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by R. Alton Gilbert
Federal Reserve Bank of St. Louis
My comments focus on the implications of new payment methods for the relationship between the government and providers of payment services. My views on this topic are my own, and not necessarily those of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
New payment methods which have been the focus of press coverage are stored value cards and electronic payments for households, including payment methods with information transmitted over the Internet. Stories about these payment arrangements tend to focus on the technology--how systems work or might work in the future. Details of the technology are important for government efforts to prosecute illegal activities and to limit tax evasion. Development of these new payment arrangements raises this question: Will they undermine the efforts of the government in law enforcement that rely on banks reporting large deposits or withdrawals of currency and maintaining records of wire transfers of funds?
My comments deal with other aspects of government policy: monetary policy, and supervision and regulation of the providers of payment services to ensure a safe payment system. For these aspects of government policy, details of the technology are less important than for law enforcement.
Monetary Policy
Implications of the new payment arrangements for the conduct of monetary policy depend on whether the central bank targets on monetary aggregates. If so, the central bank will want information from new providers of payment services on their outstanding liabilities used for making payments. It is not necessary to supervise and regulate providers of payment services to get this information. For instance, the Federal Reserve obtains information for calculating the monetary aggregates from nonbank issuers of travelers checks and from money market mutual funds.
Information about the activities of new providers of payments services is not important for the conduct of monetary policy if the central bank targets on interest rates. Thus, the implications of new payment arrangements for the conduct of monetary policy are rather trivial.
Supervision, Regulation and the Discount Window
Implications of new monetary arrangements for supervision and regulation may be more significant. Since financial institutions are subject to various forms of regulation, it is necessary to define what I mean by supervision and regulation:
1. Supervisors restrict the types of assets in which firms under their jurisdiction may invest.
2. Through examinations supervisors assess the quality of the firms' assets and the capacity of their managers to manage risk.
3. Supervisors have authority to require changes in the behavior of firms, including authority to require them to increase their capital or cease operations.
Some of the firms entering the payments industry by offering new types of services are not banks. Should these new providers of payment services be supervised and regulated as banks? Is it important, for preserving stability of the payment system, that they be granted access to the discount window? An argument for exempting these firms from supervision and regulation, and denying access to the discount window, is that market forces will ensure stability of the payment system. The market discipline argument rests on the following assumptions:
1. Market discipline will force the nonbank providers of payment services to hold adequate cash balances to satisfy the demands of their customers to cash out of their payment systems.
2. These nonbank firms will arrange credit lines with banks to guarantee that they always have enough cash to meet their commitments. The banks offering credit lines will impose market discipline on the activities of these firms.
3. If these nonbank firms invest some of the cash provided by their customers in earning assets, they will select high quality earning assets, to maintain the confidence of their customers.
4. Failure of one nonbank provider of payment services would not undermine customer confidence in the other nonbank providers. Customers of these firms would be able to distinguish accurately among the payment providers on the basis of the risk they assume.
Is there evidence to support these assumptions? Such evidence must be derived from periods with a variety of experience with payment system stability and a variety of relationships among providers of payment services. The relevant period in the history of banking in the United States is that prior to formation of the Federal Reserve System in 1914. While payments technology has changed since 1914, the issues involving the determinants of a stable payment system remain the same.
Major institutions in this history are clearinghouses, which functioned somewhat like central banks. Banks formed clearinghouses for efficient clearing and settlement of payments. Operation of clearinghouses required a great deal of cooperation among their member banks, especially during periods of financial crises. Clearinghouses engaged in activities similar to supervision and regulation of their member banks, to ensure that the financial condition of each member warranted support during a financial crisis (see Gorton and Mullineaux 1987).
During occasional financial crises, bank customers attempted to withdraw their deposits in the form of currency. Banks attempted to cope with these large cash withdrawals through mutual support coordinated through their clearinghouses. Banks loaned their cash reserves to the clearinghouse member banks experiencing the greatest difficulty coping with depositor withdrawals. Clearinghouses created special certificates during crisis periods (called loan certificates) that the members agreed to accept in settlement through their clearinghouses. This arrangement freed banks to use their cash reserves to meet the demands of depositors, rather than holding inventories of reserves for settlement at the clearinghouse. The discount window of the Federal Reserve was modelled after these actions of clearinghouses during banking panics. Clearinghouses were effective in limiting the effects of bank runs during some banking panics. On other occasions, actions of the clearinghouses were not adequate to deal with panics, and banks resorted to suspension of cash payments to their depositors.
To understand why banks attempted to deal with panics through cooperative actions, it is necessary to understand the conflict between the interest of banks as individual organizations and banks as a group during a crisis. The best actions for an individual bank would be to meet the liquidity needs of its customers while keeping its cash reserves as high as possible, and refuse to lend to other banks. Loss of public confidence in a competing bank might drive the bank out of business. Actions by individual banks to guard their own cash reserves, however, would make the crisis worse. It is in the interest of banks as a group, in contrast, that each use its cash reserves to meet the demands of its depositors and lend to the banks having the greatest difficulty meeting the demands of their customers. Through such actions banks might be able to restore confidence of the depositors at all banks in the community.
I draw the following conclusions from this history:
1. Banks are vulnerable to runs by their depositors. Runs by depositors on some banks tended to undermine the confidence of the depositors of other banks.
2. Behavior of banks during periods of widespread runs by depositors indicates that banks found cooperative actions to be more effective than reliance on market mechanisms in dealing with such financial crises (see Dwyer and Gilbert 1989).
3. Such cooperation was more effective in dealing with crises if all providers of payment services were members of the organization that coordinated the activities of banks (see Tallman and Moen 1995).
4. Speed of actions by clearinghouses in dealing with panics was essential to success. Government sanction made such actions more effective (see Roberds 1995).
5. Conflicts of interest among banks as competitors may have limited the effectiveness of such private actions in dealing with financial crises (see Goodhart 1985).
Banking history does not support the assumptions that underlie the argument for exempting nonbank providers of payment services from government supervision and regulation. These five lessons from history indicate that a central authority is necessary to deal with disruptions in the operation of the payment system that could result from banking panics. The central authority should have jurisdiction over all providers of payment services: authority to supervise and regulate, and responsibility to provide support in a crisis. To deal with conflicts of interest among private firms, that central authority should be a government agency.
Implications for the Future
In our financial system the Federal Reserve is the organization established by the government to deal with financial crises. I conclude from examination of U.S. banking history that all firms which offer liabilities used by the public for making payments should be required to obtain banking charters. They would be supervised and regulated as banks, and have access to the discount window to help them deal with occasional liquidity problems.
I do not think that it is necessary to apply this prescription at this time to all such firms. There is a lot of research and development in the payment system at this time, and the dollar amounts of payments settled through the new arrangements are small. I think that the government should limit its actions that would discourage this research and development. The new payment services discussed in the press might become important elements of our payment system, or they might fail to attract the interest of substantial numbers of consumers.
While I don't know the outcome of these experiments, I can predict the nature of the relationship between the government and providers of payment services in the future. The firms whose liabilities are used for making payments will have bank charters, will be supervised and regulated as banks by government agencies, and will have access to the discount window. We may get to this future through deliberate planning, or through some future crises in the operation of new entrants to the payments business. History has many examples of crises in the operation of firms that provide payment services that led to changes in the relationship between the government and providers of payment services. The challenge for government policy involves choosing a path to this future that facilitates innovation while limiting the potential trauma for those who begin using the new arrangements for making payments.
References
Dwyer, G.P., Jr., and Gilbert, R.A. (1989) “Bank Runs and Private Remedies.” Federal Reserve Bank of St. Louis Review (May/June): 43-61.
Goodhart, C. (1985) The Evolution of Central Banks: A Natural Development? London: London School of Economics and Political Science.
Gorton, G., and Mullineaux, D. (1987) “The Joint Production of Confidence: Endogenous Regulation and Nineteenth Century Commercial-Bank Clearinghouses.” Journal of Money, Credit and Banking (November): 457-68.
Roberds, W. (1995) “Financial Crises and the Payments System: Lessons from the National Banking Era.” Federal Reserve Bank of Atlanta Economic Review (May/June): 15-31.
Tallman, E.W., and Moen, J. (1995) “Private Sector Responses to the Panic of 1907: A Comparison of New York and Chicago.” Federal Reserve Bank Atlanta Economic Review (March/April): 1-9.
Prepared for the Cato Institute's 14th Annual Monetary Conference, May 23, 1996, Washington, D.C.