The Federal Reserve provides payment services to banks and other depository institutions. The Fed's largest payment service is the "Fedwire" funds transfer system, which moves over $1 trillion every day. . .
Once its account is credited by the Fed, the receiver (Citibank, for example) is insulated if the sender (say, Chase) does not have the funds at the end of the day. If Chase can't pay, however, the U.S. taxpayer effectively will.
By law, the Federal Reserve must charge banks enough to cover its costs while providing payment services. Yet, in recent years, while making their case for other policies they desire, members of the Fed’s Board of Governors have repeatedly identified Fedwire as a source of subsidy. Fedwire does indeed provide a large subsidy and one at odds with federal law.
Federal law directs the Federal Reserve to establish prices for its payment services on the basis of costs, as a result of the Depository Institutions Deregulation and Monetary Control Act of 1980 (MCA). Each year,
- the Fed's Board of Governors has confirmed that fees for Fedwire, and like services, all cover their expenses and that the Fed thereby complies with this law.
- Yet members of the Board have also asserted that Fedwire is a subsidy for depository institutions.
Can they have it both ways? Is the Fed complying with the law? The answer to both of these questions appears to be No.
What is Fedwire?
The Federal Reserve's "Fedwire" system helps banks make payments to one another, using their credit at the Federal Reserve Banks. Fedwire fund transfers are initiated by a sending bank. The Fed
- processes the sender's instruction,
- debits (reduces) the sender's account on the Fed's books,
- and credits (increases) the Fed account for the receiving bank.
The Fed will credit the receiver's account even if the sender doesn’t have enough money of its own at the time of the transfer. This is an element of what the Fed calls "finality." Once its account is credited by the Fed, the receiver (Citibank, for example) is insulated if the sender (say, Chase) does not have the funds at the end of the day. If Chase can't pay, however, the U.S. taxpayer effectively will.
Up to $1 billion can be transferred in a single Fedwire, but fees do not vary with the size of the transfer, even if the transfer uses overdraft credit.
Fund transfer rates are charged on a per transfer basis, with some discount when a large number of transfers are made. The rates typically are less than a $1 for a single transfer. So, if a bank sends a $900 million Fedwire, it costs less than a buck, plus a modest amount for any overdraft credit utilized. Banks pay very modest fees for accessing daylight credit through the Fed. On an annualized interest rate basis, intraday overdraft credit costs a small fraction of 1%. By way of contrast, when you and I bounce a $20 check for a couple of days, we can pay a fee of $25, which makes for a very large annualized interest rate.
There is only a very small risk that banks using Fedwire will default on payment. Yet daylight overdrafts average over $100 billion at their peak, every day. A default can be very costly. One reason offered for not incorporating risk of loss to Federal Reserve banks in "wire transfer services" has been that losses incurred have historically been close to zero. However, the Federal Reserve Act calls for pricing to recover "costs actually incurred," not "actual losses." To illustrate this point, it is useful to note that many people hold, and pay a price for, fire insurance even if they have never had a fire at their house. Banks benefit from the Fed’s insurance policy there is no reason why they shouldn’t also pay a sufficient insurance premium.
The Fed excludes overdraft fee revenue from its priced services recovery calculation, like it excludes intraday interest expense from the costs to be recovered. Yet, on average during the day, there is over $30 billion of overdraft credit in the Fedwire system. It is hard to come up with any precise measure of an appropriate interest rate for this credit, given that the unique Fed guarantee is something a private market cannot, by definition, provide.
Stepping back for a simply back-of-the-envelope calculation, it seems reasonable to consider short-term market interest rates as a reference rate. Applying only a 3% interest rate to this daily stock of credit leads to an annual foregone interest revenue of about $1 billion. With 100 million Fedwire transfers each year, a simple allocation of this cost directly to the number of Fedwires leads to a fee of $10 per transfer a far cry from current fees well below $1. For a higher estimate, consider the interest rates banks charge you and me for bouncing a check for two days, and what that might mean for taxpayer revenue.
Why is efficiency important?
On March 31st, 1980 President Jimmy Carter signed the MCA into law. The legislation called for the Federal Reserve to establish prices for its payment services on the basis of costs. Prior to 1980, the Federal Reserve had provided these services exclusively to member banks and for free. Free payment services were part of a failing strategy to keep member banks in the Fed system. Member banks were dissatisfied because they could not earn a return on their reserves deposited with the Fed, and so were leaving. Congress eased this problem by directing all depository institutions to maintain reserves at the Fed while allowing them to keep less money in reserve. At the same time, Congress directed the Fed to charge fees to cover all its costs of providing payment services.
The loophole came in how the Fed chose to define the costs of operation. The MCA says "all direct and indirect costs" incurred must be paid for by fees "over the long run." The Fed counts communications, computer, and other operation and labor expenses amongst these costs.
- Intraday interest expense is not included, however, even as the law stipulated that u2018float' would be one of the costs to be covered.
- In addition, much of the cost of monitoring the risks of those overdrafts is not included.
Yet the MCA's payment services provisions were designed to make sure the Fed was not subsidizing all or parts of the financial industry through under-priced services. By leaving out credit, insurance and monitoring costs, the Fedwire pricing system has violated the spirit of the MCA for over twenty years.
Given the way the Fed has decided to measure "cost," they have recouped slightly more than "costs" in fees. In the annual report for the year 2000, for example, priced services were reported to have recovered 101.1% of their costs, and 100.8% of their costs over the 10-year period ending in 2000. Fed leaders regularly assert their responsibility in complying with the law by pointing to these accounting figures to make their case. For example, Federal Reserve Board Chairman Alan Greenspan stated in 1996 testimony,
… priced services are subject to the inherent discipline of the marketplace as the Federal Reserve must control costs in order to meet the statutory directives for cost recovery in the Monetary Control Act. … If we provide these services inefficiently, we price ourselves out of the market.
Over the past decade, our track record has been good. The Reserve Banks have recovered 101 percent of their total cost of providing priced services, including the targeted return on equity. I should also note that, by recovering not only our actual costs but also the imputed costs that a private firm would incur, the Federal Reserve’s priced services have consistently contributed to the amount we have transferred to the Treasury. During the past decade, priced services revenue has exceeded operating costs by almost $1 billion.
Similarly, Vice Chair Rivlin stated in September 1997 congressional testimony on another matter that:
"Taxpayers do not subsidize the cost of the Federal Reserve’s check transportation" (emphasis in original). … The Monetary Control Act of 1980 (MCA) addressed that issue by requiring the Federal Reserve, over the long run, to set fees for its priced payment services to recover all direct and indirect costs of providing those services.
The Board of Governors repeatedly assures us that costs are being covered by the Fedwire system, yet they also have repeatedly testified to the opposite. For example, in July 1997 testimony to the Senate, former Fed chairman Alan Greenspan stated:
"… a number of observers have argued that there is no subsidy associated with the federal safety net for depository institutions deposit insurance, and direct access to the Federal Reserve’s discount window and payment system guarantees. The Board strongly rejects this view."
In 1998 testimony that similarly identified a bank’s ability to "tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank," along with "access to the discount window and the payment system," as elements of a "safety net subsidy," the chairman said:
"…the safety net has predictably created a moral hazard; the banks determine the level of risk-taking and receive the gains therefrom, but do not bear the full cost of the risk; the remainder is borne by the government."
More recently, in a 2005 speech, former Chairman Greenspan explicitly identified Fedwire as a source of subsidy. Consider the remarks below in light of his above-noted 1996 assertion that the Fed's priced services are subject to the u2018inherent discipline of the marketplace' because the Fed prices them to recover their costs:
The need for safety and soundness supervision and regulation has been greatly reinforced in the past century to address the market distortions that are unavoidable consequences of the special benefits provided to banks, benefits that were promulgated because of the tensions between bank contributions to growth and concerns about banks’ role in economic instability. These benefits are access to the Federal Reserve’s discount window; access to the payment system, especially Fedwire; and deposit insurance. These provisions, collectively often called the bank safety net, were designed to minimize the potential for asset or other problems in the banking system to disrupt the real economy, but, as an unavoidable byproduct, also provide an important subsidy to banks. By protecting depositors and counterparties, they also reduce, if not eliminate, much of the market discipline that constrained risk-taking by nineteenth-century banks (emphasis added).
Fed leaders have used the "Fedwire is a subsidy" argument while making their case for other policies they desire, but have left themselves open to a simple question. Can the Fed have it both ways? Whatever the motivation for the inconsistency, the result of the subsidy is clear. Banks are taking full advantage of this cheap credit. Fedwire is very popular (over a trillion dollars goes over it every day) for a reason.
How much money is involved? A New York Fed article titled "The Timing and Funding of Fedwire Fund Transfers" estimated the share of Fedwire fund transfers from three sources:
- existing balances,
- overdrafts and
- incoming payments (within one minute of the subject transfer).
The authors found that 35% of transfers were funded by existing balances, 25% were funded by incoming payments and 40% of transfers were funded by overdrafts. These estimates did not account for the possibility that an incoming payment could itself be an overdraft, and therefore likely understates the degree to which overdraft credit funds final payments. Still, 40% of total daily transfers represents over $500 billion worth of transfers being funded by cheap overdrafts every day.
Why not subsidize the banking industry?
A subsidy is not necessarily a bad thing, if a central banker can figure out how to make it achieve the "socially optimal" volume of interbank transfers.
A more realistic view is that policy is being influenced by well organized and interested groups, at the expense of the public.
Whatever one’s view about the value of subsidies per se, subsidizing Fedwire operation is simply not a matter for Federal Reserve discretion. US law forbids it. The taxpayer is being taken to the cleaners. Congress doesn't seem to care that a law it created is being used for advertising purposes even in testimony received by Congress.
 Testimony of Chairman Alan Greenspan; "Recent reports on Federal Reserve operations," Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate July 26, 1996
 One can compile a long list of these references.
 James McAndrews and Samira Rajan, "The Timing and Funding of Fedwire Funds Transfers," Federal Reserve Bank of New York, Economic Policy Review, July 2000
Andrea Crandall was very helpful in preparing this article, which is a summary of a longer paper I developed beginning in late 1999 while working at the Federal Reserve Bank of Chicago. This article originally appeared at Sanders Research Associates.
February 14, 2007