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April 2, 2012

What defines an efficient market?

"There was an active debate on whether the Reserve Banks should be involved in card-based systems, but we concluded that card systems were not something that the Reserve Banks needed to become operationally involved in. [We concluded] that the private sector was developing these systems appropriately on their own, and that it didn't need public sector intervention." (From Louise Roseman's keynote address at the November 2011 Retail Payments Risk Forum conference, "The Role of Government in Payments Risk and Fraud.)

I recently re-watched video clips from Louise Roseman's keynote address at our November 2011 Retail Payments Risk Forum conference. In these clips, Roseman, who is the director of Reserve Bank operations and payment systems at the Board of Governors, explained that the Fed occasionally, but not always, provides payments services. She mentioned that when credit cards started to appear, the Fed debated whether or not they had a role in that market. However, the Fed determined that the market was functioning well enough on its own and that intervention was not justified.

Roseman discussed a contrasting example of when the Fed did intervene in a market: check clearing in the 1910s. In the 20th century, paper checks had to be physically presented at the bank they were drawn on in order to clear. While this process was easy for checks drawn on and deposited at banks located in the same major city, it was much more difficult for checks that had to travel inter-city or were drawn on country banks. To process these out-of-town checks, banks had to manage multiple correspondent relationships. Across banks and clearinghouses, this meant frequent handling and duplication of effort. And when a receiving bank did not have a correspondent relationship with the paying bank, these checks did not clear at par—that is, paying banks charged presentment fees for settling checks with noncorrespondents.

To minimize presentment fees, banks would sometimes send checks on a circuitous route. What follows is a real example of one check's meanderings. (This journey is documented in Clearing Houses and Credit Instruments, a 1911 publication of the National Monetary Commission.) Woodward Brothers of Sag Harbor, NY, wrote a check for $43.56 from its account at the Peconic Bank to Berry, Lohman, and Rasch of Hoboken, NJ. The check was deposited at the Second National Bank of Hoboken. The Second National Bank of Hoboken sent the check to Harvey Fisk and Sons, of New York, who sent the check to the Globe National Bank of Boston, who sent it to the First National Bank of Tonawanda (on the far western border of New York). From Tonawanda, the check made its way to the National Exchange Bank of Albany, was forwarded to the First National Bank of Port Jefferson, went on to the Far Rockaway Bank, and ended up going back to the Big Apple at Chase National Bank. From Chase, the check went to Queens County Bank of Brooklyn, and finally back to the Peconic Bank of Sag Harbor!

At the time, many bankers pushed for the Fed to provide check clearing to reduce these inefficiencies. The Fed obliged, which resulted in savings to the whole market and all checks clearing at par.

Check clearing is just one example of a payment system in which the Fed could improve the overall efficiency of clearing and settlement processes. Are there other markets for which we could replicate this success? What defines an efficiently functioning market?

Jennifer WindhBy Jennifer C. Windh, a senior payments risk analyst in the Retail Payments Risk Forum at the Atlanta Fed

April 2, 2012 in checks , payments | Permalink


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