The Effect on U.S. Banking
of Payment System Changes by Neil B. Murphy*
It is now three decades since the dawn of the “checkless,
cashless society” was proclaimed. Cash
is still in use, although much of it is outside the United States, and many
checks are still being written. It is
tempting to dismiss the predictions of those days as being misguided and of no
major consequence for the structure and financial health of the banking
industry in the United States. However,
major changes in the U.S. payment system as a whole are underway. These changes will have an effect on costs,
profitability, mix of business, and delivery systems that must be considered in
an assessment of the future of banking in the United States.
It is traditional for a payment system to be the primary
concern of the central bank.1
This tradition is related to the central bank’s responsibility for
monetary policy. After all, the central
bank creates a nation’s money supply, and the payment system influences the
velocity of that money and its utility when households, businesses, and
governmental units make payments. Thus,
the focus of the central bank’s concern is the efficiency of the payment system
and the avoidance of any systemic risk arising from its operations. Moreover, the central bank is concerned with
mitigating any moral hazard that may occur because of such activities as discount
window lending and the supplying of intraday credit (daylight overdrafts) to
participants in the central bank’s large-value funds transfer service
(Fedwire). Indeed, central bankers have
been meeting for some time to deal with these problems. The Committee on Payment and Settlement
Systems (CPSS) is composed of central bankers from the G-10 countries and is
housed at the Bank for International Settlements in Basle, Switzerland. The CPSS has issued many influential reports
concerning these issues and recently published a set of “best practices” for
systemically important payment systems.2 The CPSS has also published reports that
discuss the role of the central bank in retail payment systems.3
The focus of this paper is on the changes underway that
influence the health of the banking industry in the United States. At the outset, it should be noted that the
United States is somewhat of an outlier among developed 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 actually declined in recent years and the share
of checks in total noncash payments has been declining for some time.
In the United States, the
central bank (the Federal Reserve System) owns and operates substantial
segments of the payment system. In most
countries, the central bank supervises but does not operate the retail payment
Furthermore, the focus of this paper is on payment systems
other than the large-value payment systems.
At the heart of every nation with highly developed financial markets is
a real-time gross settlement system (RTGS) that is operated by the central
bank. In such a system, funds are wired
by banks on behalf of their customers to other banks. The banks actually transfer funds from and to
their accounts on the books of the central bank. In the United States, the RTGS is Fedwire,
which is owned and operated by the Federal Reserve System. The gross feature of the system refers
to the fact that each transaction is settled separately. An alternative that requires less liquidity
for the banks involved is a netting system in which payments to and from banks
accumulate and only 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
until the accumulated inflows and outflows are netted and settled. The real-time feature of the system
means that the funds received are available at exactly the time when they
arrive. There is no wait for accumulated
inflows and outflows to largely offset each other, with only a smaller net
amount transferred. More funds are
transferred by Fedwire and the Clearing House Interbank Payment System (CHIPS),
a private sector large-value payment system, than by any other payment
method. However, the number of
transactions is small, and most of the activity is confined to a small number
of money-center banks.4 This
is not meant to downplay the importance of these systems, but the proper focus
for them has been the risk management associated with either intraday loans
(daylight overdrafts) or the potential systemic effect of unwinding payments in
a multilateral netting system when one of its participants is unable to settle
its obligation. These systems are highly
automated and will probably not change too much in the future in response to
forces of technology or shifts in consumer preferences.
However, there are changes underway in the United States in
noncash retail payment systems other than the large-value payment systems that
will affect the future of the banking industry.
These include a diminution in the number of checks written and increases
in electronic forms of payment.
Moreover, even though fewer checks are being written, the number is
still very large in absolute terms and in comparison with the number in most
other countries. Therefore, efforts are
underway to “electronify” the checks early in the process of clearing and
settlement, sending the information contained on the check forward
electronically. This is expected to be
cheaper and faster than current methods, in which large numbers of pieces of
paper are transported around the country.
Characteristics of Payment Services and Banking
All noncash methods of payment involve interbank transfers
of funds. Hence, many basic product
lines in banking are tied to the various systems by which balances are
transferred from one bank to another on behalf of customers. These products involve either a direct charge
to a customer’s demand deposit account as a result of a transfer, or a payment
on behalf of a customer—a loan to the customer that will be satisfied at a
future date. In most of the payment
systems, it is efficient to have a network that includes all bank
participants. Thus, all products tied to
an interbank transfer network involve the following:
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
externalities. That is, a product or
service tied to a network has value that is enhanced by its link to other
users. This is especially true for
communication systems, and it can be argued that payment systems are really
forms of communication systems.5 Consider the value of a telephone that is not
connected to any other callers. Clearly,
the value of the telephone and a contract to use it to communicate depends on
the use of the same product and service by large numbers of other users. This gives rise to a situation in which there
is a potential trade-off between efforts to achieve universality of use to
maximize these externalities and the concern about limiting competition and
innovation. It also 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, involve some risks. In a cash transaction, clearing and
settlement of the payment occur immediately.
For most interbank payment systems, there is a delay between the time a
payment is initially cleared and the time the participants settle all claims
among themselves. All participants must
be able to meet their net settlement obligations to the network. If one participant cannot settle, many other
transactions are at risk. In some cases,
there is also 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 especially true for debit transfer
There are two basic types of interbank transfers: credit
transfers and debit transfers. In a debit
transfer, a payer sends a payment instrument, usually a check, to a
payee. The payee then deposits the check
in its bank, which collects the check through the interbank payment
system. Hence, the payee has a
provisional 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. Only when the payment instrument
clears 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 involves payers and payees, whereas settlement risk involves
banks in the interbank funds transfer system.
For debit transfer systems, both counterparty and settlement risk
exist. For credit transfer systems, only
settlement risk exists.8
If a payment system may be viewed as a communications
network, all participants must have clear agreements as to their duties and
obligations related to their participation.
This is reflected in law, in regulations, and in contractual agreements
among the various parties to the network.
In the United States, there are a number of different legal and
regulatory arrangements for the different networks, and there are also
situations in which different transactions in the same network have different
legal and regulatory arrangements.
Moreover, there are differences among the networks as to exactly who
owns and operates the network.
Payment Systems in the
In the United States, there are a number of different
payment networks that have evolved over time.
These include the following:
The system of check
payments—a debit transfer system—which is presently paper based and the
networks for which they are operated by both the banking community and the
Federal Reserve System.
The automated clearing
house (ACH) system, which is an electronic batch-processing system in which
most of the processing is done by Federal Reserve Banks. Transactions can be either debit or credit
The debit and credit card
systems, whose networks either have evolved from automated teller machine (ATM)
networks or are owned and operated by a few major card organizations, primarily
VISA and MasterCard.
The common element in all these systems is the
communications link between banks in which information regarding payments and
customer accounts is transmitted from one bank to another, with appropriate
adjustment to customer account balances.
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 also cases in which funds
are advanced through the system on behalf of the payer, to be credited to the
payee’s demand deposit account. In such
cases, the bank has a receivable from the payer to be settled later 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 oldest interbank payment system in
the United States. It evolved in the
second half of the nineteenth century as banks in the United States switched
from note issue to deposit banking as a result of a 10 percent tax on notes.10 Indeed, two of the reasons for the
establishment of the Federal Reserve System were to implement a nationwide
check-clearing system (since U.S. banking laws precluded any bank from having a
national network of branches) and to eliminate the practice of nonpar banking
(the bank on which a check was drawn might not honor the full value of the
check when it was presented for payment).11
The legal framework for the check system comprises both
state and federal laws and regulations.
The Uniform Commercial Code (UCC) represents an agreement among the
states to adopt similar laws in the area of commerce. Within that code are several parts that deal
with payments and settlement: Article 3
(negotiable instruments), Article 4 (bank deposits and collections), and
Article 4a (fund transfers, including wholesale ACH credit transfers). In addition, Congress passed the Expedited
Funds Availability Act of 1987 (EFAA), which gave the Federal Reserve System
the responsibility of implementing improvements in the check collection
system. When the Federal Reserve acts on
that authority, federal law supersedes state law. The Federal Reserve has several regulations
that affect check collection: Regulation
CC and Regulation J both affect the processing of collections and returns
through the Federal Reserve System. On
October 28, 2003, Congress passed and the president signed the Check Truncation
Act of 2003, which paves the way for electronic presentment and collection of
Within that legal framework, the check collection system
does not function through a single channel.
When a payee receives a check, he or she deposits it in a bank. That bank then has a number of choices
available to collect the check:
It is possible that the payer and payee do business with the
same bank. In that case, balances 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 delay in settlement. Also, the processing costs are lower. The consolidation of the banking industry has
increased the probability that any given check will result in an on-us
The bank of first deposit may decide to present the check
directly to the bank on which the check is drawn. This occurs in situations where two banks are
in close proximity and have a lot of bilateral transactions. This is known as a “direct send.”
The bank of first deposit may present the check to a local
clearing house, an arrangement whereby a number banks agree to meet for the
purpose of presenting checks to each other and settling the net differences at
the end of an agreed-upon period.
The bank of first deposit may avail itself of the services
of another bank—a correspondent bank—to collect the check on its behalf.
The bank of first deposit may deposit the check with its
local Federal Reserve Bank, which will then collect the check from the bank on
which it is drawn.
In 1980, the Depository Institutions Deregulation and
Monetary Control Act (DIDMCA) required that the Federal Reserve charge for its
clearing and settlement services. Before
that time, Federal Reserve services were provided without any direct, explicit
charge. As might be expected, however,
correspondent banks that competed with the Federal Reserve objected to this
arrangement. To compete on a comparable
basis, the Federal Reserve was required to base its prices charged for clearing
and settlement services on its explicit costs and on an adjustment for the cost
of capital that its competitors must factor into their cost structures.14 In addition, the Federal Reserve System must
recover all its costs in the provision of these services. The choice made by the bank of first deposit
depends on the relative costs and benefits of the different channels.
In 2001, it was estimated that 41.2 billion checks were
written in the United States.
Approximately 43 percent of these checks cleared through the Federal
Reserve System; 28 percent cleared as direct sends, clearing house items, or
through correspondent banks; and 29 percent were “on-us” checks.15
It has long been known that the U.S. payments system depends
more on checks than is the case in all other industrialized nations.16 Since a great deal of effort, energy, and expense is incurred in moving large
amounts of paper long distances, the demise of the check has been seen as
inevitable and desirable. 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 single check may
pass through several channels, it has been difficult to collect such data every
year. However, there are several
benchmark years in which exhaustive surveys were undertaken. The practice was then to extrapolate out from
those benchmarks on the basis of incomplete information and assumptions about
the proportion of checks going through the various channels. Such benchmarks were available as a result of
surveys undertaken by the Federal Reserve System in 1979 and 1995. 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 Settlement Systems on the payment systems of
selected countries. The report is an
annual publication with data for a number of wealthy nations, prepared in a
similar format for purposes of comparative analysis. As late as 2001, when data for 1999 were
reported, it was believed (primarily on the basis of extrapolations from the
1995 benchmark) that there were over 67 billion checks processed in the United
States. However, as a result of a
substantial survey undertaken by the Federal Reserve, it was determined that in
the year 2000 there were only 42.5 billion checks written in the United States.17 In a prescient article, Humphrey, Pulley, and
Vesala forecast that the number of checks written would peak in 1997.18 It is estimated that in 2001, the number
declined once again to 40.2 billion checks (CPSS, 2002). It had generally been believed that check
growth had been positive but smaller than the growth in alternative electronic
payments, resulting in a reduction in the check share of noncash payment
instruments in the United States.19
The latest developments suggest that the share of electronic payments
has increased faster than was originally believed. Further evidence of the decline in checks
written arose recently, when the Federal Reserve indicated that the number of
checks processed during 2003 had declined at a faster rate than had been
forecast. Because the Federal Reserve
must recover all its costs in supplying processing services, it announced that
it was raising its charges to banks, reducing the credits to banks for clearing
balances maintained at the Federal Reserve, and changing the method of
calculating imputed income from investing the clearing balances. At the same time, it announced a reduction in
charges for processing electronic automated clearing house (ACH) payments.20 This raising of prices for processing paper
and lowering of prices for processing electronic transactions should reinforce
the trends already in place.
However, it should be noted that, notwithstanding the
unexpected change in the volume of checks processed, the United States is still
relatively more dependent on checks than its counterparts. In 2001, the United States wrote 144.6 checks
per capita, more than twice as many as the next-highest user of checks—France,
with 71.2 checks per capita. Countries
in Continental Europe, except France, have virtually eliminated checks:
Belgium, Germany, Italy, the Netherlands, Sweden, and Switzerland all had 10 or
fewer checks per capita in 2001. In
Sweden, there was 0.2 check per capita written in the year 2001 (CPSS ).
The latest developments for the check system in the United
States are related to what might be called the “electronification” of
checks. There are two such strands of
this process; one is underway already and the other will probably be available
in the near future. First, the ACH
system has developed three new applications that use the check as a device to
trigger a debit transfer on the ACH system.
In one of these applications, the point-of-purchase (POP) application, a
merchant receives a check in payment for goods or services. Instead of depositing the check in the
familiar process, the merchant uses a terminal to scan the information on the
bottom of the check (the “MICR” line) and the amount of the sale. 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 also a legal transformation in which the check is no longer a
negotiable instrument governed by the UCC and Federal Reserve regulations
pertaining to checks, but is instead a “source document” for an electronic
transaction that is subject to the Federal Reserve’s Regulation E (a regulation
promulgated as a result of the Electronic Fund Transfer Act of 1978). In a similar move (the second ACH
application), the ACH system developed the accounts-receivable check (ARC),
which is designed to transform checks to “source documents” as consumers mail
checks to lockboxes in payment of routine bills. That is, the customer is notified that the
check is an authorizing device allowing the payee to initiate a debit transfer
transaction through the ACH system.
Again, the legal status of the check changes, and the operative legal
and regulatory environment changes from UCC/Federal Reserve check rules to
Electronic Fund Transfer Act/Regulation E electronic transaction rules. The ARC application is available only 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
substantially. For the ARC transaction,
there were 5.3 million transactions in the third quarter of 2002, which grew to
43.7 million in the third quarter of 2003.
In the same period, the POP application grew from 28.7 million to 38.4
million. Another area for check
electronification is in returning checks (RCK) via the ACH system (the third
ACH application). That is, when a
customer pays with a check, he or she is notified that should the check be
returned for insufficient funds, the payee will initiate a debit transfer
through the ACH system to collect the amount.
In this case, the paper process has failed, and the payee has access to
faster and cheaper collection the second time around. This application has increased from 4.8
million transactions in the third quarter of 2002 to 5.8 million transactions
in the third quarter of 2003. Hence, the
ACH system has evolved to transform and process several new types of
application, all designed to replace the paper movement of physical checks with
The final step in electronification of checks—the second of
the two strands referred to above—is underway at the present time. Instead of piecemeal ACH applications for
point of sale or routine consumer bill payments, this step involves a complete
transformation of the processing of paper.
This is called the Check Truncation Act of 2003, which the president
signed on October 28, 2003. The
Expedited Funds Availability Act of 1987 had given the Federal Reserve the task
of making recommendations to improve the payments system—in effect, superseding
the UCC—and the Federal Reserve System proposed the check truncation
legislation.22 What is
envisioned here is the “truncation” of checks early in the process of physical
transportation. At that step, a digital
image of the check will move electronically through the process. This will eliminate the physical
transportation of checks and allow the images to be retrieved as needed by
customers to show evidence of having made payment.23 It is too early to know exactly how this
development will affect the number of checks processed and the channels through
which the images of checks will pass on the way to collection.
It is interesting to compare this development with some of
those in the European Union (EU). The EU
has moved to a single banking market and a single currency.24 While the large-value payment system in Euros
is connected seamlessly throughout the EU, this was not the case for
cross-border retail payments. However,
the EU and the European Central Bank (ECB) reasoned that the benefits of a
single, integrated, competitive banking market could not be achieved without an
efficient retail payment system in which cross-border payments would be made
with the same speed and fees as domestic payments. The EU and ECB encouraged the banks to
develop such a system. Since
developments did not proceed as rapidly as the EU and ECB wanted, the EU
enacted legislation requiring the banking industry to process cross-border
payments under the same terms as domestic payments. The industry responded by setting up a Single
European Payments Area concept that is similar to an ACH connecting the
domestic payment systems in all 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 complete the single market in banking, considers the benefits of the
credit transfer to be sufficient and therefore encourages these transfers while
ignoring the debit transfer.26
The Automated Clearing House (ACH) System
The ACH system is a batch-processing electronic payment
system for small-value payments. Unlike
the large-value payment systems (Fedwire and CHIPS), which process only credit
transfers, the ACH system processes both credit and debit transfer
payments. Financial institutions belong
to one of 29 regional associations and participate in the ACH system as either
originating depository financial institutions (ODFI) or receiving depository
financial 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 file of transfers,
delivers it to the ODFI, and the ODFI delivers 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 national association of depository
financial institution members, the National Automated Clearing House
Association (NACHA), which determines all the rules and regulations that govern
There are a number of laws that provide the legal and
regulatory framework for the ACH system.
For corporate transactions, the UCC is the operative law. The Check Truncation Act of 2003 has
implications for the ACH system as well.
For consumer transactions, the Electronic Fund Transfer Act of 1978 is
the operative law, and Federal Reserve Regulation E is the operative
regulation. In addition, the federal
government’s role in electronic payments is governed by federal law,
specifically 31 C.F.R. 31, Part 210.
According to the provisions of the EFT Expansion Act/Debt Collection
Improvement Act of 1996, the U.S. government has committed itself to using
electronic payments for all payments to employees, vendors, and recipients of
benefits. Moreover, federal tax
collections are migrating to electronic form as well. Most states are following the lead of the
federal government in this area.
According to NACHA, in December 2002 almost 19,500
depository financial institutions participated in the ACH system as RFDIs,
while approximately 8,000 participated as OFDIs.27
From 1992 to 2002, the volume of ACH transactions increased
at a double-digit percentage-rate change each year, going from 2.2 billion
transactions in 1992 to over 8.9 billion transactions in 2002, a compound
annual rate of growth of over 13.5 percent.
In contrast, the number of checks actually declined over the same
period. In the early days of the ACH, a
large proportion of the volume was attributable to government payments. In 1992, government transactions were 24
percent of the total, while in 2002 this declined to less than 10 percent. It is reported that 98 percent of federal
employees use direct deposit of payroll, while 80 percent of all Social
Security recipients use direct deposit of benefits. As noted above, electronic payment to vendors
is virtually mandatory. Thus, the
government is not likely to be a future source of major growth in volume.
One change in the types of applications for the ACH system
is the movement to nonrecurring transactions.
In the past, the ACH system developed applications for recurring
payments, such as direct deposit of payroll and benefits, and for recurring
debits for the same amount for payments such as mortgages, installment loans,
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 all 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 include the
point-of-purchase (POP) application discussed above, payments authorized over
the telephone (TEL), and payments initiated over the Internet (WEB). These are all transactions that require a
separate process each time a transaction is initiated. For many traditional applications, such as
direct deposit, the consumer enters into an agreement one time, and the process
is opaque to him or her. All that these
consumers know (when there are no problems) is that balances appear in their
accounts at certain times or that certain amounts are deducted at certain
times. The consumers themselves are
passive. In the newer applications, the
initiator is an active participant.
Since these are new applications, the growth rate for them is very high,
starting from a very low base.
Automatic Teller Machines (ATMs) and Payments
by Debit Cards
One of the first electronic banking applications was the
implementation of the ATM. It is
arguable as to whether this is really a payment system in the sense of the
other systems discussed here. That is,
the vast majority of transactions are cash withdrawals 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 development of this application there was
no network. However, this application
does allow the customer access to cash, which is a payment alternative, and in
that sense the banking system is allowing the customer to have efficient access
to using cash to make payments. Also,
use of the ATM allows the customer to economize on the use of currency, and
evidence indicates that customers therefore hold higher deposit balances than
otherwise would be the case.28
In the early days of the implementation of ATM programs,
there were questions as to whether these would be considered branch offices and
hence be regulated by the McFadden Act and the various state branching
laws. If they were, the deployment of
this new application could be limited.
However, in 1985 the U.S. Supreme Court upheld a circuit court ruling
that an ATM was not a branch. As a
result of this ruling and the popularity of the ATM with customers, especially
upscale consumers, the number of ATMs increased dramatically.29 As the deployment of ATMs continued, some
banks started networks that allowed customers of other banks to access their
accounts. This required someone, usually
a large bank at the outset, to operate a “switch” that would route transactions
among the various banks participating in the network. The basic idea was to enhance customer
convenience by expanding the locations at which access was available. In addition, networks allowed banks to take
advantage of scale economies in processing by increasing the potential number
of transactions per machine. Over time
these networks expanded and merged. This
trend has resulted in several large regional networks, a few national networks,
and a group of smaller networks. The
number of networks peaked at approximately 130 in the mid-1980s; now fewer 40 are
operating. Moreover, transaction volume
is concentrated in a small number of large networks. In 1985, the top three networks processed 11
percent of the transaction volume; in 2002 that percentage exceeded 100 percent
(some transactions are counted more than once, since they may travel over
several networks). As these networks
expanded, they negotiated reciprocity agreements with other networks,
effectively expanding the reach of any single customer’s ATM card. In addition, national networks can and do
serve as bridges between regional networks.
Most ATMs (over 98 percent) are part of shared networks, and as a result
of both reciprocity and bridging they are national (or international, in the
case of the Visa and MasterCard networks).30 The ownership structure of the networks has
changed dramatically also, 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
As a result of almost 25 years of development, the ATM
application is the most mature of electronic banking services. There are presently over 350,000 ATMs
deployed in the United States. The
proportion of off-premise ATMs has increased dramatically as banking offices
that are candidates for on-premise ATMs have been saturated. Also, as the cost of machines has declined
over the years, the break-even volume necessary to justify the investment cost
has declined. Hence, the number of
transactions has steadily increased while the number of transactions per
machine peaked in the early 1990s and has steadily declined since then.
As the ATM networks expanded, it became apparent that they
could be used for other transactions as well.
Thus, the ATM networks evolved into the point-of-sale (POS) networks
accessed by debit cards. Customers
became familiar with the process of accessing their accounts with a plastic
card through the ATM, and the use of the same cards and networks at the point
of sale evolved naturally. The customer
would access the network with a plastic card in a manner similar to the ATM,
would identify himself or herself with a personal identification number (PIN),
and funds could be deducted from the customer’s account. The only difference is that the funds were
not made available 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 virtual universal network coverage through reciprocity and
bridging, it was possible for the customer to make payment on-line at the point
of sale easily.
Debit card transactions have been growing rapidly. In 1979, they were virtually nonexistent,
whereas in 2000, 8.3 billion such transactions were recorded. When compared with general-purpose credit
cards, a much more mature product, the relative growth is striking. In 1995, there were 1.4 billion debit card
transactions and 7.8 billion general-purpose credit card transactions, whereas
in 2000 the comparable numbers were 8.3 billion and 12.3 billion. In 2000, debit cards accounted for 11.6
percent of all retail noncash payments, up from 2.2 percent in 1995. From 1995 to 2000, debit card transactions
grew at the fastest rate of all types of retail noncash payments (a 41.8
percent annual rate, compared with a 2.2 percent growth rate for all payments).31
Within the debit card industry, there are two types of
transactions. One is an on-line
transaction activated by a PIN at the point of sale, with immediate debiting of
the customer’s account and crediting of the merchant’s account. All this information travels over the same
networks as the ATM transactions, and there are fees involved for the merchant,
who is charged on a fee-per-transaction basis.
There are also point-of-sale transactions that are known as off-line,
signature-based transactions. In this case,
the information flows over the credit card networks managed by Visa or
MasterCard. In the on-line transaction,
there is a PIN to identify the cardholder, whereas in the off-line transaction
the merchant is responsible for verifying the identity of the cardholder. In the off-line transaction there is also a
delay in transferring the funds, and, most importantly, 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 generally larger in that case. For
that reason, the banks have discouraged the use of on-line debit transactions
in favor of the off-line debit card.
Merchants have opposed this. In
2003, a major court case involving Wal-Mart and Visa and MasterCard was
settled. In that case, the retailers
opposed the “honor-all-cards” rule that required any merchant accepting either
Visa or MasterCard credit cards to honor all their cards, including the
off-line debit cards. Wal-Mart wished to
honor the credit cards but not the off-line debit cards. The settlement—that merchants no longer have
to honor all cards—will probably affect the structure of fees over all of the
varying debit card networks and move volume to the PIN-based transactions.
Credit cards are the most mature electronic payments
product. Although individual retailers
had issued cards to their customers for many years, the general-purpose credit
card dates back to Diners Club in 1950.32 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 would have to carry only a single card to be able to
dine. It was assumed that businessmen
who customarily had business lunches and dinners would find this appealing and
that those restaurants that sought to attract their business would also find it
appealing. This resulted in the Diners
Club program. During the 1950s, a number
of banks tried to introduce bank credit cards without much success. Not until 1958 did American Express, Carte
Blanche, Chase Manhattan Bank, and Bank of America enter the field. In 1962, Chase Manhattan left the business
and American Express reportedly considered giving up its travel and
entertainment card. Not until 1966 did
Bank of America establish a franchise operation for its card, then known as
BankAmericard. Thus, a franchisee bank
could issue a credit card that could be used nationally (and eventually
internationally). BankAmerica Service
Corporation also established a network that allowed payments between banks
dealing with merchants and banks issuing the cards to consumers. This was quickly followed by a consortium of
banks that established the Interbank Card Association, which established
another network and bank card eventually known as MasterCard.33 In 1970, Bank of America spun off BankAmerica
Service Corporation to a (bank) member-based organization that eventually
became Visa USA. Thus, both MasterCard
and Visa USA basically offer a franchise to their members and manage the
interchange system, establishing the pricing of interchange services and the
rules and regulations governing these operations. There was a shaky start that saw huge losses
due to large-scale unsolicited issuance of cards in the late 1960s (a practice
that is now illegal); there was also a time when rampant inflation and high
interest rates made the bank credit card business unprofitable. However, the acceptance of bank credit cards
at the point of sale (which now includes a personal computer attached to the
Internet) became so widespread that it is difficult to imagine that this oldest
of the widely used electronic payment systems is less than 50 years old.
The legal and regulatory environment for the bank credit
card industry includes state law (mainly usury laws), federal consumer credit
law, and the outcome of court cases. The
maximum rate that a lender can charge for consumer credit is established on a
state-by-state basis. This became a
difficult problem for the industry when interest rates were very high, and in
some states legal maxima were less than banks’ cost of funds. In a landmark court decision in 1978, the
U.S. Supreme Court ruled that the lender’s location determined the operative
state usury ceiling no matter where the customer may live, even if the state in
which the customer lived had a lower usury ceiling. This gave incentive to large card issuers to
find a lender-friendly state in which to establish national operations. Several states, especially South Dakota and
Delaware, aggressively solicited such bank card operations. In the 1970s, Congress enacted a number of
consumer credit protection laws, at least partly as a response to the marketing
and other practices of the bank credit card industry. These laws include the Truth-in-Lending Act
of 1968, the Fair Credit Billing Act of 1974, the Equal Credit Opportunity Act
of 1974, the Fair Credit Reporting Act of 1971, the Fair Debt Collection
Practices Act of 1977, and the Electronic Fund Transfer Act of 1978. In addition, federal bankruptcy law affects
bank credit card operations.
There are now over 1.2 billion credit cards in the United
States. Of these, 551.9 million are
issued directly by retailers; the rest are bank credit cards or travel and
entertainment cards. The number of transactions
grew from 12.9 billion in 1997 to 17 billion in 2001, an annual growth rate of
5.78 percent. The proportion of retailer
card transactions for 2001 was 11 percent
of the total, down from 15 percent in 1997. The number of merchant locations at which
these cards may be used is over 13 million.
Summary of Recent Developments 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 slow. The different payment systems reflect the
development of competing networks with a variety of legal and regulatory
environments. The only common theme is
that payments are routed through an interbank system. There are also a variety of owners and
operators of the networks, including public bodies for checks and the ACH (the
Federal Reserve System), national membership organizations for open networks of
general-purpose bank credit cards (Visa and MasterCard), closed networks for
some general-purpose credit cards (American Express and Discover), and
proprietary (both bank and nonbank) organizations for ATM and PIN-based on-line
debit card networks. In general, 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
actually declined. In table 1, the
number of transactions for the various categories are shown for 1979, 1995, and
2000, the years for which accurate data are available.
Who uses electronic banking?
The answer is households, governments, and businesses.
A number of studies have examined the determinants of
household use of payment services. It
was found that the adoption process for new electronic banking services
followed a predictable pattern, one in which demographic factors including
income, wealth, education, and position in the life cycle (age) were
systematically associated with the adoption of new payment products and
services. In an early contribution,
Mandell found that credit card use was positively associated with income,
wealth, education, and age.34
In the 1980s, a study by Murphy and Rogers and two studies by Daniels
and Murphy found similar 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 all demographic groups.
Kenickell and Kwast examined the data in the 1995 Survey of Consumer
Finances and found that higher income and financial assets, and more years of
education were all positively correlated with use of electronic banking
services. Age is more complex because
older households are less likely to use electronic banking, all other factors
held constant, for almost all electronic banking services except direct
deposit—a correlation reflecting the very high acceptance of direct deposit by
Social Security recipients.36
Stavins analyzed the data from the 1998 Survey of Consumer Finances with
similar results.37 Using the
most recent Survey of Consumer Finances (2001), Mester showed that over 88
percent of households use some form of electronic payment instrument (ATM,
debit card, direct deposit, automatic bill 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 households, direct deposit rose from 46.8 percent
to 67.3 percent, and automatic bill paying rose from 21.8 percent to 40.3
percent. The most mature of applications,
the ATM, rose from 61.2 percent to 69.8 percent. In Mester’s findings all the previously
determined relationships between use and demographics remained, but the
penetration had increased substantially, as reflected in the data on the
dramatic increase in debit card transactions and the reduction in the number of
Governments and Businesses
As indicated above, in the United States all levels of
government have actively pursued the use of electronic banking in making and
receiving payments, including payments to employees, benefit recipients, and
vendors. This has been largely
successful, and the number of checks written by all levels of government has
declined. As noted above, government
payments through the ACH system have increased modestly in recent years,
indicating that for government this process is largely complete.
The business sector receives payments from households in
various ways. Households pay businesses
at the point of sale by cash, check, or debit or credit card. They pay businesses mostly by check in
response to invoices through the mail.
Businesses pay each other usually by check or through the ACH, and
increasingly businesses pay taxes through the ACH as well. There are no business databases comparable to
the Federal Reserve’s Survey of Consumer Finances. Hence, one has to seek indirect evidence from
numerous sources to determine business use of electronic banking. First, it is clear that retail businesses
find it necessary to accept debit or credit cards at the point of sale. Casual inspection of retail sites combined
with a reported total of point-of-sale terminals in excess of 13 million in the
United States is sufficient to indicate that businesses find it either
convenient and low cost, or a business necessity, to accept POS electronic
payments.39 The concept of
point of sale has been expanded to include the telephone and the Internet, and
the credit or debit card is the payment instrument of choice here.
NACHA publishes data about the types of transactions
processed through the ACH system. It is
possible to make reasonable assumptions about the source and destination of
many of these transactions and their use by businesses and governments. First, all direct deposits are considered
business or government payments to households.
This is one of the largest applications on the ACH system, with over 3.8
billion transactions in 2002. As
indicated in the 2001 Survey of Consumer Finance and reported by Mester (2003),
the direct deposit of payroll, Social Security, and other benefits, as well as
pension and dividend payments, has been very popular with consumers. As a result its growth from 2001 to 2002 was
only 4.7 percent, smaller than the double-digit-percentage increases in most
other electronic transactions. Direct
debits through the ACH involving recurring payments from consumers to
businesses were over 2.8 billion in 2002, a 10.08 percent increase from 2001. These two applications—direct deposits and direct
debits—usually represent recurring transactions.
Some of the other new ACH applications involve businesses in
transactions that are not recurring.
First, there is the point-of-purchase application in which a consumer
check is transformed from a negotiable instrument to a source document. This involves a consumer-to-business
transaction at the point of sale and is a direct substitute for either a debit
or a credit card transaction. Other
nonrecurring payment transactions from consumers to businesses include Internet
and telephone-initiated transactions.
Finally, a recent addition to the consumer-to-business electronic
transaction menu is the accounts-receivable application, in which a check
mailed to a lockbox is transformed at that point to a source document that is
processed through the ACH system. All
these applications have grown at very high rates.
Finally, within the ACH system there are various
business-to-business transactions. These
include trade payments as well as intracorporate payments designed to aggregate
cash balances from a number of banks into a single account that can be used to
efficiently make payments and invest surplus funds. These have grown at double-digit rates in
recent years, in excess of 12 percent from 2001 to 2002.40
Another way to gain some insight into business use of
electronic banking is to examine the findings of a number of surveys of
corporate use of cash management services.
For example, in 2002 Phoenix-Hecht conducted its annual Cash Management
Monitor and received responses from 1,665 corporations with annual sales in
excess of $100 million. One of the many
findings of the survey was that over 97 percent of large corporations and 92
percent of upper-middle-size corporations already used the ACH
extensively. Indeed, Phoenix-Hecht sees
little opportunity for expanded ACH volume in any application except
consumer-authorized debits. Another
interesting finding is the use of sweep accounts by over 75 percent of all
reporting corporations. Sweep accounts
allow daily movement of funds from demand deposit accounts into an overnight
repurchase agreement or money market mutual fund. This is important for corporate use of
electronic payment services. That is,
corporations move funds out of demand deposit accounts where explicit 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 lowest-cost payment services.41 Moreover, respondents indicated that imaging
technology and Internet applications were important areas being considered.42 Phoenix-Hecht also conducts a Middle Market
Monitor for companies with annual sales between $40 million and $100
million. 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 technology
applications. Middle-size companies also
used sweep products as well. In
summarizing the results of the middle-market company survey, Phoenix-Hecht
indicated that “although middle market companies typically use fewer cash
management products than large companies, as a group the middle market usage
‘profile’ is becoming more like that of the larger companies.”43 In a similar survey, Treasury Strategies,
Inc., asked 131 large corporations (less than $1 billion to $25 billion in
annual revenues) many questions about their treasury activities. While there were no specific questions on the
use of particular payment services, there was substantial emphasis among
respondents on streamlining operations, lowering costs, and aggressively using
technology to do so. Over 65 percent of
all respondents used treasury work stations, a process that implies intensive
management of all aspects of treasury operations, including adoption of
least-cost methods of making payments.44
While businesses, especially large and middle-market
businesses, are aggressively using electronic payment methods, they are still
involved in paper transactions. In a
recent Federal Reserve study, it was estimated that consumers were the largest
sector that wrote checks (50.9 percent of all checks written), and most of them
(almost 2/3 of all checks written) were sent to businesses.45 Businesses were the second largest writer of
checks (32.3 percent of the total), mostly to consumers and other
businesses. It would appear that the
best candidates for further business adoption of electronic payment products
would be check conversion or check truncation at the point at which checks are
remitted to businesses, in many cases a lockbox. Also, there is room for expansion of
electronic services to business-to-business payments. A recent study by the Association for
Financial Professionals indicates that while most respondents used the ACH for
payroll disbursements and cash concentration, payments to other businesses was
limited by a number of factors, the most important of which was internal lack
of integration of payments and accounting system technology.46
Check Writing and
An International Perspective
When the United States is compared with 13 other advanced
industrial nations in 2001, an interesting pattern emerges. When measures of electronic banking are
considered, the United States has a very high usage factor. For example, the United States has a large
number of ATMs compared with its population.
The average for the 13 countries is 875 ATMs per million inhabitants,
while in the United States there are 1,137 ATMs per million. The United States has more than the average
number of POS terminals that accept debit cards per inhabitant, more than the
average number of debit card transactions per inhabitant, more than the average
number of POS terminals 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 held by inhabitants.
However, the United States is still an outlier when it comes to check
writing. In 2001, there were 144.6
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 would 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 sale, and the large number of checks written indicates that
the number of cashless payment transactions per inhabitant in the United States
is much larger than in all other countries in this sample. There are 270.3 cashless payment instruments
used per inhabitant in the United States and more than 201.1 cashless payment
instruments used per inhabitant in France, the next highest.47 Hence, the key to adopting a higher
proportion of low cost transactions in the United States lies with reducing the
number of checks written, since the adoption of most electronic payments has
been successful, whether one examines trends or international comparisons.48
Pricing Payment Services
In the United States, there is a historical link between the
regulatory environment and the nature of pricing for payment services,
especially checks. For many years, banks
were prohibited from paying interest to demand deposit customers, and there was
a ceiling on what could be paid to customers with savings accounts or
certificates of deposit. As interest
rates in general rose in the post–World War II period, incentives were created
for banks to pay implicit interest on deposits in the form of reduced fees on
checking (perhaps all the way to no service charge), increased convenience
through the construction of branch offices in many locations, and other means
of convincing customers to keep funds on deposit when explicit interest payments
to these customers were either zero or below market. This led to a situation of cross-subsidies in
general and overuse of checks in particular.
Customers with high balances and fewer checks written were
cross-subsidizing those with low balances and many checks written. There were few if any incentives to limit
check writing.49 At the same
time, credit card pricing had created cross-subsidies as well. Credit card customers generate revenues for
card-issuing banks in three ways: first, they pay interest on unpaid balances;
second, they may pay an annual fee; and third, their transactions generate
interchange revenue. Since interest is
not charged to many customers who do not carry unpaid balances at the end of the
billing cycle, these customers do not pay directly for the costs they generate
by their credit card activity. In
addition, at the point of sale the customer is not charged a different price
for the goods or services depending on whether he or she chooses a low- 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
low-cost transaction, the bank has an incentive to have a card transaction
migrate to the bank credit card or the off-line debit card because the merchant
discount paid to the bank is higher.
Hence, there is no explicit pricing incentive for the customer to choose
the lowest-cost method of making payment.50
Although the regulation limiting interest payments on deposits was
removed in 1980, there is still a perceived preference on the part of consumers
for pricing arrangements that do not involve per-item charges for checks
written.51 In the Federal
Reserve payments project in 2002, it was noted that the number of checks
written per household has increased over time, while the government and the
business sector have made more progress in replacing checks with electronic
payments.52 There is indirect
evidence that pricing has an effect on decision making by business about checks
versus electronic payments. First, most
large and middle-size corporations actively manage their cash, and they invest
all deposits on a daily (overnight) basis, usually 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 compe titive rate on these balances, 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 tools. In addition,
Phoenix-Hecht conducts and publishes surveys on the prices of specific
transaction services,53 and the surveys of corporate cash management
practices indicate that annual reviews (including 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 proposals (RFPs) for banks offering cash
management services.54 As
indicated above, in their use of electronic banking services, middle-market
corporations resemble larger corporations as banks refine their offerings and
saturate the large corporate market.
This migration process to smaller firms will increase the use of
electronic banking for smaller 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
evidence that this would happen on the consumer side if explicit pricing were
somehow introduced? There is very
limited 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 Vale for Norway, a
country that implemented explicit per-item prices for a number of payment
instruments used at the point of sale.
The findings supported a strong substitution effect of electronic for
paper transactions at the point of sale.56
Banking Profitability and Regulatory Oversight
This review of the development of payment systems in the
United States indicates the following:
Banks will have to adapt their offerings and internal
back-office processing to reflect the changes underway, leading to greater use
of electronic banking by consumers.
Fortunately, although the process of change has recently accelerated,
the trends should not overwhelm the industry.
Since more electronic transactions are cheaper to process,
as is the conversion or truncation (or both) of checks, banks that do not
explicitly charge for transaction services on a per-item basis will see a
reduction in costs. For banks that have
explicit fees for each service (mainly banks that supply cash management
services), it will be necessary to ensure that the profit margins on the
electronic transaction services are commensurate with those on the paper
Since cross-subsidization and implicit pricing lead to
distortions, overuse of some services, and lack of transparency, there is no
justification for the remaining restriction on paying interest on demand
deposits. Interest is allowed for consumer
accounts, and large businesses have evaded the restriction by using sweep
accounts. The Federal Reserve should pay
interest on bank balances, and banks should not be restricted in paying
interest on any demand deposit account.
There has been and will continue to be consolidation in the
provision of cash management services to large corporations, but banks of all
sizes will be able to continue to serve their customers with a mix of
capabilities, including ATMs, on- and off-line debit cards, credit cards,
acting as receivers of ACH payments on behalf of their customers, and other
services. There should be no reason to
believe that these trends by themselves will have any substantial impact on the
market structure of the banking industry.
Bank regulators must concern themselves with operational
risk. The developments discussed in this
paper indicate that regulators must be aware of the risk implications of the
changes in payment systems and must adapt their approaches accordingly.
Regarding operational risk, one important aspect that must
be considered by bank regulators 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 regulated banks, the risk management
procedures of these firms may have significant implications for bank
Banks and bank regulators need to be concerned about the
market structure of the network providers, especially those for ATMs, debit
cards, and credit cards. Significant
consolidation among network providers has already occurred, and any further
concentration raises concerns about pricing, service quality, and product
innovation in this segment of the market, one in which bank regulators have no
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