by Paul M. Connolly, Retail Payments Product Director, Federal Reserve Bank of Boston
National Automated Clearing House Association 1996 Payments Conference
San Francisco, California
April 16, 1996

     It's a pleasure for me to be part of this conference. As Tom mentioned, I'd like to look with you at the future retail payments system, and, within that, the role of the ACH.

    First, we can see where we are with retail payments today, and look at some of the forces for change that will help to shape the future. Then we can consider future directions to pursue, with emphasis on promoting and enhancing the ACH.

    Retail payments today continue to be dominated by the paper check. By our best guess, check volumes have grown to 60 billion or more annually.

    The rate of growth seems to have slowed, to perhaps 1 or 2 percent. I am hearing some knowledgeable people say that the growth has stopped. I think we need more evidence before we can say so, but it is more credible than ever before to believe that it may stop before too long.

    Ten years ago there were only about 500 million ACH payments. Last year there were about 3 billion. That's still only 5 percent of check volume, but that's impressive growth.

    And the ACH has lots of room for further growth, as I will discuss.

    After years of slow growth, point-of-sale (POS) transactions are estimated to have come close to 1 billion in 1995, spurred by wider acceptance by merchants, and the option to use ATM cards as "debit cards" in stores.

    All of this leaves aside the huge volumes and continued growth for credit card transactions, which, strictly speaking, are extensions of credit rather than payments, but functionally are used in place of checks, cash or debit cards. Credit cards now are accepted in many new places, most notably in supermarkets. And we are offered all sorts of new incentives to use them more, including frequent flier miles, credits toward buying a car, and other purchase credits.

    Besides the ongoing growth in these familiar alternatives to the check, we can see some new or intensifying forces for change. One of these forces is the array of new electronic payment options.

    Stored-value cards, smart cards, home banking systems, and services available through the Internet promise new choices and added convenience for consumers and businesses. It is too early to tell how these options will progress, but some of them are likely to flourish. In some cases they will displace cash payments more than check payments, though some impact on check volume should also be expected.

    The home banking option gets at consumer check-writing in the home more directly than the other options. And that's where consumers write most of their checks. It is happening at pretty low levels now, but it will be growing.

    Another force for change is the ever more sophisticated consumer, ever more willing to use electronics, when the electronics provide greater convenience. Close to 40 percent of households have PC's. We are using automated telephone services for more purposes. One notable trend, on college campuses, is the rapid growth in proprietary electronic card systems to pay for meals, books, and other purchases. Soon we will have millions of young people in the workforce who are accustomed to making payments electronically, perhaps providing a critical mass for more widespread adoption of new payment options.

    And another force for change, with which all of you are quite familiar, is competition. Corporations, large and small, really are competing with international firms in a global marketplace. Firms in many nations enjoy cost advantages and governmental support which make it difficult for American firms to compete successfully. The ongoing pressure in all businesses to improve efficiency and reduce overhead will only intensify. All facets of business are being scrutinized, including how payments are made and received. The larger a business' volume of payments handled, the greater the incentive to move away from the paper-bound check system to some electronic alternatives.

    No industry is more competitive than banking these days, and here also we can only expect current forces to intensify. If banks did not already have enough competitors within the industry, they now face non-bank competition for an ever-increasing portion of what had been the "business of banking". Certainly this stands to be true in the payments arena, where new providers are in the wings.

    These non-bank providers of payment services may have cost advantages over banks for a variety of reasons. One particular advantage is that they will confine themselves to electronic options. None of them intend to process paper.

    Nobody has to process paper - except the banks. The banks alone will be stuck with the expenses and inefficiencies of paper payments, putting them at a competitive disadvantage, unless the banks themselves become a force for change.

    One important future direction for change is to collect those paper checks electronically.

    Even if we all get behind electronic payments, change is more likely to come slowly than swiftly. We will have many billions of checks to process each year for a long time. And while we have made the check collection system work pretty well, it is costly, slow relative to electronic alternatives, prone to delays and errors, and increasingly subject to criminal exploitation. The more we believe the check will endure as a popular means of payment, the more we should commit to changing the check system for the better, with electronics.

    To address electronic check presentment issues comprehensively, the Federal Reserve and banking industry leaders have formed an Advisory Group on Electronic Check Presentment. This group, with participants from a national cross-section of banks, large and small, as well as representatives from industry groups pursuing ECP initiatives, wants to establish ECP without paper collection as its common goal. We will pursue tests and studies that can help to chart a course to get a lot of the costs and risks out of today's check collection system.

    Another vitally important future direction is to accelerate conversion to electronic payments. Collecting the checks electronically will be good. Replacing the checks in most cases will be better.

    We can do a lot to promote and enhance the ACH, and convert billions more checks to ACH. In addition, we should support other safe, convenient new electronic options where they seem more likely than the ACH to displace some uses of checks and cash.

    In thinking about the future for the ACH, we have a lot of issues that require attention. In selecting certain ones to discuss today I am not suggesting that only these topics are important. But I think they belong on any list of ACH issues going forward.

    The issues I will look at briefly with you are: education and promotion; ease of use; pricing incentives; finding the best niches; and risk management.

    Levels of awareness about the ACH and how it works are relatively low. Everyone knows how to write a check. Most people never have heard of the ACH, including most people who get paid by direct deposit. Most consumers and many businesses have only the vaguest notions about bill payment via the ACH. There is some amount of increased use of the ACH - and my hunch is a pretty good-sized amount - that can be attained through sustained efforts to increase corporate and consumer awareness of the ACH and its benefits.

    Last year and this year the Federal Reserve has stepped up its educational and promotional efforts for the ACH, in collaborative efforts with others. In 1995 we undertook with NACHA a groundbreaking campaign to reach out to about 20,000 corporations, utilities, charities, and other enterprises - with letters from the Presidents of the 12 Reserve Banks - to support NACHA's direct payment campaign. NACHA has had more than a thousand responses to these letters, and we hope to see many new ACH transactions as a result.

    This year the U.S. Treasury, NACHA, and others, including the Federal Reserve, are co-sponsoring a public information campaign to reach consumers with the benefits of direct payment. And in another initiative, the Social Security Administration, NACHA, and the Federal Reserve are communicating with all large banks in the country to renew efforts to convert more Social Security checks to direct deposit. Once again, the Reserve Bank Presidents are sending letters, co-signed with the Social Security Director, to the CEO's of the large banks.

    The Reserve Banks want to work with the regional ACH associations on an ongoing basis to promote the ACH. At my Boston Fed we have the very active and effective New England ACH Association serving our region, and have been pleased to support a variety of NEACH programs over the years. We want to do more with NEACH in the future, and I firmly believe that the more we do together to promote the ACH, the better results we will get. All Reserve Banks want to act on this principle with their local associations.

    We can grow the ACH considerably with more education and promotion. However, as a service it has some limitations that discourage some users. We need to ask how we can improve the ACH so it is easier for businesses and consumers to use.

    One basic issue is the receptivity of depository institutions to participating in the ACH. After all these years, we still have some institutions which will not accept ACH transactions; not many, and mostly very small institutions. But enough so that the ACH is not a universal payment mechanism, as the check is. This discourages some consumers from converting to direct deposit, and one large mutual fund has told us that this is a barrier to making more payouts to consumers via the ACH. All of us in the financial industry should work toward universal acceptance of ACH.

    "Receptivity" means more than that, too. We all know that most home banking payments, initiated electronically by consumers, are completed with checks - so-called preauthorized drafts. This is silly. We've done the hard part, changing consumer behavior, but we've stumbled on what should be the easier part, bank-to-bank electronic payments. This should be fertile ground for new ACH volume.

    We all need to understand why these payments are not being completed electronically, and break through those barriers.

    Sometimes, when a consumer considers signing up for direct payment, or a business considers launching an effort to promote direct payment, the up-front effort is discouraging. People also hear horror stories - some exaggerated but others with a basis in fact - about getting charged for somebody else's bills, or not being able to change payment arrangements easily when they change their banks. Some improvements have been made in the prenotification process, and more needs to be done, with start-up procedures, change procedures, and quality control, by banks and businesses, to make the ACH more accessible and even more reliable.

    A fundamental reason for consumer resistance to ACH direct payment is the perceived loss of control, relative to check-writing. Sometimes consumers like to pay a bill a little late, or pay an amount different from the exact amount due. They can do these things with a check, and vary what they do from one month to the next.

    We should think about adding a new dimension of consumer control to the ACH; somehow allowing the consumer to initiate the ACH payment, with an authorization through the mail or over the telephone. That's not the way we always have thought about the ACH, but why not?

    The ACH rules and the liabilities, real or perceived, that accompany them, also impede some use of the ACH. NACHA and others are aware of the obstacles posed by the 60-day right of recision and other rules and are addressing them. All of the rules have valid purposes, but when they lead participants to regard checks as less risky than the ACH, we have to take another look at them.

    And we in the Federal Reserve have more to learn about how to improve our services in ways that facilitate greater use of the ACH. We hope that flow processing and faster delivery of ACH transactions to banks will encourage businesses to use ACH more - for part-time payrolls, for instance, where our previous batch processing deposit deadlines did not work well. We now have a new software platform that we can modify more readily to improve service and help banks to promote the ACH to their customers.

    When we think about our Federal Reserve services, we think about our ACH prices as well. We need to know how our pricing affects banks' pricing of ACH to corporate customers.

    For instance, we reduced Federal Reserve ACH prices as of January 1. My sense is that some banks realize this and some do not. We need to do a better job of getting good news like this across to the right people in all depository institutions. But when we do, does it make any difference? Do changes in Fed prices change the prices banks charge? Or, does a reduction in Fed prices prompt any greater efforts by banks to work with their customers to increase ACH use?

    If not, why not? We in the Fed need to know more about how our pricing can make a difference.

    More broadly, for all of us trying to stimulate greater use of the ACH, what approaches to pricing will do so? What do corporations need from their banks in ACH pricing? What are the economics of ACH processing for the banks? If we offered much higher fixed fees and much lower per-item fees, would that encourage banks and their customers to convert more check payments to ACH? Would explicit volume discounts do that? Is the pricing corporations see from their banks so different from Reserve Bank pricing to the banks, that what the Federal Reserve does with its pricing does not matter?

    My sense is that our pricing does matter to some extent, and can matter more, but we need to find out more about it, and we want your input.

    And an even broader issue for the banking industry is how the pricing for check-writing and check collection affects conversion of checks to the ACH. The use of checks is costly, and consumers and businesses have to pay for it. However, particularly on the consumer side the recovery of these costs is hidden in minimum balances, no-interest accounts, fees for new checks, bounced check fees, and the like. Checking accounts often are advertised as "free", or have fixed monthly fees that, if anything, encourage more check-writing rather than less. It is very difficult for a bank to do otherwise in a highly competitive environment. As an industry, though, we have to ask why we want to perpetuate the costly, error-prone check process with these pricing practices.

    In the check collection process, current law and practice impose all of the costs on the recipient of the check and her bank, and none on the check-writer and his bank. Float costs also are absorbed on the collection side, and float actually rewards the check-writer. By contrast, a paying bank is charged for incoming ACH transactions, and ACH eliminates some of the float now benefitting the check-writer. To encourage migration from checks to ACH, and to electronic payments in general, we really should move some check collection costs to the parties that impose those costs by issuing the checks.

    Here again, we need your input. Do check pricing and check collection costs get in the way of conversion to ACH? If you believe so from your experience, we want to work with you to find ways to change the balance for the better.

    For years we talked about the ACH as "the electronic check", the alternative to check-writing. Now, it is far from the only electronic option. Some electronic mechanisms have features, such as spontaneous use, convenience in the home, and user control, that make them superior alternatives to replace check and cash payments. So, for the future, where should all of us target our efforts to maximize ACH use? What are the best niches for the ACH?

    For openers, none of the new mechanisms looks better than the ACH for paying people their salaries. And yet, after 20 years with direct deposit, the majority of workers in the United States still are paid by check. We ought to set a goal to double the use of ACH direct deposit.

    Since ACH has had its widest acceptance as a means to put money into consumers' accounts, we should emphasize other applications that do so. For example, monthly investments by consumers in mutual funds. Also, dividend payments from funds and from corporations.

    For consumer bill payments, we might want to focus on payments where concerns about the timing or the amount are minimized.

    These include relatively low-value payments that occur in the same amount every month or every quarter: payments too small and too routine to worry about, payments that accentuate the convenience of the ACH. We should pursue other consumer payments as well, and if we can add a dimension of consumer control, as I mentioned earlier, we will increase the conversion rate for all of them.

    Corporate payments to target might include the clearly low-risk payments to other businesses. There is growing concern about large-value payments migrating to the ACH, and properly so. However, many business payments originated by firms known by their banks to be creditworthy, with appropriate controls over origination, are low-risk, and we should try to convert many more of them from checks to ACH.

    Businesses also can be encouraged to use the ACH for low-value "convenience" payments, such as travel advances and reimbursements to employees, awards programs, tuition reimbursements, and others.

    Debit cards, stored-value cards, home banking, and other options will be more attractive than the ACH for many payments, but the ACH still has plenty of opportunity to grow.

    And growth in ACH activity will require more attention to risk issues. This topic by itself could take up a whole session, and I will just touch on it here, to make sure we keep it in front of us as we plan for the future of the ACH.

    ACH risk comes in a variety of forms. The ACH has credit risk, as do most payment mechanisms. ACH payments rest on the creditworthiness of the depository institutions that send and receive them, as well as on the creditworthiness of the corporations originating payments. Processors, including the Federal Reserve, need sufficient knowledge of each depository institution to be able to anticipate possible credit problems. Banks need similar knowledge about their corporate customers, including the controls in place for origination of payments by third parties in the corporate customer's name. A bank needs to be even more concerned about its own controls over third parties originating payments in the name of the bank.

    These risks, controls, and judgments hover over the payments processing and the eventual settlement for the payments. As we grow the ACH we need to do more to reduce and control these risks.

    The ACH return item process is swifter and more reliable than the check return item process, but it needs further improvement. The faster we deliver the payment and deliver the return, the more certainty and confidence we build into the ACH.

    When our new flow processing system is completely implemented, we will be extending our return item deposit deadline to accelerate returns. We have already been asked to go to an even later deadline than the new one we have planned, and we will do as much as we can to reduce this source of risk.

    And operational risk is a concern that will grow with ACH item and dollar volumes. The good news is that the ACH system has become important to more banks, businesses, and consumers. The other side is that the ACH system cannot "go down" for any lengthy period without upsetting a lot of people. So, more of us need backup systems, contingency plans, and disaster recovery capabilities. We may have lost some of this, or impeded it, with bank consolidations and centralized processing. All of us need to take a fresh look at what we would be able to do in the event of an extended outage of our ACH processing system.

    There are numerous other issues of importance to the future of the ACH. I hope you agree that these are among the most important, and I hope this discussion has been helpful.