The Federal Reserve and Electronic Payments: What do considerations of principle, experience and reputation tell us?
Top of the Ninth
Gary H. Stern
- President, 1985-2009
Published December 1, 2001 | December 2001 issue
This Reserve bank has set out principles that we believe should guide the future role of the Federal Reserve in the payments system, a subject of some recent review and debate. Other observers have a different perspective, relying on a qualitative, anecdotal examination of the Fed's historical role in the payments system as support for continued direct provision of retail and wholesale payment services. I argue below that evaluating the Federal Reserve's history within a bit more structure suggests congruence between our experience and already articulated principles; both recommend a judicious, perhaps even wary, approach to initiatives that involve leading the provision of new retail electronic payment services. Instead, we may more effectively contribute to the shift from paper checks through means other than direct provision of new services. This position, as we shall see, also better ensures the Federal Reserve's credibility and independence.
Of course, I am mindful that a series of payments issues may well be reviewed in the wake of the Sept. 11 terrorist attacks. Lessons learned from that analysis could relate to the Fed's role in payments systems. However, I do not believe that these observations, while potentially important, will alter the relevant principles; indeed, these principlesgrounded in theory and tested over timeshould bear consideration in any future plans, regardless of motivation.
The essay in our 2000 annual report (The Region, April 2001) presents principles to guide the Federal Reserve's role in the transition from paper check to electronic payments, as well as in providing payment services more generally. The essay"Thoughts on the Fed's Role in the Payments System," by Ed Green and Dick Toddargues that the principle of specialization can clarify the types of payment activities the Fed is best suited to carry out. "By focusing their resources and efforts on their respective areas of special strength," the authors contend that specialization allows institutions such as the Fed "to serve the public best. ..." Applying this general principle to the Fed, the authors conclude that only a subset of the Fed's current payment processing operations are core activities in which a central bank should naturally specialize. Based on the Fed's neutrality in dealing with private firms and a long-held role in maintaining accounts that all banks can own, Green and Todd argue that interbank settlement services are the Fed's core payments system function.
Noncore activities, according to the essay, include operations related to the clearing of retail payments such as checks and ACH. While the essay explicitly rejects the notion that the Fed exit these businesses in the short term, it argues that the central bank "... most effectively supports its overall mission by de-emphasizing noncore activities that intrude significantly on the private sector." The authors note that any shift from noncore activities would likely take place over the medium term, making consideration of our prospective role appropriate at this juncture.
In addition to this principle, the essay highlights the multiple means by which the Federal Reserve interacts with and influences the payments system. Direct provision of services is only one method for achieving our public goals. For example, some have argued that the Federal Reserve should directly provide payment services in order to bring competition to markets that may otherwise only have one service provider. Alternatively, Green and Todd note that the Fed can support standards, public infrastructure including laws that facilitate new technologies, and regulations that make the threat of competition real to incumbent firms, thereby dissipating monopoly power.
The movement from paper to electronic payments has had a long gestation. A number of organizations, including the Federal Reserve, have offered test products and services to determine effective strategies for turning paper checks into electronic payments. After reviewing some of these efforts, staff at the Minneapolis Reserve bank drew tentative conclusions about what the Fed might learn from its own experience. Interestingly, the practical experience of the Fed is consistent with the general principles articulated by Green and Todd. Some specific lessons from our history that we should consider include the following:
The Federal Reserve has contributed to the evolving payments system through means other than direct service provision. For example, the Federal Reserve System has providedand continues to providebasic research on the payments system, thereby filling in key gaps in industry knowledge. The Fed has also led efforts to identify legal and/or regulatory barriers to electronic payments and so has successfully modified policies that limited acceptance of electronic payments.
The Federal Reserve has had relative success encouraging payment innovations when it relies on its comparative strengths. These strengths include, for example, determining if the business relationship between the Fed and the U.S. Treasury offers
cost-effective opportunities for electronification. These opportunities benefit from the scale of payments the Treasury can commit to the early phase of a new payment product, provided such initiatives are done in the context of meeting the government's direct payment needs in a safe and secure fashion.
The Federal Reserve has not faced the challenge of shifting paper checks to electronics alone. The advent of new technology in the current period may enhance the likelihood that Fed electronic products will succeed. That said, the Fed's history does not provide clear support for those who argue that we should significantly expand our payment operations or rely primarily on direct service provision to facilitate electronic payments.
I believe the Federal Reserve's primary objective is to maximize long-run economic growth through price stability. An independent and credible central bank is critical to achieving price stability. Not surprisingly then, policymakers must consider how actions taken by the Federal Reserve, even in areas not normally linked to monetary policy, will affect our independence and credibility.
To the degree the Federal Reserve seeks leadership in the provision of payment services in competition with private-sector entities, we face the possibility of being viewed as just one of many organizations driven by private interests. Such a reputation could reduce support for steps we take to benefit the economy in the long term, steps that could have short-term costs. Undertaking new initiatives in the direct provision of payments also could involve large investments with the real chance of failure. Conflict with private firms, in addition, could trigger concerns about the extent of our role in payments. In sum, sensitivity to our credibility and independence suggests a prudent, if not limited, role for the Fed in taking on new payment provision responsibilities. At the least, considerations of the Fed's future role in the payments system should be grounded in established principles.