As of October 28, when the federal Check Clearing for the 21st Century Act—known as Check 21—became effective, banks have the opportunity to process and settle checking transactions faster and more economically by using electronic check substitutes in their back-office operations, instead of traditional paper-based negotiable instruments. But even as one segment of the U.S. government clears the way for a voluntary system that may save banks billions of dollars each year in processing costs, an Emory University professor and other experts point out that another government entity, the Federal Reserve, may be wasting national resources by remaining involved in check processing, even though its services may in fact not be needed.

An Expanding Bureaucracy Refuses to Yield

“The Federal Reserve, like many other government organizations, enjoys expanding its power and has done so by cultivating a constituency made up of large banks that support it,” observes George J. Benston, a professor of finance, accounting and economics at Emory University’s Goizueta Business School. He previously co-authored a paper, with Florida State University professor of finance David B. Humphrey, for Banking Strategies magazine titled The Case for Downsizing the Fed. “In the process, the Fed has become involved in areas like banking that could perhaps be better served by the private sector. Check 21 is a prime example of this.”

Under a traditional paper-based processing system, checks are physically transported—often through a network of airplanes and trucks—from the institution to which they are deposited back to the bank that pays them. Although financial institutions for years have had the technology to process checks electronically and often used it within their own branches, it took the September 11, 2001 attacks— which disrupted check transport for many financial institutions from coast-to-coast—to spur federal legislation that paved the way for a national electronic processing system.

“The Federal Reserve payments processing operation was appropriate in an earlier era, when state laws prohibited banks from branching nationwide (and often within states), which made transfers of checks among banks in different states difficult,” explains Benston. “Fed involvement in check processing was also spurred by ‘non par checking,’ the practice by individual banks of clearing checks at a discount from face value. The Fed did away with non-par checking in 1913 and the Riegel-Neal Interstate Banking and Branching Efficiency Act of 1994 allowed banks to branch nationwide. Thus, these reasons for a federal government agency being in the check processing business no longer exist.”

He adds that electronic technology, particularly the systems used under Check 21, has made paper-based payments processing a “costly anachronism.” Although an argument could perhaps be made for preserving the Fed's role in handling large-value ($4 million or more) “Fedwire” transfer payments, where the integrity of the financial markets is at stake, he argues that the central bank's involvement in “more mundane” check processing and automated clearing house (ACH) activities could easily be handled by businesses.

Can Private Agencies Do A Better Job?

“Private interests have developed such innovations like credit cards, and have a track record with new electronic technology that’s better than that of the Federal Reserve,” says Benston. “Despite this, Fed representatives have objected to privatization, claiming it would disrupt the payments system, unreasonably impose higher prices for check services on small- and mid-size banks, and compromise the Fed's ability to conduct monetary policy. But the validity of those arguments is questionable.”

In fact, says Benston, the Fed’s foray into banking matters diverts it from its primary mission of controlling the money supply and interest rates.

Benston is not the only person who has called the Fed on the carpet about its involvement with the banking regulatory processes. In an essay titled The Case for Overhauling the Federal Reserve, Nobel Prize-winning economist Milton Friedman argued that the Fed should be stripped of its regulatory functions. Instead, he says, those activities could be instead combined with what he termed the “largely overlapping functions” of the FDIC (Federal Deposit Insurance Corporation) and the comptroller of the currency.

Such a combined agency should have no monetary powers, according to Friedman. Instead, it “might well include the operating functions of the Federal Reserve Banks, the monitoring of reserve requirements, issuance of currency, clearing of checks, reporting of data, and so forth.”

He adds that a separate monetary-control agency could be a “very small body, charged solely with determining the total quantity of high-powered money through open-market operations. Its function would be clear, highly visible, and subject to effective accountability.”

A similar point of view is voiced by Catherine England, the chair of the Accounting, Economics, and Finance Department in the School of Business Administration at Marymount University. In a paper written for the Cato Institute titled Regulatory Restructuring: Resolving The Fed’s Conflicting Roles, she argues that the Fed is not only the nation’s central bank, it is also the lender of last resort and a bank regulator, and it competes with banks in providing certain services (such as Automated Clearing House functions). “Many authors” she says, have argued that these multiple roles create conflicts of interest.

For example, she notes, “the Federal Reserve does not need the discount window (the location at the Federal Reserve where financial institutions go to borrow money) to provide liquidity to the financial system. More neutral open market operations can accomplish that function.”

In fact, she argues that the Fed’s use of the discount window to direct assistance to individual institutions or groups of institutions has produced “alarming” results. As evidence, England points to the results of a House Banking Committee inquiry that examined the period of January 1, 1985 and May 10, 1991. During that time, she says it was reported that “530 banks that borrowed from the Fed’s discount window had failed within three years of the onset of their borrowing. Of these 530 failed institutions, 437 had been able to borrow from the Fed despite having been assigned the lowest supervisory rating—CAMEL 5. The acronym for the five measures of bank health is Capital adequacy, Asset quality, Management, Earnings, and Liquidity. A CAMEL 1 institution is considered in good health while a CAMEL 5 institution is viewed as being in eminent danger of failing.

Quoting from reports in the study, England adds “Sixty percent of these institutions had loans amounting to $8.3 billion outstanding to the Fed at the time of their failure, and $7.9 billion of this total was extended to institutions with CAMEL 5 ratings. In the face of this evidence, it is difficult to believe that the Federal Reserve remains committed to lending only to solvent banks.”

Thus, she continues, it is “time to re-examine the role of the Fed in the bank regulatory process. The Fed’s most important contribution to financial stability is proper conduct of monetary policy. By removing the Fed from bank supervision and by closing the discount window, the Fed would be freed to focus its attention on monetary policy.”

Interestingly, from 1996 to 1997, the federal committee on the Federal Reserve in the Payments Mechanism did consider a series of issues that ranged from liquidation of the Fed's role and withdrawal from the payment system, to helping ensure “a future” with electronic payments as the norm. Known informally as “The Rivlin Committee,”—it was headed by Alice M. Rivlin, who was then Vice Chair, Board Of Governors Of The Federal Reserve System—the group issued a report in January 1998 that arrived at two general conclusions: “The Federal Reserve should remain a provider of both check collection and automated clearing house (ACH) services with the explicit goal of enhancing the efficiency, effectiveness and convenience of both systems, while ensuring access for all depository institutions,” and “The Federal Reserve should play a more active role, working closely and collaboratively with providers and users of the payments system, both to enhance the efficiency of check and ACH services and to help evolve strategies for moving to the next generation of payment instruments.”

Based on its latest activities, the Fed appears to be committed to those courses of action.

At a time when America’s faith in its monetary policy appears to have devolved to a single person, Fed Chairman Alan Greenspan, Emory’s Benston sees little chance for change in the Fed’s “aggressive” posture. And he says the nation as whole will lose out as a result.

“Back when Congress chartered the Federal Reserve System in 1913 and gave the Fed the authority to establish a national check-clearing system, banks faced significant government restrictions that prevented the market from establishing an effective, industry-run alternative. But today, the state of affairs can be compared to the communications market before the AT&T breakup,” suggests Benston. “When one company controlled the entire telephony system—under government decree—there was not a great deal of incentive to innovate. The real advances in technology and cost savings came about after the breakup and the introduction of competition. Under Greenspan, we’re not likely to see a retreat in the Fed’s deep involvement in the banking system. But perhaps things will be different under the next Fed chairman.”