The Future of Banking in America

Transcription

1 The Future of Banking in America The Effect on U.S. Banking of Payment System Changes by Nei B. Murphy* Introduction It is now three decades since the dawn of the checkess, cashess society was procaimed. Cash is sti in use, athough much of it is outside the United States, and many checks are sti being written. It is tempting to dismiss the predictions of those days as being misguided and of no major consequence for the structure and financia heath of the banking industry in the United States. However, major changes in the U.S. payment system as a whoe are underway. These changes wi have an effect on costs, profitabiity, mix of business, and deivery systems that must be considered in an assessment of the future of banking in the United States. It is traditiona for a payment system to be the primary concern of the centra bank. 1 This tradition is reated to the centra bank s responsibiity for monetary poicy. After a, the centra bank creates a nation s money suppy, and the payment system infuences the veocity of that money and its utiity when househods, businesses, and governmenta units make payments. Thus, the focus of the centra bank s concern is the efficiency of the payment system and the avoidance of any systemic risk arising from its operations. Moreover, the centra bank is concerned with mitigating any mora hazard that may occur because of such activities as discount window ending and the suppying of intraday credit (dayight overdrafts) to participants in the centra bank s arge-vaue funds transfer service (Fedwire). Indeed, centra bankers have been meeting for some time to dea with these probems. The Committee on Payment and Settement Systems (CPSS) is composed of centra bankers from the G-10 countries and is housed at the Bank for Internationa Settements in Base, Switzerand. The CPSS has issued many infuentia reports concerning these issues and recenty pubished a set of best practices for systemicay important payment systems. 2 The CPSS has aso pubished reports that discuss the roe of the centra bank in retai payment systems. 3 * Nei B. Murphy, CTP, AAP, is a Professor of Finance in the Department of Finance, Insurance, and Rea Estate Schoo of Business at the Virginia Commonweath University. The research for this paper was funded through a grant by the FDIC. 1 The payment system as a whoe comprises a number of component payment systems; thus the word system is used in this paper sometimes to refer to the overa system and sometimes to refer to the individua components. 2 See CPSS (2001). 3 See CPSS (2000, 2003). FDIC BANKING REVIEW , VOLUME 16, NO. 2

2 The Future of Banking The focus of this paper is on the changes underway that infuence the heath of the banking industry in the United States. At the outset, it shoud be noted that the United States is somewhat of an outier among deveoped nations when it comes to the nature of its payment systems: The use of the check as a means of payment is far greater in the United States than in any other country, even though the number of checks has actuay decined in recent years and the share of checks in tota noncash payments has been decining for some time. In the United States, the centra bank (the Federa Reserve System) owns and operates substantia segments of the payment system. In most countries, the centra bank supervises but does not operate the retai payment system. Furthermore, the focus of this paper is on payment systems other than the arge-vaue payment systems. At the heart of every nation with highy deveoped financia markets is a rea-time gross settement system (RTGS) that is operated by the centra bank. In such a system, funds are wired by banks on behaf of their customers to other banks. The banks actuay transfer funds from and to their accounts on the books of the centra bank. In the United States, the RTGS is Fedwire, which is owned and operated by the Federa Reserve System. The gross feature of the system refers to the fact that each transaction is setted separatey. An aternative that requires ess iquidity for the banks invoved is a netting system in which payments to and from banks accumuate and ony the net difference is transferred. What that means is that, on receipt of the funds, the recipient bank and its customer do not have access to those funds unti the accumuated infows and outfows are netted and setted. The rea-time feature of the system means that the funds received are avaiabe at exacty the time when they arrive. There is no wait for accumuated infows and outfows to argey offset each other, with ony a smaer net amount transferred. More funds are transferred by Fedwire and the Cearing House Interbank Payment System (CHIPS), a private sector arge-vaue payment system, than by any other payment method. However, the number of transactions is sma, and most of the activity is confined to a sma number of money-center banks. 4 This is not meant to downpay the importance of these systems, but the proper focus for them has been the risk management associated with either intraday oans (dayight overdrafts) or the potentia systemic effect of unwinding payments in a mutiatera netting system when one of its participants is unabe to sette its obigation. These systems are highy automated and wi probaby not change too much in the future in response to forces of technoogy or shifts in consumer preferences. However, there are changes underway in the United States in noncash retai payment systems other than the arge-vaue payment systems that wi affect the future of the banking industry. These incude a diminution in the number of checks written and increases in eectronic forms of payment. Moreover, even though fewer checks are being written, the number is sti very arge in absoute terms and in comparison with the number in most other countries. Therefore, efforts are underway to eectronify the checks eary in the process of cearing and settement, sending the information contained on the check forward eectronicay. This is expected to be cheaper and faster than current methods, in which arge numbers of pieces of paper are transported around the country. Some Basic Characteristics of Payment Services and Banking A noncash methods of payment invove interbank transfers of funds. Hence, many basic product ines in banking are tied to the various 4 For a discussion of whoesae payment systems in genera, see Fokerts- Landau (1997); and for a discussion of risk management for Fedwire, see Coeman (2002). The CPSS best practices, or core principes, are appropriatey appied to systemicay important payment systems, and Fedwire is certainy such a system. Recenty the Federa Reserve pubished a Sef Assessment of Compiance with the Core Principes for Systemicay Important Payment Systems (2001). 2004, VOLUME 16, NO FDIC BANKING REVIEW

3 Effect on U.S. Banking of Payment System Changes systems by which baances are transferred from one bank to another on behaf of customers. These products invove either a direct charge to a customer s demand deposit account as a resut of a transfer, or a payment on behaf of a customer a oan to the customer that wi be satisfied at a future date. In most of the payment systems, it is efficient to have a network that incudes a bank participants. Thus, a products tied to an interbank transfer network invove the foowing: The paying customer The bank at which the paying customer has an account The receiving customer The bank at which the receiving customer has an account (which may not be the same as the customer s bank) An operator of a network in which many banks may participate. The notion of a network gives rise to the concept of network externaities. That is, a product or service tied to a network has vaue that is enhanced by its ink to other users. This is especiay true for communication systems, and it can be argued that payment systems are reay forms of communication systems. 5 Consider the vaue of a teephone that is not connected to any other caers. Ceary, the vaue of the teephone and a contract to use it to communicate depends on the use of the same product and service by arge numbers of other users. This gives rise to a situation in which there is a potentia trade-off between efforts to achieve universaity of use to maximize these externaities and the concern about imiting competition and innovation. It aso raises the issue of who owns and operates the network. Interbank payments, when there is not an instantaneous transfer of funds as there is in a cash transaction, invove some risks. In a cash transaction, cearing and settement of the payment occur immediatey. For most interbank payment systems, there is a deay between the time a payment is initiay ceared and the time the participants sette a caims among themseves. A participants must be abe to meet their net settement obigations to the network. If one participant cannot sette, many other transactions are at risk. In some cases, there is aso some counterparty risk in that a customer may not have sufficient funds to honor a payment instrument that is presented through a network. This is especiay true for debit transfer transactions. There are two basic types of interbank transfers: credit transfers and debit transfers. In a debit transfer, a payer sends a payment instrument, usuay a check, to a payee. The payee then deposits the check in its bank, which coects the check through the interbank payment system. Hence, the payee has a provisiona credit to its account, contingent on the payment instrument s being honored upon presentment. The risk is that the payer (the counterparty) does not have sufficient funds to honor the check. Ony when the payment instrument cears is the payee free from the counterparty risk. 6 In a credit transfer, the payer notifies its bank to transfer funds to the account of the payee in the payee s bank. Thus, the recipient of the communication, the payee s bank, does not need to worry about counterparty risk. Either the payer has sufficient funds to make the transfer, or the payer s bank advances sufficient funds to make the transfer. 7 Note that counterparty risk invoves payers and payees, whereas settement risk invoves banks in the interbank funds transfer system. For debit transfer systems, both counterparty and settement risk exist. For credit transfer systems, ony settement risk exists. 8 5 For an extensive discussion of the network characteristics of payment systems, see Lacker and Weinberg (1998). 6 Not a debit transfers are checks, for debit transfers occur in the Automated Cearing House (ACH) system in the United States. That is, a payer authorizes a payee to transfer funds through the ACH system by having the payee s bank present an eectronic debit through the ACH and deduct funds from the account of the payer in the payer s bank. There is sti counterparty risk in that the payer must have sufficient funds. 7 Whether something is caed a credit transfer or a debit transfer depends on the action of the receiving financia institution. If the receiving financia institution debits the payer s account, it is a debit transfer. If the receiving financia institution credits the payee s account, it is a credit transfer. It shoud be noted that ony credit transfers occur on the arge-vaue RTGS payment systems. 8 The exception to this, of course, is the RTGS arge-vaue payment systems in which settement occurs instantaneousy. However, if the centra bank advances funds to participants during the day (dayight overdraft), that FDIC BANKING REVIEW , VOLUME 16, NO. 2

4 The Future of Banking If a payment system may be viewed as a communications network, a participants must have cear agreements as to their duties and obigations reated to their participation. This is refected in aw, in reguations, and in contractua agreements among the various parties to the network. In the United States, there are a number of different ega and reguatory arrangements for the different networks, and there are aso situations in which different transactions in the same network have different ega and reguatory arrangements. Moreover, there are differences among the networks as to exacty who owns and operates the network. Payment Systems in the United States In the United States, there are a number of different payment networks that have evoved over time. These incude the foowing: The system of check payments a debit transfer system which is presenty paper based and the networks for which they are operated by both the banking community and the Federa Reserve System. The automated cearing house (ACH) system, which is an eectronic batch-processing system in which most of the processing is done by Federa Reserve Banks. Transactions can be either debit or credit transfers. The debit and credit card systems, whose networks either have evoved from automated teer machine (ATM) networks or are owned and operated by a few major card organizations, primariy VISA and MasterCard. The common eement in a these systems is the communications ink between banks in which information regarding payments and customer accounts is transmitted from one bank to another, with appropriate adjustment to customer account baances. In most cases, the customer account is a demand deposit account that is adjusted (debited for the payer, and credited for the payee). However, there are aso cases in which funds are advanced through the system on behaf of the payer, to be credited to the payee s demand deposit account. In such cases, the bank has a receivabe from the payer to be setted ater according to the credit agreement between the payer and the bank. This describes a credit card transaction. 9 The Check System The check system is the odest interbank payment system in the United States. It evoved in the second haf of the nineteenth century as banks in the United States switched from note issue to deposit banking as a resut of a 10 percent tax on notes. 10 Indeed, two of the reasons for the estabishment of the Federa Reserve System were to impement a nationwide check-cearing system (since U.S. banking aws precuded any bank from having a nationa network of branches) and to eiminate the practice of nonpar banking (the bank on which a check was drawn might not honor the fu vaue of the check when it was presented for payment). 11 The ega framework for the check system comprises both state and federa aws and reguations. The Uniform Commercia Code (UCC) represents an agreement among the states to adopt simiar aws in the area of commerce. Within that code are severa parts that dea with payments and settement: Artice 3 (negotiabe instruments), Artice 4 (bank deposits and coections), and Artice 4a (fund transfers, incuding whoesae ACH credit transfers). In addition, Congress passed the Expedited Funds Avaiabiity Act of 1987 (EFAA), which gave the Federa Reserve System the responsibiity of impementtransaction invoves some credit risk if the bank to which credit has been advanced cannot bring its account back to zero at the end of the settement period. 9 There may be some debate as to whether a credit card transaction and the credit card networks constitute a payment system, since the payer s demand deposit account is not debited as a resut of the transaction. However, payment does occur over an interbank network, and the Committee on Payment and Settement Systems, the utimate arbiter of things reated to payment systems, incudes credit card transactions in its data on different countries payment systems in its Red Book. 10 See Friedman and Schwartz (1963). 11 See Weinberg and Lacker (1998). 2004, VOLUME 16, NO FDIC BANKING REVIEW

5 Effect on U.S. Banking of Payment System Changes ing improvements in the check coection system. When the Federa Reserve acts on that authority, federa aw supersedes state aw. The Federa Reserve has severa reguations that affect check coection: Reguation CC and Reguation J both affect the processing of coections and returns through the Federa Reserve System. On October 28, 2003, Congress passed and the president signed the Check Truncation Act of 2003, which paves the way for eectronic presentment and coection of checks. 12 Within that ega framework, the check coection system does not function through a singe channe. When a payee receives a check, he or she deposits it in a bank. That bank then has a number of choices avaiabe to coect the check: It is possibe that the payer and payee do business with the same bank. In that case, baances are shifted on the books of that bank, and there are no interbank transactions. This is known as an on-us transaction, in which there is no deay in settement. Aso, the processing costs are ower. The consoidation of the banking industry has increased the probabiity that any given check wi resut in an on-us transaction. 13 The bank of first deposit may decide to present the check directy to the bank on which the check is drawn. This occurs in situations where two banks are in cose proximity and have a ot of biatera transactions. This is known as a direct send. The bank of first deposit may present the check to a oca cearing house, an arrangement whereby a number banks agree to meet for the purpose of presenting checks to each other and setting the net differences at the end of an agreed-upon period. The bank of first deposit may avai itsef of the services of another bank a correspondent bank to coect the check on its behaf. The bank of first deposit may deposit the check with its oca Federa Reserve Bank, which wi then coect the check from the bank on which it is drawn. In 1980, the Depository Institutions Dereguation and Monetary Contro Act (DIDMCA) required that the Federa Reserve charge for its cearing and settement services. Before that time, Federa Reserve services were provided without any direct, expicit charge. As might be expected, however, correspondent banks that competed with the Federa Reserve objected to this arrangement. To compete on a comparabe basis, the Federa Reserve was required to base its prices charged for cearing and settement services on its expicit costs and on an adjustment for the cost of capita that its competitors must factor into their cost structures. 14 In addition, the Federa Reserve System must recover a its costs in the provision of these services. The choice made by the bank of first deposit depends on the reative costs and benefits of the different channes. In 2001, it was estimated that 41.2 biion checks were written in the United States. Approximatey 43 percent of these checks ceared through the Federa Reserve System; 28 percent ceared as direct sends, cearing house items, or through correspondent banks; and 29 percent were on-us checks. 15 It has ong been known that the U.S. payments system depends more on checks than is the case in a other industriaized nations. 16 Since a great dea of effort, energy, and expense is incurred in moving arge amounts of paper ong distances, the 12 For a discussion of the ega and reguatory environment of payments in the United States, see CPSS (2003). 13 In Gerdes and Waton (2002), it is noted that the proportion of on-us checks has not increased much even though the industry has consoidated. They attribute this to the reduction in checks written for cash (these are being repaced by ATM withdrawas) whie on-us checks sent to payees have increased. 14 For a thorough discussion of the methods and rationae for cacuating the private sector adjustment factor (PSAF), see Green, Lopez, and Wang (2003). 15 It is not the usua practice for the centra bank to operate substantia segments of retai payment systems, nor is the Federa Reserve s roe as both operator and reguator without controversy. The Federa Reserve undertook an extensive review of its roe severa years ago and concuded that present arrangements are satisfactory. See Board of Governors of the Federa Reserve System (1998). 16 For an exceent review of comparative deveopments of payment practices in major industriaized nations, see Humphrey, Sato, Tsurumi, and Vesaa (1996). FDIC BANKING REVIEW , VOLUME 16, NO. 2

6 The Future of Banking demise of the check has been seen as inevitabe and desirabe. However, obtaining accurate information on the exact number of checks processed in the United States is not easy. Given the number of routes that any check might take and the fact that a singe check may pass through severa channes, it has been difficut to coect such data every year. However, there are severa benchmark years in which exhaustive surveys were undertaken. The practice was then to extrapoate out from those benchmarks on the basis of incompete information and assumptions about the proportion of checks going through the various channes. Such benchmarks were avaiabe as a resut of surveys undertaken by the Federa Reserve System in 1979 and On the basis of those surveys and other fragmentary information, it appears that the number of checks processed in the United States was overestimated for a number of years. It is instructive to examine the report of the Committee on Payment and Settement Systems on the payment systems of seected countries. The report is an annua pubication with data for a number of weathy nations, prepared in a simiar format for purposes of comparative anaysis. As ate as 2001, when data for 1999 were reported, it was beieved (primariy on the basis of extrapoations from the 1995 benchmark) that there were over 67 biion checks processed in the United States. However, as a resut of a substantia survey undertaken by the Federa Reserve, it was determined that in the year 2000 there were ony 42.5 biion checks written in the United States. 17 In a prescient artice, Humphrey, Puey, and Vesaa forecast that the number of checks written woud peak in It is estimated that in 2001, the number decined once again to 40.2 biion checks (CPSS, 2002). It had generay been beieved that check growth had been positive but smaer than the growth in aternative eectronic payments, resuting in a reduction in the check share of noncash payment instruments in the United States. 19 The atest deveopments suggest that the share of eectronic payments has increased faster than was originay beieved. Further evidence of the decine in checks written arose recenty, when the Federa Reserve indicated that the number of checks processed during 2003 had decined at a faster rate than had been forecast. Because the Federa Reserve must recover a its costs in suppying processing services, it announced that it was raising its charges to banks, reducing the credits to banks for cearing baances maintained at the Federa Reserve, and changing the method of cacuating imputed income from investing the cearing baances. At the same time, it announced a reduction in charges for processing eectronic automated cearing house (ACH) payments. 20 This raising of prices for processing paper and owering of prices for processing eectronic transactions shoud reinforce the trends aready in pace. However, it shoud be noted that, notwithstanding the unexpected change in the voume of checks processed, the United States is sti reativey more dependent on checks than its counterparts. In 2001, the United States wrote checks per capita, more than twice as many as the next-highest user of checks France, with 71.2 checks per capita. Countries in Continenta Europe, except France, have virtuay eiminated checks: Begium, Germany, Itay, the Netherands, Sweden, and Switzerand a had 10 or fewer checks per capita in In Sweden, there was 0.2 check per capita written in the year 2001 (CPSS [2002]). The atest deveopments for the check system in the United States are reated to what might be caed the eectronification of checks. There are two such strands of this process; one is underway aready and the other wi probaby be avaiabe in the near future. First, the ACH system has deveoped three new appications that use the check as a device to trigger a debit transfer on the 17 See Gerdes and Waton (2002). 18 Their projections were based on data avaiabe up to 1996, even though the pubication date of the artice is One casuaty of this decine is the Federa Reserve System itsef, which announced in February 2003 that it was consoidating its check-processing operations, eiminating this activity from 13 offices and reducing staff by a projected net of 400 empoyees. See Federa Reserve Bank of Boston (2003). 20 See Board of Governors of the Federa Reserve System (2003a, 2003b). 2004, VOLUME 16, NO FDIC BANKING REVIEW

7 Effect on U.S. Banking of Payment System Changes ACH system. In one of these appications, the point-of-purchase (POP) appication, a merchant receives a check in payment for goods or services. Instead of depositing the check in the famiiar process, the merchant uses a termina to scan the information on the bottom of the check (the MICR ine) and the amount of the sae. The merchant then returns the check to the customer with the word void printed on it and informs the customer that the check amounts to authorization for the merchant to initiate a debit transfer transaction through the ACH network. There is aso a ega transformation in which the check is no onger a negotiabe instrument governed by the UCC and Federa Reserve reguations pertaining to checks, but is instead a source document for an eectronic transaction that is subject to the Federa Reserve s Reguation E (a reguation promugated as a resut of the Eectronic Fund Transfer Act of 1978). In a simiar move (the second ACH appication), the ACH system deveoped the accounts-receivabe check (ARC), which is designed to transform checks to source documents as consumers mai checks to ockboxes in payment of routine bis. That is, the customer is notified that the check is an authorizing device aowing the payee to initiate a debit transfer transaction through the ACH system. Again, the ega status of the check changes, and the operative ega and reguatory environment changes from UCC/Federa Reserve check rues to Eectronic Fund Transfer Act/Reguation E eectronic transaction rues. The ARC appication is avaiabe ony for consumer payments at the present time. In the past year, from the third quarter of 2002 to the third quarter of 2003, the number of transactions in each category (ARC and POP) grew substantiay. For the ARC transaction, there were 5.3 miion transactions in the third quarter of 2002, which grew to 43.7 miion in the third quarter of In the same period, the POP appication grew from 28.7 miion to 38.4 miion. Another area for check eectronification is in returning checks (RCK) via the ACH system (the third ACH appication). That is, when a customer pays with a check, he or she is notified that shoud the check be returned for insufficient funds, the payee wi initiate a debit transfer through the ACH system to coect the amount. In this case, the paper process has faied, and the payee has access to faster and cheaper coection the second time around. This appication has increased from 4.8 miion transactions in the third quarter of 2002 to 5.8 miion transactions in the third quarter of Hence, the ACH system has evoved to transform and process severa new types of appication, a designed to repace the paper movement of physica checks with eectronic coection. 21 The fina step in eectronification of checks the second of the two strands referred to above is underway at the present time. Instead of piecemea ACH appications for point of sae or routine consumer bi payments, this step invoves a compete transformation of the processing of paper. This is caed the Check Truncation Act of 2003, which the president signed on October 28, The Expedited Funds Avaiabiity Act of 1987 had given the Federa Reserve the task of making recommendations to improve the payments system in effect, superseding the UCC and the Federa Reserve System proposed the check truncation egisation. 22 What is envisioned here is the truncation of checks eary in the process of physica transportation. At that step, a digita image of the check wi move eectronicay through the process. This wi eiminate the physica transportation of checks and aow the images to be retrieved as needed by customers to show evidence of having made payment. 23 It is too eary to know exacty how this deveopment wi affect the number of checks processed and the channes through which the images of checks wi pass on the way to coection. It is interesting to compare this deveopment with some of those in the European Union (EU). The EU has moved to a singe banking market and a 21 See NACHA The Eectronic Payments Association (2003). 22 See Check 21 Act, Pubic Law , October 28, Many banks and thrift institutions have aready truncated checks by not returning them to customers. This act wi stop the movement of paper earier in the process. Moreover, for many years, credit union egisation and reguation have made truncation of credit union share drafts mandatory. FDIC BANKING REVIEW , VOLUME 16, NO. 2

8 The Future of Banking singe currency. 24 Whie the arge-vaue payment system in Euros is connected seamessy throughout the EU, this was not the case for cross-border retai payments. However, the EU and the European Centra Bank (ECB) reasoned that the benefits of a singe, integrated, competitive banking market coud not be achieved without an efficient retai payment system in which cross-border payments woud be made with the same speed and fees as domestic payments. The EU and ECB encouraged the banks to deveop such a system. Since deveopments did not proceed as rapidy as the EU and ECB wanted, the EU enacted egisation requiring the banking industry to process cross-border payments under the same terms as domestic payments. The industry responded by setting up a Singe European Payments Area concept that is simiar to an ACH connecting the domestic payment systems in a the member nations. 25 What is interesting is that the EU/ECB focus is on credit transfers in the EU, rather than debit transfers, or checks. It appears that the EU, in its efforts to compete the singe market in banking, considers the benefits of the credit transfer to be sufficient and therefore encourages these transfers whie ignoring the debit transfer. 26 The Automated Cearing House (ACH) System The ACH system is a batch-processing eectronic payment system for sma-vaue payments. Unike the arge-vaue payment systems (Fedwire and CHIPS), which process ony credit transfers, the ACH system processes both credit and debit transfer payments. Financia institutions beong to one of 29 regiona associations and participate in the ACH system as either originating depository financia institutions (ODFI) or receiving depository financia institutions (RDFI) or both. Originators and receivers are customers, and, as indicated, the transactions can be either credit or debit transfers. The originator prepares a fie of transfers, deivers it to the ODFI, and the ODFI deivers the data to the ACH operator, who then transmits the information to the RDFI, who either credits or debits the account of the receiver, depending on the nature of the transfer. There is a nationa association of depository financia institution members, the Nationa Automated Cearing House Association (NACHA), which determines a the rues and reguations that govern the network. There are a number of aws that provide the ega and reguatory framework for the ACH system. For corporate transactions, the UCC is the operative aw. The Check Truncation Act of 2003 has impications for the ACH system as we. For consumer transactions, the Eectronic Fund Transfer Act of 1978 is the operative aw, and Federa Reserve Reguation E is the operative reguation. In addition, the federa government s roe in eectronic payments is governed by federa aw, specificay 31 C.F.R. 31, Part 210. According to the provisions of the EFT Expansion Act/Debt Coection Improvement Act of 1996, the U.S. government has committed itsef to using eectronic payments for a payments to empoyees, vendors, and recipients of benefits. Moreover, federa tax coections are migrating to eectronic form as we. Most states are foowing the ead of the federa government in this area. According to NACHA, in December 2002 amost 19,500 depository financia institutions participated in the ACH system as RFDIs, whie approximatey 8,000 participated as OFDIs. 27 From 1992 to 2002, the voume of ACH transactions increased at a doube-digit percentage-rate change each year, going from 2.2 biion transactions in 1992 to over 8.9 biion transactions in 2002, a compound annua rate of growth of over 13.5 percent. In contrast, the number of checks actuay decined over the same period. In the eary days of the ACH, a arge proportion of the voume was attributabe to government payments. In 1992, government transactions were 24 per- 24 For a discussion of this, see Murphy (2000). 25 See European Centra Bank (2003). 26 Humphrey, Puey, and Vesaa (2000) note that the European credit transfer systems have been much more amenabe to technoogica change than the check (debit transfer) system in the United States. 27 See NACHA (2003). 2004, VOLUME 16, NO FDIC BANKING REVIEW

9 Effect on U.S. Banking of Payment System Changes cent of the tota, whie in 2002 this decined to ess than 10 percent. It is reported that 98 percent of federa empoyees use direct deposit of payro, whie 80 percent of a Socia Security recipients use direct deposit of benefits. As noted above, eectronic payment to vendors is virtuay mandatory. Thus, the government is not ikey to be a future source of major growth in voume. One change in the types of appications for the ACH system is the movement to nonrecurring transactions. In the past, the ACH system deveoped appications for recurring payments, such as direct deposit of payro and benefits, and for recurring debits for the same amount for payments such as mortgages, instament oans, insurance payments, and other such payments. On the corporate side, direct payment of vendors, payment of taxes, and corporate concentration of funds from a number of banks were a recurring repetitive transactions. Once a payment is arranged, it is repeated without the need for frequent authorizations and other arrangements. In recent years, the ACH community has turned its attention to transactions initiated by consumers. These incude the point-of-purchase (POP) appication discussed above, payments authorized over the teephone (TEL), and payments initiated over the Internet (WEB). These are a transactions that require a separate process each time a transaction is initiated. For many traditiona appications, such as direct deposit, the consumer enters into an agreement one time, and the process is opaque to him or her. A that these consumers know (when there are no probems) is that baances appear in their accounts at certain times or that certain amounts are deducted at certain times. The consumers themseves are passive. In the newer appications, the initiator is an active participant. Since these are new appications, the growth rate for them is very high, starting from a very ow base. Automatic Teer Machines (ATMs) and Payments by Debit Cards One of the first eectronic banking appications was the impementation of the ATM. It is arguabe as to whether this is reay a payment system in the sense of the other systems discussed here. That is, the vast majority of transactions are cash withdrawas in which the customer and the bank interact, but there is no third or fourth party to the transaction, and at the outset of the deveopment of this appication there was no network. However, this appication does aow the customer access to cash, which is a payment aternative, and in that sense the banking system is aowing the customer to have efficient access to using cash to make payments. Aso, use of the ATM aows the customer to economize on the use of currency, and evidence indicates that customers therefore hod higher deposit baances than otherwise woud be the case. 28 In the eary days of the impementation of ATM programs, there were questions as to whether these woud be considered branch offices and hence be reguated by the McFadden Act and the various state branching aws. If they were, the depoyment of this new appication coud be imited. However, in 1985 the U.S. Supreme Court uphed a circuit court ruing that an ATM was not a branch. As a resut of this ruing and the popuarity of the ATM with customers, especiay upscae consumers, the number of ATMs increased dramaticay. 29 As the depoyment of ATMs continued, some banks started networks that aowed customers of other banks to access their accounts. This required someone, usuay a arge bank at the outset, to operate a switch that woud route transactions among the various banks participating in the network. The basic idea was to enhance customer convenience by expanding the ocations at which access was avaiabe. In addition, networks aowed banks to take advantage of scae economies in processing by increasing the potentia number of transactions per machine. Over time these networks expanded and merged. This trend has resuted in severa arge regiona networks, a few nationa networks, and a group of smaer networks. The 28 See Danies and Murphy (1994a, 1994b). 29 For a discussion of the contemporaneous demographic pattern of adoption of ATMs, see Murphy and Rogers (1986). FDIC BANKING REVIEW , VOLUME 16, NO. 2

10 The Future of Banking number of networks peaked at approximatey 130 in the mid-1980s; now fewer 40 are operating. Moreover, transaction voume is concentrated in a sma number of arge networks. In 1985, the top three networks processed 11 percent of the transaction voume; in 2002 that percentage exceeded 100 percent (some transactions are counted more than once, since they may trave over severa networks). As these networks expanded, they negotiated reciprocity agreements with other networks, effectivey expanding the reach of any singe customer s ATM card. In addition, nationa networks can and do serve as bridges between regiona networks. Most ATMs (over 98 percent) are part of shared networks, and as a resut of both reciprocity and bridging they are nationa (or internationa, in the case of the Visa and MasterCard networks). 30 The ownership structure of the networks has changed dramaticay aso, with an increase in the number and share of networks owned by nonbanks. This shift has occurred as the number of networks owned by joint ventures of banks has decined. As a resut of amost 25 years of deveopment, the ATM appication is the most mature of eectronic banking services. There are presenty over 350,000 ATMs depoyed in the United States. The proportion of off-premise ATMs has increased dramaticay as banking offices that are candidates for on-premise ATMs have been saturated. Aso, as the cost of machines has decined over the years, the break-even voume necessary to justify the investment cost has decined. Hence, the number of transactions has steadiy increased whie the number of transactions per machine peaked in the eary 1990s and has steadiy decined since then. As the ATM networks expanded, it became apparent that they coud be used for other transactions as we. Thus, the ATM networks evoved into the point-of-sae (POS) networks accessed by debit cards. Customers became famiiar with the process of accessing their accounts with a pastic card through the ATM, and the use of the same cards and networks at the point of sae evoved naturay. The customer woud access the network with a pastic card in a manner simiar to the ATM, woud identify himsef or hersef with a persona identification number (PIN), and funds coud be deducted from the customer s account. The ony difference is that the funds were not made avaiabe in the form of cash but instead were transferred to the account of a merchant who decided to accept the debit card as a way for the customer to pay for goods and services. Of course, with virtua universa network coverage through reciprocity and bridging, it was possibe for the customer to make payment onine at the point of sae easiy. Debit card transactions have been growing rapidy. In 1979, they were virtuay nonexistent, whereas in 2000, 8.3 biion such transactions were recorded. When compared with generapurpose credit cards, a much more mature product, the reative growth is striking. In 1995, there were 1.4 biion debit card transactions and 7.8 biion genera-purpose credit card transactions, whereas in 2000 the comparabe numbers were 8.3 biion and 12.3 biion. In 2000, debit cards accounted for 11.6 percent of a retai noncash payments, up from 2.2 percent in From 1995 to 2000, debit card transactions grew at the fastest rate of a types of retai noncash payments (a 41.8 percent annua rate, compared with a 2.2 percent growth rate for a payments). 31 Within the debit card industry, there are two types of transactions. One is an on-ine transaction activated by a PIN at the point of sae, with immediate debiting of the customer s account and crediting of the merchant s account. A this information traves over the same networks as the ATM transactions, and there are fees invoved for the merchant, who is charged on a fee-per-transaction basis. There are aso point-of-sae transactions that are known as off-ine, signature-based transactions. In this case, the information fows over the credit card networks managed by Visa or MasterCard. In the on-ine transaction, there is a 30 For a thorough discussion of the ATM/debit card network industry, see Hayashi, Suivan, and Weiner (2003). 31 See Gerdes and Waton (2003). 2004, VOLUME 16, NO FDIC BANKING REVIEW

11 Effect on U.S. Banking of Payment System Changes PIN to identify the cardhoder, whereas in the offine transaction the merchant is responsibe for verifying the identity of the cardhoder. In the off-ine transaction there is aso a deay in transferring the funds, and, most importanty, there is a difference in the fee structure. The merchant is charged a fee based on the size of the transaction, and the fees to the bank are generay arger in that case. For that reason, the banks have discouraged the use of on-ine debit transactions in favor of the off-ine debit card. Merchants have opposed this. In 2003, a major court case invoving Wa-Mart and Visa and MasterCard was setted. In that case, the retaiers opposed the honor-a-cards rue that required any merchant accepting either Visa or MasterCard credit cards to honor a their cards, incuding the off-ine debit cards. Wa-Mart wished to honor the credit cards but not the off-ine debit cards. The settement that merchants no onger have to honor a cards wi probaby affect the structure of fees over a of the varying debit card networks and move voume to the PIN-based transactions. Credit Cards Credit cards are the most mature eectronic payments product. Athough individua retaiers had issued cards to their customers for many years, the genera-purpose credit card dates back to Diners Cub in At that time, as the name indicates, the basic idea was to have a credit card accepted by a number of restaurants in Manhattan, and customers woud have to carry ony a singe card to be abe to dine. It was assumed that businessmen who customariy had business unches and dinners woud find this appeaing and that those restaurants that sought to attract their business woud aso find it appeaing. This resuted in the Diners Cub program. During the 1950s, a number of banks tried to introduce bank credit cards without much success. Not unti 1958 did American Express, Carte Banche, Chase Manhattan Bank, and Bank of America enter the fied. In 1962, Chase Manhattan eft the business and American Express reportedy considered giving up its trave and entertainment card. Not unti 1966 did Bank of America estabish a franchise operation for its card, then known as BankAmericard. Thus, a franchisee bank coud issue a credit card that coud be used nationay (and eventuay internationay). BankAmerica Service Corporation aso estabished a network that aowed payments between banks deaing with merchants and banks issuing the cards to consumers. This was quicky foowed by a consortium of banks that estabished the Interbank Card Association, which estabished another network and bank card eventuay known as MasterCard. 33 In 1970, Bank of America spun off BankAmerica Service Corporation to a (bank) member-based organization that eventuay became Visa USA. Thus, both MasterCard and Visa USA basicay offer a franchise to their members and manage the interchange system, estabishing the pricing of interchange services and the rues and reguations governing these operations. There was a shaky start that saw huge osses due to arge-scae unsoicited issuance of cards in the ate 1960s (a practice that is now iega); there was aso a time when rampant infation and high interest rates made the bank credit card business unprofitabe. However, the acceptance of bank credit cards at the point of sae (which now incudes a persona computer attached to the Internet) became so widespread that it is difficut to imagine that this odest of the widey used eectronic payment systems is ess than 50 years od. The ega and reguatory environment for the bank credit card industry incudes state aw (mainy usury aws), federa consumer credit aw, and the outcome of court cases. The maximum rate that a ender can charge for consumer credit is estabished on a state-by-state basis. This became a difficut probem for the industry when interest rates were very high, and in some states ega maxima were ess than banks cost of funds. In a andmark court decision in 1978, the U.S. Supreme Court rued that the ender s ocation determined the operative state usury ceiing no matter where the customer may ive, even if the 32 See Mande and Murphy (1976) and Mande (1990). 33 See Evans and Schmaensee (1999). FDIC BANKING REVIEW , VOLUME 16, NO. 2

12 The Future of Banking state in which the customer ived had a ower usury ceiing. This gave incentive to arge card issuers to find a ender-friendy state in which to estabish nationa operations. Severa states, especiay South Dakota and Deaware, aggressivey soicited such bank card operations. In the 1970s, Congress enacted a number of consumer credit protection aws, at east party as a response to the marketing and other practices of the bank credit card industry. These aws incude the Truth-in-Lending Act of 1968, the Fair Credit Biing Act of 1974, the Equa Credit Opportunity Act of 1974, the Fair Credit Reporting Act of 1971, the Fair Debt Coection Practices Act of 1977, and the Eectronic Fund Transfer Act of In addition, federa bankruptcy aw affects bank credit card operations. There are now over 1.2 biion credit cards in the United States. Of these, miion are issued directy by retaiers; the rest are bank credit cards or trave and entertainment cards. The number of transactions grew from 12.9 biion in 1997 to 17 biion in 2001, an annua growth rate of 5.78 percent. The proportion of retaier card transactions for 2001 was 11 percent of the tota, down from 15 percent in The number of merchant ocations at which these cards may be used is over 13 miion. Summary of Recent Deveopments in Payment Systems in the United States In the past 25 years, the nature of the payments system in the United States has changed. In part the change has been dramatic; in part it has been sow. The different payment systems refect the deveopment of competing networks with a variety of ega and reguatory environments. The ony common theme is that payments are routed through an interbank system. There are aso a variety of owners and operators of the networks, incuding pubic bodies for checks and the ACH (the Federa Reserve System), nationa membership organizations for open networks of generapurpose bank credit cards (Visa and MasterCard), cosed networks for some genera-purpose credit cards (American Express and Discover), and proprietary (both bank and nonbank) organizations for ATM and PIN-based on-ine debit card networks. In genera, the ACH and the debit card transactions have witnessed the greatest growth, whereas credit card transaction growth has been modest and payments by check have actuay decined. In tabe 1, the number of transactions for the various categories are shown for 1979, 1995, and 2000, the years for which accurate data are avaiabe. Tabe 1 The Use of Checks Has Decined Whie the Use of Retai Eectronic Payments Has Increased Type of Payment Number (biions) Check Retai Eectronic Payments Debit Card Credit Card Genera Purpose Private Labe Retai ACH Source: George R. Gerdes and Jack K. Waton II, The Use of Checks and Other Noncash Payment Instruments in the United States, Federa Reserve Buetin 88, no.8 (August 2002), 361. Users of Eectronic Banking Who uses eectronic banking? The answer is househods, governments, and businesses. Househods A number of studies have examined the determinants of househod use of payment services. It was found that the adoption process for new eectronic banking services foowed a predictabe pattern, one in which demographic factors incuding income, weath, education, and position in the ife cyce (age) were systematicay associated with the adoption of new payment products and services. In an eary contribution, Mande found that credit card use was positivey associated with 2004, VOLUME 16, NO FDIC BANKING REVIEW

13 Effect on U.S. Banking of Payment System Changes income, weath, education, and age. 34 In the 1980s, a study by Murphy and Rogers and two studies by Danies and Murphy found simiar patterns for the adoption of banking and payment products and services. 35 More recent studies found that the patterns remain the same, but the trend is toward greater use by a demographic groups. Kenicke and Kwast examined the data in the 1995 Survey of Consumer Finances and found that higher income and financia assets, and more years of education were a positivey correated with use of eectronic banking services. Age is more compex because oder househods are ess ikey to use eectronic banking, a other factors hed constant, for amost a eectronic banking services except direct deposit a correation refecting the very high acceptance of direct deposit by Socia Security recipients. 36 Stavins anayzed the data from the 1998 Survey of Consumer Finances with simiar resuts. 37 Using the most recent Survey of Consumer Finances (2001), Mester showed that over 88 percent of househods use some form of eectronic payment instrument (ATM, debit card, direct deposit, automatic bi paying, or smart card ). This is an increase from 76.5 percent. From 1995 to 2001, debit card use rose from 17.6 percent to 47 percent of househods, direct deposit rose from 46.8 percent to 67.3 percent, and automatic bi paying rose from 21.8 percent to 40.3 percent. The most mature of appications, the ATM, rose from 61.2 percent to 69.8 percent. In Mester s findings a the previousy determined reationships between use and demographics remained, but the penetration had increased substantiay, as refected in the data on the dramatic increase in debit card transactions and the reduction in the number of checks written. 38 Governments and Businesses As indicated above, in the United States a eves of government have activey pursued the use of eectronic banking in making and receiving payments, incuding payments to empoyees, benefit recipients, and vendors. This has been argey successfu, and the number of checks written by a eves of government has decined. As noted above, government payments through the ACH system have increased modesty in recent years, indicating that for government this process is argey compete. The business sector receives payments from househods in various ways. Househods pay businesses at the point of sae by cash, check, or debit or credit card. They pay businesses mosty by check in response to invoices through the mai. Businesses pay each other usuay by check or through the ACH, and increasingy businesses pay taxes through the ACH as we. There are no business databases comparabe to the Federa Reserve s Survey of Consumer Finances. Hence, one has to seek indirect evidence from numerous sources to determine business use of eectronic banking. First, it is cear that retai businesses find it necessary to accept debit or credit cards at the point of sae. Casua inspection of retai sites combined with a reported tota of point-of-sae terminas in excess of 13 miion in the United States is sufficient to indicate that businesses find it either convenient and ow cost, or a business necessity, to accept POS eectronic payments. 39 The concept of point of sae has been expanded to incude the teephone and the Internet, and the credit or debit card is the payment instrument of choice here. NACHA pubishes data about the types of transactions processed through the ACH system. It is possibe to make reasonabe assumptions about the source and destination of many of these transactions and their use by businesses and governments. First, a direct deposits are considered business or government payments to househods. This is one of the argest appications on the ACH system, with over 3.8 biion transactions in As indicated in the 2001 Survey of Consumer Finance and reported by Mester (2003), 34 See Mande (1970). 35 See Murphy and Rogers (1986) and Danies and Murphy (1994a, 1994b). 36 See Kennicke and Kwast (1997). 37 See Stavins (2001). 38 See Mester (2003). 39 It shoud be noted that the United States ranks high in per capita depoyment of EFTPOS (eectronic fund transfer point-of-sae) terminas in comparison with other deveoped countries. See CPSS (2003). FDIC BANKING REVIEW , VOLUME 16, NO. 2

14 The Future of Banking the direct deposit of payro, Socia Security, and other benefits, as we as pension and dividend payments, has been very popuar with consumers. As a resut its growth from 2001 to 2002 was ony 4.7 percent, smaer than the doube-digit-percentage increases in most other eectronic transactions. Direct debits through the ACH invoving recurring payments from consumers to businesses were over 2.8 biion in 2002, a percent increase from These two appications direct deposits and direct debits usuay represent recurring transactions. Some of the other new ACH appications invove businesses in transactions that are not recurring. First, there is the point-of-purchase appication in which a consumer check is transformed from a negotiabe instrument to a source document. This invoves a consumer-to-business transaction at the point of sae and is a direct substitute for either a debit or a credit card transaction. Other nonrecurring payment transactions from consumers to businesses incude Internet and teephone-initiated transactions. Finay, a recent addition to the consumer-to-business eectronic transaction menu is the accounts-receivabe appication, in which a check maied to a ockbox is transformed at that point to a source document that is processed through the ACH system. A these appications have grown at very high rates. Finay, within the ACH system there are various business-to-business transactions. These incude trade payments as we as intracorporate payments designed to aggregate cash baances from a number of banks into a singe account that can be used to efficienty make payments and invest surpus funds. These have grown at doube-digit rates in recent years, in excess of 12 percent from 2001 to Another way to gain some insight into business use of eectronic banking is to examine the findings of a number of surveys of corporate use of cash management services. For exampe, in 2002 Phoenix-Hecht conducted its annua Cash Management Monitor and received responses from 1,665 corporations with annua saes in excess of $100 miion. One of the many findings of the survey was that over 97 percent of arge corporations and 92 percent of upper-midde-size corporations aready used the ACH extensivey. Indeed, Phoenix-Hecht sees itte opportunity for expanded ACH voume in any appication except consumer-authorized debits. Another interesting finding is the use of sweep accounts by over 75 percent of a reporting corporations. Sweep accounts aow daiy movement of funds from demand deposit accounts into an overnight repurchase agreement or money market mutua fund. This is important for corporate use of eectronic payment services. That is, corporations move funds out of demand deposit accounts where expicit payment of interest is prohibited. In this case, banks do not offer any earnings credit to offset fees, and therefore corporations have incentives to adopt the owest-cost payment services. 41 Moreover, respondents indicated that imaging technoogy and Internet appications were important areas being considered. 42 Phoenix-Hecht aso conducts a Midde Market Monitor for companies with annua saes between $40 miion and $100 miion. In 2003, 1,260 companies responded. Over 86 percent of these companies used the ACH, and many respondents indicated that initiating transactions over the Internet is one of the more important technoogy appications. Middesize companies aso used sweep products as we. In summarizing the resuts of the midde-market company survey, Phoenix-Hecht indicated that athough midde market companies typicay use fewer cash management products than arge companies, as a group the midde market usage profie is becoming more ike that of the arger companies. 43 In a simiar survey, Treasury Strategies, Inc., asked 131 arge corporations (ess than $1 biion to $25 biion in annua revenues) many questions about their treasury activities. Whie there were no specific questions on the use of particuar payment services, there was substantia emphasis among respondents on streamining operations, owering costs, and aggressivey using 40 See NACHA (2003). 41 For a discussion of the use of sweep accounts in cash management, see Cook, Murphy, and Siverberg (2000). 42 See Phoenix-Hecht (2002). 43 See Phoenix-Hecht (2003), , VOLUME 16, NO FDIC BANKING REVIEW

15 Effect on U.S. Banking of Payment System Changes technoogy to do so. Over 65 percent of a respondents used treasury work stations, a process that impies intensive management of a aspects of treasury operations, incuding adoption of eastcost methods of making payments. 44 Whie businesses, especiay arge and middemarket businesses, are aggressivey using eectronic payment methods, they are sti invoved in paper transactions. In a recent Federa Reserve study, it was estimated that consumers were the argest sector that wrote checks (50.9 percent of a checks written), and most of them (amost 2/3 of a checks written) were sent to businesses. 45 Businesses were the second argest writer of checks (32.3 percent of the tota), mosty to consumers and other businesses. It woud appear that the best candidates for further business adoption of eectronic payment products woud be check conversion or check truncation at the point at which checks are remitted to businesses, in many cases a ockbox. Aso, there is room for expansion of eectronic services to business-to-business payments. A recent study by the Association for Financia Professionas indicates that whie most respondents used the ACH for payro disbursements and cash concentration, payments to other businesses was imited by a number of factors, the most important of which was interna ack of integration of payments and accounting system technoogy. 46 Check Writing and Eectronic Banking: An Internationa Perspective When the United States is compared with 13 other advanced industria nations in 2001, an interesting pattern emerges. When measures of eectronic banking are considered, the United States has a very high usage factor. For exampe, the United States has a arge number of ATMs compared with its popuation. The average for the 13 countries is 875 ATMs per miion inhabitants, whie in the United States there are 1,137 ATMs per miion. The United States has more than the average number of POS terminas that accept debit cards per inhabitant, more than the average number of debit card transactions per inhabitant, more than the average number of POS terminas that accept credit cards per inhabitant, and more than the average number of credit card transactions per inhabitant. The same is true for number of cards (debit or credit) issued and hed by inhabitants. However, the United States is sti an outier when it comes to check writing. In 2001, there were checks per inhabitant written in the United States, more than twice as many as in France, the next-highest user of checks. The United States uses many fewer credit transfers as woud be expected for a country that has been dominated by checks for so many years. The combination of high ATM use, high card use at the point of sae, and the arge number of checks written indicates that the number of cashess payment transactions per inhabitant in the United States is much arger than in a other countries in this sampe. There are cashess payment instruments used per inhabitant in the United States and more than cashess payment instruments used per inhabitant in France, the next highest. 47 Hence, the key to adopting a higher proportion of ow cost transactions in the United States ies with reducing the number of checks written, since the adoption of most eectronic payments has been successfu, whether one examines trends or internationa comparisons. 48 Pricing Payment Services and Products In the United States, there is a historica ink between the reguatory environment and the nature of pricing for payment services, especiay checks. For many years, banks were prohibited from paying interest to demand deposit customers, and there was a ceiing on what coud be paid to customers with savings accounts or certificates of deposit. As interest rates in genera rose in the post Word War II period, incentives were creat- 44 See Treasury Strategies, Inc. (2003). 45 See Federa Reserve System (2002). 46 See Association for Financia Professionas (2002). 47 See CPSS (2003). 48 A cassic review of how payment systems operate in Europe, Japan, and the United States can be found in Humphrey, Sato, Tsurumi, and Vesaa (1996). FDIC BANKING REVIEW , VOLUME 16, NO. 2

16 The Future of Banking ed for banks to pay impicit interest on deposits in the form of reduced fees on checking (perhaps a the way to no service charge), increased convenience through the construction of branch offices in many ocations, and other means of convincing customers to keep funds on deposit when expicit interest payments to these customers were either zero or beow market. This ed to a situation of cross-subsidies in genera and overuse of checks in particuar. Customers with high baances and fewer checks written were cross-subsidizing those with ow baances and many checks written. There were few if any incentives to imit check writing. 49 At the same time, credit card pricing had created cross-subsidies as we. Credit card customers generate revenues for card-issuing banks in three ways: first, they pay interest on unpaid baances; second, they may pay an annua fee; and third, their transactions generate interchange revenue. Since interest is not charged to many customers who do not carry unpaid baances at the end of the biing cyce, these customers do not pay directy for the costs they generate by their credit card activity. In addition, at the point of sae the customer is not charged a different price for the goods or services depending on whether he or she chooses a ow- or high-cost method of payment. Since the merchant pays a fee to the bank (the merchant discount) that is based on the size of the transaction and the customer does not benefit from using the ow-cost transaction, the bank has an incentive to have a card transaction migrate to the bank credit card or the off-ine debit card because the merchant discount paid to the bank is higher. Hence, there is no expicit pricing incentive for the customer to choose the owest-cost method of making payment. 50 Athough the reguation imiting interest payments on deposits was removed in 1980, there is sti a perceived preference on the part of consumers for pricing arrangements that do not invove per-item charges for checks written. 51 In the Federa Reserve payments project in 2002, it was noted that the number of checks written per househod has increased over time, whie the government and the business sector have made more progress in repacing checks with eectronic payments. 52 There is indirect evidence that pricing has an effect on decision making by business about checks versus eectronic payments. First, most arge and midde-size corporations activey manage their cash, and they invest a deposits on a daiy (overnight) basis, usuay through sweep arrangements. This may be construed as a market-based innovation to avoid the impact of the prohibition of interest payments on business demand deposits. Since banks must pay a competitive rate on these baances, they must charge fees that cover their costs of providing transaction services to these business customers. The Phoenix-Hecht and Treasury Strategies, Inc., surveys discussed above support the use of these cash management toos. In addition, Phoenix-Hecht conducts and pubishes surveys on the prices of specific transaction services, 53 and the surveys of corporate cash management practices indicate that annua reviews (incuding of pricing) are common. Moreover, the corporate cash management community has worked to standardize formats for categories of services and procedures for designing requests for proposas (RFPs) for banks offering cash management services. 54 As indicated above, in their use of eectronic banking services, midde-market corporations resembe arger corporations as banks refine their offerings and saturate the arge corporate market. This migration process to smaer firms wi increase the use of eectronic banking for smaer corporations in the future. If we accept that pricing incentives have caused businesses and governments to economize on high-cost methods of payment, is there any evi- 49 The ink between pricing, reguation, and eectronic funds transfer is discussed in Murphy (1977). 50 It shoud be noted that the tota cost of making the transaction is important to the payer, incuding posta costs if the mais are invoved as we as the time and transportation costs invoved in making the transaction. The switch to eectronic payments by consumers may refect changes in the tota cost even though the expicit transaction costs are not charged directy to them. 51 The Federa Reserve conducts an annua survey of retai fees of depository institutions. For a summary of the findings of these surveys, see Hannan (2002). See aso Stavins (1999). 52 See Gerdes and Waton (2002). 53 See Phoenix-Hecht (2003). 54 See Association for Financia Professionas (2003, 2003). 2004, VOLUME 16, NO FDIC BANKING REVIEW

17 Effect on U.S. Banking of Payment System Changes dence that this woud happen on the consumer side if expicit pricing were somehow introduced? There is very imited evidence, in those instances in which per-item pricing is observed for consumers in the United States, that it has the expected effect on check writing. 55 However, the most rigorous, thorough econometric examination of the effect of pricing on choice of payment instrument was conducted by Humphrey, Kim, and Vae for Norway, a country that impemented expicit per-item prices for a number of payment instruments used at the point of sae. The findings supported a strong substitution effect of eectronic for paper transactions at the point of sae. 56 Impications for Banking Profitabiity and Reguatory Oversight This review of the deveopment of payment systems in the United States indicates the foowing: Banks wi have to adapt their offerings and interna back-office processing to refect the changes underway, eading to greater use of eectronic banking by consumers. Fortunatey, athough the process of change has recenty acceerated, the trends shoud not overwhem the industry. Since more eectronic transactions are cheaper to process, as is the conversion or truncation (or both) of checks, banks that do not expicity charge for transaction services on a peritem basis wi see a reduction in costs. For banks that have expicit fees for each service (mainy banks that suppy cash management services), it wi be necessary to ensure that the profit margins on the eectronic transaction services are commensurate with those on the paper transaction services. Since cross-subsidization and impicit pricing ead to distortions, overuse of some services, 55 See Murphy (1991). 56 See Humphrey, Kim, and Vae (2002). Other studies of cross-country anayses of payments faied to find significant reationships between pricing and use because of poor data and itte appication of per-item pricing. See Humphrey, Puey, and Vesaa (1996). and ack of transparency, there is no justification for the remaining restriction on paying interest on demand deposits. Interest is aowed for consumer accounts, and arge businesses have evaded the restriction by using sweep accounts. The Federa Reserve shoud pay interest on bank baances, and banks shoud not be restricted in paying interest on any demand deposit account. There has been and wi continue to be consoidation in the provision of cash management services to arge corporations, but banks of a sizes wi be abe to continue to serve their customers with a mix of capabiities, incuding ATMs, on- and off-ine debit cards, credit cards, acting as receivers of ACH payments on behaf of their customers, and other services. There shoud be no reason to beieve that these trends by themseves wi have any substantia impact on the market structure of the banking industry. Bank reguators must concern themseves with operationa risk. The deveopments discussed in this paper indicate that reguators must be aware of the risk impications of the changes in payment systems and must adapt their approaches accordingy. Regarding operationa risk, one important aspect that must be considered by bank reguators is the trend toward nonbank ownership and operation of significant portions of the payment networks. Since the operation of these networks has a direct effect on the risk exposure of reguated banks, the risk management procedures of these firms may have significant impications for bank reguators. Banks and bank reguators need to be concerned about the market structure of the network providers, especiay those for ATMs, debit cards, and credit cards. Significant consoidation among network providers has aready occurred, and any further concentration raises concerns about pricing, service quaity, and product innovation in this segment of the market, one in which bank reguators have no direct responsibiity. FDIC BANKING REVIEW , VOLUME 16, NO. 2

18 The Future of Banking Bibiography Association for Financia Professionas (AFP) Eectronic Payments Initiatives and the Internet: Report of Survey Resuts. AFP a. AFP Guide to Account Anaysis: Statement Standards and Transaction Set 822 Impementation Guide. AFP b AFP Service Codes: A Standard for Reporting and Anayzing Bank Compensation. AFP. Berger, Aen N., and David B. Humphrey Interstate Banking and the Payments System. Journa of Financia Services Research 1, no. 2: Board of Governors of the Federa Reserve System Fedwire Funds Transfer System: Sef-Assessment of Compiance with the Core Principes for Systemicay Important Payment Systems The Future of Retai Eectronic Payments Systems: Industry Interviews and Anaysis. Staff Study a. Docket No. OP-1165, Notice of 2004 Fee Schedues b. Docket No. R-1152, Notice on Imputed Investment Income on Cearing Baances. Bradford, Terry, Matt Davies, and Stuart E. Weiner Nonbanks in the Payments System. Working Paper No Federa Reserve Bank of Kansas City. Chakravorti, Sujit, and Timothy McHugh Why Do We Use So Many Checks? Federa Reserve Bank of Chicago Economic Perspectives (3rd Quarter): Check 21 Act, Pubic Law , October 28, Coeman, Stacy Pangay The Evoution of the Federa Reserve s Intraday Credit Poicies. Federa Reserve Buetin (February): Committee on Payment and Settement Systems Rea-Time Gross Settement Systems. Bank for Internationa Settements Retai Payments in Seected Countries: A Comparative Study. Bank for Internationa Settements Cearing and Settement Arrangements for Retai Payments in Seected Countries. Bank for Internationa Settements Core Principes for Systemicay Important Payment Systems. Bank for Internationa Settements and other years. Statistics on Payment and Settement Systems in Seected Countries. Bank for Internationa Settements a. Poicy Issues for Centra Banks in Retai Payments. Bank for Internationa Settements b. The Roe of Centra Bank Money in Payment Systems. Bank for Internationa Settements. 2004, VOLUME 16, NO FDIC BANKING REVIEW

19 Effect on U.S. Banking of Payment System Changes. 2003c. Payment and Settement Systems in Seected Countries. Bank for Internationa Settements. Committee on the Federa Reserve in the Payments Mechanism (Rivin Committee) The Federa Reserve in the Payments Mechanism. Board of Governors of the Federa Reserve System. Danies, Kenneth N., and Nei B. Murphy. 1994a. The Impact of Technoogica Change on the Currency Behavior of Househods. Journa of Money, Credit, and Banking 26: b. The Impact of Technoogica Change on Househod Transactions Baances. Journa of Financia Services Research 8, no. 2: European Centra Bank Toward a Singe Euro Payments Area Progress Report. Evans, David S., and Richard Schmaensee Paying with Pastic: The Digita Revoution in Buying and Borrowing. MIT Press. Federa Reserve Bank of Boston Press Reease: Federa Reserve Banks Announce Changes to Increase Efficiency in Check Services as Check Voumes Decine Nationwide. Financia Services Poicy Committee of the Reserve Banks. Federa Reserve System Retai Payments Research Project: A Snapshot of the U.S. Payments Landscape. Federa Reserve System. Fokerts-Landau, David Whoesae Payments and Financia Discipine, Efficiency, and Liquidity. Working Paper No. 97/154. Internationa Monetary Fund. Friedman, Miton, and Anna J. Schwartz Monetary History of the United States, Princeton University Press. Gerdes, George R., and Jack K. Waton II The Use of Checks and Other Noncash Payment Instruments in the United States. Federa Reserve Buetin (August): Green, Edward J., Jose A. Lopez, and Zhenyu Wang Formuating the Imputed Cost of Equity Capita for Priced Services at Federa Reserve Banks. Federa Reserve Bank of New York Economic Poicy Review 9, no. 3: Hancock, Diana, and David B. Humphrey Payment Transactions, Instruments, and Systems: A Survey. Journa of Banking and Finance 21: Hannan, Timothy H Retai Fees of Depository Institutions, Federa Reserve Buetin (September): Hayashi, Fumiko, and Eizabeth Kee Technoogy Adoption and Consumer Payments: Evidence from Survey Data. Working Paper Series WP Federa Reserve Bank of Kansas City. Hayashi, Fumiko, Richard Suivan, and Stuart E. Weiner A Guide to the ATM and Debit Card Industry. Working Paper No. WP Federa Reserve Bank of Kansas City. Hogarth, Jeanne M., and Kevin H. O Donne Banking Reationships of Lower- Income Famiies and the Governmenta Trend toward Eectronic Payment. Federa Reserve Buetin (Juy): FDIC BANKING REVIEW , VOLUME 16, NO. 2

20 The Future of Banking Humphrey, David B The Economics of Eectronic Benefit Transfer Payments. Federa Reserve Bank of Richmond Economic Quartery 82, no. 2: Humphrey, David B., Moshe Kim, and Brent Vae Reaizing the Gains from Eectronic Payments: Costs, Pricing, and Payments Choice. Journa of Money, Credit, and Banking 33, no. 1: Humphrey, David B., Lawrence B. Puey, and Jukka Vesaa Cash, Paper, and Eectronic Payments: A Cross-Country Anaysis. Journa of Money, Credit, and Banking 28, no. 4: The Check s in the Mai: Why the U.S. Lags in the Adoption of Cost- Saving Eectronic Payments. Journa of Financia Services Research 17, no. 1: Humphrey, David B., Satsuya Sato, Masayoshi Tsurumi, and Jukka M. Vesaa The Evoution of Payments in Europe, Japan, and the United States. Poicy Research Working Paper The Word Bank. Kennicke, Arthur B., and Myron L. Kwast Who Uses Eectronic Banking? Resuts from the 1995 Survey of Consumer Finance. Working Paper No Board of Governors of the Federa Reserve System. Lacker, Jeffrey M., and John A. Weinberg Can the Fed be a Payment Systems Innovator? Federa Reserve Bank of Richmond Annua Report, Mande, Lewis Credit Card Use in the United States. Institute for Socia Research, University of Michigan The Credit Card Industry: A History. Twayne Pubishers. Mande, Lewis, and Nei B. Murphy Bank Cards. American Bankers Association. Mester, Loretta Changes in the Use of Eectronic Means of Payment: Federa Reserve Bank of Phiadephia Business Review (3rd Quarter): Murphy, Nei B Bank Credit Cards, NOW Accounts, and Eectronic Funds Transfer. Magazine of Bank Administration (March): The Impact of Payment Systems Innovation on Check Writing. Journa of Retai Banking 1, no. 2: Determinants of Househod Check Writing: The Impacts of the Use of Eectronic Banking Services and Aternative Pricing of Checking Services. Financia Services Review 1, no 1: European Union Financia Deveopments: The Singe Market, the Singe Currency, and Banking. FDIC Banking Review 13, no. 1:1 18. Murphy, Nei B., David C. Cooke, and Staney C. Siverberg Sweep Accounts in the United States. Payment Systems Wordwide (Summer): Murphy, Nei B., and Lewis Mande The NOW Account Decision: Profitabiity, Pricing, Strategies. Bank Administration Institute. Murphy, Nei B., and Ronad C. Rogers Life Cyce and Consumer Financia Innovation: An Empirica Study of the Adoption Process. Journa of Bank Research 17, no. 1: , VOLUME 16, NO FDIC BANKING REVIEW