Question

How does the Federal Reserve facilitate the payments mechanism?

Answer 1

Unlike central banks in most other countries, the Federal Reserve System has always played a major role in developing and operating the check and ACH retail payments mechanisms in the United States. About 25 percent of all employees in the Federal Reserve Banks are currently engaged in processing such payments.Federal Reserve undertaking important initiatives in the U.S. retail payments system, including the following:

• Fostering the development of new computer-driven check sorting equipment to help to bring automation to the check-clearing process forty years ago;

• Stepping forward to provide operational support for the automated clearing house, or ACH, the first U.S. retail electronic payment mechanism, during the 1970s when hardly anyone was familiar with the “direct deposit” and “direct payment” products of the ACH;

• Using regulatory authority and operational services to implement the Expedited Funds Availability Act of 1987 so that consumers who deposited checks could enjoy the use of their money earlier, while at the same time risks in the banking system were reduced; and

• Undertaking a lengthy research and development program during the 1980s and 1990s to test the application of digitized image technology to check processing.

Detailed past, oresent and future roles the Federal Reserve plays in the U.S payments system :

(A) Innovations with potential benefits for the overall payments system, and indeed for society, will languish unless the Federal Reserve or some other entity with broadbased, longer-term benefits in mind pursues them. Once Fed research had shown that an innovative technology would work, the manufacturers and the banks moved ahead with their applications for it. The Reserve Banks also applied it in the check services they provide to depository institutions.

(B) The same understandable reluctance or inability of most private entities to step The Role Of The Federal Reserve In The Payments System 159 forward without a clear business case led to the Federal Reserve’s operational role in the Automated Clearing House, or ACH. A second, related lesson is that the Federal Reserve can be effective as a collaborative partner to implement ideas initiated by others. The idea for the ACH, for instance, was developed by the clearing houses in California and other banking industry leaders in the United States and in Europe. The U.S. bankers needed operational support to bring the idea to life as a national electronic payments mechanism. The Federal Reserve helped the banking industry to move its own good idea ahead.

(C) Similarly, the banking industry, through a project of the American Bankers Association in the 1950s, invented the “MICR line”—the black numbers printed on the bottom of paper checks in magnetic ink. The MICR line standard was prepared for the automation of check-sorting, which into the 1960s still was done by hand. Five Reserve Banks subsidized the testing of prototype automated solutions from five firms, for the benefit of all participants in the check system. A third lesson is that the Federal Reserve’s operational role in processing payment transactions adds to its capacity to improve the payments system. In the development of equipment to sort checks, the Federal Reserve did not just provide a financial subsidy. The Reserve Banks contributed the time and expertise of their check managers and staff and used portions of their “live work” to test the prototypes. In the late 1980s, after the Congress passed the Expedited Funds Availability Act to give consumers faster access to their deposited funds, the Federal Reserve Board was obliged to implement the Act with regulations. Solid operational knowledge allowed the Federal Reserve to propose and subsequently adopt regulatory change that was both ambitious and practical and brought about important improvements in the check system. And as a final lesson, standards are essential for a unified national payments mechanism accessible to all participants. Support from an entity with a concern for the broad payments system, more than for its own individual interests, sometimes is needed to put a standard in place.

The Federal Reserve has played above three distinguishable roles in standards-setting. One has been to see the need for a standard, earlier than others, and to take the lead in bringing parties together to develop a standard. In the work on check image technology, the Federal Reserve joined with the American Bankers Association to organize a standards work group and led the work group that brought forward the current standard for the exchange of images produced by different systems. Another role of the Federal Reserve has been to complement the standards work of the private sector and use regulatory authority to bring a standard into common practice. As part of the effort to implement the Expedited Funds Availability Act in 1987 and 1988, the Board of Governors proposed a check endorsement standard that settled the few 160 Paul M. Connolly and Robert W. Eisenmenger remaining issues that competing firms had not been able to settle among themselves. Then, after a public comment process, the Board’s regulatory authority ensured that the standard would be adopted widely and swiftly. A third role has been to help the private sector put its standards into use. Over a ten-year period in the 1950s and 1960s, the Reserve Banks worked with large and small depository institutions to persuade them to put the new magnetic ink onto the checks they provided to their customers. Then, in 1967, to support the industry further, the Reserve Banks announced that checks that did not comply with the standard would not be accepted for normal collection. This measure put the industry’s own standard “over the top.”

In near future The U.S. retail payments system will become more electronic. In its operational role, the Federal Reserve can help this trend along by leading and supporting efforts to make check collection more electronic and efforts to enhance the ACH and promote its use. New electronic payment mechanisms may not include much of an operational role for the Federal Reserve. Indeed, some of them may not even be operated by banks, although they may interface with bank-based mechanisms such as the ACH to settle the transactions done through nonbank channels. The Federal Reserve does not have to have a handson, operational involvement in all payment mechanisms to foster improvements in the payments system. However, such hands-on involvement has proved beneficial in the past, and if the System finds that a new operational role will serve public purposes in the future, it should be prepared to assume that role. In addition, the history we have reviewed demonstrates that the Federal Reserve can help to advance the payments system in other ways as well: as a collaborative partner; as a judicious, informed regulator; as a researcher; as an educator; as a developer and advocate for essential standards; and as a stakeholder with a unique combination of operational savvy and a commitment to continuous improvement of the overall payments system for the benefit of the public.