GAO-16-614 Accessible Version, PAYMENT SERVICES: Federal Reserve's Competition with Other Providers Benefits Customers, but Additional Reviews Could Increase Assurance of Cost Accuracy

Accessible Version

PAYMENTSERVICES

FederalReserve’s

Competitionwith

OtherProviders

BenefitsCustomers,

butAdditional

ReviewsCould

IncreaseAssuranceof

CostAccuracy

ReporttotheChairman,Committeeon

FinancialServices,Houseof

Representatives

August 2016

GAO-16-614

United States Government Accountability Office

Highlights of GAO-16-614, a report to the

Chairman, Committee on Financial Services,

House of Representatives

August 2016

PAYMENT SERVICES

Federal Reserve’s Competition with Other Providers

Benefits Customers, but Additional Reviews Could

Increase Assurance of Cost Accuracy

Why GAO Did This Study

Federal Reserve Banks compete with

private-sector entities to provide

services while Federal Reserve Board

staff also supervise the Reserve Banks

and other service providers and

financial institution users of these

services. The Monetary Control Act

requires the Federal Reserve to

establish fees for its services on the

basis of costs, including certain

imputed private-sector costs. GAO was

asked to review issues regarding the

Federal Reserve’s role in providing

payment services. Among other

objectives, GAO examined (1) how

well the Federal Reserve calculates

and recovers its costs, (2) the effect of

the Federal Reserve on competition in

the market, and (3) market participant

views on the Federal Reserve’s role in

the payments system.

GAO analyzed cost and price data

trends; reviewed laws, regulations, and

guidance related to Federal Reserve

oversight and provision of payment

services; and interviewed Federal

Reserve officials, relevant trade

associations, randomly selected

payment service providers, customer

financial institutions, and other market

participants.

What GAO Recommends

GAO recommends that the Federal

Reserve consider ways to incorporate,

where appropriate, additional costs

faced by private-sector competitors in

its simulated cost recoveries and

periodically obtain an external audit

that tests the accuracy of the methods

it uses to capture and simulate its

costs. The Federal Reserve noted

steps they will take to address GAO’s

recommendations.

What GAO Found

The Federal Reserve Banks are authorized to provide payment services—such

as check clearing and wire transfers—to ensure continuous and equitable access

to all institutions. The Depository Institutions Deregulation and Monetary Control

Act of 1980 (Monetary Control Act) requires the Federal Reserve to establish

prices for its payment services on the basis of the costs incurred in providing the

services and give due regard to competitive factors and the provision of an

adequate level of services nationwide. GAO found the Federal Reserve had a

detailed cost accounting system for capturing these costs that generally aligned

with federal cost accounting standards. Although this system was evaluated and

found effective by a public accounting firm in the 1980s, it has not undergone a

detailed independent evaluation since then. In addition to the actual costs it

incurs in providing services, the Federal Reserve also must include an allocation

of imputed costs which takes into account the taxes that would have been paid

and the return on capital that would have been provided if the services had been

furnished by a private firm. Although its processes for simulating the imputed

costs generally were reasonable, the Federal Reserve did not impute certain

compliance costs private-sector firms can face—such as for planning for

recovery and orderly wind down after financial or other difficulties. Including

additional simulated costs competitors can incur and obtaining periodic external

evaluations of its cost accounting practices would provide greater assurance that

the Federal Reserve fully includes appropriate costs when pricing its services.

Since the mid-2000s, the effects of Federal Reserve participation in the payment

services market have included lower prices for many customers; overall market

share for competitors also increased. Although some competitors raised

concerns about some Federal Reserve pricing practices, customers GAO

interviewed generally were satisfied with its services and prices. The Federal

Reserve also has a process for assessing its pricing and products to help ensure

it is not unfairly leveraging any legal advantages. Since 2005, the Federal

Reserve lowered prices for checks and smaller electronic payments while

increasing prices for wire transfers. During this time, private-sector competitors’

market share expanded overall. But the Federal Reserve’s only competitor in

small electronic payments and wire transfers told GAO that increased regulatory

costs and competitive pressure from the Federal Reserve creates difficulties for

the long-term viability of private-sector operators.

Most market participants GAO interviewed were satisfied with how the Federal

Reserve performed various regulatory and service provider roles in the payments

system. Most of the 24 participants GAO interviewed had no concerns over how

the Federal Reserve separated its supervisory activities from its payment

services activities. The Federal Reserve also has begun collaborating with

market participants to pursue improvements to the safety, speed, and efficiency

of the payment system. Although some competitors said the Federal Reserve

should reduce its payment services role, many participants supported having the

Federal Reserve remain an active provider. Federal Reserve staff indicated that

these activities provide the Federal Reserve with sufficient revenue to enable it to

provide ubiquitous access at affordable prices.

View GAO-16-614. For more information,

contact Lawrance Evans at (202) 512-8678 or

[email protected].

Letter 1

Page i GAO-16-614 Payment System Competition

Background 3

Federal Reserve Has Processes in Place to Comply with Cost

Recovery Requirements 16

While Some Competitors Expressed Concerns about Some

Federal Reserve Payment Service Practices, Users Appeared

to Benefit 34

Market Participants Generally Viewed the Federal Reserve as

Managing Potential Payment Services Conflicts 51

Market Participants Generally Support a Continued Role for the

Federal Reserve in the Payments System 57

Conclusions 64

Recommendations for Executive Action 64

Agency Comments, Third-Party Views, and Our Evaluation 65

Appendix I: Objectives, Scope, and Methodology 67

Appendix II: Federal Reserve Payment Services Cost Accounting 72

Appendix III: Private Sector Adjustment Factor (PSAF) Methodology 75

Appendix IV: Competitive Impact Assessment Process 79

Appendix V: Comments from the Federal Reserve 83

Appendix VI: GAO Contact and Staff Acknowledgments 86

Appendix VII: Accessible Data 87

Agency Comment Letter 87

Data Tables 90

Tables

Table 1: Annual Cost Recovery Percentages for the Federal

Reserve, by Payment Service Type, 2007—2015

(percentage) 30

Table 2: 2014 Federal Reserve Payment Services Direct and

Indirect Costs (in Dollars) 73

Table 3: Component Expenses Calculated by the Federal

Reserve’s Private-Sector Adjustment Factor (PSAF) in

2015 and 2016, dollars in millions 77

Contents

Data Table for Figure 4: U.S. Noncash Payments by Transaction

Type, 2000–2012 90

Data Table for Figure 5: Rolling 10-year Average Cost Recovery

Rates for Federal Reserve Payment Services, 1996-2015

(percentage) 91

Data Table for Figure 6: Federal Reserve Revenues by Payment

Service, 2005–2014 (2015 Dollars in Millions) 91

Data Table for Figure 7: Market Shares (Based on Dollar Volume)

of Federal Reserve and Private-Sector Providers in

Check, Automated Clearing House (ACH), and Wire

Transfer Payments, 2001–2013 91

Figures

Page ii GAO-16-614 Payment System Competition

Figure 1: Steps Involved in a Typical Check Payment in the United

States 6

Figure 2: Steps Involved in a Typical Wire Transfer Payment in the

United States 8

Figure 3: Example of Steps Involved in an Automated Clearing

House Payment from a Business to an Individual in the

United States 10

Figure 4: U.S. Noncash Payments by Transaction Type, 2000–

2012 15

Figure 5: Rolling 10-year Average Cost Recovery Rates for

Federal Reserve Payment Services, 1996-2015

(percentage) 29

Figure 6: Federal Reserve Revenues by Payment Service, 2005–

2014 (2015 Dollars in Millions) 31

Figure 7: Market Shares (Based on Dollar Volume) of Federal

Reserve and Private-Sector Providers in Check,

Automated Clearing House (ACH), and Wire Transfer

Payments, 2001–2013 47

Page iii GAO-16-614 Payment System Competition

Abbreviations

ACH Automated Clearing House

Board Board of Governors of the Federal Reserve System

Check 21 Check Clearing for the 21st Century Act of 2003

CHIPS Clearing House Interbank Payment Service

ECCHO Electronic Check Clearing House Organization

Federal Reserve Federal Reserve System

PACS Planning and Control System

PSAF private-sector adjustment factor

Reserve Banks Federal Reserve Banks

TCH The Clearing House Payments Company L.L.C.

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Page 1 GAO-16-614 Payment System Competition

441 G St. N.W.

Washington, DC 20548

August 30, 2016

The Honorable Jeb Hensarling

Chairman

Committee on Financial Services

House of Representatives

Dear Mr. Chairman:

With the value of checks and electronic payment transfers exceeding a

quadrillion dollars in 2015, a reliable and efficient payments system is

essential for the economic stability of the United States. The Board of

Governors (Board) and the 12 Federal Reserve Banks of the Federal

Reserve System (Federal Reserve) play multiple roles in the payments

system, including functioning as the nation’s central bank, supervising

financial institutions, and providing payment services to market

participants. The Reserve Banks offer a range of payment services to

depository institutions and the federal government, including collecting

checks; electronically transferring funds; issuing, transferring, and

redeeming U.S. government securities; distributing and receiving

currency and coin; and maintaining accounts for reserve and clearing

balances.

The Board oversees the operations of the Reserve Banks and

serves as a regulator of certain aspects of payment services in the United

States. As part of its oversight, the Board issues regulations that apply to

the payment services activities of the Reserve Banks and the private-

sector entities that compete with them. Where these roles potentially

overlap or conflict, the Federal Reserve faces the challenge of managing

or separating the roles in ways that help ensure it fulfills each role without

exerting undue influence or giving itself an advantage at the expense of

As the nation’s central bank, one of the Federal Reserve’s tools for conducting monetary

policy is the setting of reserve requirements that mandate that all depository institutions

hold a percentage of certain types of deposits as reserves in the form of vault cash, as a

deposit in the institution’s account at a Federal Reserve Bank, or as a deposit in a pass-

through account at a correspondent institution (one that provides check clearing and other

services for other institutions). See 12 U.S.C. §§ 248, 461; 12 C.F.R. § 204.5(a), (d). More

than 6,000 U.S. depository institutions maintain a Federal Reserve account at the Reserve

Bank in their district and about 1,900 of these account holders maintain balances for the

purposes of satisfying reserve requirements on behalf of themselves or other depository

institutions, and these accounts also can be used to settle payments.

Letter

the banking industry or its private-sector competitors in providing payment

services.

In 2000, we reviewed the potential conflicts of interest posed by the

Federal Reserve’s operation of a payment system that competes with

private-sector systems operated and owned by institutions that the

Federal Reserve also supervises.

Page 2 GAO-16-614 Payment System Competition

We found no evidence to suggest that

the Federal Reserve had not adequately separated its multiple roles in

the payments system. However, the overall U.S. payments system has

evolved since our 2000 report. Technology has dramatically changed

many aspects of the payments process, notably in the transition from the

use and settlement of paper checks to electronic payments. In addition,

the Federal Reserve has begun publicly exploring how the United States

can develop a near real-time payment system to facilitate payments

between individuals and businesses as several other countries are

moving to. When Congress mandated that the Reserve Banks offer

payment services to nonmember depository institutions on terms

comparable to those for member banks, it also required that the Banks

publish prices for these services that were established over the long run

on the basis of all the direct and indirect costs actually incurred in

providing the services, including certain imputed costs that would have

been incurred if the services had been furnished by a private firm.

You asked us to update our 2000 report and in particular, review the

Federal Reserve’s management of its potential conflicts of interest in the

U.S. payments system, including issues relating to the costs and pricing

of its services. This report examines (1) how effectively the Federal

Reserve captures and recovers its payment services costs; (2) the effect

of the Federal Reserve’s practices on competition in the payment

services market; (3) how the Federal Reserve mitigates the inherent

conflicts posed by its various roles in the payments system; and (4)

market participant viewpoints on the future role of the Federal Reserve in

the payments system. This report focuses on three payment system

products offered by the Federal Reserve—check clearing, electronic

payments known as Automated Clearing House (ACH) payments, and

wire transfer payments—because these are the services in which the

Federal Reserve primarily competes with private-sector entities.

GAO, Federal Reserve System: Mandated Report on Potential Conflicts of Interest,

GAO-01-160 (Washington, D.C.: Nov. 13, 2000).

To address these objectives, we analyzed data on the reported costs and

revenues of Federal Reserve payment services from 1996 to 2015 and

how pricing and fee structures for the services had changed over this

period. We took steps to assess the reliability of these data and

determined they were sufficiently reliable for our analysis. Although we

analyzed the processes by which the Federal Reserve accounts for its

reported costs and revenues, we did not include detailed testing of the

Federal Reserve’s cost accounting controls related to its priced services

activities. We reviewed relevant legislation and Federal Reserve policies,

regulations, and guidance relevant to payment services activities. We

reviewed audits that external and internal audit organizations performed

of Federal Reserve payment system costs and activities. We also

reviewed the Federal Reserve’s policies that outline the criteria it would

consider before offering a new payment service. We interviewed Board

and Reserve Bank staff and 34 market participants, including financial

trade associations whose members participate in payment systems and

issue rules governing payment system activities; payment services

providers, including those that compete with the Federal Reserve; and

banks and credit unions that were end users of payments systems

services from other private-sector providers and the Federal Reserve.

The sample of banks and the sample of credit unions we interviewed

were both composed of a nonprobability stratified sample based on tiers

by asset size, including interviewing the five largest banks and randomly

selecting a number of banks from the large, mid-sized, and smaller tiered

banks. For credit unions we randomly selected institutions from larger and

from smaller credit unions. We also interviewed both financial institution

and nonbank entities that provided competing payments services

randomly selected within type of institution. We also interviewed staff from

the Department of Justice about competition issues. For more information

on our methodology, see appendix I.

We conducted this performance audit from November 2014 to August

2016 in accordance with generally accepted government auditing

standards. Those standards require that we plan and perform the audit to

obtain sufficient, appropriate evidence to provide a reasonable basis for

our findings and conclusions based on our audit objectives. We believe

that the evidence obtained provides a reasonable basis for our findings

and conclusions based on our audit objectives.

The Federal Reserve has long had a role in the U.S. payments system.

One of the major impetuses for the creation of the Federal Reserve was

to reduce the potential for disruptions in payments that periodically

Page 3 GAO-16-614 Payment System Competition

Background

occurred in the United States. During a financial crisis in 1907 stemming

from losses arising from the San Francisco fire and the failure of the

Knickerbocker Trust in New York City, payments were largely suspended

throughout the country because many banks and clearinghouses, which

served as centralized locations for banks to exchange checks for clearing,

refused to clear checks drawn on certain banks. These refusals led to

liquidity problems in the banking sector and the failure of otherwise

solvent banks, which exacerbated the impact of the crisis on businesses

and individuals.

With the passage of the Federal Reserve Act, Congress established the

Federal Reserve in 1913 in part as a response to these events.

Page 4 GAO-16-614 Payment System Competition

The

Federal Reserve Act also directed the Federal Reserve to supply

currency in the quantities demanded by the public and gave it the

authority to establish a national check-clearing system. Previously, some

paying banks (on which checks had been drawn) had refused to pay the

full amount of checks (nonpar collection) and some had been charging

other fees to the banks presenting checks to be paid. To avoid paying

these presentment fees, many presenting banks routed checks to banks

that were not charged presentment fees by paying banks. This circuitous

routing resulted in extensive delays and inefficiencies in the check-

collection system. In 1917, Congress amended the Federal Reserve Act

to prohibit banks from charging the Reserve Banks presentment fees and

to authorize nonmember banks as well as member banks to collect

checks through the Federal Reserve System.

As the nation’s central bank, the Federal Reserve manages U.S.

monetary policy, supervises certain participants in the banking system,

and serves as the lender of last resort. The Federal Reserve System

consists of the Board of Governors in Washington, D.C., and 12 Reserve

Banks with 24 branches located in 12 districts across the nation. The

Board is a federal agency, and the Reserve Banks are federally chartered

and organized like private corporations each with a board of directors and

with their shares owned by their member banks. The Board is responsible

for maintaining the stability of financial markets, supervising banks that

are members of the Federal Reserve and bank and savings and loan

holding companies, and overseeing the operations of the Reserve Banks.

Federal Reserve Act, Pub. L. No. 63-43, 38 Stat. 251 (1913).

Pub. L. No. 65-25, 40 Stat. 232 (1917).

The Board has delegated some of these responsibilities to the Reserve

Banks, which also provide payment services to depository institutions and

government agencies. As a result, the Federal Reserve has dual roles as

both payment systems operator and as a regulator of payment system

participants.

The role of the Federal Reserve Banks as a provider of several payment

services in the United States contrasts with that of the central banks of

other countries. According to a study by the Bank for International

Settlements, which provides services to other central banks, of the 13

foreign jurisdictions examined, central banks in 11 operated large value

payment transfer systems—as the Reserve Banks do—but only 2 central

banks (those in Belgium and Germany)—also operated check-clearing

and electronic retail payment networks.

Page 5 GAO-16-614 Payment System Competition

To improve the functioning of check services, Congress instituted a par-

value (face value) check collection service to simplify the check-clearing

process in the Federal Reserve Act, and gave the Federal Reserve

operational (through the Reserve Banks) and regulatory (through the

Board) roles in check collection. Interbank checks are cleared and settled

through a check-collection process that includes presentment and final

settlement.

Presentment occurs when checks are delivered by the bank

that received them—which currently almost exclusively involves

transmission of electronic images—to paying banks for payment. The

checks may be sent either directly to the paying bank or through another

entity—either another bank, a check clearinghouse, or a correspondent

bank—that would ultimately deliver them to the paying banks (see fig. 1).

The paying banks then decide to honor or return the checks. Settlement

ultimately occurs when collecting banks are credited and paying banks

debited, usually through accounts held at a Reserve Bank or at

correspondent banks that provide check clearing and other services for

other institutions. As part of its role in regulating check collection, the

See Bank for International Settlements, Committee on Payment and Settlement Systems

of the Group of Ten Countries, Payment and Settlement Systems in Selected Countries,

(Basel, Switzerland, April 2003). The 13 foreign jurisdictions reviewed were those in

Belgium, Canada, the Euro area, France, Germany, Hong Kong, Italy, Japan,

Netherlands, Singapore, Sweden, Switzerland, and the United Kingdom.

Interbank checks are those in which the bank of first deposit and the paying bank are

different. “On-us” checks are deposited or cashed at the same bank on which they are

drawn.

Federal Reserve Board promulgated regulations that govern various

aspects of these processes, including Regulation CC (which covers how

quickly banks must make funds from checks and other deposits available

for withdrawal and governs aspects of interbank check collection and

return), and Regulation J (which covers how institutions can collect and

return checks and other items through the Reserve Banks).

Page 6 GAO-16-614 Payment System Competition

Figure 1: Steps Involved in a Typical Check Payment in the United States

For Regulation CC, see 12 C.F.R. pt. 229. Section 1086 of the Dodd-Frank Wall Street

Reform and Consumer Protection Act amended the Expedited Funds Availability Act to

make the Board’s authority for the EFA Act’s provisions implemented in Subpart B of

Regulation CC joint with the Consumer Financial Protection Bureau. Pub. L. No. 111-203,

§ 1086, 124 Stat. 1376, 2085 (2010). For Regulation J, see 12 C.F.R. pt. 210.

To facilitate electronic check processing, some banks can create an

electronic image of a paper check at their branches, while others

transport the paper to centralized locations where the paper is imaged.

Page 7 GAO-16-614 Payment System Competition

After imaging, an image cash letter is assembled and sent directly to a

paying bank, an intermediary bank, or to a collecting bank (such as a

Reserve Bank or a correspondent bank) or to an image exchange

processor for eventual presentment to the paying bank. The Reserve

Banks offer imaged check products—FedForward, FedReceipt, and

FedReturn—for a fee to banks that use its check collection services to

present checks for payment at other institutions.

Similarly, other entities

that offer check-clearing services charge fees or use other mechanisms

to obtain compensation for such services, or institutions may not charge

each other when directly exchanging images.

The Fedwire Funds Service (Fedwire), the Federal Reserve’s wire

payments service, began in 1918 as a funds transfer service and initially

used Western Union’s telegraph lines to transmit payments.

The current

Fedwire network provides a real-time gross settlement system in which

about 6,000 participants can initiate electronic funds transfers that are

immediate, final, and irrevocable. Depository institutions and others that

maintain an account with a Reserve Bank can use the service to send

payments directly to, or receive payments from, other participants.

Depository institutions also can use a correspondent relationship with a

Some check images are created by bank customers through a process called remote

deposit capture.

According to Federal Reserve staff, FedForward is a Reserve Bank service in which

checks are deposited with a Reserve Bank and presented for collection either as

substitute checks or electronically using image cash letters. (A cash letter is a group of

checks packaged and sent by one bank to another bank, clearinghouse, or a Reserve

Bank office. A cash letter is accompanied by a list containing the dollar amount of each

check, the total amount of the checks, and the number of checks sent with the cash letter.)

FedReceipt is a Reserve Bank service in which a paying bank agrees to permit the

Reserve Banks to present checks to it electronically. FedReturn is a Reserve Bank service

that permits paying banks to return checks to depository banks by sending image cash

letters to the Reserve Banks, which will return the checks in image cash letters or as

substitute checks to the depository banks.

In addition to the Fedwire Funds service, the Reserve Banks also provide the Fedwire

Securities Service, a securities settlement system that enables participants to hold,

maintain, and transfer eligible securities, including those issued by the U.S. Department of

the Treasury, other federal agencies, government-sponsored enterprises, and certain

international organizations, such as the World Bank. Securities are held and transferred in

book-entry form. This report will refer to the Fedwire Funds service as Fedwire.

Fedwire participant to make or receive transfers indirectly through the

system. Participants use Fedwire to handle time-critical payments (such

as settlement of interbank purchases, sales of federal funds, securities

transactions, real estate transactions, or disbursement or repayment of

large loans). The U.S. Department of the Treasury, other federal

agencies, and government-sponsored enterprises also use Fedwire to

disburse and collect funds. A private-sector entity, The Clearing House

Payments Company L.L.C. (TCH), operates a competing wire transfer

service—the Clearing House Interbank Payment System (CHIPS)—that is

used for similar purposes as Fedwire. Figure 2 shows how a typical wire

transfer payment occurs.

Figure 2: Steps Involved in a Typical Wire Transfer Payment in the United States

Page 8 GAO-16-614 Payment System Competition

In response to concerns over high volumes of paper checks in the

payments system, the Federal Reserve worked with the private sector in

the 1970s to develop an electronic system to exchange payments known

as Automated Clearing House (ACH). These payments are often used for

small or recurring transactions, such as direct deposit of payrolls or

payment of utility, mortgage, or other bills. The Reserve Banks’ Retail

Payments Office operates an ACH payment network (called FedACH). By

agreement (in the form of an operating circular), ACH transactions are

conducted under rules and operating guidelines developed by a nonprofit

banking trade association, NACHA (formerly the National Automated

Clearing House Association). With limited exceptions, Federal Reserve

staff indicated that the Reserve Banks incorporate the association’s rules

by reference in their ACH operating circulars, which represents the

agreement between a Reserve Bank and its customers on the terms and

conditions of the FedACH services. TCH also operates its own ACH

network—the Electronic Payments Network—through which its members

can transmit and receive ACH payments to or from the customers of their

institutions. The Federal Reserve and TCH exchange ACH payments

originated by their customer institutions that are bound for institutions

using the other’s ACH network. Both the sending and the receiving

institutions typically are charged fees for ACH transactions. Figure 3

illustrates a typical ACH payment.

Page 9 GAO-16-614 Payment System Competition

Figure 3: Example of Steps Involved in an Automated Clearing House Payment from

Page 10 GAO-16-614 Payment System Competition

a Business to an Individual in the United States

In 1980, Congress enacted changes that expanded the role of the

Federal Reserve in the payments system. The Monetary Control Act of

1980 (Monetary Control Act) extended the Federal Reserve’s reserve

requirements to all depository institutions, not just member banks of the

Federal Reserve.

The act also allowed the Reserve Banks to offer

payment services to all depository institutions that had previously been

available at no cost to their members. Part of the legislative history of the

Pub. L. No. 96-221, Tit. I, 94 Stat. 132, 132 (1980). Requiring that depository institutions

hold a percentage of certain types of deposits as reserves in the form of vault cash or as

deposits at accounts at a Federal Reserve Bank or a correspondent institution is one of

the tools the Federal Reserve uses for conducting monetary policy. This act’s extension of

these reserve requirements to all institutions was to increase their effectiveness in

achieving desired changes in the money supply.

Monetary Control Act indicates that since the act required nonmember

institutions to meet reserve requirements, it was reasonable to also

provide such institutions with access to Reserve Bank payment

services.

Page 11 GAO-16-614 Payment System Competition

At this time, the act required the Federal Reserve to begin

charging all institutions for such services.

Because this change placed the Reserve Banks and private-sector

providers of payment services in competition with each other, the act

included certain requirements to encourage competition between the

Reserve Banks and private-sector providers to ensure provision of

payment services at an adequate level nationwide. The Monetary Control

Act required the Board to establish a fee schedule for Reserve Bank

payment services, under which all services are required to be priced

explicitly. The act also required that over the long run, fees be established

on the basis of all direct and indirect costs actually incurred in providing

the priced services, including imputed costs that would have been

incurred by a private-sector provider, giving due regard to competitive

factors and the provision of an adequate level of such services

nationwide.

In describing the policies adopted to implement the

126 CONG. REC. 6897 (1980) (statement of Sen. Proxmire).

12 U.S.C. § 248a. The Monetary Control Act requires that the Federal Reserve Board

establish the schedule of fees for the following services: (1) currency and coin services;

(2) check clearing and collection services; (3) wire transfer services; (4) automated

clearing house services; (5) settlement services; (6) securities safekeeping services; (7)

Federal Reserve float; and (8) any new services that the Federal Reserve System offers,

including but not limited to payment services to effectuate the electronic transfer of funds.

The act also directed the Board to publish (for public comment) a set of pricing principles

and a proposed schedule of fees based on those principles and then to put into effect the

fee schedule which is based on those principles. The schedule of fees prescribed must be

based on enumerated principles: (1) All Federal Reserve Bank services covered by the

fee schedule shall be priced explicitly. (2) All Federal Reserve Bank services covered by

the fee schedule shall be available to nonmember depository institutions and such

services shall be priced at the same fee schedule applicable to member banks, except

that nonmembers shall be subject to any other terms, including a requirement of balances

sufficient for clearing purposes, that the Board may determine are applicable to member

banks. (3) Over the long run, fees shall be established on the basis of all direct and

indirect costs actually incurred in providing the Federal Reserve priced services, including

interest on items credited prior to actual collection, overhead, and an allocation of imputed

costs, which takes into account the taxes that would have been paid and the return on

capital that would have been provided had the services been furnished by a private

business firm, except that the pricing principles shall give due regard to competitive

factors and the provision of an adequate level of such services nationwide. (4) Interest on

items credited prior to collection shall be charged at the current rate applicable in the

market for federal funds.

requirements of the Monetary Control Act, the Board stated that the act’s

legislative history indicated Congress sought to encourage competition to

ensure that these services would be adequately available nationwide and

at the lowest cost to society. According to these Board policies, the

Reserve Banks provide payment services to promote the integrity and

efficiency of the payments mechanism and ensure that payment services

are provided to all depository institutions on an equitable basis and in an

environment of competitive fairness.

Page 12 GAO-16-614 Payment System Competition

In participating in the payments system, the Federal Reserve has taken

various actions to make the system more efficient. For example, in the

1950s the Federal Reserve contributed to the adoption of magnetic ink

character recognition, which allowed routing and other processing

information to be printed in machine-readable ink on the bottom of the

check’s face, which helped automate check processing. As discussed

earlier, the Federal Reserve worked with the private sector to develop the

ACH system in the 1970s. Initially, ACH volumes were low with most

volume growth attributed to government-initiated transactions, because

high startup costs made private-sector banks reluctant to invest in and

use the network. For a few years following the implementation of the

Monetary Control Act, the Federal Reserve subsidized the ACH network,

which helped the network obtain sufficient volume to become successful.

To improve the clearing of checks, Congress passed the Check Clearing

for the 21st Century Act (Check 21), which became effective October 28,

2004, which was legislation supported by the Federal Reserve.

Check

21 facilitates check truncation, which is the substitution of the original

physical check with a legal equivalent (called a substitute check).

According to the trade association that establishes rules for exchanging

check images, checks are generally processed as images.

Federal Reserve System, Policies: The Federal Reserve in the Payments System,

Issued 1984, revised in 1990.

Pub. L. No. 108-100, 117 Stat. 1177 (2003).

According to Federal Reserve staff, banks are required to present paper checks unless

they have the agreement of the paying bank to accept electronic presentment. By creating

the concept of a substitute check, this act allowed banks earlier in the collection chain to

transmit electronically because the presenting bank has a means of creating the legal

equivalent of the paper check for presentment if need be (and likewise paying banks that

have some legal obligation to provide “original” checks were able to provide a substitute

check).

In 1998, a committee of senior Federal Reserve executives examined

whether the Federal Reserve’s participation in the payments system

remained justified in light of changes occurring in the financial services

and technology sectors at the time. This committee’s report addressed

the results of its review of the role the Federal Reserve played in the use

of checks and ACH payments in the retail payments system, including

considering whether any changes in its role could affect the integrity,

efficiency, and accessibility of this system.

Page 13 GAO-16-614 Payment System Competition

After examining check-

clearing activities, the committee concluded that Reserve Banks’

withdrawal from the check collection market would disrupt the system in

the short-run, with little promise of substantial benefit over the longer run.

The committee noted that withdrawing from check clearing could increase

check collection prices to small and remote depository institutions and

could disrupt the migration from paper to electronic payments. Similarly,

the report concluded that having the Reserve Banks remain in the ACH

market would be more conducive to the future efficiency and migration to

electronic payments, including joint efforts with industry participants to

spur innovation in products and increase ACH usage.

In addition to the Reserve Banks, other entities offer payment system

services to financial institutions. To process check payments, financial

institutions can set up direct, individual connections with other financial

institutions with which they can exchange check images for clearing of

checks drawn on the accounts of their respective customers. Institutions

also can submit their checks to clearinghouses that process and transmit

check image files for clearing to the respective clearinghouse members

on which the checks are drawn. For example, in addition to operating the

only other ACH and wire transfer networks that compete with the offerings

of the Federal Reserve, TCH also acts as a clearinghouse for check

images. Other competitors that provide checking services include

correspondent banks, bankers’ banks, and corporate credit unions. The

financial institution customers of these entities will send or receive their

checks, ACH payments, or wire transfers using these entities’ systems,

See Committee on the Federal Reserve in the Payments Mechanism, Federal Reserve

System, The Federal Reserve in the Payments Mechanism, (January 1998). This study

excluded cash processing, a service normally expected of a central bank, as well as credit

and debit card processing in which the Reserve Banks play no direct operational role. The

study also excluded other “wholesale” payment services of the Reserve Banks, such as

large-value funds and Fedwire securities transfers.

OtherEntitiesInvolvedin

thePaymentsSystem

which may pass them to other entities, including individual institutions,

TCH, or the Reserve Banks, for processing. Some financial institutions

also use nonfinancial third-party data processors that aggregate

payments for these services and route them to other entities, including

the Reserve Banks or their competitors, for processing.

From 2000 through 2012, total noncash payments grew, and check

volumes declined, as the use of other payments types increased.

According to data the Federal Reserve reported in 2013, noncash

payments—including those made with debit cards, credit cards, ACH, and

prepaid cards (but excluding wire transfers)—grew almost 69 percent

from 2000 to 2012.

Page 14 GAO-16-614 Payment System Competition

The fastest growing payment method was debit

cards, whose use grew by more than 466 percent over this period. The

number of ACH payments also grew by more than 255 percent, while the

number of check payments declined by more than 56 percent. Figure 4

shows how the use of payment types changed in this period.

Board of Governors of the Federal Reserve System, The 2013 Federal Reserve

Payments Study: Recent and Long-Term Trends in the United States: 2000–2012,

detailed report and updated data release (Washington, D.C.: July 2014). This is the

Federal Reserve’s most recent triennial study of payment market trends, which publishes

payment statistics for a single point in time every 3 years.

CheckVolumesDeclineas

UseofOtherPayment

TypesRises

Figure 4: U.S. Noncash Payments by Transaction Type, 2000–2012

Page 15 GAO-16-614 Payment System Competition

The changes in the relative use of the various payment methods largely

reflect consumers switching from check use to card-based or other

payment methods. According to the Federal Reserve’s analysis,

consumers wrote about 8 billion fewer checks to businesses in 2012 than

they had in 2006, and businesses wrote 4 billion fewer checks in 2012 to

consumers or other businesses than they had in 2006. Federal Reserve

staff noted that although check volumes have declined, the dollar value of

payments made by checks—estimated by the checking industry

association to exceed $20 trillion in 2013—indicates that checks are still

an important payment method in the United States because businesses

continue to use them to make payments to other businesses.

The growth in ACH payments encompassed its increased use for making

various types of payments, including for payroll deposits and automatic

bill payments, as well as increased use by consumers to make one-time

payments over the Internet. Although it had not obtained the volume of

wire transfers as part of past triennial reports, the Federal Reserve

analysis estimated that more than 287 million wire transfers occurred in

2012, with a combined value of about $1,116 trillion. Consumer senders

accounted for just 6 percent of total wire transfers in 2012.

The Federal Reserve Banks incur various costs as part of their provision

of payment services. To fully account for these costs, the Federal

Reserve uses a detailed accounting system for accumulating and

reporting cost, revenue, and volume data for the payment and other

services Reserve Banks conduct. The Federal Reserve’s cost-accounting

practices generally align with those used in the private sector and with

cost-accounting standards for federal entities. As part of setting fees for

its payment services, the Federal Reserve is required to also impute

some additional costs that it would have incurred if it were a private entity.

Although various options could be used to calculate these imputed costs,

each with their own trade-offs or methodological challenges, the current

methodology the Federal Reserve uses appears reasonable. However,

the Federal Reserve is not currently including certain costs that its

private-sector competitors may incur, including costs related to integrated

planning for recovery and orderly wind down of operations. According to

Federal Reserve data from 1996 through 2015, the Federal Reserve

Banks generally recovered the identified costs of providing payment

services, as required by the act. Although the Federal Reserve has

various internal controls to help ensure it accurately captures its payment

services costs, it has not obtained a detailed, independent evaluation of

the reliability of these processes in over three decades.

The Federal Reserve Banks use a detailed cost accounting system that

helps them meet several requirements relating to how to set the fees

charged for payment services and account for and recover the costs

incurred in providing them. The Monetary Control Act requires that over

the long run the Federal Reserve’s fees be established on the basis of all

direct and indirect costs incurred in providing payment services, and an

allocation of imputed costs that would have been incurred by a private-

sector provider. Because the Board must set fees based on the total of

these costs, failure to account for all of its actual costs could result in the

Federal Reserve underpricing its services and competing unfairly with

private-sector providers.

According to data provided to us by the Federal Reserve, the Federal

Reserve Banks incurred over $410 million in actual costs as part of

providing payment services in 2014. These costs include personnel costs,

such as salaries and benefits of employees who perform payment

services activities, as well as those associated with equipment, materials,

supplies, shipping, and other costs for payment services activities.

Additionally, costs associated with overhead and support services

(activities benefitting multiple Reserve Banks, but performed under a

Page 16 GAO-16-614 Payment System Competition

FederalReserveHas

ProcessesinPlaceto

ComplywithCost

Recovery

Requirements

FederalReserveUsesa

DetailedSystemfor

AccountingfortheFull

CostsAssociatedwithIts

PaymentServices

centralized function) are allocated to the payment services. For example,

expenses associated with functions such as sales and accounting are

categories of support costs for payment services activities. The majority

of the actual costs the Federal Reserve incurs in providing payment

services—78 percent in 2014—are support costs related to activities such

as developing software applications, implementing information security,

and providing help desk services.

The Planning and Control System (PACS) Manual for the Federal

Reserve Banks establishes cost-accounting policies and provides a

uniform reporting structure for accumulating and reporting cost, revenue,

and volume data for the payment and other services conducted by the

Reserve Banks.

Page 17 GAO-16-614 Payment System Competition

This system establishes a set of rules and procedures

used to determine the full cost of these services. Costs are accounted for

at the individual Reserve Bank level and subsequently aggregated to

reflect costs for all payment services throughout the Federal Reserve

System.

Federal Reserve staff told us that the cost-accounting practices in the

PACS manual generally align with practices used in the private sector.

Additionally, based on our analysis, these practices align with cost-

accounting standards developed for federal entities. While generally

accepted accounting standards exist for the preparation of financial

statements, no single set of authoritative or uniform standards have been

developed that apply to the cost accounting practices used in the private

sector. In the private sector, systems like PACS typically are used to

provide management with internal information for making decisions on

cost efficiency and capability.

Although no single or uniform set of standards apply to cost accounting

practices in the private sector, Federal Reserve staff acknowledged that

information from PACS helps them manage their operations similar to the

way in which other organizations use cost accounting information.

Cost accounting is the accounting process that aims to capture an entity’s costs of

production by assessing the costs associated with the various inputs and steps of

production as well as fixed costs such as depreciation of capital equipment. While cost

accounting is often used within an entity to aid in decision making, financial accounting

information is what is presented to those outside the organization. Financial accounting is

a different representation of costs and financial performance that includes the entity’s

assets and liabilities.

FederalReserveBanks’

CostAccountingPractices

AlignwithPrivate-Sector

PracticesandFederal

Standards

However, they noted that their cost accounting system is detailed and

granular to ensure that they account for all costs when pricing their

payment services as required. The Board engaged an independent public

accounting firm to conduct an evaluation of its payment services pricing

methodology in 1984. This accounting firm’s evaluation included testing

whether costs incurred by the Reserve Banks were adequately captured

and whether support and overhead costs were appropriately allocated.

This auditor’s report concluded that the Federal Reserve’s accounting

and reporting systems that captured its payment services revenues and

costs were operating effectively. In addition, the accounting firm noted

that its testing confirmed that PACS had adequate controls that were

being followed and ensured that costs were being accurately captured.

Furthermore, representatives of the independent public accounting firm

that conducted the 2014 financial audit of the financial statements of the

Federal Reserve System told us that the Reserve Banks have thorough

and redundant internal controls for financial reporting even in comparison

to many commercial organizations. The representatives of this firm told us

that their audits of the expense categories that appear in the Federal

Reserve’s financial statements had not identified significant problems.

They noted that this likely reflected the Federal Reserve’s thorough

system of controls. However, the representatives of this firm told us that

they had not audited the expenses allocated to the payment services

specifically.

In addition, our analysis indicated that the Federal Reserve’s cost

accounting practices aligned with broad cost accounting standards for

federal entities. The Federal Accounting Standards Advisory Board

developed the Statement of Federal Financial Accounting Standards 4:

Managerial Cost Accounting Standards and Concepts (SFFAS 4) to help

federal entities provide reliable and timely information on the full cost of

federal programs. Reserve Banks are not required to comply with these

accounting standards because they are not a government agency but

rather federally chartered corporations. However, to provide one measure

of the quality of the Federal Reserve’s practices, we compared PACS

with the requirements of the cost accounting standard for federal entities.

SFFAS 4 directs government entities to meet five standards for their cost

accounting, and our analysis indicated that the Federal Reserve’s PACS

Page 18 GAO-16-614 Payment System Competition

addressed each of these.

Page 19 GAO-16-614 Payment System Competition

For example, as prescribed in SFFAS 4,

PACS defines specific responsibility segments and provides the Reserve

Bank a process for accounting for the full costs of their services. Based

on this analysis, we concluded that the design of the Federal Reserve’s

system generally aligned with the elements recommended by the

standard. See appendix II for further details on the Reserve Banks’ cost

accounting practices.

Based on our analysis and discussions with market participants and

financial experts, the methodology the Federal Reserve uses to calculate

imputed payment services costs appears reasonable, but some market

participants noted that alternate methodologies might be more

appropriate. As previously discussed, the Monetary Control Act requires

the Federal Reserve to establish fees on the basis of direct and indirect

costs, including an allocation of imputed costs which takes into account

the taxes that would have been paid and the return on capital that would

have been provided if a private firm had provided the services. The total

of the imputed costs and return on capital is referred to as the private-

sector adjustment factor (PSAF). The Board approves the PSAF annually

as part of its annual process for approving fees for the Reserve Banks’

priced services. The PSAF methodology calculates four additional costs

that a typical private-sector payment services provider would incur: debt

financing costs, equity financing costs (or return on equity), taxes, and

payment services’ share of Federal Reserve Board expenses.

See

appendix III for further details on the PSAF methodology.

Over the years, the PSAF has declined significantly, following similar

trends in declining transactions, revenues, and assets associated with the

Federal Reserve Banks’ payment service activities. Following declining

payment services revenues and assets, as well as changes in practices

The five standards are (1) accumulating and reporting costs of activities on a regular

basis for management information purposes, (2) establishing responsibility segments to

match costs with outputs, (3) reporting full costs of goods and services, (4) recognizing the

costs of goods and services provided from federal entities, and (5) using appropriate

costing methodologies to accumulate and assign costs to outputs.

Federal Reserve officials said that the Board Expenses included in the PSAF are real

expenses that represent the costs associated with the Board’s supervision of the Reserve

Banks’ payment services. They noted that Board expenses are included in the PSAF

because they are not captured in PACS, as that cost accounting system only captures real

costs incurred by the Reserve Banks.

FederalReserve’sCurrent

ProcessforSimulating

Private-SectorCosts

AppearsReasonable,but

DoesNotCurrently

AccountforCertainCosts

among payment services customers, the total imputed costs arising from

the Federal Reserve’s PSAF calculations declined from $150 million in

2002 (or an inflation-adjusted basis of nearly $194 million using 2015

dollars) to $13 million in 2016. However, as a percentage of total payment

services assets, the PSAF increased slightly from 1.3 percent to 1.5

percent during this period. Federal Reserve staff said that they use

publicly available information to calculate the imputed elements of their

PSAF methodology and publish the methodology and its results annually

in the Federal Register. Additionally, all proposed and finalized changes

to the PSAF methodology, as well as a summary of the public comments

on these changes, are published in the Federal Register and posted to

the Federal Reserve’s website. Federal Reserve staff indicated that they

follow this approach to help ensure that the PSAF methodology is

transparent and that its results can be more easily verified by the private

sector.

As part of its attempts to improve its accuracy and conform the PSAF to

changes in the payment system market, Federal Reserve staff noted that

the Board has made numerous changes to the methodology over the

years. The Federal Reserve staff said that they consider changes to the

PSAF methodology when conditions in the marketplace or industry

suggest that practices in the markets or other changes have occurred that

should be considered in the methodology for imputing costs. They said

that in those situations they evaluate different options to improve the

methodology and request public comments on the strongest options

before adopting a new approach. We reviewed the changes made

between 1980 and 2014 and found that the Federal Reserve had publicly

sought comment on significant changes to its PSAF methodology 10

times during this period. These include changes to how the return on

equity is calculated and to the peer group used to approximate the levels

of debt and equity in the model. See appendix III for further details on

changes to the PSAF methodology over time.

Private-sector market participants have criticized the Federal Reserve for

not accounting for or imputing into the PSAF certain regulatory

compliance costs that private-sector providers incur. These costs include

those associated with federal antimoney-laundering requirements,

increased audit and risk management, overseeing the risks posed by

service vendors, and integrated planning for recovery and wind down of

operations. The Federal Reserve has said that it accounts for some of

these costs as actual expenses incurred by the Reserve Banks, and that

it has been considering how the other costs might be incorporated into

the PSAF.

Page 20 GAO-16-614 Payment System Competition

Concerns over Whether All

Relevant Costs Are Included in

the PSAF

In May 2015, the Electronic Check Clearing House Organization

(ECCHO) submitted a letter to the Board expressing concerns over the

Federal Reserve’s failure to account for certain costs being borne by

private-sector check services providers and urged it to conduct a

complete (de novo) competitive impact analysis of the Reserve Banks’

check image services. ECCHO specifically noted that many of its

members that provide check processing services to other institutions

incur costs associated with compliance with federal antimoney-laundering

requirements. In a written response sent in December 2015, the Chair of

the Federal Reserve Board’s Committee on Federal Reserve Bank Affairs

said that if private-sector banks incur material antimoney-laundering

compliance costs related to their check collection services that the

Reserve Banks do not, it might be appropriate for Reserve Banks to

impute such costs as part of the PSAF. However, Federal Reserve staff

said that correspondent banks have informed them that determining the

proportion of antimoney-laundering costs that relate to check services

specifically would be difficult, because they do not allocate compliance

costs directly to this service. Federal Reserve officials said in their

response to ECCHO that, while they did not see the need for the

complete competitive impact analysis that ECCHO requested, they

continue to consider how they could identify ways to incorporate these

costs into the PSAF methodology if they are material. However, until the

Federal Reserve determines and implements such costs into the PSAF,

the imputed costs will not reflect these actual expenses incurred by many

of the Federal Reserve’s competitors.

Additionally, enhanced regulatory standards, including those that apply to

entities designated as systemically important financial market utilities,

have raised regulatory compliance costs for the Federal Reserve’s key

competitor.

Page 21 GAO-16-614 Payment System Competition

Under the Dodd-Frank Wall Street Reform and Consumer

Protection Act, entities engaged in payment, clearing, or settlement

activity must be designated as systemically important by the Financial

Stability Oversight Council if the Council determines that the failure of or a

disruption to the functioning of the entity could create, or increase, the risk

of significant liquidity or credit problems spreading among financial

institutions or markets and thereby threaten the stability of the U.S.

Financial market utilities are any persons that manage multilateral systems for the

purpose of transferring, clearing, or settling payments, securities, or other financial

transactions among financial institutions or between financial institutions and the persons,

subject to certain exclusions. 12 U.S.C. § 5462(6).

financial system.

Page 22 GAO-16-614 Payment System Competition

Such entities then become subject to heightened

prudential and supervisory provisions intended to promote robust risk

management and safety and soundness. The act required the Federal

Reserve to issue rules to prescribe risk-management standards for those

financial market utilities designated as systemically significant for which

the Board is the supervisory agency. In November 2014, the Board

issued amendments to Regulation HH, based on the international risk-

management standards for payment services that are systemically

important developed by the Committee on Payment and Settlement

Systems (CPSS) and the Technical Committee of the International

Organization of Securities Commissions (IOSCO).

Regulation HH

requires designated financial market utilities to implement rules,

procedures, or operations designed to ensure that the financial market

utility meets or exceeds various standards, including, among others,

those relating to its governance, risk management and credit risk.

For

example, the entity must have an integrated plan for its recovery and

orderly wind down, maintain unencumbered liquid financial assets

sufficient to cover the greater of the cost to implement its recovery and

orderly wind-down plans and 6 months of current operating expenses,

and hold equity greater than or equal to the amount of unencumbered

liquid financial assets required.

Representatives from TCH told us that complying with these standards

has increased their regulatory compliance costs and that they question

the extent to which the Federal Reserve has appropriately incorporated

these costs into the PSAF.

TCH estimated that their efforts to comply

with these requirements have increased their operating costs by 10

percent, including additional costs associated with their Risk Office that

conducts activities related to information technology security, risk

management, liquidity risk and orderly recovery and wind-down planning,

Pub. L. No. 111-203, Tit. VIII, 124 Stat. 1376, 1802 (2010).

79 Fed. Reg. 65,543, 65,557 (Nov. 5, 2014) (codified at 12 C.F.R. pt. 234). The

international standards on which the revised Regulation HH was based were the

Principles for Financial Market Infrastructures (PFMI) developed by CPSS and IOSCO in

2012. Effective September 2014, the CPSS changed its name to the Committee on

Payments and Market Infrastructures.

12 C.F.R. § 234.3.

The Financial Stability Oversight Council designated TCH as a systemically important

financial market utility on the basis of its role as the operator of CHIPS.

among other things. They also said that they incur greater costs

associated with responding to their customers’ due diligence reviews

regarding vendor management, an element of the federal bank

examination process in which federal bank examiners evaluate a financial

institution’s third-party relationships as a component of their overall risk-

management processes.

The Federal Reserve has incorporated some, but not all, of these

expenses into the imputed costs it calculates as part of the PSAF.

Federal Reserve staff have said that although the Reserve Banks’

payment services are not always subject to the same regulatory regime

as similar services provided by the private sector, the Reserve Banks are

subject to Board supervision and that these oversight costs are already

included in the PSAF as Board expenses and are being recovered

through revenue from the services. Additionally, Federal Reserve staff

told us that the Reserve Banks have devoted increased resources to

audit and risk management functions and that costs associated with these

functions—including additional personnel—are captured in PACS as

internal audit costs at the product line level. Federal Reserve staff said

that the amount of these costs had increased in recent years as they

hired additional staff to perform expanded oversight activities.

Additionally, in order to foster competition with private-sector financial

market utilities that are required to hold liquid net assets funded by equity

to manage general business risk, the Federal Reserve Board requires the

Fedwire Funds service to impute equity held as liquid financial assets

equal to 6 months of estimated current operating expenses. To meet this

requirement the Fedwire Funds service imputed an additional $2.7 million

in equity above the $51.1 million it imputed to meet other capital

requirements.

Page 23 GAO-16-614 Payment System Competition

This additional imputed equity, at the equity financing rate

in the 2016 PSAF, resulted in the Federal Reserve having to recover

additional imputed financing costs of $265,000. Federal Reserve staff

also clarified that, as a service provider of last resort, the Fedwire Funds

Service is subject to unique requirements that do not apply to CHIPS. For

example, the staff noted, Reserve Banks have incurred (and continue to

incur) substantial expenses in recent years to develop, implement, and

test manual procedures for settling systemically important transactions in

For its imputed PSAF capital structure, the Federal Reserve seeks to have its level of

equity meet the requirements for a well-capitalized institution, which includes the

standards that total capital to risk-weighted assets ratio of at least 10 percent and a

leverage ratio (tier 1 capital to total assets) of at least 5 percent.

the unlikely event that the Fedwire Funds Service automated systems are

not available. Additionally, Federal Reserve staff told us that they also

receive inquiries from customers conducting vendor management due

diligence. Federal bank examiners told us that they have not noticed any

differences in how either the Reserve Banks or TCH respond to questions

from financial institutions on their vendor relationship and that in the

course of an examination they would look at an institution’s relationship

with the Federal Reserve the same way as they would view an

institution’s relationship with TCH.

However, the Federal Reserve has not incurred or imputed costs related

to a plan for recovery and orderly wind down that is required of CHIPS. In

a 2014 request for comment on revisions to its Policy on Payment System

Risk, the Board noted that Fedwire services do not face business risk that

would cause the service to wind down in a disorderly manner and disrupt

the stability of the financial system because the Federal Reserve, as the

central bank, would support a recovery or orderly wind down of the

service, as appropriate, to meet public policy objectives.

Page 24 GAO-16-614 Payment System Competition

As a result,

Federal Reserve staff said, the Board currently does not require the

Fedwire service to develop recovery or orderly wind-down plans or to

estimate or impute the costs of developing those plans. However,

estimating what these costs would be for its own operations if it were a

private firm and including them in its PSAF methodology would enable the

Federal Reserve to more completely impute costs that it would have

incurred as a private firm in order to meet its cost recovery goals.

As previously noted, the Monetary Control Act states that the Federal

Reserve must impute certain costs for its payment services that would

have been incurred if a private firm had provided them. Additionally, the

79 Fed. Reg. 2838, 2842 (Jan. 16, 2014). The Federal Reserve’s Policy on Payment

System Risk sets out standards on management of risks of financial market utilities that

are subject to the Federal Reserve’s supervisory authority but are not designated financial

market utilities, including those operated by the Federal Reserve Banks. The policy

applies to public and private-sector systems expected to settle a daily aggregate gross

value of U.S. dollar-denominated transactions exceeding $5 billion on any day during the

next 12 months. These payment systems are required to identify, monitor, and manage

general business risk and hold sufficient liquid net assets funded by equity to cover

general business losses so that it can continue operations and services as a going

concern if those losses materialize. Further, liquid net assets should at all times be

sufficient to ensure a recovery or orderly wind down of critical operations. Designated

financial market utilities subject to the Board’s Regulation HH are not subject to the risk-

management standards set out in the policy.

Reasonableness of

Methodology

act states that the Federal Reserve’s pricing principles shall give due

regard to competitive factors and the provision of an adequate level of

services nationwide. However, the act does not specify exactly how the

Federal Reserve should impute these costs and various ways could

reasonably exist to do so. The Federal Reserve has stated that there is

no perfect private-sector proxy for imputing these costs and that the

PSAF methodology represents a reasonable approximation of the costs,

though some market participants have criticized the methodology.

Nevertheless, some market participants have questioned the

appropriateness of the Federal Reserve’s current PSAF methodology.

Representatives from TCH said that the PSAF should be calculated using

a peer group comprising payments-processing companies. They noted

that in 2015 their company’s equity capital was materially larger than the

imputed equity levels calculated by the Federal Reserve. However,

neither the Board’s rule on risk management standards for systemically

important financial market utilities that it regulates nor the international

framework for addressing risks of financial market utilities on which it was

based dictates any specific equity requirements other than to hold at least

6 months of current operating expenses funded by equity for liquidity

reasons and equity greater than or equal to the amount of liquid net

assets required.

Some have argued that the Federal Reserve’s current approach for

imputing debt and equity into the PSAF—in which it uses financial data

from all U.S. publicly traded firms in Standard and Poor’s Compustat

database—does not sufficiently reflect the financial activities that its

payment services represent. Furthermore, the U.S. publicly traded firm

market includes many firms that are engaged in industries outside of

payment services that may be even less similar to the Federal Reserve

than is TCH. However, Federal Reserve staff said that basing the imputed

debt and equity levels on a peer group consisting of firms providing

payment services, such as large bank holding companies, is not optimal

because such firms engage in many different lines of business and have

risk profiles dissimilar to the payment services provided by the Reserve

Banks. Additionally, the Federal Reserve has noted that a methodology

based on all publicly traded firms decreases the risk of price volatility that

could result from changes in the characteristics or financial results of a

limited peer group. If the Federal Reserve’s product pricing had to vary

widely each year because of large variability in the PSAF, such volatility

could be disruptive to its customers and the payment systems market.

Page 25 GAO-16-614 Payment System Competition

Furthermore, the PSAF methodology uses data in the public domain to

help ensure that the PSAF calculation is replicable and transparent.

Federal Reserve staff noted that the Monetary Control Act states that all

Reserve Bank services shall be priced explicitly, which the Board

interprets as being fully transparent in their pricing. Many private-sector

payment services providers, including TCH, are not publicly traded and

do not provide publicly available financial information, which, if used to

calculate the PSAF, could hamper the Federal Reserve’s goal of

maintaining the transparency and replicability of its methodology.

Transparency can be an important goal, and our 2000 report included

recommendations that the Federal Reserve implemented to increase the

transparency and involvement of market participants in its pricing

activities.

Page 26 GAO-16-614 Payment System Competition

As noted, the Federal Reserve has attempted to use different

methodologies for calculating the PSAF, including previously using the

financial data from a peer group of bank holding companies to calculate

the PSAF’s target return on equity. Although the Federal Reserve no

longer bases the PSAF methodology’s peer group on the top 50 bank

holding companies, the resulting equity financing rates have remained

similar. We reviewed the return on equities for the top 50 bank holding

companies from 2006 through 2015, and found that the average pre-tax

return on equity was 10.5 percent for these bank holding companies,

which is similar to the 10.1 percent pre-tax return on equity used in the

Federal Reserve’s 2015 PSAF calculation.

Because the PSAF is a proxy for private-sector costs and profit

dependent on a range of variables, and because of the Reserve Banks’

unique structure and operation and the lack of perfectly comparable

private-sector competitors, the calculation of the PSAF amount involves

trade-offs and assumptions that could be reasonably debated. For

example, assumptions on how to impute the return on equity in the

methodology can dramatically affect the overall figure. However, as

previously noted, changing the way the equity is imputed to include

nonpublic financial information might come at the cost of transparency

and replicability of the methodology.

See GAO, Federal Reserve System: Mandated Report on Potential Conflicts of Interest

GAO-01-160 (Washington, D.C.: July 19, 2001).

While the Federal Reserve’s approach seems reasonable, any single

PSAF figure calculation could be reasonably criticized based on the

assumptions made and trade-offs chosen. Likewise, different trade-offs

and assumptions could result in higher or lower PSAF figures. We asked

three finance experts to review the Federal Reserve’s PSAF

methodology.

Page 27 GAO-16-614 Payment System Competition

All three experts said that the methodology and the

assumptions used to make the calculations seemed reasonable. One

finance professor said that specific assumptions on rates that the Federal

Reserve uses were standard assumptions to use, though there may be

some disagreement within each one, which could be expected. Another

finance professor said that the Federal Reserve’s approach appears to be

reasonable without being unnecessarily complex, and added that any

alternative models might add more complexity for little benefit.

We also reviewed the methodology and the changes made from 2005

through 2014 and determined that many of the assumptions used rely on

professional judgments and involve trade-offs between precision and

ease of calculation. For example, the Federal Reserve simplified its

calculation for computing the methodology’s equity financing rate in 2005.

Previously, the methodology averaged the results of three separate

financing models based on (1) the return on equity investors would

demand based on the risk in the market, (2) the average 5-year ratio of

net income-to-book value of equity among a peer group of bank holding

companies, and (3) a forward-looking approach estimating the discounted

present value of all future cash flows. Ultimately, the Board changed the

methodology to use only the model based on the expected rate of return

on equity that investors would demand based on the risk in the market,

because they considered this approach to be a well-known, generally

accepted, and theoretically sound model that is simpler and more

transparent than other approaches. In 2005, this change reduced the

PSAF from the $161 million it would have been under the three-model

approach, to $90.8 million under the simplified one-model approach.

However, annual fluctuations in peer group earnings or in projected cash

flows could have made the PSAF lower under the three-model approach

than under the one-model approach in a given year.

The finance experts were business school professors selected based on their

background or expertise in finance and were interviewed about their opinions of how the

PSAF methodology imputed debt and equity financing costs.

According to Federal Reserve reporting on cost recovery rates from 1996

through 2015, the Reserve Banks have recovered or come close to

recovering all actual and imputed costs for all of their payment services.

As noted previously, the Monetary Control Act requires fees to be

established, over the long run, on the basis of the costs actually incurred,

and an allocation of the imputed costs that would have been incurred by a

private-sector provider. To meet this mandate, the Board has developed

an internal goal of recovering 100 percent of its costs for all its explicitly

priced payment services over a 10-year period. Federal Reserve staff told

us that the Monetary Control Act did not provide a specific definition of

“over the long run,” but they used 10 years for their targeted recovery

time frame.

The Federal Reserve annually reports how well it has met its 100 percent

recovery goal over 10-year periods. As shown in figure 5, in the rolling 10-

year periods that cover 1996-2015, the Federal Reserve achieved at least

a 97.9 percent recovery for every 10-year period during this span.

However, a relatively low-cost recovery rate of 85.1 percent in 2003

lowered the 10-year rates for eight of the periods.

Page 28 GAO-16-614 Payment System Competition

In 2003, the Federal

Reserve’s check services had a net loss of more than $65 million that the

Federal Reserve attributed to significant one-time costs related to

consolidation activities, a decline in volumes, and greater use of products

with lower margins. The significant loss in that one year resulted in the

Federal Reserve falling short in achieving its 100-percent cost recovery

goal in each of the ten periods that included 2003 in the calculations. The

Federal Reserve’s cost recovery rates in the three most recent periods—

none of which include the 2003 cost recovery figures—exceeded 100

percent.

In 2003, the Federal Reserve’s check services had a net income loss of more than $65

million. According to the Federal Reserve, the net income loss that year largely resulted

from higher-than-planned pension costs, lower-than-forecasted volume, customers’

moving to lower-margin products, and check restructuring costs for staff separation and

writing down legacy paper equipment. The significant loss in that one year resulted in the

Federal Reserve falling short in achieving its 100-percent cost recovery goal in the eight

periods that included 2003 in the calculations.

FederalReserve

GenerallyHasAchieved

ItsCostRecoveryGoals

Figure 5: Rolling 10-year Average Cost Recovery Rates for Federal Reserve Payment Services, 1996-2015 (percentage)

Page 29 GAO-16-614 Payment System Competition

Although the Federal Reserve Banks generally have come close to

recovering all of their actual and imputed costs for their payment services

in aggregate, the extent to which individual payment services recovered

their costs varied more widely from year to year (see table 1). Cost

recovery variations between products in a given year may be due to

circumstances specific to those products. For example, in 2014, the

Federal Reserve Banks’ ACH service recovered 86.7 percent of its costs.

The lower rate was due to a nearly $32 million charge incurred that year

associated with a multiyear technology initiative that was to have

modernized a processing platform but had been suspended that year. In

contrast, in the same year, greater-than-expected check volume resulted

in cost recoveries of more than 115 percent for that product line, which

helped the Federal Reserve Banks achieve their overall cost recovery

goals for that year and in the 10-year periods that included 2013 and

2014.

Table 1: Annual Cost Recovery Percentages for the Federal Reserve, by Payment Service Type, 2007—2015 (percentage)

Page 30 GAO-16-614 Payment System Competition

2007

2008

2009

2010

2011

2012

2013

2014

2015

Check

100.7

97.8

92.8

107.1

105.4

108.8

115.4

115.6

113.0

ACH

107.6

101.5

93.4

103.4

100.8

101

101.2

86.7

100.7

Fedwire

107.3

100.4

92.1

100.6

103

98.8

98.6

103.2

103.9

Source: FederalReserve.│GAO-16-614

Fedwire cost recovery figures include revenues and expenses associated with the National

Settlement Service, a multilateral settlement system that provides financial institutions involved in

private-sector settlement arrangements a means to settle the obligations that arise under that

arrangement using accounts held at their Reserve Bank.

From 2005 to 2014, annual revenues and expenses across the Federal

Reserve Banks’ payment service products varied. Since 2005, the total

revenue the Federal Reserve Banks earned from providing check, ACH,

and wire transfer services declined by nearly 54 percent, from about $881

million in 2005 to $409 million in 2014 (a decline of nearly $1.1 billion to

$414 million, almost 61 percent in 2015 dollars). This decline was largely

due to a steep reduction in the expenses and imputed costs related to the

Federal Reserve Banks’ check services, which corresponded with the

transition to digital check images and the decline in commercial check

transactions. From 2005 to 2014, the number of checks the Federal

Reserve Banks processed fell from 12.2 billion to 5.7 billion. The decline

in expenses correspondingly reduced the need for the Federal Reserve

Banks to obtain as much revenue from this product line (that is, to

achieve cost recovery). Check service revenue fell from over $740 million

in 2005 to almost $175 million in 2014, which was a decline from $888

million to nearly $177 million in 2015 dollars (see fig. 6). In contrast, total

revenues for ACH and Fedwire increased from a combined total of about

$140 million in 2005 to over $234 million in 2014. In inflation-adjusted

2015 dollars, this equals an increase of almost $69 million.

Figure 6: Federal Reserve Revenues by Payment Service, 2005–2014 (2015 Dollars

Page 31 GAO-16-614 Payment System Competition

in Millions)

Federal Reserve staff said that the cost structures for each of the check,

ACH, and wire payment services have significant differences. For

example, check clearing is more labor-intensive than the other services

and consequently incurs more personnel costs as a share of its

expenses. In 2015, personnel costs for check services represented more

than 15 percent of that service’s operational costs, while personnel costs

represented less than 3 percent of operational costs for Fedwire. Federal

Reserve staff identified personnel, information technology services, and

software application development as key cost drivers for the payment

services.

Although the Federal Reserve appears to have a sound system for

capturing its payment services costs, it has not obtained an independent

review involving detailed testing of the accuracy of its cost accounting

process in more than 30 years. As previously noted, in 1984, shortly after

it was mandated to capture and recover these costs, the Board had an

external review by an independent public accounting firm of its pricing

methodology, including evaluations of its cost accounting PACS process

and the PSAF. At that time, the accounting firm’s report concluded that

the processes the Federal Reserve had implemented to capture its costs

FederalReserve’s

ProcessforCapturingIts

PaymentServicesCosts

HasNotBeenExternally

ReviewedinDecades

were sound and that the overall PSAF methodology was logical and

complied with the Monetary Control Act.

The Federal Reserve obtains some assurance that cost accounting

practices for its payment services continue to be adequate from a unit

within the staff of the Board that conducts rotating reviews of the Reserve

Banks’ operations. Federal Reserve staff said that this unit reviews all the

Reserve Banks on a triennial basis (4 of the 12 banks each year) to

evaluate each bank’s effectiveness in producing reliable expense

information in compliance with PACS manual requirements. These

reviews examine the processes and controls relating to the cost-allocation

processes (including how expenses related to centrally provided

information technology activities are allocated) and internal support

charges. In these reviews, this internal unit identifies deficiencies and

control weaknesses and makes recommendations for improvement. In

addition, we reviewed the reviews the internal unit performed of the 12

Reserve Banks and of the Federal Reserve Information Technology

group between 2012 and 2015. Although some of these reviews noted

deficiencies with how the Reserve Banks were complying with the cost

accounting practices prescribed in the PACS manual, these issues were

characterized as “minor” or “less-significant” by the reviewers and,

according to Federal Reserve staff, did not result in any material cost

distortion. In addition, we reviewed a sample of nine audits that Reserve

Banks’ internal auditors had completed since 2011. Of these nine audits,

eight included reviews of controls relating to cost accounting practices. All

of the reviews concluded that overall management controls were

“effective” and one which provided a “generally effective” assessment.

External audits of the financial statements of the Federal Reserve System

overall and of the individual Reserve Banks are conducted annually.

However, these audits do not include detailed testing of the accuracy of

the processes used to capture or allocate costs associated with the

payment services, and thus the Federal Reserve does not obtain specific

assurance about the accuracy of these practices. Although staff from the

independent public accounting firm that conducted the Federal Reserve’s

financial audit in 2014 told us that the Federal Reserve Banks have

thorough processes, their audits did not include steps to review payment

services costs and revenues because these costs were not in the scope

of the audit.

The Committee of Sponsoring Organizations of the Treadway

Commission’s (COSO) Internal Control-Integrated Framework—a leading

framework for designing, implementing, and conducting internal control

Page 32 GAO-16-614 Payment System Competition

and assessing the effectiveness of internal control—states that

compliance with applicable laws and regulations is a key objective for an

organization establishing internal controls. Under this framework, a key

means of providing such assurance can be the performance of monitoring

activities, which includes the use of an independent third party to perform

specific evaluations of whether aspects of an organization’s internal

controls are present and functioning. The annual financial audit does not

address the Federal Reserve’s payment services, representatives from

the accounting firm told us, because they do not meet the materiality

threshold. However, the Federal Reserve Banks must accurately capture

their costs to ensure the Board is meeting the mandate in the Monetary

Control Act for the Board to set fees on the basis of all direct and indirect

costs.

The Federal Reserve believes that the internal controls of the Reserve

Banks, internal audits by the Reserve Bank audit departments, and the

review process and examinations by the Board of Governors staff are

adequate for reasonably ensuring the accuracy of its accounting of costs

associated with payment services. Although we analyzed the processes

by which the Federal Reserve accounts for actual and imputed costs, we

did not include detailed testing of the Federal Reserve’s calculations or

cost accounting controls related to its priced services activities. By

obtaining periodic independent reviews to determine if the practices used

to capture all costs directly incurred by payment service activities and the

methods used to identify costs arising in other areas that should be

allocated to payment services are sound and that staff are adequately

complying with these practices, the Federal Reserve could attain greater

assurance that it is complying with its requirements under the Monetary

Control Act to set fees on the basis of all direct and indirect costs.

Page 33 GAO-16-614 Payment System Competition

The Reserve Banks have added new services and fee structures

(including volume-based pricing) for customers to help ensure that they

retain adequate revenues to maintain their presence in the market.

Financial institution customers we interviewed generally were satisfied

with the Reserve Banks’ services and fees; however, some competitors

questioned the fairness of some Reserve Bank pricing practices such as

bundling discounts and volume-based pricing. To help ensure that the

Reserve Banks compete fairly, the Board has established pricing policies

and processes for assessing the competitive effects of changes to the

Reserve Banks’ payment fees and services. Although the Reserve Banks’

actions may be affecting some competitors’ profitability, our analysis of

the Reserve Banks’ fee and volume trends suggests that their actions to

compete appear to have reduced payments services costs for some

users to date.

In response to changes in the product market for payments, and in an

effort to generate sufficient revenues to achieve full cost recovery, the

Federal Reserve has added new products and pricing structures.

According to Federal Reserve documents, the Reserve Banks have

introduced new services and pricing structures to retain existing

customers and attract volume from both existing and new customers. As

noted earlier, the Reserve Banks provide payment services both to

promote the efficiency of the payments mechanism and to ensure that

payment services are provided to all depository institutions on an

equitable basis. To achieve this, the Reserve Banks expanded the use of

pricing structures that provide discounts to customers that send them

higher volumes of transactions to process. In 1993, the Board approved

volume-based fees for the Reserve Banks’ noncash collection service

and several check products. One of the objectives of adopting volume-

based fees at that time was to encourage more efficient use of payment

services (by addressing differences in demand through fees). In

approving these fees, the Board asked its staff to recommend guidelines

on the use of volume-based fees, which were then adopted in 1997 and

published in the Federal Register.

Page 34 GAO-16-614 Payment System Competition

At that time the Board also approved

specific volume-based fees for the ACH origination service. In 2010, the

Reserve Banks expanded this practice by introducing several volume-

62 Fed. Reg. 14,146 (Mar. 25, 1997).

WhileSome

Competitors

ExpressedConcerns

aboutSomeFederal

ReservePayment

ServicePractices,

UsersAppearedto

Benefit

AsProductMarkets

Changed,theFederal

ReserveAddedNew

ServicesandPriceTiers

forSomeCustomersto

EnsureItEarnsSufficient

Revenue

based pricing tiers for customers receiving ACH transactions.

Page 35 GAO-16-614 Payment System Competition

The new

pricing tiers charge customers lower per-item fees as transaction volumes

with the Federal Reserve increase.

The Reserve Banks also introduced fixed monthly fees to retain or

increase their payment services revenues. In 2009, the Board approved a

new monthly participation fee for the Reserve Banks’ Fedwire service in

addition to the per-item charges. Originally set at $60 per month, by 2014

this fee had increased to $90. For the ACH service, the Board approved a

new monthly minimum fee in 2010, which was $25 for customers that

originated payments and $15 for customers that received payments. By

2015, these fees had risen to $35 and $25, respectively. Because fixed

expenses constitute much of the costs of providing these services,

Federal Reserve staff said that adding fixed fees was their way of better

matching pricing structures to corresponding cost structures.

In addition to pricing changes, the Reserve Banks have introduced

discounts to benefit customers that use them to process transactions for

multiple payment products. For example, customers that transact at least

90 percent of their ACH payments a month through the Reserve Banks

and enable electronic receipt of checks from the Reserve Banks for all of

their routing numbers can receive a per-item fee discount on certain

check-clearing transactions. According to Federal Reserve staff, this

allows them to reward customers that use multiple services with a

discount in one of those services, which increases the likelihood that

these customers will continue to use the Federal Reserve.

Reserve Bank customers with whom we spoke generally were satisfied

with the services and pricing they received, but some competitors raised

concerns about the fairness of a number of pricing practices.

Representatives of Reserve Bank customers—12 banks and credit

unions that were selected, in part, using random selection across three

asset size groupings—with whom we spoke generally were satisfied with

the Reserve Banks’ service offerings and prices.

ACH services include origination and receipt services. Also, ACH transactions can be

either debits or credits. For example, an institution can use an ACH origination service to

send either a debit or credit to a receiving institution.

CustomersGenerally

WereSatisfiedwith

FederalReserveServices,

butSomeCompetitors

QuestionedtheFairness

ofSomePractices

· Representatives of seven institutions said that they thought the

Reserve Banks’ pricing of payment services was reasonable and

competitive. For example, representatives from one large credit union

said that the Federal Reserve’s prices are low and that they also

provided a good service.

· Representatives from two other institutions said that they valued the

Reserve Banks above private-sector providers for other reasons. For

example, the representative of one small community bank said that,

while private-sector payment service pricing generally may be lower

or even significantly cheaper, the bank will continue to use the

Reserve Banks’ services because doing so allows it to remain

independent and provide top-quality service to its customers without

depending on a private-sector provider. A representative of a large

credit union said that, while the credit union might be able to get more

favorable pricing from private-sector providers, the difference would

not be enough to warrant switching from the Reserve Banks. The

representative added that the credit union had confidence in the

Reserve Banks’ services and felt that the Reserve Banks were looking

out for its interests.

· For the remaining three institutions, representatives from two said

that, while they did not have much insight into the pricing of providers

they do not use, they generally believe that pricing was comparable or

competitive between the Federal Reserve and the private sector. A

representative of one of the three institutions told us that the institution

switched to the Federal Reserve in 2007 because of unhappiness with

the fees and service of its private-sector provider. Representatives

from one institution said that the Federal Reserve and private-sector

pricing was similar for checks and wire payments, but not for ACH

payments, where they said the Federal Reserve had better prices.

However, some private-sector competitors with whom we met expressed

concerns with the fairness of some of the Federal Reserve’s pricing

practices, specifically in the following areas: bundling discounts, volume-

based pricing, the competitive environment for check clearing, the ACH

interoperator fee, cost effectiveness, and the Federal Reserve’s ability to

innovate.

TCH—the Reserve Banks’ largest competitor in general and their sole

competitor in ACH and wire payment services—stated that a bundling

discount offered by Reserve Banks to customers that use multiple

payment services unfairly take advantage of the Federal Reserve’s

unique market position. Specifically, TCH staff said that the Federal

Page 36 GAO-16-614 Payment System Competition

Bundling Discounts

Reserve’s Retail Payments Premium Receiver product, which rewards

banks that transact a higher volume of ACH transactions with the

Reserve Banks by offering a discount for certain check forward payments,

represents an unfair bundling of services. According to TCH

representatives, this discount represents a cross-subsidy between

services, which they allege violates the intent of the Monetary Control Act.

Federal Reserve staff noted that this product offers attractive pricing

discounts to smaller financial institutions, unlike many of its other

discounts that focus on larger financial institutions, and is intended to

serve as a customer retention tool. Specifically, they said that the lower

price allowed them to retain customer volume, which is needed to achieve

economies of scale. According to its policy on the provision of financial

services, the Federal Reserve maintains an operational presence in the

payment system to contribute to economic efficiency. Additionally, the

Federal Reserve has said that the Retail Payments Premium Receiver

product is consistent with the letter and spirit of the Monetary Control Act

and the Board’s pricing principles, noting that revenues from either check

or ACH services do not contribute toward recovering costs for the other

service and therefore do not represent a cross-subsidy. Furthermore, staff

said that the Reserve Banks are not in a unique position in relation to

providing “relationship pricing,” as private-sector institutions also use such

pricing structures. Officials at the Department of Justice told us that

product bundling is not necessarily anticompetitive and is practiced in a

wide range of industries.

Some private-sector competitors expressed concerns that the Reserve

Banks charged customers more in markets in which the Reserve Banks

face less competition to enable lower pricing in markets in which they

face more competition. Competitor concerns included the following:

· One large bank provider with large corporate customers explained

that, because the Reserve Banks have access to some smaller or

more remote financial institutions, they charge other institutions a

higher rate to collect checks drawn on these smaller institutions,

taking advantage of their access and relatively exclusive relationships.

The price for sending a check to another institution is determined, in

part, by the pricing tier in which that institution is included.

· TCH staff said that the Reserve Banks offer steep discounts to large

financial institutions in markets where they compete for business and

offset these discounts by charging higher fees to smaller financial

institutions that have no alternatives to the Federal Reserve. They

considered this to be an anticompetitive pricing practice. They noted

Page 37 GAO-16-614 Payment System Competition

Volume-Based Pricing

that TCH faces difficulty obtaining smaller financial institutions as

customers because the costs in switching providers may outweigh the

pricing benefits for these institutions.

Federal Reserve staff said that volume-based pricing is a common

practice they believe helps maintain the efficiency of payment services.

Federal Reserve staff said that they follow volume-based pricing

principles when establishing pricing tiers and do not price their services

below marginal cost. They added that they assign items drawn on a

financial institution to a tier based on the number of checks the Reserve

Banks present to that financial institution, with those institutions with more

volume assigned to a lower-priced tier. They also noted that the private

sector similarly establishes tiers based on volume. Because private-

sector competitors have similar price structures, and because any higher

prices paid by lower-volume customers likely do not increase their overall

costs significantly (as discussed later), this practice also appears to

benefit the payment services market overall.

Some private-sector competitors raised concerns that certain protections

that helped ensure fair competition for processing paper checks have not

been carried over into the electronic environment. The Federal Reserve

has been examining this issue. Staff from TCH and ECCHO noted that,

until a regulatory change in 1994, the Reserve Banks had a statutory

advantage over private-sector competitors when presenting paper checks

to paying banks. According to the Federal Reserve Act and Federal

Reserve regulations, the Federal Reserve can obtain a same-day

payment from a paying bank by debiting the paying bank’s account at a

Reserve Bank without being charged a presentment fee. To address this

advantage the Board adopted Regulation CC’s same-day settlement rule

in 1992, effective beginning in 1994.

Page 38 GAO-16-614 Payment System Competition

The same-day settlement rule

allowed any bank to present paper checks to any other bank by 8:00 a.m.

for settlement that same day without presentment fees. According to

Federal Reserve staff, this regulatory change reduced the Federal

Reserve’s competitive advantage and allowed banks to compete more

effectively.

57 Fed. Reg. 46,956 (Oct. 14, 1992) (codified at 12 C.F.R. § 229.36(f)).

The Board originally requested comments on a proposal to provide for a later 2:00 p.m.

deadline, but stated that the overwhelming proportion of commenters opposed this

deadline.

Competitive Environment for

Check Clearing

However, according to ECCHO staff, the transition to the exchange of

check images has removed the effect of the competition-enhancing

change because Regulation CC does not apply to electronic images.

They explained that check image exchange, unlike the presentment of

paper checks, requires institutions to have legal agreements for and

electronic connections between both parties, both of which can be costly

to establish. The Board attempted to address this advantage by twice

requesting comment, in 2011 and in 2014, on whether to modify

Regulation CC to include similar presentment provisions for the exchange

of check images. Although the Board has not yet taken final action on

these proposals, they did not receive significant support from

commenters, with payments trade groups noting both policy and

operational issues.

Page 39 GAO-16-614 Payment System Competition

Additionally, commenters did not provide any

alternative approaches that could be used to address the perceived

competitive disadvantage. In a December 2015 letter (in response to a

May 2015 letter from ECCHO raising these issues), the Chair of the

Federal Reserve’s Committee on Federal Reserve Bank Affairs said that

Federal Reserve staff have been asked to review certain pricing practices

related to electronic checks to determine whether any changes to Federal

Reserve policies, procedures, products, or fee structures were warranted.

This letter states that the Federal Reserve will continue to engage in

dialogue with ECCHO and industry stakeholders on steps to improve the

competition and efficiency of the check system, and Federal Reserve staff

told us in that they continue to consider ways to address these concerns.

TCH, as the only private-sector operator of ACH payments, told us that it

is concerned that the Reserve Banks have been taking advantage of their

market position to charge an artificially high fee for processing

transactions that TCH sends to them. Representatives of TCH explained

that, for ACH payments, both institutions involved have to process a

transaction, regardless of which one originates or receives the payment.

ACH payments generated by customers of TCH or the Federal Reserve

but bound for customers of the other provider must pass between both

operators, thus creating an interoperator transaction. In such cases, the

party that receives the item charges the other party “interoperator fees.”

However, TCH sends more items to the Reserve Banks because its large

bank customers typically generate large volumes of payments on behalf

For the two proposed rules, see 79 Fed. Reg. 6674 (Feb. 4, 2014); 76 Fed. Reg. 16,862

(Mar. 25, 2011).

ACH Interoperator Fee

of their business customers—many of which are sent to institutions that

use the Reserve Banks for ACH receipt. As a result, according to TCH

representatives, the interoperator fee benefits the Reserve Banks at the

expense of TCH. TCH representatives believe no costs exist that would

justify charging any price for these transactions.

However, Federal Reserve staff said that the Reserve Banks incur the

same costs when processing ACH files from a depository institution or

private-sector operator. If the Federal Reserve and TCH lowered or

eliminated the interoperator fee, the Federal Reserve likely would have to

increase prices for ACH payments made entirely within its network to

recover the lost revenue. This could effectively raise prices for its

customers while lowering them for TCH’s customers. Federal Reserve

staff said they established the interoperator fee below the average 2013

per-transaction cost to originate a FedACH item, not including electronic

connection costs. This average origination cost is based on operating

costs and imputed costs and has been fairly stable since the

determination of the fee.

While differences exist in cost structures between the Federal Reserve

and the private sector, these differences largely reflect differences in

customer bases. For example, TCH staff raised concerns over the cost-

effectiveness of the services provided by the Federal Reserve, noting that

they operate much more cost effectively on a per-item basis than the

Reserve Banks. Specifically, TCH said that its average cost per

transaction for check, ACH, and wire items was approximately 16 percent

to 29 percent of the average cost per transaction for the three products

offered by the Reserve Banks.

Page 40 GAO-16-614 Payment System Competition

However, TCH told us that they primarily

serve large financial institutions. The other competitors of the Reserve

Banks, including large commercial banks, a bankers’ bank, corporate

credit unions, and a nonbank service provider, also tended to serve

narrower ranges of customers. For example, representatives of some

large banks with whom we spoke said that they tended to provide

payment services mostly to larger entities. Staff from a large bank told us

that they mainly provide check processing services targeted to smaller

institutions in areas where their bank has support staff.

Although we reviewed Federal Reserve pricing schedules, we did not review TCH’s

pricing information.

Cost Effectiveness

In contrast, our analysis of Federal Reserve data indicated that the

Reserve Banks provide payment services to thousands of institutions

across a range of asset sizes, including large numbers of smaller

institutions. For example, about 86 percent of the Reserve Banks’ 3,665

forward check customers and about 94 percent of their ACH receipt

customers had less than $1 billion in assets. Federal Reserve staff told us

that providing payment services to many of these customers is more

costly because low-volume users are the largest users of customer

support services, resulting in higher per-item costs for these customers.

The account setup and maintenance costs also result in higher per-item

costs for low-volume customers. The Federal Reserve staff also noted

that they incur other expenses not borne by their private-sector

competitors, such as those related to processing transactions manually in

the event of a disruption. If TCH had a similar customer base and costs

as the Reserve Banks, its costs would likely be higher on a per item basis

and would be more similar to that of the Reserve Banks. Similarly, if the

Reserve Banks left the market for payment services, and TCH and the

other providers took on these customers, their costs per transaction

would likely increase due to the higher costs of serving the customers

currently served by the Reserve Banks, thus reducing or eliminating any

cost-effectiveness advantage. Correspondingly, if the Reserve Banks

provided services only to the larger customers that process larger

volumes, their costs per item would similarly be lower and their cost

effectiveness would appear higher.

The Federal Reserve noted that some of the differences in cost structures

provide competitive advantages to competitors of the Reserve Banks.

However, these cost differences may not be significant enough incentive

for current Federal Reserve customers to turn to other providers. For

example, staff from TCH said they have difficulty encouraging smaller

institutions to use TCH for payment services because many of these

institutions have payment volumes that are too low to produce savings

significant enough to justify a switch from the Federal Reserve.

TCH representatives expressed concerns that the Federal Reserve’s

pricing and other behaviors have limited competitors’ ability to promote

innovation in the payments system. Representatives from TCH said that

the Federal Reserve’s pricing strategies have left little room for

profitability in providing payment services, leading to an overall reduction

in investment in research and development necessary for continued

innovation in the payments industry. They also added that any

innovations developed by TCH need to be accepted by the Federal

Reserve, which can present a challenge. For example, TCH

Page 41 GAO-16-614 Payment System Competition

Ability to Remain Profitable

and Innovate

representatives said that they developed a universal payments identifier

to increase privacy protections and reduce fraud in electronic payments,

but the Federal Reserve did not adopt this innovation. Representatives

from the Federal Reserve noted that they partnered with TCH to deploy

this capability so that TCH customers wishing to use these identifiers for

ACH payments could do so without concern that such payments would be

rejected if they were routed across ACH networks. However, the Reserve

Banks said that there was little market demand for this capability by their

customers and determined not to offer the service directly.

In contrast, Federal Reserve staff said that the Federal Reserve’s

involvement in the payments market has contributed to the development

of new products and more efficient processes over time. Federal Reserve

staff and some market participants cited the Federal Reserve’s role in

multiple market innovations. For example, Federal Reserve staff indicated

that the remote capture of check deposits using smartphones and online

service access were an outcome of the check image improvements that

grew out of the Check 21 Act, which the Board helped to develop and the

Reserve Banks helped to implement. In addition, a representative from a

payment service provider said that the Federal Reserve was essential in

transitioning the check-clearing industry to image exchange after Check

21 became effective in 2004. The representative added that the Federal

Reserve has been helping to facilitate international ACH payments by

creating connections to other countries. Other market participants said

that the Federal Reserve has been leading the way on faster payment

initiatives such as same-day ACH (payments can clear and settle on the

same day they are submitted). The Reserve Banks began offering an opt-

in same-day ACH settlement service for certain debit transactions in

2010, and expanded this service to include support for credit transactions

in 2013. Federal Reserve staff said that their push toward instituting a

same-day ACH service, along with NACHA’s rule amendment in 2015

allowing for same-day ACH payments, will help their customers develop

new products, such as direct deposit for hourly payroll, which benefits

users as well. With customers increasingly demanding faster, ubiquitous,

safe, and inexpensive payment solutions, at least 18 other countries have

Page 42 GAO-16-614 Payment System Competition

developed real-time retail payments systems, according to a 2015 white

paper from an international payments network.

Page 43 GAO-16-614 Payment System Competition

Representatives from TCH said that increased regulatory costs along with

what they see as the unfair way that the Federal Reserve is competing in

payment services is creating difficulties for the long-term viability of

private-sector operators. TCH staff said that appropriate competition in

the market for payment services, including higher prices, would facilitate

continued research and development by the private sector, leading to

ongoing private-sector innovation in the payments system.

While the Monetary Control Act requires the Federal Reserve to give due

regard to competitive factors and the provision of an adequate level of

such services nationwide when pricing its payment services, the act does

not address the preferred type or extent of private-sector competition in

the payments industry. Federal Reserve staff said that there are clear

benefits to vigorous competition with the private sector, such as the

additional resilience provided to large bank customers due to the

presence of two wire payment operators. In addition, they said that the

competition between the two is helpful in ensuring both entities are as

responsive as possible to customer needs. However, they also noted that

the overall costs to the market of having two ACH operators are higher

because of the loss of some economies of scale. Federal Reserve staff

added that, while it is not their intent to drive TCH out of business, they

also are not convinced it is necessary to have two operators, as many

other countries only have one provider for such services. Because the

effect of changing any Federal Reserve pricing likely would allow TCH to

raise its own prices, the benefits of such actions for the overall

marketplace and end-users is not clear. Conversely, if the Federal

Reserve withdrew from the market, the costs to the overall payments

system could decrease, but since TCH would likely have to expand its

infrastructure and market reach, its costs would increase, and the effect

on overall prices also would be unclear.

SWIFT, The Global Adoption of Real-Time Retail Payments Systems (RT-RPS) (La

Hulpe, Belgium: 2015), accessed on June 6, 2016, this white paper can be downloaded

at: https://www.swift.com/your-needs/real-time-payments

To help ensure that they compete fairly with private-sector payment

services providers and set fair pricing, the Reserve Banks must adhere to

various pricing principles and Board policies. As discussed previously, the

policies include the pricing principles established in the Monetary Control

Act, which required Federal Reserve payment services to be priced at the

same fee schedule for Federal Reserve members and nonmembers and

that such fees be established on the basis of all direct and indirect costs,

giving due regard to competitive factors and the provision of an adequate

level of such services nationwide. The Board has adopted several

additional pricing principles to help ensure that the Reserve Banks

compete fairly.

· Generally, the Reserve Banks must set prices for each payment

service so that revenues match costs over the long run. However, the

Board’s pricing principles acknowledge that the Reserve Banks may

set below-cost prices for a service if it is in the interest of providing

adequate service nationwide. But such a decision would require a

Board announcement.

· The Reserve Banks also must ensure that their services and pricing

are responsive to the changing needs of particular markets and

provide advance notice for changes in fees and significant changes in

service arrangements to permit orderly adjustments by users and

providers of similar services.

To help ensure that Reserve Bank pricing determinations give adequate

regard to competitive factors, Federal Reserve staff told us that they

follow industry standards and best practices for pricing their services.

They said that the factors they consider are similar to those that other

service providers such as correspondent banks would consider. These

factors include

· the costs associated with the service;

· the cost structure, such as the extent to which costs are fixed or

variable;

· payment volumes;

· industry trends;

· the price sensitivity of customers; and

· the extent to which the market for the product or service is

competitive.

Page 44 GAO-16-614 Payment System Competition

FederalReserveHas

ProcessesandPoliciesto

HelpEnsurePricing

Fairness

They explained that price sensitivity—the extent to which a customer is

likely to react to a pricing change—for a product is particularly important

when determining whether to use volume pricing. For example, they said

that higher-volume customers are fairly price sensitive; that is, they are

more likely to send more or less business to the Reserve Banks

depending on the prices charged. With the cost to provide services to

higher-volume customers being lower than for other customers, staff said

that using volume pricing to set lower prices for higher-volume customers

was reasonable. Federal Reserve staff also said that they sometimes use

pricing to influence consumer demand. For example, for a legacy product

such as the access fee for using a dial-up connection to the Reserve

Banks, they might increase the price to discourage its use. The Federal

Reserve considers the various competitive factors for each pricing or

service change proposal (typically during its annual pricing process).

Each pricing or service change proposal during the process must

consider customer, competitive, and policy implications before the

Reserve Banks bring a formal proposal to the Board. At the beginning of

this process, Federal Reserve staff consider market feedback from the

prior year’s pricing changes and analyze market trends and projections as

they develop new pricing proposals.

The Board also has policies to prevent the Reserve Banks from engaging

in anticompetitive or predatory pricing. According to the Department of

Justice, predatory pricing occurs when a firm charges prices that are

temporarily set below its incremental costs in an attempt to harm

competitors. Department of Justice staff involved in antitrust and

anticompetitive legal cases told us that a firm can be deemed to be

competing unfairly if it is engaged in predatory pricing, bundling its

products anticompetitively, or engaged in anticompetitive tying—requiring

the purchase of additional products as part of another purchase. Federal

Reserve staff told us that they used volume-based pricing in accordance

with principles the Board published in the Federal Register in 1997, which

are intended to avoid the risk of predatory pricing. These principles note

that volume-based fees “promote the efficient use of payment services by

allowing Reserve Banks to set variable fees closer to the incremental

costs of providing services.”

Page 45 GAO-16-614 Payment System Competition

Federal Reserve staff said that they take

into account competitive factors when establishing volume-based pricing

because the need to attract sufficient revenue from large-volume

62 Fed. Reg. 14,146, 14,147 (Mar. 25, 1997).

customers better ensures that prices charged to low-volume customers

do not get too expensive. However, these principles also state that the

Reserve Banks will not price a particular service below its marginal cost,

or the cost of clearing one more item. According to these principles, this

type of pricing constraint is well established in antitrust law and is

intended to prevent predatory pricing.

In addition to these principles, the Federal Reserve conducts a

competitive impact analysis for all proposed changes to products and

prices and for all new products and prices. The analyses help ensure that

the Reserve Banks are not unfairly leveraging any legal advantages they

have over private-sector competitors—such as differing legal authority or

their dominant market position deriving from such legal differences.

According to a policy statement outlining its practices, the Federal

Reserve will conduct a competitive impact analysis on all proposed

operational or legal changes determined to have a substantial effect on

market participants, even if the competitive effects are not apparent on

the face of the proposal.

Page 46 GAO-16-614 Payment System Competition

In practice, Federal Reserve staff noted that

they also conduct competitive impact analyses for routine proposals

(those that only moderately affect existing product offerings). See

appendix IV for more information about how the Board conducts and

reviews competitive impact analyses.

Based on Federal Reserve data and estimates and our analysis and

interviews, the presence of the Reserve Banks in the payments services

market appears to have reduced payments services costs for some

customers to date. For instance, from 2001 through 2013 private-sector

providers increased their market share for check, ACH, and wire

services—an indication that the Reserve Banks have not necessarily

negatively affected competition in these markets (see fig. 7). In 2001, the

Reserve Banks had about 57 percent of the share of the market for check

payments, about 64 percent of the market for wire payments, and more

than 85 percent of the market for ACH transactions. By 2013 (the most

recent data available at the time of this review), the Reserve Banks’

market share had declined in each of these payment services, with the

largest declines occurring in the ACH market. Their share of payments

Federal Reserve System, Policies: The Federal Reserve in the Payments System,

issued in1984, revised in 1990, accessed on June 2, 2015,

http://www.federalreserve.gov/paymentsystems/pfs_frpaysys.htm

TheFederalReserve’s

PresenceAppearstoHave

GenerallyBenefitted

PaymentServiceUsers

originated declined from 86 percent to 49 percent and their share of

payments received from 87 percent to 63 percent.

Figure 7: Market Shares (Based on Dollar Volume) of Federal Reserve and Private-Sector Providers in Check, Automated

Page 47 GAO-16-614 Payment System Competition

Clearing House (ACH), and Wire Transfer Payments, 2001–2013

Although the Federal Reserve’s most recent triennial payments study

included market share data through 2013, some more recent data also

exist.

· ECCHO staff, using a different methodology, in 2014 and 2015

estimated that the Federal Reserve had between 42 percent and 44

percent of the check-clearing market.

· For ACH, the Federal Reserve had around 55 percent of the market

share for ACH originations and about 62 percent of the market for

ACH receipts in 2014 and 2015, according to our analysis of Federal

Reserve and NACHA data provided by the Federal Reserve.

· For wire payments, the Federal Reserve had about 55 percent of

market share in 2014 and 51 percent in 2015, according to our

analysis of Federal Reserve and TCH data provided by the Federal

Reserve.

These data suggest that the Reserve Banks’ market share for both check

and wire payments has continued to decline since 2013, although their

share of the ACH market has stabilized in the last few years.

The effect of the Reserve Banks’ competition in the markets for payment

services can vary across customers, but generally has resulted in lower

prices for payment transactions, according to Federal Reserve and TCH

staff. Federal Reserve staff told us that by competing actively to gain

more volume and new customers through their pricing and product

offerings, they have exerted downward pressure on prices for payment

services. TCH staff told us that the prices they charge their customers are

largely based on the cost of providing those services, taking into account

the prices set by their competitors in the marketplace.

The competition with the Reserve Banks often lowered prices for

competitors’ customers as well. Private-sector payment service providers

told us that the Reserve Banks’ published prices act as a baseline for the

industry. For example, TCH primarily serves large banks in a network

that, with few exceptions, offers the same pricing to all its members.

Representatives of TCH told us that they price their services based

largely on the cost of providing those services, taking into consideration

the price set by the marketplace, which includes the pricing offered by the

Reserve Banks and other private-sector entities. One nonbank service

provider that performed check processing said that most large banks try

to keep their prices about 10 percent lower than the Reserve Banks’. The

bankers’ bank and corporate credit unions we interviewed generally serve

smaller institutions in distinct geographical areas, such as a particular

state. Staff from the bankers’ bank said that the Reserve Banks’ fee

schedules serve as the pricing starting point for the industry.

Some of these competitors told us that they often offer additional services

to attract customers, similar to the Reserve Banks, and one also offers

discounts for customers that use multiple products and services. Another

servicer said that although they used to set prices directly off of the

Reserve Banks, they now use a model that can generate a range of

prices that allows them to maintain profitability. Although staff from one

bankers’ bank said that they were unable to offer prices as low as the

Reserve Banks’, they competed by offering more personalized customer

service than other competitors.

Our analysis of the Reserve Banks’ revenue and volume data shows that

many customers generally appear to have benefitted from lower prices in

recent years. We examined volume and revenue data for each of the

Page 48 GAO-16-614 Payment System Competition

Reserve Banks’ check, ACH, and wire services and determined that, in

general, while price ranges have expanded as previously noted, average

costs for financial institution customers generally decreased in recent

years.

Page 49 GAO-16-614 Payment System Competition

· For all check items, the Reserve Banks earned average revenue per

item of $0.0249 in 2014, down 82 percent from $0.160 in 2007.

Federal Reserve staff noted that the primary driver of this cost decline

has been the transition from exchanging paper checks to check

images.

· One of the most used check processing product types the Reserve

Banks offer involves processing files containing check images.

From

2004 to 2011 the most used product of this type was for files

submitted by 8:00 p.m. (in 2012, the deadline was changed to 9:00

p.m.). The average cost per file processed went from $0.054 in 2007

to $0.020 in 2015—a decline of almost 63 percent.

Similarly, many customers paid less for their ACH origination and receipt

transactions over time as the Reserve Banks’ average per-item ACH

revenues declined, although some customers benefited more than others.

Specifically, the average revenues per item for ACH items decreased

from $0.0046 in 2005 to $0.0044 in 2014, or about 5 percent. For both

ACH origination and receipt services, the Reserve Banks saw the

proportion of revenue, and the total revenue earned from their largest

customers, decline while revenues increased from all other customers,

despite the number of institutions in these categories remaining stable.

For example, the share of ACH revenue earned from institutions with

more than $1 billion in assets declined from 60 percent in 2005 to 56

percent in 2014, although total revenues from these customers grew from

$35.6 million to $46.4 million, or from $42.7 million to $46.9 million in

2015 dollars. Because these larger institutions likely serve many other

end-user business and retail customers, these lower costs likely benefited

such end-users. The tendency of other providers to match or attempt to

set lower prices than the Reserve Banks also would extend the benefits

The Federal Reserve revenue data we analyzed represent the payment services costs

paid by financial institution customers of the Federal Reserve.

This product is the Federal Reserve’s Mixed Image Cash Letter.

of lower Reserve Banks prices to the end-users that use other payment

service providers.

For its Fedwire service the Reserve Banks increased their revenues from

larger and midsize customers as their revenues declined from their

largest customers.

· Overall, Reserve Bank customers paid 76 percent more for wire

transfers from 2005 to 2014—which reflects the costs of system

upgrades that occurred during this time.

· From 2005 to 2014, the share of Fedwire revenues earned from the

largest institutions (more than $1 billion in assets) declined from 78.1

percent in 2005 to 64.9 percent in 2014, although total revenues from

these customers grew from almost $36 million to almost $50 million

(or from about $43.2 million to $50.5 million in 2015 dollars) in that

span.

· Revenues from the next largest institutions ($200 million to $1 billion

in assets) increased from 8.5 percent to 13 percent.

· In contrast, the revenues from the smallest institutions (less than $50

million in assets) remained under 1 percent.

Although smaller customers faced price increases, their actual costs are

smaller than those incurred by larger institutions. For example, small

credit union customers paid the Reserve Banks an average of $1,672

annually to receive ACH payments and small banks paid $1,772 in 2014.

In contrast, banks with more than $1 billion in assets paid an average of

almost $78,000 annually to send and receive FedACH payments that

year. We compared these average ACH expenses to the noninterest

expense amounts for all banks and credit unions with more than $1 billion

in assets and found that these ACH expenses would represent from

about 0.12 percent to 0.18 percent of the median institution’s total

noninterest expenses, but for the small institutions (those with less than

$50 million in assets), these ACH expenses would represent from about

Page 50 GAO-16-614 Payment System Competition

0.05 percent to 0.48 percent of the median institution’s total noninterest

expenses.

Page 51 GAO-16-614 Payment System Competition

Smaller institutions received far fewer Fedwire payments than larger

institutions, on average. The average small credit union received between

100 and 224 Fedwire payments annually from 2005 through 2014, and

small banks similarly received between 115 and 188. In contrast, the

average Reserve Bank customer with more than $1 billion in assets

received between 188,000 and 210,000 Fedwire payments annually in

the same period. As a result, the average amount spent on Fedwire

originations and receipts by smaller institutions was far lower than for

larger institutions. From 2005 to 2014 (the last year full data were

available), the average small credit union spent between $244 and

$1,838 annually to send and receive Fedwire transactions, or $914 on

average. Similarly, small banks spent between $396 and $1,442 on

Fedwire transactions, or $1,058 on average. In contrast, the largest

Federal Reserve customer banks spent between $48,000 and $77,000

annually, or almost $62,000 on average.

The Federal Reserve performs various roles, including managing

monetary policy, supervising bank holding companies and certain banks,

and acting as a lender of last resort, which create potential conflicts of

interest with the Reserve Banks’ role as provider of payment services. To

prevent Reserve Bank staff from inappropriately using any knowledge

gained from other activities (such as bank examinations) to increase the

competitiveness of their payment services, the Board has established

various policies and processes. In 1984, the Board issued various

standards to minimize the potential that the various roles of the Federal

Reserve could provide advantages for its payment services activities.

These include organizing the Reserve Banks’ operations so that the

duties of staff responsible for the Reserve Banks’ nonpayment services

activities do not overlap with those of the staff who conduct payment

services. Under this structure, Reserve Bank personnel with responsibility

for payment services (unless acting in the capacity of president or first

vice president) are prohibited from being responsible for monetary policy,

bank supervision, or lending.

Noninterest expenses are for resources other than borrowed funds and generally

include the costs of resources (such as compliance staff or consulting services) banks and

credit unions are likely to employ to comply with regulations.

MarketParticipants

GenerallyViewedthe

FederalReserveas

ManagingPotential

PaymentServices

Conflicts

Similarly, payment services personnel are prohibited from making policy

decisions affecting monetary policy, bank supervision, or lending matters.

Reserve Bank personnel involved in monetary policy, bank supervision,

or lending are permitted to provide to Reserve Bank payment services

personnel certain confidential information obtained in the course of their

duties. However, sharing the information would have to fulfill an important

supervisory objective, preserve the integrity of the payment mechanism,

or protect the assets of the Reserve Banks. In such cases, information is

to be provided on a need-to-know basis and only with the approval of

senior management.

To prevent payment services staff from obtaining information that could

be used for competitive advantage from the Federal Reserve’s

supervisory activities, Federal Reserve staff told us they have restrictions

on access to the databases that store examination information and other

confidential supervisory information. Board staff noted that the Reserve

Banks have groups that monitor credit risks to the Reserve Bank to

protect the assets of the Reserve Bank as well as to protect the payment

system generally. The staff in these groups have access to confidential

supervisory information to perform this activity, and sometimes must

share information with the payment services staff when implementing risk

controls on particular institutions’ accounts. The guidance that Federal

Reserve staff provided to us addressing credit risk monitoring activities

includes a section reminding Reserve Bank staff to share information on a

need-to-know basis only. A Board review conducted in 2005 that

surveyed the Reserve Banks on their information-sharing practices found

that staff were sharing information only when appropriate.

To limit potential for conflicts, Federal Reserve staff also have limited the

extent to which the information technology systems that financial

institutions use to access payment systems activities integrate with

functions related to other Federal Reserve activities. For instance, the

Reserve Banks offer a system known as Fedline, which provides the

ability to conduct transactions across various payment system services. A

July 2015 memorandum to staff responsible for statistics and deposit

reserves activities noted that staff responsible for payment services sales

had suggested that the applications for other business lines be more fully

integrated into Fedline to allow more seamless movement among these

activities. However, the memorandum reminds these staff that the

applications for the other business line functions were purposefully

segregated from the payment system applications in Fedline to better

ensure that staff adhered to conflict-of-interest standards for payment

services.

Page 52 GAO-16-614 Payment System Competition

The Federal Reserve also includes information in training to help ensure

that relevant staff are aware of restrictions intended to prevent payment

services activities from benefiting from information obtained from other

Federal Reserve activities. Federal Reserve Board staff explained that

conflict-of-interest issues are not covered in a separate training course

but instead are addressed as part of other training. The 1984 standards

note that Reserve Bank staff are expected to provide full and accurate

information on Federal Reserve services (including features, quality,

prices, and operating requirements) to enable depository institutions to

make informed decisions, and that comparisons of Federal Reserve

services with those of other providers should be fair and objective. During

initial training, employees who work in the sales and marketing areas are

made aware of these policies to help ensure that their sales interactions

with banks avoid any inappropriate discussions. The staff noted that the

credit risk management staff developed some training modules and an

online training course that was shared among the 12 Reserve Banks that

includes information on the Board’s guidance on information sharing.

In addition to the Board’s policies, the individual Reserve Banks whose

staff conduct payment service activities also have policies that restricted

information sharing and other activities that could create potential

conflicts. We reviewed the policies of five of the Reserve Banks that

conduct payment services activities to determine if they addressed

behavior that could create conflicts of interest among supervisory,

payment services, and other activities. Each of the five Reserve Banks

have policies that restrict the sharing of information between payment

services staff and supervisory or other Reserve Bank staff. In addition,

four of the banks specifically restrict supervisory staff from discussing

payment services issues with financial institutions. Three of the banks’

policies also note that payment services staff should not disclose to other

Reserve Bank staff whether a financial institution was a payment services

customer. In addition, three of the banks’ policies note that decisions on

whether to take supervisory actions against a financial institution should

not be based on whether or not the institution was a payment services

customer. The Reserve Bank policies generally note that sharing of

information between payment services and staff with other responsibilities

Page 53 GAO-16-614 Payment System Competition

could occur if such sharing served a specific supervisory purpose or if the

information was otherwise publicly available.

Page 54 GAO-16-614 Payment System Competition

To determine compliance with the policies to prevent staff from sharing

information or exerting influence to advantage its payment services

activities, the Board also conducts periodic reviews to evaluate the

Reserve Banks’ application of the policies. The Division of Reserve Bank

Operations and Payment Systems within the Board is responsible for

conducting operations reviews of the Reserve Banks. As previously

discussed, Board staff told us that they review operations at four Reserve

Banks each year. As part of these reviews, Board staff discuss the

Reserve Banks’ information sharing practices for staff and provide

feedback to the banks about any concerns with the management of

confidential supervisory information.

The Federal Reserve also indicated that oversight by other auditors also

helps provide assurance that it is taking adequate steps to minimize

conflicts between its payment system activities and its other roles. The

Board’s Inspector General conducts reviews that sometimes address the

Board’s oversight of Reserve Bank payment systems activities. For

example, in September 2014 the Inspector General reported on the

extent and effectiveness of oversight (by the Division of Reserve Bank

Operations and Payment Systems) of the Reserve Banks’ Fedwire and

other wholesale financial services activities.

The Inspector General’s

review stated that it had not identified any deficiencies regarding the

efficiency and effectiveness of the Board staff’s oversight, and that the

staff employed off-site monitoring, ongoing communication, on-site

reviews, and assistance from the general auditors at the Reserve Banks

to provide oversight of the Reserve Banks’ wholesale financial services.

The Board’s 1984 policy that sets out standards for the Reserve Banks’

payment services activities notes that an additional level of external

review comes from providing the public with the ability to comment on

significant Board proposals on Reserve Bank payment services activities.

In some cases the banks’ policies also specifically noted other reasons for allowing

sharing, including preserving the integrity of the payment mechanism or protecting the

assets of the Reserve Banks.

Office of the Inspector General, Board of Governors of the Federal Reserve System,

Opportunities Exist to Enhance the Onsite Reviews of the Reserve Banks’ Wholesale

Financial Services, 2014-FMIC-B-014 (Washington, D.C.: Sept. 30, 2014).

The Federal Reserve also has a process for addressing complaints about

its payment system activities. Federal Reserve staff told us that they have

sometimes received questions from market participants on these

operations. If the issue is not resolved to the participant’s satisfaction,

they can escalate the matter to the chair of the Board’s Committee on

Federal Reserve Bank Affairs. This person is responsible for investigating

and responding to complaints concerning actions of Reserve Bank

personnel who are alleged to be inconsistent with the standards related to

conflicts arising from its payment systems’ activities.

Discussions with Federal Reserve staff and market participants suggest

that the Reserve Banks comply with the policies intended to prevent them

from using their other roles to benefit their payment services activities.

When we last reported on the potential conflicts between the Reserve

Bank’s payment services activities and the other roles of the Federal

Reserve in 2000, we found no evidence to suggest that the Reserve

Banks had not adequately separated their multiple roles.

Page 55 GAO-16-614 Payment System Competition

Since then,

Board staff told us that they have rarely received complaints relating to

conflicting roles in the payments system. For example, in the last 5 years,

staff recalled one instance in which they received a complaint from a

competing payment clearing organization. The complaint related to an

alleged incident in which a Reserve Bank payment systems sales

employee purportedly told a financial institution that use of Reserve Bank

payment services would help them comply with any regulatory

requirements. Board staff pursued the complaint, but were unable to

address the specific allegation due to lack of details regarding the

incident. However, Board staff held discussions with Reserve Bank staff

responsible for payment services sales to reinforce policies concerning

conflicts of interest. According to the Federal Reserve staff, Board staff

advised the competing payment clearing organization of the steps that

were taken in response to its complaint, and the organization did not

pursue its concern with the chair of the Board’s Committee on Federal

Reserve Bank Affairs.

Most market participants we interviewed also indicated that they did not

have concerns that the Reserve Banks were inappropriately using their

various roles to benefit their payment services activities. To help assess

how well the Reserve Banks were managing potential conflicts among

GAO-01-160.

their different roles, we interviewed 24 providers and users of payment

services (including the top 5 largest banks and a randomly selected group

of service providers and end users).

Page 56 GAO-16-614 Payment System Competition

These entities included:

· 12 financial institutions and nonbank entities that compete with the

Reserve Banks to provide payment services; and

· 12 banks and credit unions that were end-user customers of private-

sector providers, the Reserve Banks, or both (including 6 also

supervised by the Federal Reserve).

Of the 12 entities we interviewed that were end-user customers of

payment services, most (10 of 12) did not express concerns with the

Federal Reserve’s multiple roles. For example, staff at one large bank

said the Federal Reserve managed any potential conflicts of interest

between its payments side and its regulatory side well and that they had

not seen evidence of conflicts. They noted that their discussions with

Federal Reserve examination staff focused on safety and soundness, and

conversations with the Federal Reserve payments services staff were

similar to those they would have with a private-sector vendor. Of the

entities with concerns, one was a credit union not supervised by the

Federal Reserve whose representatives said that they were unsure of the

need for the Federal Reserve to function as both a regulator and provider

in the payment system. The other was a large bank, whose staff noted

that although they were not aware of any situation where a Federal

Reserve examiner raised concerns with their bank’s use of private-sector

providers, they did note that concerns existed over whether the Federal

Reserve is fully recovering its costs or whether it uses its advantages

over private-sector competitors.

Similarly, of the 12 entities we interviewed that competed with the

Reserve Banks, representatives of 9 of these entities did not express any

concerns over the Federal Reserve’s management of its multiple roles.

To ensure that we obtained opinions from a range of payment services competitors and

end-users, we interviewed the top 5 largest banks, 4 of which compete with the Reserve

Banks and 1 that was only an end-user of their services. We also interviewed 11

institutions that were randomly selected banks from large, medium, and small size

groupings and large and small size groupings of credit unions. The 12 entities we

interviewed that competed with the Reserve Banks included 4 of the top 5 largest banks, 7

randomly selected entities and 1 judgmentally selected service provider identified in other

interviews as being a major provider of payment services.

Representatives of the 3 remaining entities did express some concerns.

For example, staff at one payment services provider told us that some

banks have been told by Federal Reserve staff that if they did not process

sufficient volumes on both of the competing ACH networks—those

operated by The Clearing House and by the Reserve Banks—it could be

seen as a supervisory issue. Representatives of another institution told us

that when they moved their check-clearing business from the Federal

Reserve to a competing provider more than 3 years ago, Federal Reserve

payment services employees allegedly made comments suggesting

negative implications for the institution. But since then, the Federal

Reserve has been this entity’s primary supervisor and the representatives

said that the Federal Reserve has not taken any inappropriate actions.

The third entity that expressed concerns was a large bank that is

supervised by the Federal Reserve and offers payment services to

others. Representatives of this bank noted their Federal Reserve

examiners had not exercised any pressure on their institution to use the

Federal Reserve’s payment services but questioned the appropriateness

of the Federal Reserve offering comments on pricing on the ACH

payment association’s proposal to implement same-day ACH

transactions.

Page 57 GAO-16-614 Payment System Competition

Federal Reserve staff noted that these concerns related to

the establishment, calculation, and future management of an interbank

fee (in the nature of an interchange fee) for the ACH system’s same-day

settlement transactions that would be processed by the Reserve Banks

as an ACH operator under the proposed rules of NACHA for this service.

Market participants we interviewed generally support the Reserve Banks’

role as providers of payment services. Many of the 34 market participants

we interviewed—bank and credit union users of payment services and

private-sector providers of payment services (both direct competitors and

others involved in payment services activities)—said that the Federal

Reserve has an important role in the payment system. Several market

participants, including those that compete with the Reserve Banks in

providing payment services, said that the Federal Reserve successfully

promotes ubiquitous access to payment services and should continue to

do so.

While ACH transactions are normally processed and settled the next day, in December

2014, NACHA sought public comments on implementing same-day processing of ACH.

MarketParticipants

GenerallySupporta

ContinuedRolefor

theFederalReserve

inthePayments

System

Representatives of all 12 financial institutions that we interviewed that

used the Reserve Banks’ payment services generally expressed positive

views about the Federal Reserve’s roles in the payment system, including

comments about the Federal Reserve providing stability, promoting

competition, ensuring access to all institutions, and promoting innovation

in the payments industry. Representatives of one large bank said that the

Reserve Banks have strengthened competition in the market and put

pressure on private-sector providers, which has benefitted all parties.

Representatives of a community bank said that they think the Reserve

Banks provide a valuable service, especially to community banks.

Representatives from 2 of the 12 financial institutions had concerns about

the Federal Reserve’s roles in payment services. Representatives from

one large federal credit union said that the Reserve Banks’ prices were

low and their service very good, but worried that the Reserve Banks’

actions to lower prices might weaken competition in this market. In

contrast, representatives of several smaller financial institutions with

whom we met said that they appreciated the Reserve Banks’ services in

the payments system and preferred to use their services over a private-

sector competitor. One bank official from a smaller institution said that

although the Reserve Banks’ prices were not necessarily lower than the

prices of private-sector providers, the official preferred the quality of

service in the provision of services.

Similarly, in our interviews all three payment service providers that do not

compete directly with the Reserve Banks said that they generally thought

the Reserve Banks’ provision of payment services has helped the

payment services industry. One provider said that the Federal Reserve

actively promoted innovation in the payments industry, citing the Federal

Reserve’s involvement in transitioning the check industry to digital

imaging, despite the resulting decrease in its own market share in that

payment service. Representatives from another provider said that they

believed that the Federal Reserve has always played the role of an

“industry helper” and cited the Federal Reserve’s roles in guiding the

industry toward adopting innovations in the coming years.

However, representatives from some competing payment service

providers said that they would prefer the Reserve Banks to compete less

actively in the payment services market. At least 6 of 12 competing

payment service providers and one trade association with members that

are competing providers said that they thought the Reserve Banks should

compete less actively in the payment services market, and several

suggested that the Federal Reserve instead become more of a payment

service “provider of last resort,” as illustrated in the following examples.

Page 58 GAO-16-614 Payment System Competition

· Representatives from one large bank said that for years they

considered the Reserve Banks as providing a critical function through

their connections to many institutions. But they noted that the Reserve

Banks recently made price and product changes to attract more

business and that undermined market competition. The staff said that

they would prefer the Reserve Banks to become providers of last

resort.

· Some private-sector providers suggested that the Federal Reserve

stop providing payment services and instead focus more on ensuring

ubiquitous access to all financial institutions or simply act as a

regulator by creating and overseeing rules for the private-sector

providers. Staff from one medium-sized bank said that they thought

the Reserve Banks should instead focus on setting the rules as a

regulator of the payments system, while staff from a corporate credit

union said the Reserve Banks should instead focus on settlement,

and not clearing of payments. However, Federal Reserve staff told us

that cost recovery requirements dictate that the Reserve Banks

remain an active service provider, because being a “provider of last

resort” would require them to make transactions too expensive. They

said that larger-volume customers likely would use other providers,

leaving revenue from the lower-volume customers that remained to

recover costs. Moreover, they indicated that, if the Reserve Banks

were providers of last resort, the Federal Reserve would likely not be

able to meet its statutory cost-recovery requirement and would not

further its mission to foster the efficiency of the payments system or

ensure ubiquitous access.

· Representatives of two payment service providers said that the

Federal Reserve could be more transparent in its payment service

pricing and compliance with the Monetary Control Act’s cost recovery

requirements. The pricing principles the Board developed in response

to the Monetary Control Act require the Reserve Banks to publish their

prices and to solicit public comments when proposing pricing or

product changes that are expected to have significant longer-term

effects on the payments system.

Representatives of TCH said that, while TCH welcomes competition from

the Federal Reserve, they believe that such competition should be strictly

in compliance with the Monetary Control Act, and that the Federal

Reserve should be transparent about such compliance.

Page 59 GAO-16-614 Payment System Competition

In acknowledgment of the need to ensure that the United States keeps

pace with advancements in the payments system, the Federal Reserve

has been convening groups of stakeholders to explore ways to improve

the payments system, including bringing about faster and more secure

payments. The Federal Reserve cited the rapid changes to the payments

process brought on by high-speed data networks and other technology,

as well as the escalating security threats towards existing payment

systems, as evidence of the need for all stakeholders to join to improve

the payment system. (Payment system stakeholders include large and

small businesses, emerging payments firms, card networks, payment

processors, consumers, financial institutions, and government agencies.)

Furthermore, consumers and businesses have begun to desire fast,

convenient, ubiquitous, safe, and inexpensive payment options, according

to an international payments network. While other countries have

developed real-time or near real-time retail payments systems, the U.S.

payments system does not have a ubiquitous, convenient, and cost-

effective way for consumers and businesses to make real-time or near

real-time payments. According to a 2015 white paper from the same

international payments network, 18 countries have real-time retail

payments systems, an additional 12 countries have been either exploring

or developing them, and another 17 have been considering developing a

system that would span multiple countries.

Page 60 GAO-16-614 Payment System Competition

In one example, Australia

has been making the transition to its New Payments Platform, which is

designed to enable future payments to be processed and settled in real

time with finality, even outside of normal banking hours.

To help begin the process and explore and solicit input on concepts and

criteria for a new system for the United States, the Federal Reserve

published a public consultation paper on improving the payments system

in September 2013.

This paper provided perspectives on the key gaps

in the current U.S. payment system and identified desired outcomes to

address the gaps. Specifically, the Federal Reserve identified eight gaps

and opportunities for improvement in the current payment environment,

SWIFT, The Global Adoption of Real-Time Retail Payments Systems (RT-RPS) (La

Hulpe, Belgium: 2015), accessed June 6, 2016.

https://www.swift.com/your-needs/real-time-payments.

The Federal Reserve Banks, Payment System Improvement – Public Consultation

Paper, September 10, 2013, accessed June 6, 2016.

https://fedpaymentsimprovement.org/wp-content/uploads/2013/09/Payment_System_Impr

ovement-Public_Consultation_Paper.pdf.

TheFederalReserveHas

BeenEngaging

StakeholderstoImprove

thePaymentsSystem

which included end users’ increased demand for real-time transactions

and timely notifications; the lack of ubiquity in currently operating

electronic payment services (as compared with legacy systems such as

checks); and the challenges associated with cross-border payments. The

paper also identified five desired outcomes to be achieved within 10 years

to address these gaps and opportunities. These desired outcomes

included having payment participants collectively identify and embrace

key improvements, implementing process improvements that reduce

costs and increase innovations over the long run, and having a system

that offers consumers and businesses greater choice and security.

The Federal Reserve obtained nearly 200 written responses from industry

stakeholders on the consultation paper, and published these responses

and the Federal Reserve staff summary of the responses on its website.

Page 61 GAO-16-614 Payment System Competition

According to the summary document, about 75 percent of the written

responses agreed with the gaps, opportunities, and desired outcomes the

paper had identified. Commenters also suggested additional areas for

focus, particularly related to ensuring comparable regulation for payment

providers and addressing the needs of the unbanked or underbanked.

For example, according to the Federal Reserve’s summary document,

depository institutions broadly argued that they are held to higher

regulatory and risk-management standards than nonbank payment

providers, and merchants expressed desire for a payment system

governance structure that allows them to have more influence. According

to the summary document, many respondents opined that a 10-year plan

to improve the payments system was not aggressive enough, and that

more action should be taken in the near term.

To advance this effort, in January of 2015 the Federal Reserve issued

Strategies for Improving the U.S. Payment System, a document that sets

forth its strategies for bringing together all stakeholders to improve the

Stakeholder comments and comment summary documents available at:

http://www.fedpaymentsimprovement.org.

The Federal Deposit Insurance Corporation has defined “unbanked” households as

those without checking or savings accounts and “underbanked” households as those that

have such accounts but also rely on alternative financial services. See Federal Deposit

Insurance Corporation, 2013 FDIC National Survey of Unbanked and Underbanked

Households, October 2014, accessed July 5th, 2016.

http://www.fdic.gov/householdsurvey.

payment system.

Page 62 GAO-16-614 Payment System Competition

In this document, the Federal Reserve refined and

finalized the five desired outcomes into the following categories: speed,

security, efficiency, international, and collaboration. In addition, the

Federal Reserve identified five strategies to improve the payment system

in the United States:

· actively engage with stakeholders on initiatives designed to improve

the U.S. payment system;

· identify effective approaches for implementing a safe, ubiquitous,

faster payments capability in the United States;

· work to reduce fraud risk and advance the safety, security, and

resiliency of the payment system;

· achieve greater end-to-end efficiency for domestic and cross-border

payments; and

· enhance Reserve Bank payments, settlement, and risk-management

services.

Since then, the Federal Reserve has been forming task forces of industry

stakeholders, with one task force focused on evaluating effective

approaches of a faster payments system, and the other focused on

promoting payment security. These task forces have developed

effectiveness criteria for assessing alternative solutions for faster

payments and the Federal Reserve has also appointed key staff to

support and guide these efforts.

Although some market participants expressed concerns to us about the

Federal Reserve’s process for moving toward a faster payments solution,

Federal Reserve staff told us that these concerns appeared to reflect

misunderstandings of the process. For example, representatives from a

payment service trade association with whom we spoke said that the

Federal Reserve was making edits and inserting criteria in documents

containing stakeholder perspectives to emphasize its own service

offerings. Specifically, they said that the Federal Reserve inserted a

criterion that suggested that all faster payments positions should settle

Federal Reserve System, Strategies for Improving the U.S. Payment System, January

26, 2015.

https://fedpaymentsimprovement.org/wp-content/uploads/strategies-improving-us-paymen

t-system.pdf

with the Reserve Banks. However, Federal Reserve staff noted that the

criterion in question states “The solution should either enable settlement

in central bank money, or minimize and strictly control the credit and

liquidity risk arising from the use of commercial bank money for the inter-

provider settlement process.” They added that settlement in central bank

money does not mean that the Reserve Banks would operate the faster

payments solution, as evident in TCH’s ACH service that settles using

central bank money. Federal Reserve staff also told us that the drafting of

the criteria documents for the Faster Payments Initiative took place during

meetings of the Faster Payments Task Force and Steering Committee,

and that this was a transparent and rigorous process.

Representatives from a large bank also said that they were concerned

about an intellectual property requirement contained in the participation

agreement for stakeholders involved in the faster payments planning

process. They said that the Federal Reserve required participants to sign

an agreement that included language noting anything coming out of the

discussion would be the intellectual property of the Federal Reserve.

Because of these terms, the bank decided not to participate, and they

said that they knew of other financial institutions that felt similarly.

However, Federal Reserve staff said that the characterization of the

participation agreement language is not correct and that the agreement

does not limit a participant’s use of its own intellectual property. Instead,

they said that the agreement includes terms for fair, reasonable, and

nondiscriminatory licensing of intellectual property. In addition, there is an

opt-out provision in the agreement that allows participants to identify any

intellectual property present in a final report before it is published and

decline to grant the license for it. Furthermore, based on feedback from

the industry related to the intellectual property provisions, the Federal

Reserve revised the participation agreement in March 2016 to reduce the

scope and legal burdens for the participant in licensing its intellectual

property. Federal Reserve staff said that the vast majority of current

members have signed this agreement and additional industry participants

have also joined their effort after these revisions were made.

Page 63 GAO-16-614 Payment System Competition

Federal Reserve staff stated that 29 new members and approximately 81 percent of the

existing members executed the new agreement, with total membership of 292 as of July 1,

2016. According to Federal Reserve staff, feedback provided to them suggested that slight

attrition in membership was due to interest and capacity and not a result of concerns with

the amended agreement.

The presence and activities of the Federal Reserve in the payments

system generally have been beneficial, including by helping to lower the

cost of processing payments for many end-users. Market participants also

generally supported having the Federal Reserve continue to play multiple

roles in the payment system. The Federal Reserve also continues to

support innovation and process improvements for the payments in the

United States.

To help ensure that it competes fairly with the private sector, the Federal

Reserve uses a cost accounting system for capturing its payment system

costs that is detailed and generally in alignment with comparable federal

standards. It also uses a reasonable approach to impute the costs that it

would bear if it was a private entity and includes these in the costs that it

recovers with its payment services revenues. However, the Federal

Reserve has not included in its imputed costs some costs that its

competitors incur. These include those related to developing plans for

recovery and orderly wind down, which are costs that its primary

competitor in wire transfers has had to incur to comply with new

requirements for resolution planning for systemically important payment

system entities. Also, the Federal Reserve has not included costs borne

by private-sector providers related to complying with antimoney-

laundering requirements. By including these costs, the Federal Reserve

would more completely impute and recover costs that it would have

incurred as a private firm.

In addition, although it also conducts internal reviews to help ensure that

it captures the required costs accurately, the cost accounting system has

not been specifically reviewed by an external auditor in more than 30

years. Internal control standards state that compliance with applicable

laws and regulations is a key internal control objective, and a key means

of providing such assurance can be the performance of monitoring

activities, which can include external reviews, to ensure that such

compliance is occurring. Having its cost accounting practices periodically

subject to independent testing would provide greater assurance that the

Federal Reserve is complying with the Monetary Control Act.

To provide greater assurance that the Federal Reserve is complying with

the Monetary Control Act’s requirement to establish fees on the basis of

costs actually incurred and an allocation of imputed private-sector costs,

the Chair of the Federal Reserve Board of Governors of the Federal

Reserve System should:

Page 64 GAO-16-614 Payment System Competition

Conclusions

Recommendationsfor

ExecutiveAction

· Consider ways to incorporate the costs related to integrated planning

for recovery and wind down and compliance with antimoney-

laundering requirements, to the extent practicable, in its imputed

private-sector cost methodology.

· Periodically obtain independent testing of the methods the Federal

Reserve uses to capture its actual costs and simulate those of the

private sector.

We provided a draft of this report to the Federal Reserve and to The

Clearing House for review and comment. The Federal Reserve provided

written comments that we reprinted in appendix V. The Federal Reserve

and The Clearing House also provided technical comments that we

incorporated, as appropriate.

In written comments, the Federal Reserve stated that it is planning to take

steps in response to both recommendations. In response to our

recommendation that it consider ways to incorporate costs related to

integrated planning for recovery and wind down and compliance with

antimoney-laundering requirements in its imputed private-sector cost

methodology, the Federal Reserve’s letter stated that it will consider ways

to incorporate these costs. The Federal Reserve noted that, in some

cases, these costs are difficult to measure, given the challenges in

obtaining financial information from private-sector payment service

providers. In other cases, the Federal Reserve noted that it already bears

costs that its competitors do not. In response to our recommendation that

the methods the Federal Reserve uses to capture its actual costs and

simulate those of the private sector be independently tested periodically,

the Federal Reserve stated that it will procure an independent review of

the methods used for capturing actual and imputed costs related to its

payment services. We acknowledge this step and note that having such

reviews performed periodically will provide greater assurance to all

payment services market participants of the Federal Reserve’s

compliance with the Monetary Control Act.

Along with its technical comments, The Clearing House noted an

appreciation of our recommendations that the Federal Reserve consider

ways to incorporate certain costs borne by the private sector in providing

payment services and obtain periodic independent cost-capturing system

testing. However, The Clearing House also stated that it was

disappointed in our other findings, which did not appear to reflect the data

provided to us on a variety of issues. We believe we incorporated the

Page 65 GAO-16-614 Payment System Competition

AgencyComments,

Third-PartyViews,

andOurEvaluation

information provided by The Clearing House to the extent possible as

appropriate.

As agreed with your office, unless you publicly announce the contents of

this report earlier, we plan no further distribution until 30 days from the

report date. At that time, we will send copies to the Federal Reserve and

other interested parties as appropriate. In addition, the report will be

available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact

me at (202) 512-8678 or [email protected]. Contact points for our Offices

of Congressional Relations and Public Affairs may be found on the last

page of this report. GAO staff who made key contributions to this report

are listed in appendix v.

Sincerely yours,

Lawrance L. Evans, Jr.

Director, Financial Markets

and Community Investment

Page 66 GAO-16-614 Payment System Competition

Appendix I: Objectives, Scope, and

Methodology

This report focuses on three payment system services offered by the

Federal Reserve—check clearing, electronic payments known as

Automated Clearing House (ACH) payments, and wire transfer

payments—because these are the services in which the Federal Reserve

competes with private-sector entities. This report examined (1) how

effectively the Federal Reserve captures and recovers its payment

services costs; (2) the effect of the Federal Reserve’s practices on

competition in the payment services market; (3) how the Federal Reserve

mitigates the inherent conflicts posed by its various roles in the payments

system; and (4) market participant viewpoints on the future role of the

Federal Reserve in the payments system.

To examine how effectively the Federal Reserve has recovered the costs

of providing these payment services, we analyzed data on overall

reported revenues and expenses associated with the three payment

services from 1996 through 2015. We also analyzed data on the specific

expenses associated with the payment services from 2001 through 2014

to identify relevant trends and cost structures. We assessed the reliability

of these data by interviewing relevant Federal Reserve officials about the

controls and quality assurance practices they used to compile these data,

and determined the data were reliable for these purposes. We

interviewed Federal Reserve staff about the processes used for capturing

these costs and reviewed the Federal Reserve’s Planning and Control

System (PACS) Manual for Federal Reserve Banks, which establishes

cost accounting policies for the payment services at all Federal Reserve

Banks, whose staff conduct the payment services activities. We obtained

expert opinions on the soundness of the policies and practices detailed in

the PACS manual, including consulting internally with a cost accounting

expert within GAO, as well as with representatives from the auditing firm

that had conducted the 2014 audit of the Federal Reserve’s financial

statements. We analyzed 12 reviews conducted by an internal Board staff

between 2012 and 2015 and a judgmental selection of 9 audits conducted

by the internal audit staff of the Reserve Banks to determine the extent of

their findings related to cost accounting practices.

Page 67 GAO-16-614 Payment System Competition

We also reviewed the

only external audit that had examined the cost accounting practices at the

Federal Reserve Banks that had been conducted in 1984. No private-

sector cost accounting standards existed to compare to the cost

The internal Reserve Bank audits were selected from a list of payment service audits

conducted at the Reserve Banks between 2011 and December 2015.

AppendixI:Objectives,Scope,and

Methodology

Appendix I: Objectives, Scope, and

Methodology

accounting practices followed by the Reserve Banks, which are federally

chartered but organized as private corporations. As a result, we

compared the design of PACS to the elements that federal managerial

cost accounting standards—Statement of Federal Financial Accounting

Standards 4—recommend be included in federal agency cost accounting

systems to determine how the Federal Reserve’s practices aligned with a

comparable standard.

To determine how the Federal Reserve was imputing and recovering

costs that would have been incurred had its payment services been

provided by a private firm, in accordance with the Monetary Control Act,

we examined data and documentation relating to the Federal Reserve’s

methodology for computing this “private sector adjustment factor” (PSAF).

Based on our assessment of the controls and quality assurance practices

the Federal Reserve used to compile these data, we determined the data

were reliable for this purpose. We consulted with an internal GAO

financial markets expert, a financial analyst who monitors payment

service market participants, and three academic financial experts on the

reasonableness of the methodology’s assumptions. We reviewed notices

in the Federal Register from 2005 through 2014 that detailed proposed

and final changes to the methodology over this period. For further

explanation of these issues we spoke with Federal Reserve staff who

oversee payment services activities. We also interviewed a financial trade

association that issues rules governing payment system activities and

whose members participate in the payments industry, as well as

representatives of a major payment services provider to get their opinions

on the Federal Reserve’s PSAF methodology. We also reviewed industry

documentation on criticisms of the Federal Reserve’s PSAF methodology.

To examine how the Federal Reserve prices its payment services and

assesses the impact of its competition in this market, we analyzed volume

and pricing data for the Federal Reserve’s check, wire, and ACH payment

services from 2004 to 2014, including publicly available fee schedules.

We also analyzed Federal Reserve pricing and revenue data for each of

these services, including examining trends in service prices over time. To

ensure that these data were sufficiently reliable for our purposes, we

verified that we had obtained complete data on the revenue by type of

customer by comparing them to the annual revenue totals reported

publicly by the Federal Reserve. Based on this comparison and our

assessment of the controls and quality assurance practices the Federal

Reserve used to compile these data, we determined the data were

reliable for this purpose. We also reviewed Federal Reserve

documentation on pricing its services and on competitive impact

Page 68 GAO-16-614 Payment System Competition

Appendix I: Objectives, Scope, and

Methodology

analyses, including policies, guidance, and Federal Register notices. We

interviewed Federal Reserve staff for information on how they price their

services and compete in the payments market. We also interviewed staff

from the Department of Justice to better understand what practices can

be considered anticompetitive.

For the perspectives of market participants on the Federal Reserve’s

pricing and competitive impact in the payments industry, we interviewed

34 market participants, including:

· 7 financial trade associations whose members participate in payment

systems and/or issue rules governing payment system activities

(NACHA and the Electronic Check Clearing House Organization).

· 12 entities that provide payment services that compete with the

Federal Reserve, including

· 3 nonfinancial institution service providers,

· 6 correspondent banks that provide payment services to other

institutions but also offer banking services to individual corporate

and retail customers,

· 2 corporate credit unions and 1 bankers’ bank that conduct

payment services and other activities for other institutions.

· 3 nonfinancial institution payment services providers that did not

compete with the Federal Reserve.

· 12 financial institutions that were end users of payment services from

other private-sector providers and/or the Federal Reserve, including

· 8 banks (including 6 that were regulated by the Federal Reserve),

and

· 4 credit unions.

We selected the financial institutions that used the Federal Reserve or

private-sector providers in two ways. First, we interviewed the 5 largest

bank holding companies by total assets in the United States. Some of

these institutions are both providers of payment services and users of the

Page 69 GAO-16-614 Payment System Competition

Appendix I: Objectives, Scope, and

Methodology

Federal Reserve’s services. Second, we interviewed an additional 11

banks and credit unions that were chosen by random selection within the

following tiers based on total assets:

· Banks (7)

· >$50 billion (3 large)

· $10-$50 billion (2 midsized)

· <$10 billion (2 small)

· Credit Unions (4)

· >$5 billion (3 large)

· <$5 billion (1 small)

The entities we interviewed that provide payment services were those

selected randomly from a larger sample of institutions identified by a

payments industry association and those identified in other interviews as

service providers with valuable knowledge of the industry.

We also analyzed data from the Federal Reserve that included the

revenues it earned from various customer categories that it tracked

internally. These categories included various ones for customer

institutions of various asset sizes and for other entities, such as bankers’

banks or foreign banks. We used these data to identify the extent to

which the Federal Reserve’s revenues had changed over time and how

the amounts paid by different customer groups had changed. Because of

circumstances in the check market—including the industry’s transition to

images—we determined that the data for check were only sufficiently

comparable from the period between 2007 and 2014, which was the last

year that we obtained complete transaction volume data from the Federal

Reserve. Data for ACH and wire transfers appeared to be sufficiently

comparable from 2005 to 2014. Based on our assessment of the controls

and quality assurance practices the Federal Reserve used to compile

these data, we determined the data were reliable for this purpose.

To examine how the Federal Reserve mitigates the inherent conflicts

posed by its various roles in the payments system, we reviewed the

Federal Reserve’s policies related to its payment services organizational

structure and the requirements related to the conduct of its staff in the

Monetary Control Act and relevant Federal Reserve policies. We also

reviewed additional guidance the Federal Reserve provided to its staff on

the conduct of its payment services activities. We also reviewed training

Page 70 GAO-16-614 Payment System Competition

Appendix I: Objectives, Scope, and

Methodology

materials the Federal Reserve used to inform its staff about requirements

relating to its payment services activities. In addition, we reviewed audits

or other reviews done by the Board’s Inspector General or other bodies

related to the conduct of its payment services activities. We interviewed

the Federal Reserve Board staff who oversee payment services activities,

including about the extent to which they received complaints from market

participants and about the conduct of the Federal Reserve’s payment

services activities. In addition, we interviewed representatives of the 34

market participants to obtain their perspectives on the conflicts in the

Federal Reserve’s roles in the U.S. payments system.

To examine market participant viewpoints on the future role of the Federal

Reserve in the payments system, we interviewed representatives of the

34 market participants, including bank and credit union users of payment

services and private-sector providers of payment services (both direct

competitors and others involved in payment system activities). We also

reviewed the Federal Reserve’s policies that outline the criteria it would

consider before offering a new payment service, including comment

letters publicly posted by industry stakeholders in response to the Federal

Reserve’s public consultation paper. We also obtained views of Federal

Reserve staff about their payments improvement initiative.

We conducted this performance audit from November 2014 to August

2016 in accordance with generally accepted government auditing

standards. Those standards require that we plan and perform the audit to

obtain sufficient, appropriate evidence to provide a reasonable basis for

our findings and conclusions based on our audit objectives. We believe

that the evidence obtained provides a reasonable basis for our findings

and conclusions based on our audit objectives.

Page 71 GAO-16-614 Payment System Competition

Appendix II: Federal Reserve Payment

Services Cost Accounting

The Monetary Control Act requires that over the long run the Federal

Reserve’s fees be established on the basis of all direct and indirect costs

actually incurred in providing payment services, and an allocation of

imputed costs that would have been incurred by a private-sector provider.

The Federal Reserve Banks use a detailed cost accounting system that

helps them meet their requirements relating to how to set fees and

account for and recover costs incurred as part of providing payment

services.

According to data provided to us by the Federal Reserve, The Federal

Reserve Banks incurred more than $410 million in costs as part of

providing payment services in 2014 (see table 2). Of these, personnel

costs represented about 7 percent of total payment services costs.

Support costs represented the large majority of the costs of payment

services activities. Nearly 78 percent of the overall costs of providing

payment services arose from almost $320 million of expenses allocated

to those services by the Federal Reserve’s National Support Services.

These costs included the expenses arising from developing software

applications, implementing information security, providing help-desk

services, business development activities, accounting, and other support

functions. The Federal Reserve Banks’ payment services were also

allocated more than $28 million in local support services costs that

include Reserve Bank information, technology services, audit expenses,

and general administrative services. More than $22 million in various

overhead costs—representing about 5 percent of overall payment

services costs—were also allocated to payment services activities, and

these included, Federal Reserve staff told us, expenses associated with

overall corporate-wide functions such as bank administration, accounting,

and contingency planning.

Page 72 GAO-16-614 Payment System Competition

AppendixII:FederalReservePayment

ServicesCostAccounting

FederalReservePayment

ServicesCosts

Appendix II: Federal Reserve Payment

Services Cost Accounting

Table 2: 2014 Federal Reserve Payment Services Direct and Indirect Costs (in Dollars)

Page 73 GAO-16-614 Payment System Competition

Actual cost ($)

Percentage of total cost

Total cost

410,305,215

100.0

Personnel

28,961,178

7.06

Materials and supplies

146,077

0.04

Equipment

356,925

0.09

Software costs

8,124,382

1.98

Shipping

316,514

0.08

Travel

566,509

0.14

Communications

148,557

0.04

Building

160,946

0.04

Other

1,154,666

0.28

Recoveries

(95,851)

-0.02

Support

348,120,529

84.84

Local support

28,156,949

6.86

National support

319,963,580

77.98

Development/maintenance of software applications

138,817,178

33.83

Use of the Fedline application and associated utilities

75,146,371

18.31

National information technology support

31,173,454

7.60

Management, including planning, oversight and

management of production environment

32,353,097

7.89

Sales and business development services

19,308,006

4.71

Accounting and other support functions

23,165,475

5.65

Overhead

22,344,784

5.45

Source: Federal Reserve. | GAO-16-614

Notes: This table excludes the additional imputed costs that the Federal Reserve adds to its payment

services costs to simulate the costs that would also be incurred if these services were provided by a

private-sector entity.

Recoveries are defined as receipts of funds for an incidental service or product produced by the

Reserve Banks in the course of accomplishing the basic responsibilities of the Federal Reserve

System. Recoveries include, but are not limited to, receipts for such items as tenant rent, cafeteria

services, and manual fees, periodicals, publications, and regulations.

According to the Planning and Control System (PACS) Manual for the

Federal Reserve Banks, every dollar expended (or received) by the

Reserve Banks is recorded into three cost categories: account,

department, and activity. Federal Reserve staff described how a Reserve

Bank’s expense related to a $10,000 contribution to the employees’

retirement thrift plan account would be recorded in the following way.

ReserveBanks’Cost

AccountingSystem

Appendix II: Federal Reserve Payment

Services Cost Accounting

· Initially, costs are recorded at the account level. In this example, these

contributions are recorded in a “Retirement and other benefits – Thrift

Plan” expense account.

· Because the contributions were made for employees who work in

different departments, the Federal Reserve would allocate these

expenses to departments using various allocation methods. For

example, the Retail Electronic Payments Department at a given

Reserve Bank would be allocated some of the retirement expenses.

The allocation would be calculated based on a “salary dollar ratio

distribution,” equal to the salary expense of the department divided by

the total salary expense of the Reserve Bank. Therefore, if the

salaries in the department represented 1 percent of the salaries of the

Reserve Bank, 1 percent of the retirement plan contribution ($100)

would be allocated to the Retail Electronic Payments Department.

· Subsequently, the Federal Reserve would further allocate this

departmental expense among the various activities that the

department tracks. For example, if 70 percent of the department’s

operations were devoted to automated clearing house (ACH) activities

and 30 percent were associated with check processing, $70 of the

department’s allocated retirement expense would be recorded under

ACH activity and $30 under check activity.

Similarly, the Federal Reserve Banks’ payment services would be

allocated support and overhead expenses using the methods and

procedures prescribed in the PACS manual, such as using a fixed

percentage of some other factor or on a dollar-ratio basis. For example,

maintenance expenses incurred at one Reserve Bank may be allocated

to payment services activities on the basis of the amount of space their

operations occupy in the bank’s buildings.

Page 74 GAO-16-614 Payment System Competition

Appendix III: Private Sector Adjustment Factor

(PSAF) Methodology

As it is required under the Monetary Control Act to calculate imputed

private-sector costs and return on capital, the Board of Governors of the

Federal Reserve System (Board) has developed a PSAF methodology

that allows it to calculate four costs that they do not incur, but that a

typical private-sector payment services provider would incur: debt

financing costs, equity financing costs (or return on equity), taxes, and

payment services’ share of Federal Reserve Board expenses. A private

firm providing payment services would need to raise capital to obtain the

funds to invest in the necessary facilities, equipment, and other assets

needed to conduct these activities. To determine the financing costs

associated with this debt and equity capital, the Federal Reserve

compiles the values of the actual assets it uses to conduct payment

services activities. In addition to its premises, furniture, and equipment,

these values may include an asset corresponding to the Federal

Reserve’s net pension plan obligations. The PSAF methodology assumes

that any short-term assets—such as supplies—are to be financed with

short-term debt and that long-term assets—such as facilities and

equipment—would be financed with long-term liabilities and a

combination of imputed long-term debt and equity. The methodology also

assumes that the Federal Reserve would use the same percentage mix of

long-term debt and equity that it derives from the U.S. publicly traded firm

index to finance its long-term assets not offset by long-term liabilities.

Page 75 GAO-16-614 Payment System Competition

Once it has identified the imputed amount of debt and equity it would

need to fund its capital structure, the Federal Reserve calculates the rates

for debt and equity financing. Using publicly available, market-based

interest rates, it calculates a total amount of interest that it would have to

pay for the year on the mix of short- and long-term debt amounts that

were identified based on its asset structure.

In 2016, the Federal

Reserve’s PSAF methodology determined that it would have paid a rate

Data for U.S. publicly traded firms are from the Standard and Poor’s Compustat®

database. This database contains information on more than 6,000 U.S. publicly traded

firms, which approximates the entirety of the U.S. market.

The imputed short- and long-term debt financing rates are derived from the nonfinancial

commercial paper rates from the Federal Reserve Board’s H.15 Selected Interest Rates

release (AA and A2/P2) and the annual Merrill Lynch Corporate & High Yield Index rate,

respectively.

AppendixIII:PrivateSectorAdjustment

Factor(PSAF)Methodology

Appendix III: Private Sector Adjustment Factor

(PSAF) Methodology

of 0.3 percent on $19 million of short-term debt.

Page 76 GAO-16-614 Payment System Competition

The long-term debt

financing rate was 4.2 percent.

To determine the cost of the equity it would have to use to finance its

payment services activities’ assets, the Federal Reserve uses a generally

accepted financial formula for calculating the expected rate of return on

equity that investors would demand based on its risk relative to the

market as a whole.

In 2016, the PSAF model calculated a pre-tax return

on equity of about 9.8 percent, which represented additional imputed

financing costs of $5.3 million.

After these total imputed financing costs of debt and return on equity are

calculated, the Federal Reserve’s PSAF methodology imputes two

additional costs that a private-sector firm likely would incur. The first of

these additional costs is an amount equivalent to the sales taxes that the

Federal Reserve Banks would have incurred based on budgeted outlays

for materials, supplies, and capital. These costs must be included as part

of the allocation of imputed costs under the criteria listed in the Monetary

Control Act. Furthermore, these costs are imputed rather than actual

because the Federal Reserve Banks are exempt from paying sales taxes

under the Federal Reserve Act. Then payment services’ share of Federal

Reserve Board expenses, which Federal Reserve staff said are costs

associated with the Board’s supervision of the payment services

operations conducted by the Reserve Banks, are included in the PSAF,

because, Federal Reserve staff told us, these costs are not captured by

the PACS (which captures the actual costs Reserve Banks incur). In

2016, the expenses related to Board supervision and to imputed sales

taxes were calculated to be $5.0 million and $2.8 million, respectively.

80 Fed. Reg. 70,783, 70,789 (Nov. 16, 2015).

In 2016, the Federal Reserve’s net long-term assets (long-term assets minus long-term

liabilities) on its pro forma balance sheet were not great enough to require any additional

financing using imputed long-term debt in the PSAF, so the 2016 PSAF did not include

any long-term debt financing costs.

The equity financing rate is calculated using the Capital Asset Pricing Model. In this

model, the required rate of return on a firm’s equity is equal to the return on a risk-free

asset plus a market risk premium. In the Federal Reserve’s methodology, the risk-free rate

is based on the 3-month Treasury bill, the equity risk measure (its beta) is assumed to be

equal to 1.0 or the average of the risk of the market as a whole, and the market risk

premium is based on the equity market returns in excess of the risk-free rate over the

most recent 40 years.

Appendix III: Private Sector Adjustment Factor

(PSAF) Methodology

Using its PSAF methodology, in 2016 the Federal Reserve calculated a

total PSAF cost of $13.1 million that would have been incurred if the

Reserve Banks were a private-sector provider, down from $18.0 million in

2015, as shown in table 3. This amount was allocated to each payment

service based on the percentage of the projected operating expenses of

the Federal Reserve Banks’ payment services that each service

represented.

Table 3: Component Expenses Calculated by the Federal Reserve’s Private-Sector Adjustment Factor (PSAF) in 2015 and

Page 77 GAO-16-614 Payment System Competition

2016, dollars in millions

A. Cost of capital

2016

2015

Elements of capital costs

N/A

Short-term debt

$19.0 x

0.3%=

$0.1

$18.5 x

0.2%=

$0.0

Long-term debt

— x

4.2%=

$0.0

$81.9 x

5.0% =

$4.1

Equity

$53.8 x

9.8% =

$5.3

$71.9 x

10.1% =

$7.3

N/A

$5.4

N/A

$11.4

B. Other required PSAF costs

N/A

Sales tax

N/A

$2.8

N/A

$3.3

N/A

Board of Governors expenses

N/A

$5.0

N/A

$3.3

N/A

$7.8

N/A

$6.6

C. Total PSAF

N/A

$13.1

N/A

$18.0

Legend: N/A = Not applicable

Source: Federal Reserve | GAO 16 614

As part of the Federal Reserve’s attempts to improve the PSAF’s

accuracy and conform it to changes in the payment system market,

Federal Reserve staff noted that the Board has made numerous changes

to the methodology over the years.

These changes included a change made in 2000 to begin allocating a

portion of the Federal Reserve’s prepaid pension asset and

postretirement and postemployment benefit liabilities into the asset and

equity amounts the PSAF used for calculating imputed financing costs

and returns on equity. This change was made because the value of the

prepaid pension assets began to increase significantly due to large

returns generated from its investments and because the effects of prepaid

pension assets were being included in the balance sheets of the bank

holding companies the Federal Reserve was using as its peer group to

compute the PSAF’s financing rates and return on equity. This change

resulted in an additional $60.5 million of pretax imputed costs being

included in the 2000 PSAF amount. In 2005, the Federal Reserve

PSAFMethodology

ChangesOverTime

Appendix III: Private Sector Adjustment Factor

(PSAF) Methodology

simplified its methodology for calculating the PSAF’s equity financing rate

by shifting from an average of three separate financing models to a single

calculation based on the return on equity investors would demand based

on the risk in the market.

In the past, the Federal Reserve used financial information from large

U.S. bank holding companies to calculate elements of the PSAF. For

example, from 1981 to 2001, the Federal Reserve had been using the

average debt and equity proportions used by the top bank holding

companies in the United States, before setting the equity imputed into the

PSAF to meet the FDIC definition of a well-capitalized institution.

Additionally, the financial information from large bank holding companies

was used to calculate the PSAF’s return on equity until 2006 and imputed

taxes until 2013. In 2012, the Board adopted a policy of basing the

imputed capital structure, debt and ROE rates, and tax rates on data for

the U.S. publicly traded firm market. Federal Reserve staff noted that over

time bank holding companies were engaged in different businesses and

had risk profiles that were beyond those represented by the payment

services of the Reserve Banks, many of which are now provided by

nonbank entities. In 2012, the Federal Reserve amended Regulation D,

governing reserve requirements, to eliminate the clearing balance

program, which was largely modeled after similar programs offered by

correspondent banks, wherein banks maintain balances with their

correspondents. The level of clearing balances held at the Reserve Banks

had declined after the Federal Reserve began paying interest on deposit

balances held at Reserve Banks. Federal Reserve staff noted that the

elimination of the clearing balance program significantly changed the size

and nature of the assets and liabilities associated with the payment

services to such an extent that the Federal Reserve determined that the

use of bank holding companies as the peer group was no longer

appropriate for the PSAF methodology.

Page 78 GAO-16-614 Payment System Competition

Appendix IV: Competitive Impact Assessment

Process

To ensure that it is not unfairly leveraging a possible legal advantage to

benefit its payment service activities, the Board of Governors of the

Federal Reserve System (Board) formally analyzes the potential

competitive impact of any significant changes in the Reserve Banks’

payment services pricing or product offerings. The process it uses for

conducting competitive impact analyses involves determining if a

proposed change would harm other providers due to legal differences,

and then weighing the potential harm of the change to competitors

against the potential benefits to the overall payments system. For each

price or service change proposal, the Board first considers whether the

change would have a direct and material adverse effect on the ability of

other service providers to compete with the Reserve Banks. According to

its policy, if the Board identifies such an effect, staff then determine

whether the effect was due to differing legal powers or the Reserve

Banks’ dominant market position deriving from such legal differences.

According to the Federal Reserve, existing legal disparities between the

Reserve Banks and the private sector include differences in the rules for

same-day settlement of paper checks, check presentment deadlines and

locations, the ability of the paying bank to impose reasonable delivery

requirements, and the control and timing of settlement. For example,

according to the Federal Reserve Act and Federal Reserve regulations,

every paying bank must accept paper checks from the Reserve Banks,

and the Reserve Banks can obtain a same-day payment from a paying

bank by debiting the paying bank’s account at a Reserve Bank without

being charged a presentment fee. While the Board addressed this

advantage through the adoption of Regulation CC in 1992 (effective in

1994), some market participants we interviewed noted that Regulation CC

applied to paper check clearing only, and does not address the Reserve

Banks’ advantage in the exchange of check images. In 1998 the Board

proposed limiting or eliminating this and all remaining legal disparities

between it and the private-sector competitors, but based on the public

comments they received, the Board concluded that the significant costs

associated with reducing the remaining legal disparities would outweigh

any efficiency gains to the payment services industry, and could result in

a reduction in efficiency to the payments system. For example, they said

that providing for a later settlement of Reserve Bank presentments would

delay the ability of the Reserve Banks to post credits for check deposits,

making intraday account management more difficult for many banks and

potentially increasing their daylight overdraft charges.

Federal Reserve staff told us that a competitive impact analysis could

indicate that a proposed change might have an adverse effect on private-

sector competitors, but still not be considered unfair as long as it was

Page 79 GAO-16-614 Payment System Competition

AppendixIV:CompetitiveImpact

AssessmentProcess

Appendix IV: Competitive Impact Assessment

Process

determined that the Reserve Banks would not be leveraging their legal

advantages. For example, the use of volume-based pricing and the

bundling of services that has concerned some private-sector competitors

did not raise objections in the Board’s competitive impact analysis

process because these changes were not deemed to rely on a legal

advantage.

If the analysis of a proposed new product or pricing change determines

that the Reserve Banks would obtain a competitive advantage stemming

from their legal advantages, Federal Reserve staff then must continue to

evaluate the proposed change to determine if the change furthers any

overarching Board objectives, such as increasing the efficiency of the

payments system or ensuring ubiquitous access. Staff must also consider

whether the objective of the proposed change could be met in another

way that would less adversely affect competing private-sector service

providers. Finally, the Board may decide to modify the proposed change

to lessen any adverse effects, or decide that the benefits to customers

are significant enough to adopt the proposed change despite the potential

for adverse effects on other competing market participants.

To help ensure that it is complying with its pricing policies and effectively

assessing its competitive impact, the Federal Reserve conducts various

internal reviews. Federal Reserve staff said that all product and pricing

changes must first be documented in a proposal by the relevant Reserve

Bank product office. These proposals are to include customer and market

competitive impact analyses. During proposal development, product office

staff sometimes also consult with industry work groups to solicit their

feedback. Once senior leadership in the product office achieve consensus

on the proposals, staff may then send the proposals to the Reserve

Banks’ Financial Services Policy Committee for its review and approval.

Page 80 GAO-16-614 Payment System Competition

The proposals—including the associated competitive impact analyses—

then are sent to the Board, although Federal Reserve staff said that they

often have ongoing and iterative discussions with Board staff prior to its

receipt of the proposals. Board staff then conduct their own independent

analysis of the proposals, and the Board will occasionally solicit additional

The Financial Service Policy Committee is responsible for the overall direction of financial

services and related support functions for the Federal Reserve Banks, as well as for

providing Federal Reserve Bank leadership in dealing with the evolving U.S. payments

system. The Committee is composed of three Reserve Bank Presidents and two Reserve

Bank first vice presidents.

Appendix IV: Competitive Impact Assessment

Process

public comments if it anticipates any significant long-term effects

associated with the proposal. Nonroutine changes to pricing and product

offerings are subject to approval by the Board or the director of its

Division of Reserve Bank Operations and Payment Systems.

The Federal Reserve estimated that staff have completed 32 competitive

impact analyses for nonroutine proposals since 2000, in addition to the

analyses conducted for routine proposals and for the Board’s public

rulemaking process, as necessary. Nonroutine proposals are those that

create a new service, create a new product line within an existing service,

introduce new pricing structures, or are expected to generate significant

comment from market participants. The Board’s annual repricing exercise

is considered as a single, nonroutine analysis. A routine proposal,

alternatively, is a new product or proposed change that only moderately

affects existing products or is expected to result in minimal action from

market participants. Federal Reserve staff estimated that they performed

an average of 2–3 nonroutine analyses and 8–9 total analyses each year.

After a new product introduction created controversy in 2013, the Federal

Reserve added additional controls to better ensure that any subsequent

changes would not result in unfair competition with the private sector. For

their 2013 fee schedule, the Reserve Banks introduced a new check-

clearing product known as “Choice Receiver,” which offered preferential

prices to customers for using a Reserve Bank as the presentment bank.

The Choice Receiver product was initially approved by the Board but later

challenged by private-sector competitors as unfair. After reviewing more

complete information about the product, Board staff said that they

concluded that its approval had been inappropriate because the product

office had not provided sufficient information to allow the Board to

evaluate whether the product relied on the Federal Reserve’s legal

advantages. Once all the relevant information had been considered, the

Board rescinded the product later that year because it was deemed to

have a direct and material adverse effect on the ability of other service

providers to compete effectively with the Federal Reserve due to legal

differences.

As a result of this experience, Federal Reserve staff told us they modified

their internal processes for analysis and review of proposed price and

service changes. For example, they created a competitive impact analysis

template that serves as a training tool for staff (staff respond to a series of

questions evaluating the potential adverse effect of proposed changes).

Reserve Banks also implemented a concept evaluation process, which

provides a high-level overview of planned changes to products or prices

Page 81 GAO-16-614 Payment System Competition

Appendix IV: Competitive Impact Assessment

Process

in advance of formal proposals, and an enhanced postimplementation

review process, which compares the actual performance of a product or

service to the estimated changes in the original proposal. Federal

Reserve staff said that these processes together have helped provide

clarity to internal stakeholders on products in development; improved the

transparency and collaboration between product offices and Board staff;

and provided validation for prices and products after they have been

implemented.

Page 82 GAO-16-614 Payment System Competition

Appendix V: Comments from the Federal

Reserve

Page 83 GAO-16-614 Payment System Competition

AppendixV:CommentsfromtheFederal

Reserve

Appendix V: Comments from the Federal

Reserve

Page 84 GAO-16-614 Payment System Competition

Appendix V: Comments from the Federal

Reserve

Page 85 GAO-16-614 Payment System Competition

Appendix VI: GAO Contact and Staff

Acknowledgments

Lawrance Evans, (202) 512-8678, or

[email protected]

In addition to the individual named above, Cody Goebel (Assistant

Director), Nathan Gottfried (Analyst-in-Charge), William R. Chatlos, A.

Nicole Clowers, Giselle Cubillos-Moraga, Robert Dacey, Simin Ho, John

Karikari, Paul Kinney, Risto Laboski, Marc Molino, Patricia Moye, Barbara

Roesmann, and Jason Wildhagen made major contributions to this report.

Page 86 GAO-16-614 Payment System Competition

AppendixVI:GAOContactandStaff

Acknowledgments

GAOContact

Staff

Acknowledgements

(250804)

Appendix VII: Accessible Data

Page 87 GAO-16-614 Payment System Competition

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

WASHINGTON, DC 20551

DIVISION OF RESERVE BANK

OPERATIONS AND PAYMENT SYSTEM

August 9, 2016

Lawrance Evans, Jr.

Director

Financial Markets and Community Investment

United States Government Accountability Office

441 G Street, NW

Washington, DC 20548

Dear Mr. Evans:

Thank you for providing the Board of Governors of the Federal Reserve

System (“Board”) with an opportunity to review the final draft of the

Government Accountability Office (“GAO”) report titled: Payment

Services: Federal Reserve’s Competition with Other Providers Benefits

Customers, but Additional Reviews Could Increase Assurance of Cost

Accuracy (GAO-16-614). The GAO’s report reviews the Federal Reserve

Banks’ processes for calculating and recovering costs associated with

providing payments services, the effect of the Reserve Banks’ provision

of payment services on competition, and market participants’ views on the

AppendixVII:AccessibleData

AgencyComment

Letter

TextofAppendixV:

Commentsfromthe

FederalReserve

Page1

Appendix VII: Accessible Data

roles of the Board and Reserve Banks in the payments system. We

appreciate the GAO’s efforts in soliciting input from a wide range of

market participants in creating this report.

The report finds that most market participants interviewed are satisfied

with how the Board and the Reserve Banks are performing their

regulatory and service provider roles in the payments system

respectively.

Page 88 GAO-16-614 Payment System Competition

The report concludes that the Reserve Banks provide

payment services in a manner that has generally allowed them to achieve

cost- recovery goals and benefited competition in the market, as

evidenced by the Reserve Banks’ lowering of prices and competitors’

increased market share in certain areas. The report also concludes that

the Board has policies and processes in place to ensure pricing fairness,

and that the Board’s process for imputing to the Reserve Banks certain

costs incurred by the private sector appears reasonable and its Reserve

Bank cost accounting practices align with private-sector practices and

federal standards.

The GAO’s report makes two recommendations:

· Consider ways to incorporate the costs related to (1) integrated plans

for recovery and orderly wind-down, and (2) compliance with anti-

money laundering requirements, to the extent practicable, in the

Board’s imputed private sector cost methodology, and

· Periodically obtain independent testing of the methods used to

capture actual costs and simulate those of the private sector.

With respect to the GAO’s first recommendation, we will consider ways to

incorporate costs, to the extent practicable, related to (1) integrated plans

for recovery and orderly wind-down, and (2) compliance with anti-money

laundering requirements into the Board’s imputed private sector cost

The Board and Reserve Bank have differing roles as part of the Federal Reserve

System. The Reserve Banks offer payment services to depository institutions and the

federal government. The Board oversees the operations of the Reserve Banks and serves

as a regulator of certain aspects of payment services in the United States. The Board also

supervises bank holding companies, savings and loan holding companies, and state

member banks, and the Reserve Banks carry out supervisory activities under delegated

authority of the Board.

Page2

Appendix VII: Accessible Data

methodology.

Page 89 GAO-16-614 Payment System Competition

The particular complexities of incorporating such imputed

costs into the Board’s methodology warrant careful review and

assessment. An important factor to consider will be the effect of imputing

such costs on the Board’s goal of creating a replicable, transparent cost

methodology. The report notes that many private-sector payment service

providers are not publicly traded and do not provide publicly available

financial information that could be used to calculate costs related to

integrated plans for recovery and orderly wind-down or compliance with

anti- money laundering requirements. For example, as noted in the report,

we have been informed by some correspondent banks that providing

public financial information on the proportion and materiality of anti-

money laundering compliance costs attributable to specific services would

be difficult, as they do not allocate compliance costs directly in such a

manner.

Additionally, it is also worth noting that, although some differences in cost

structures, including those noted above, may facilitate the Reserve

Banks’ provision of competitively priced services, other differences may

provide competitive advantages to the private sector. For example, the

Monetary Control Act requires that fees for Reserve Bank priced services

be published and transparent to competitors and customers alike, while

competitors generally have the flexibility to individually negotiate with their

customers and do not make their fees public. Also, the report notes that

the Fedwire Funds Service is subject to unique requirements that do not

apply to competitors, and therefore the Reserve Banks have incurred

(and continue to incur) substantial expenses in recent years to develop,

implement, and test manual procedures for settling systemically important

transactions in the unlikely event that the service’s automated systems

are not available. But, despite such requirements that convey cost

advantages to private sector competitors, the Board, asymmetrically, still

mandates that the pricing of Reserve Bank provided services reflect

certain costs borne only by private sector competitors. For example, the

Fedwire Funds Service does not pose the same risk of winding down in a

disorderly manner as private-sector designated financial market utilities.

The Financial Stability Oversight Council (“FSOC”) designated The Clearing House

Payments Company L.L.C. as a systemically important financial market utility on the basis

of its role as the operator of CHIPS. Consideration of costs related to integrated planning

of recovery and wind-down will therefore be focused on the Reserve Banks Fedwire

Funds Service, and not the Reserve Banks’ FedACH Service.

Appendix VII: Accessible Data

Nonetheless, to foster competition with the private sector, the Board

requires the Fedwire Funds Service

to impute equity held as unencumbered liquid financial assets equal to six

months of estimated current operating expenses, similar to the

requirements relating to recovery and orderly wind-down set out for

designated financial market utilities in Regulation HH.

Page 90 GAO-16-614 Payment System Competition

With respect to the GAO’s second recommendation, we will procure an

independent review of the methods currently employed for capturing

actual and imputed costs related to Reserve Bank priced services.

We appreciate the GAO’s review of the Federal Reserve’s role in

payment systems, the careful and professional approach with which the

associated work was conducted, and the opportunity to comment.

Sincerely,

Matthew Eichner

Data Table for Figure 4: U.S. Noncash Payments by Transaction Type, 2000–2012

(billions)

2000

2003

2006

2009

2012

Debit

8.3

15.6

37.5

ACH

6.1

8.8

14.6

19.1

21.7

Checks

41.9

37.3

30.5

24.5

18.3

Credit cards total

15.6

21.7

26.2

Prepaid total

2.2

6.7

12 C.F.R. § 234.3. The Board states in the adopting release of Regulation HH from

November 5, 2014 (79 FR 65543), “The Board will also monitor the implementation of

[Regulation HH] and [the Federal Reserve Policy on Payment System Risk] for issues of

consistency and competitive equity between private-sector systems and the Fedwire

Funds Service.” The same year, the Board reiterated its position in a similar statement in

its final revisions to the Federal Reserve Policy on Payment System Risk on November

13, 2014 (79 FR 67326).

Page3

DataTables

Appendix VII: Accessible Data

Data Table for Figure 5: Rolling 10-year Average Cost Recovery Rates for Federal Reserve Payment Services, 1996-2015

Page 91 GAO-16-614 Payment System Competition

(percentage)

1996-2005

1997-2006

1998-2007

1999-2008

2000-2009

2001-2010

2002-2011

2003-2012

2004-2013

2005-2014

2006-

2015

98.4

99.1

98.7

97.8

97.9

98.6

99.5

102

102.9

102.6

Data Table for Figure 6: Federal Reserve Revenues by Payment Service, 2005–2014 (2015 Dollars in Millions)

2015 Inflation-Adjusted Dollars in Millions

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Check

888.4

866.0

797.8

671.0

527.9

384.1

276.0

230.0

204.3

176.6

ACH

95.2

93.6

99.9

96.0

101.8

119.4

118.9

120.0

122.1

125.7

Fedwire

73.2

73.9

72.9

66.4

70.6

85.9

89.4

94.6

99.4

111.3

Data Table for Figure 7: Market Shares (Based on Dollar Volume) of Federal Reserve and Private-Sector Providers in Check,

Automated Clearing House (ACH), and Wire Transfer Payments, 2001–2013

Mar/Apr 2001

Mar/Apr 2004

Mar/Apr 2007

Mar/Apr 2010

Mar 2013

Check

Reserve bank share

57%

53%

43%

48%

Private sector share

43%

47%

57%

52%

2000

2003

2006

2009

2012

ACH Origination

FedACH share

86%

73%

58%

50%

49%

Private sector share

14%

27%

42%

50%

51%

2000

2003

2006

2009

2012

ACH Receipt

FedACH share

87%

78%

65%

63%

Private sector share

13%

22%

35%

37%

2000

2003

2006

2009

2012

Wire*

Fedwire share

64%

66%

63%

60%

58%

CHIPS share

36%

34%

37%

40%

42%

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