February 1984), pp. 13-22.



22

Gilbert, R. Alton. “Utilization of Federal Reserve Bank Services byMember Banks: Implications for the Costs and Benefits ofMembership,” this Review (August 1977), pp. 2-15.

Gilbert, Richard J. “On the Delegation of Pricing Authority in SharedAutomatic Teller Machine Networks,” in Electronic Services Networks:A Business and Public Policy Challenge, Margaret E. Guerin-Calvert and Steven S. Wildman, eds., Praeger Publishing, 1991, pp. 115-44.

Horii, Akinari, and Bruce J. Summers. “Large-Value Transfer Systems,” inThe Payment System: Design, Management, and Supervision, BruceJ. Summers ed., International Monetary Fund, 1994, pp. 73-88.

Jessup, Paul F. The Theory and Practice of Nonpar Banking,Northwestern University Press, 1967.

Juncker, George R., Bruce J. Summers and Florence M. Young. “A Primeron the Settlement of Payments in the United States,” Federal ReserveBulletin (November 1991), pp. 847-58.

Katz, Michael L., and Carl Shapiro. “Systems Competition and NetworkEffects,” Journal of Economic Perspectives (Spring 1994), pp. 93-115.

Marjanovic, Steven. “The Fed Buys Banctec Check-Image StorageSystem,” The American Banker (February 1, 1996), p. 18.

______. “Arizona Clearing House Chief Eyes Expansion,” TheAmerican Banker (August 18, 1995a), p. 16.

______. “Chemical Joins ACH That Is Taking On the Fed,” TheAmerican Banker (January 25, 1995b), p. 14.

______. “N.Y. Clearing House Sets Deadline for ElectronicPresentment,” The American Banker (March 23, 1995c), p.1.

______. “PEOPLE IN THE NEWS: Clearing House Group NamesPresident,” The American Banker (November 15, 1994a), p. 18.

______. “Citi, 4 Other Join Clearing House Group,” The AmericanBanker (December 7, 1994b), p. 16.

Morris, Russell D. “The Fed’s Regional Check Processing Performance:What Does it Imply for Electronic Funds Transfer?” Journal of BankResearch (Summer 1974), pp. 86-91.

______. “The Fed’s RCPC Performance: A Reply,” Journal of BankResearch (Winter 1975a), pp. 257-59.

______. “A Response,” Journal of Bank Research (Spring 1975b),pp. 72-73.

Richards, Heidi Willmann. “Daylight Overdraft Fees and the FederalReserve’s Payment System Risk Policy,” Federal Reserve Bulletin(December 1995), pp. 1065-1077.

Roberds, William. “Financial Crises and The Payments System: Lessonsfrom the National Banking Era,” Economic Review, Federal ReserveBank of Atlanta (September/October 1995), pp. 15-31.

Salop, Steven C. “Deregulating Self-Regulated Shared ATM Networks,”Economics of Innovation and New Technology, (1990), pp. 85-96.

Spahr, Walter E. The Clearing and Collection of Checks, The BankersPublishing Co., 1926.

Sprague, O.M. History of Crises under the National Banking System,U.S. National Monetary Commission, Senate Document No. 538, 61Cong. 2 Sess, Government Printing Office, 1910.

Summers, Bruce J. “Risk Management in National Payment Systems,”in The New Financial Landscape: Forces Shaping the Revolution inBanking, Risk Management and Capital Markets, OECD (1995), pp.253-280.

Veale, John M., and Robert W. Price. “Payment System Float and FloatManagement,” in The Payment System: Design, Management, andSupervision, Bruce J. Summers, ed., International Monetary Fund,1994, pp. 145-63.

Viswanathan, P., and Cesar Mayo. “A Note on ‘The Fed’s RCPCPerformance,’” Journal of Bank Research (Spring 1975), pp. 70-71.

Watkins, Leonard L. Bankers’ Balances, A.W. Shaw Company, 1929.

White, Eugene N. The Regulation and Reform of the American BankingSystem, 1900-1929. Princeton University Press, 1983.

White, Hubert D., and David A. Torgerson. “A Comment on ‘The Fed’sPerformance: What Does it Imply for EFTS?’” Journal of BankResearch (Autumn 1974), pp. 193-96.



23

PAYMENT SERVICES OF THEFEDERAL RESERVE BANKS

Cash ServicesThe Reserve Banks have a government

monopoly on issuing currency, which theyprocess for banks. They also process coinissued by the United States Mint. ReserveBanks process cash deposits and shipmentswithout charge to banks, at least for a certain basic level of service, since this is considered a government function. In accepting deposits of currency and meeting orders for currency, the ReserveBanks maintain the quality and theintegrity of the currency stock. Theyemploy sophisticated processing equip-ment that separates currency fit for cir-culation from unfit currency, which isdestroyed. Reserve Banks also identifycounterfeit notes, relying on the anti-coun-terfeiting features built into the design ofthe official currency.

Check ClearingSince their formation, the Reserve

Banks have provided a nationwide checkclearing service. Check processing nowtakes place at 11 of the 12 Reserve Bankhead offices, 24 of the 25 branches, 11regional check-processing centers(RCPCs), and one additional facility. TheReserve Banks cooperate in managing thissystem in a highly-integrated manner andshare some facilities and mechanisms,including a national transportation systemfor transporting checks.

Each Federal Reserve check-processingoffice serves an official territory, which isdesignated by routing numbers encoded atthe bottom of checks. A territory mayinclude a small but highly concentratedarea, such as a city, or a larger area withbanks dispersed across a large region.Routing numbers are the de facto nationalstandard for check-clearing territoriesthroughout the United States.

The Reserve Banks accept forcollection checks (cash letters) drawn onbanks located within the same territory, aswell as checks drawn on banks located inother Federal Reserve territories.16 Thehigh degree of cooperation among theReserve Banks in processing interterritorychecks, and especially in debiting andcrediting reserve accounts of banks locatedthroughout the nation, facilitates anefficient nationwide check-clearing andsettlement system.

The Reserve Banks accept shipmentsof checks in various degrees of sorting,including unsorted, sorted by FederalReserve territory, or sorted by the banks onwhich the checks are drawn. Since sortingchecks by territories or by the banks onwhich they are drawn is costly, the banksthat send checks to the Reserve Banksalready sorted are charged less than thebanks that send checks unsorted and relyon the Federal Reserve Banks to sort them.

Like correspondent banks, ReserveBanks credit the accounts of the depositorsof checks according to published avail-ability schedules. That is, the depositorsare able to count on receiving credit forchecks drawn on banks located in differentFederal Reserve territories according to apublished time schedule, regardless of theFederal Reserve’s ability to present theitems within that schedule. Any float thatresults from mismatching the time of cred-iting the accounts of the depositing banksand the time of presentment to and debit-ing the accounts of paying banks is a costof doing business for the Federal Reserve.Float is factored into the base costs recov-ered through explicit fees.17

In recent years, the Reserve Bankshave provided a variety of value-addedcheck-clearing services, particularlyelectronic information services demandedby check-clearing customers. Banks thatreceive cash letters (bundles of checkswritten by depositors) from the Reserve

16 Cash letters are bundles ofchecks accompanied by regis-ters that list the contents of thebundles and the total value ofthe items they contain. Thesebundles are called “cash let-ters” because settlement forthe checks is in cash-equivalentfunds, subject to the rules gov-erning the return of checks.

17 For a discussion of how floatarises, is controlled, and what itcosts, see Veale and Price(1994).



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Appendix

Banks can receive electronic transmissionsthat show the account numbers and dollarvalues of individual checks, informationthat normally would be physically pre-sented later in the day. Timely availabilityof this information greatly aids banks inoffering cash-management services to theirlarge corporate customers.

In addition, the Reserve Banks arebeginning to offer electronic check-depositand presentment services, as well as trun-cation services, for banks that elect tosettle checks in this manner. ReserveBanks recently have begun to offer image-processing services both to commercialbanks and to the U.S. government. Forexample, images of government checks arecaptured and stored in archives, facilitatingfederal government investigations andclaims settlements that involve payment bycheck. In addition, commercial image ser-vices are now being provided to banks,especially services designed to expeditecheck adjustments and returns.

Automated ClearinghouseThe automated clearinghouse (ACH)

is an electronic alternative to checkprocessing. In fact, the ACH was originallymost attractive as a means of convertingpayroll disbursement and other recurringmoney transfers from check-based transac-tions to electronic transactions. The ACHis both a credit and a debit payment mech-anism; that is, customer banks can makepayments and withdrawals from accountswithin the system. Use of ACH debitentries increases the efficiency and speedof transactions such as insurancepremiums and mortgage payments, andthey facilitate the concentration of cash bytreasurers of businesses that maintaindemand deposit accounts at large numbersof banks.

The Reserve Banks began providingACH services to the United States Treasuryand commercial banks in 1972. Thefederal government was a pioneer in con-verting its own paper-based checkpayments to ACH. At its inception, ACHprocessing required a very significantinvestment in computer technology. Only

a large organization like the FederalReserve System, with its established tech-nical infrastructure and its extensiveaccess to capital, was in a position toinvest in a venture of this magnitude, forwhich the return was still uncertain. More-over, the volume of payments at ACH’sinception was not sufficient to justify thecosts of the large initial investment formost companies. An exception was theNew York Clearing House, which chose to handle the processing for ACH transac-tions in the Second Federal ReserveDistrict. Over the years, the ArizonaClearing House and Visa USA, Inc. havealso established successful ACH processingoperations. The Chicago Clearing Housealso attempted to offer an ACH processingservice but discontinued its service after afew years.

Safekeeping of Definitive Securitiesand Non-cash Collection

The Reserve Banks continue toprovide definitive safekeeping and non-cash collection services to depositoryinstitutions, but on a significantly reducedscale in comparison to earlier years.18

Definitive securities are paper instruments,such as bonds issued by state and localgovernments. Safekeeping for such securi-ties includes accepting them under a trustagreement, collecting interest coupons,and redeeming matured securities. Today,only three Federal Reserve offices providethese services as priced services, althoughthey do so for depository institutionslocated throughout the United States. Each Federal Reserve Bank does safe-keep securities it accepts as collateral fordiscount window loans and/or in its roleas fiscal agent. The demand for such ser-vices eventually will disappear completelyas all securities are converted from paperto book-entry form, with ownershiprecorded and transferred electronically inthe records of depositories.

Wire Transfer of Funds and SecuritiesBanks can transfer reserves among

themselves electronically through the Fedwire funds transfer service. This is a

18 Non-cash items are handled ona collection basis, meaning thatprinciple and interest are credit-ed to the accounts of bankswith securities in safekeepingwhen collected, not on thebasis of a published availabilityschedule.



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real-time gross settlement service that pro-vides final payment. Each transfer isprocessed separately without a netting ofpayment messages among banks (grosssettlement), and the transfer of funds isfinal, which means that it cannot bereversed. If a bank sends a paymentmessage over Fedwire and later fails whileits reserve account is overdrawn, theReserve Bank holding the overdrawnreserve account cannot recover funds fromthe receiver of the payment message. Thefinality of Fedwire funds transfers makethem a unique type of payment, quite dis-tinct from other payment services pro-vided by the Reserve Banks. For instance,the Reserve Banks do not guarantee thatcredits to reserve accounts resulting fromcheck collection are “good funds.” If aReserve Bank cannot collect from a bankon which the checks have been drawn, ithas the right to reverse the credits to thereserve account of the depositing bank.Fedwire funds transfer is a naturalmonopoly, in that only the Federal Reservecan provide final settlement of reservestransfers.

Reserve Banks began providing theFedwire funds transfer service in 1918 viatelegraph. Today the Reserve Banksoperate a highly-sophisticated computernetwork with more than 8,000 on-lineconnections to the Fedwire funds transfersystem. The Fedwire securities transferservice dates to 1967, when the ReserveBanks agreed with the United States Trea-sury to begin converting U.S. Governmentsecurities to book-entry form. Thecomputer system of the Reserve Banksbecame the depository for ownership ofthe government securities. The Fedwiresecurities transfer service is also a real-time gross settlement service, providingfor the simultaneous delivery of securitiesand payment in final funds on the books ofthe Reserve Banks.19 This delivery-versus-payment feature of securities transfers overFedwire limits the risk to participants inthe market for government securities,because a seller of securities can transferownership to a counterparty in a transac-tion without concern about whether the

counterparty will pay for the securities.Since the Reserve Banks assume any

risk from the transfer of reserves over Fed-wire, the Fedwire funds transfer service is,together with federal deposit insuranceand the discount window, part of the fed-eral safety net for the banking system. It’simportant to note that, given the highvolume, value, and velocity of wire trans-fers, the Fedwire service is able to operateefficiently as a real-time gross settlementsystem only because the banks that useFedwire have access to significant amountsof intraday credit from the Reserve Banks.When the Reserve Banks agree to processFedwire funds transfers on behalf of finan-cially troubled institutions, they essentiallyguarantee payments by these institutions,thereby providing confidence to counter-parties receiving the payments and con-tributing to the stability of the paymentssystem. The Reserve Banks manage therisk in providing this guarantee through acombination of operational and financialcontrols.

An important milestone in the Fedwirefunds and securities transfer services wasthe introduction of explicit pricing of Fed-eral Reserve intraday overdrafts on April14, 1993, to provide banks an incentive tolimit their use of intraday credit (Richards,1995; Summers, 1995).

Fiscal AgencyOne of the roles of the Federal Reserve

Banks is to serve as a fiscal agent for theU.S. government. The Reserve Banks pro-vide services to the United States Treasuryand to a variety of other government agen-cies, as requested by the TreasuryDepartment. For example, they collectchecks, process ACH transactions, andmake wire transfers on behalf of the fiscalprincipals. They provide a variety of cashmanagement services for governmentagencies, including collection, cashconcentration, and letters of credit. Inaddition, they service the public debt and,through the Fedwire securities transferservice, provide operational support forthe secondary market in U.S. governmentand agency securities. Approximately 12

19 The Reserve Banks maintainbook-entry securities accountsfor banks just as they maintainfunds accounts in which bankshold reserves.



26

percent of the annual operating expense ofthe twelve Reserve Banks is attributabledirectly to their role as fiscal agents (Fed-eral Reserve Planning and Control System).

Net SettlementNet settlement is a service provided by

the Federal Reserve Banks to a group ofbanks that clear payments amongthemselves, net their interbank positions,and settle their net debit and creditpositions through entries to their reserveaccounts. These arrangements can be clas-sified as “final” or “provisional.” Netsettlement entries classified as final are notreversible by the Reserve Banks, whereasprovisional entries are reversible.

In December of 1994, the Board ofGovernors of the Federal Reserve Systemissued a policy statement governing large-value arrangements, which establishes theconditions that such arrangements mustmeet to operate and to gain access to Fed-eral Reserve net settlement services.20

Large-value settlement arrangementsinclude electronic funds transfers (forexample, the Clearing House InterbankPayments System or CHIPS) and electronicsecurities clearing and settlement (forexample, the Government SecuritiesClearing Corporation or GSCC). To mini-mize the systemic risk associated withlarge-value netting arrangements, the newpolicy statement requires that thesearrangements be designed to achieve finalsettlement. Members use Fedwire to settletheir net debit obligations resulting fromnet settlement. Also, one private ACH ser-vice and one check-clearing arrangementuse Fedwire for net settlement.

The Reserve Banks also provide settle-ment services for small-value payments toapproximately 160 local and regionalclearinghouses throughout the country.The small-dollar settlements are for avariety of netting arrangements, predomi-nantly check clearinghouses, but also forcredit card systems and ATM and POS net-works. Settlements for these nettingarrangements are provisional. The FederalReserve does not guarantee that credits toreserve accounts resulting from use of its

provisional net settlement service rep-resent “good funds.” If a Reserve Bank isnot able to collect the net debits frommembers of a group, it may reverse theentries made to the reserve accounts forthe net settlement.

One reason depository institutionshave a strong interest in using the FederalReserve for interbank settlement is thatvirtually all depository institutions in theUnited States hold reserve accounts at the Reserve Banks (Blommestein and Sum-mers, 1994). They are uniquely positionedto meet the needs of clearinghouses with adiverse membership, since virtually all theclearinghouse members would holdaccounts with the Reserve Banks. In addi-tion, the Reserve Banks are able to offertheir natural monopoly advantage of pro-viding final settlement in central bankmoney, rather than in terms of theliabilities of another private bank.

20 Federal Reserve Press Release,December 21, 1994, DocketNo. R-0842.



27

Documents

Clearing and Settlement of U.S. Dollar Payments: Back to ... · demanded payment in gold coin, bank-notes or greenbacks.4 Banks located out-side the major ﬁnancial centers maintained