The first question one might ask is, “Why is there a need to improve the U.S. payment system?” There has been a lot of talk of late about the need to improve the infrastructure of the U.S. Mostly this has referred to things like highways, bridges, railroads, aviation, and water treatment, all of which play an important role in fostering economic growth and development. I think we should also consider the U.S. payment system a critical part of the infrastructure of this country. A modern payment system is not a luxury. It is a necessary part of a vibrant economy.

I’m encouraged by the recent progress that we’ve made with the current effort [to improve our national payment system], and it is my own conviction that the prospects for achieving the goals we’ve set out are best realized by working together. The organizers of this conference used the right word in naming it. It is imperative that we modernize the payments system, and also that the Federal Reserve and the industry join together in this effort.

I want to identify some issues that are critical to our current responsibilities and will be important in defining an appropriate role in the future, with the most effective mix of responsibility and authority.
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First, the Fed has a very important role today, working in cooperation with bank supervisors and the SEC, in establishing the capital and other prudential safeguards that are applied on a consolidated basis to the institutions that are critical to the proper functioning of financial markets.
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Second, the Fed, as the financial system’s lender of last resort, should play an important role in the consolidated supervision of those institutions that have access to central bank liquidity and play a critical role in market functioning.
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Third, the Federal Reserve should be granted explicit responsibility and clear authority over systemically important payment and settlement systems, and the ability to continue to encourage broader improvements in the over-the-counter derivatives markets.
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Fourth, the Federal Reserve Board should have an important consultative role in judgments about official intervention where there is potential for systemic risk, as is currently the case for bank resolutions under FDICIA.
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And, finally, the responsibilities for market and financial stability that are accorded the Fed in current and any future legislation will require that the Fed adopt a more comprehensive approach to financial supervision and market oversight.
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These initiatives will take time, but we expect to see substantial progress over the next two quarters.

The Federal Reserve will continue to play an important role in fostering a smoothly functioning payments system that is safe, efficient, and accessible. We also need to be flexible in carrying out our traditional functions within the payments system--as a provider of payment services, regulator, and catalyst for change--in this rapidly changing environment.

What should we look for in models of payment activity? One important principle is embodied in William Baxter’s (1983) Dictum—that the issuance, use, clearing and settlement of a payment instrument is a service of joint benefit to the buyer and the seller and that service is provided jointly by all parties to clearing and settlement. As a result, a sound economic evaluation of alternative payment policies requires assessing the effect of those alternatives on the well-being of and costs incurred by all of the parties involved. Models that omit the parties for whom banks are clearing and settling payments — the “end-users” — will fail to satisfy Baxter’s Dictum, and will be potentially misleading.

I would like to explore an alternative central bank policy regime that involves no daylight credit at all. Under this regime, the Fed would automatically “sweep” the overnight excess reserve balances of banks into reverse repurchase agreements. Specifically, at the close of Fedwire ( 6:30 p.m.) we would sell them U.S. Treasury securities in exchange for all of their excess reserve balance. At the opening of Fedwire on “the following day” (actually 9:00 p.m. the same night) the transaction would be reversed; we would buy back the securities and credit their account for the purchase amount, plus interest. Upon initiation of the service, the Fed would conduct a large one-time open market purchase of securities during the day to start the program up with abundant daylight reserves. If the interest rate were set close to or at the target fed funds rate, this scheme would allow us to curtail daylight credit without imposing much cost on banks. For every dollar of daylight credit we withdraw, we could supply an additional dollar of daylight reserves via the initial open market purchase.

I want to emphasize that the national payments system of the United States has evolved through both private- and public-sector contributions. Both sectors have been involved in technological innovation and the development of payments infrastructure. In addition, the public sector has responded by addressing legal and other barriers that adversely affect the banking system. Together, private and public sectors have contributed to a more-efficient national payments system that facilitates greater commerce and innovation. Looking forward, market needs will ultimately shape the U.S. payments system and its direction. If the past is a guide, geography will continue to decline as an important factor in the national payments system just as it has in other areas of economic activity.

It appears our nation’s pattern of payments is finally evolving — some might say it is experiencing a radical change — from one based on paper checks to one based on electronics.

Changes in the payments structure have had, and will continue to have, profound effects on our physical infrastructure. It is expected that the Fed’s paper processing role will diminish as checks recede in both absolute volume and relative importance in the retail payments system. In the interim, however, the changes taking place in payments patterns are causing us to adapt and adjust to the market’s evolution.

Most experts expect that retail payments will continue moving away from cash and paper checks toward electronic instruments.

Given the current state of the payments system, the role of markets in achieving this outcome, and the limitations on a central body to address perceived problems, the Federal Reserve should be quite careful before intervening in these markets.

From a public policy perspective the payments system does not appear to be facing serious, fundamental problems. It largely does what it is supposed to do and does it well, and it seems able to adapt effectively to the changing needs of end users.

There is no doubt that payments system change continues apace. It is preferable from my perspective that such change be driven by market forces, and it appears that largely has been the case. Central bank intervention should be reserved for cases characterized by broad and compelling societal benefits.

My sense, however, is that there are far less by way of economies of scope than would be needed to justify, on economic efficiency grounds, the current scale of Federal Reserve service provision, particularly in clearing “retail” payments such as checks and ACH. In fact, I have argued elsewhere that the evidence suggests that the Fed’s role in clearing retail payments rests on altering the allocation of clearing costs that would result from purely private provision.

Overall, a more electronic payments system will benefit society and will help improve payments system efficiency...However, the payments industry will have to rely more heavily on key telecommunications networks and computing systems. Mitigating the risk associated with greater reliance on electronic processing is vital and should be a top priority for the payments industry.