Priced services, 1988 and 1989.

Priced Services, 1988 and 1989

Since 1981, under the mandate of the Monetary Control Act of 1980, the Federal Reserve has been charging fees for the services it provides to depository institutions--fees that must, over the long run, cover the full costs of those services. In 1988, the Federal Reserve System received $801.7 million in fees for its priced services and incurred $796.6 million in costs, for a recovery rate of 100.6 percent. The 1987 rate was 104.6 percent. Given the 1989 fees for priced services announced in November 1988 and expected growth in the total provision of services, the 1989 recovery rate will be approximately 103 percent. Activity is generally expected to maintain its recent patterns of growth, with higher volumes for all services except those involving paper-based securities, for which a decline is expected.

After adjustments to receipts and costs, which are described in the notes to the tables, total 1988 revenue from Federal Reserve priced services was $667.7 million, $18.0 million above 1987 revenue (table 1). Production costs rose $46.1 million in 1988 to $552.9 million. The resulting $114.8 million in income from operations was reduced $69.9 million by imputed costs and increased $11.0 million by the net of other income and expenses; thus income before imputed income taxes was $55.9 million. After-tax income for 1988 was $37.9 million, down from $62.9 million from 1987. Each of the Federal Reserve's major service lines had before-tax income that at least covered operating and imputed costs.

In 1988, the System also continued to pursue its longer-term efforts to design electronic payment systems. It implemented special programs to improve processing of payments, especially new procedures to expedite the return of checks. It sought to bolster the efficiency and security of those systems and its ability to cope with interim outages and to restore services after disasters.

The following sections examine the activity for each priced service. Appendix table A.1 presents the pro forma balance sheet for all priced services in 1987 and 1988, and table A.2 presents activity for certain services in each Federal Reserve District.

CHECK COLLECTION SERVICE

In 1988, the Federal Reserve System processed 17.6 billion checks, 3.6 percent more than in 1987 (table 2). The service brought in $513.8 million and cost $436.6 million. After adjustment for imputed costs, and for the net of other income and expenses, the service netted $24.9 million before taxes (table 3).

In September 1988, the Board implemented new Federal Reserve services designed to speed Reserve Bank processing of returned checks. These services help banks comply with the rules on check return set out in Regulation CC. Fees for the new check-return services and revised fees for forward check collection were effective at the same time. The Federal Reserve priced its new return services explicitly and began to levy the fees on the paying bank. Forward-collection fees were reduced 11 percent on average because the returned-check processing cost in those fees was eliminated.

To expedite the return process, the Reserve Banks now send returned checks directly to the depositary bank (that is, the bank of first deposit), bypassing intermediary endorsers. Under the new procedures, the Reserve Banks process local returned checks at night, dispatching them with the forward-collection checks the next morning. The first Federal Reserve office to receive nonlocal returned checks "qualifies" the checks (that is, prepares them for high-speed processing) and dispatches them to other Federal Reserve offices the next night. Federal Reserve offices also accept returned checks that have been qualified by the paying bank or prior returning bank and dispatch them as quickly as forward-collection checks.

Revised fees for the Federal Reserve's returned-check services were approved by the Board on March 16, 1989, and became effective May 1, 1989. The Board increased the fees for returned checks in response to the decline in the cost-recovery rate of the service after the implementation of the returned-check services on September 1988. The recovery rates declined primarily because revenue was lower and costs were higher than expected as a result of the poor quality of qualified returned-check deposits. The Reserve Banks are working with depository institutions to improve the overall quality of returned-check deposits. Federal Reserve initiatives to strengthen return operations include improving the quality of carrier envelopes and of endorsements, and reducing the number of misdirected qualified returned checks and the "reject" rate of qualified deposits.

The number of returned checks has increased approximately 25 percent since the implementation of the new returned-check services. The growth of total returned-check deposits is expected to change little in 1989; qualified deposits are expected to increase, while raw deposits shrink.

In May 1988, the Board authorized the Reserve Banks to process notices of nonpayment to the depositary bank on behalf of the paying bank for returned checks of $2,500 or more, to conform to Regulation CC's expanded requirement for notice of nonpayment, which was to become effective September 1, 1988.

Also in May, the Board approved making permanent two services that had been the subject of pilot programs: check truncation (in which the bank holds the check and transmits payment information electronically) and the electronic capture of check data encoded for magnetic ink character recognition (MICR). Under the expanded MICR-capture service, Reserve Banks deliver payment information electronically or on magnetic tape, provide a returned-check and retrieval service, and deliver the checks to the paying bank several days later. Nine Reserve Bank offices provided truncation services in 1988. So far, the Reserve Banks have offered a truncation service only locally and only to paying banks that request it. Eventually, the Reserve Banks will offer a national service by truncating eligible checks at the first Reserve Bank to receive the check.

The Federal Reserve is developing a standard for machine-readable endorsements to improve their quality and further expedite the processing of returned checks. On the grounds of simplicity, cost, and compatibility with existing and future check-processing equipment and technology, a bar code appears to be the most promising type of machine-readable endorsement. Depending on the outcome of research, the Board may publish for public comment modifications to Regulation CC to incorporate such an endorsement. If it is ultimately adopted, depository institutions will be given adequate time to implement the new standard.

The Federal Reserve's digitized-image project, initiated in 1987, continues to progress successfully, and testing should be completed by 1990. By storing checks electronically rather than on microfilm, the technique has the potential to support significant efficiencies and improvements in check and return-item processing. The System is investigating the use of digitized-image processing for both high- and low-speed processing of returned checks and of government checks because the technique may be more efficient and provide better quality than does the current practice of microfilming.

ELECTRONIC PAYMENTS SERVICES

The Federal Reserve System continued to work on the design of electronic payment systems during 1988. As part of this effort, the System completed a market study that focused on the business requirements for the 1990s, investigating service offerings, operating hours, reliability, security, and formats. Also, an award was made to IBM in early 1989 to test the application of fault-tolerant (that is, highly reliable) minicomputer technology to the automated clearinghouse (ACH) service. If the test proves successful, the technology will be evaluated in terms of its Systemwide application to the ACH service as well as to other electronic payment services.

The Reserve Banks also began improving the reliability of automated systems for processing electronic payments during 1988, an effort that is expected to continue in 1989 and 1990. The aim is to streamline processing systems, automate operations, and incorporate new technology to permit faster recovery from service interruptions. As one result, the total duration of Fedwire outages in 1988 was half that in 1987.

The Federal Reserve worked on several new ways to restore services after disasters. A test of whether one Reserve Bank could provide processing backup to another demonstrated the technical feasibility of such an approach; but it also revealed the need for operational changes before the approach can be used. In November, the Board approved the establishment of a contingency backup site at the Los Angeles Branch for the electronic payment and accounting operations of the Federal Reserve Bank of San Francisco. The Federal Reserve Bank of New York, which has a dedicated contingency backup facility, completed several simulations of disaster recovery during the year. Other Reserve Banks continued to test and improve their methods of restoring electronic payment operations at the shared contingency site at Culpeper, Virginia.

The System made substantial progress in promoting electronic access for Federal Reserve services. First, it developed and tested a standard software system for intelligent terminals, known as Fedline II, to give depository institutions access to Federal Reserve services. The Reserve Banks began deploying Fedline II in the fourth quarter of 1988, with the objective of converting all intelligent connections using Federal Reserve software to Fedline II software by year-end 1991. Second, by year-end 1988, conversion to standard protocols and encryption had been completed for almost all electronic connections between Reserve Banks and depository institutions for funds transfers via low-volume terminals and for one-third of the high-volume connections.

Funds Transfer Service

The Federal Reserve processed 56 million transfers of funds in 1988, 5.7 percent more than in 1987. While the number grew more slowly than before, the value of funds transfers increased almost 13 percent to $161 trillion, compared with a rate of 12 percent in 1987.

The basic fee for funds transfers was increased from 47 cents to 50 cents effective January 1989. The volume of transfer services is expected to increase 4 percent in 1989, more slowly than in 1988, in part because mergers and consolidation of depository institutions' operations have meant a reduction in the number of transfers. The System anticipates that costs will increase in the next year or two as Reserve Banks take further action to improve both the reliability of these services and disaster-recovery capabilities. These actions, coupled with slower growth in volume, may occasion higher fees.

Until April 1989, the Reserve Banks accepted unstructured third-party transfers, but originating institutions paid a 25 cent surcharge for each transfer that did not conform to the structured format. On April 3, 1989, the structured format became mandatory.

Automated Clearinghouse Service

In 1988, the Federal Reserve processed more than 1 billion ACH items, an increase of about 17 percent from 1987 (table 2). Commercial ACH transactions accounted for approximately three-fifths of the total, or 602 million items, an increase of almost 27 percent from 1987.

To reduce credit risk in the ACH system, in December 1987 the Board approved a requirement, effective July 18, 1988, that debit returns of $2,500 or more be deposited at the Reserve Banks for processing by the nighttime deposit deadlines. This practice should accelerate the delivery of large-dollar returns by several days. To enable institutions that do not have electronic access to the Reserve Banks to comply with this requirement, the Reserve Banks began permitting the return of large-dollar debit transactions by telephone. The proportion of return items and notifications of change that is processed electronically again expanded in 1988.

New accounting procedures for credit transactions that settle on holidays or on other days when depository institutions are closed were also implemented on July 18, 1988. The procedures require that institutions originating credit transactions that settle on those days be charged as though they were open. This measure reduces risk significantly and recognizes that originating institutions can anticipate their settlement obligations.

In another measure to reduce credit risk in the ACH service, the Board authorized the Reserve Banks to obtain prefunding for credit transactions if they are concerned that an originating institution may become insolvent before the transactions are settled. The Reserve Banks can withhold some or all of the credit associated with debit transactions originated by such an institution, in anticipation of return items. This treatment parallels that for checks processed by the Federal Reserve.

In November 1988, the Board approved new ACH fees, which became effective in January 1989. Surcharges on ACH nighttime processing were reduced from 2 cents to 1.5 cents for next-day credit transactions, and from 4.5 cents to 3.5 cents for debit transactions. The System plans to simplify the ACH fee schedule still more. ACH nighttime surcharges may be reduced further, and the difference between local and interregional transaction fees, currently set at 1.0 cent and 1.7 cents respectively, may be narrowed. The System also plans to simplify further the fee schedule for the manual aspects of ACH processing, such as tape handling, output delivery, and conversion to electronic form of paper or telephonic returns and notifications of change.

The Reserve Banks will continue to encourage depository institutions to electronically originate, receive, and return ACH transactions with the Reserve Banks. Toward this end, Fedline II will be offered to depository institutions that use intelligent terminals to access Federal Reserve services. The System is also exploring other low-cost electronic alternatives for institutions receiving small volumes of ACH transactions.

BOOK-ENTRY SECURITIES SERVICE

In 1988, the Federal Reserve processed 7.9 million on-line transfers of Treasury book-entry securities, 8.5 percent more than in 1987. Transfers of federal agencies' book-entry securities totaled 2.2 million, compared with 2.1 million in 1987. The numbers are projected to increase more than 10 percent in 1989. Fees charged to depository institutions for book-entry security transfers remain in 1989 at $2.25 for on-line transfers and $7.00 for off-line transfers. However, a fee was imposed on receivers of reversals because they are the parties that originate the transfer that prompts the reversal.

In 1989, the System will redesign the book-entry securities system. This effort is a response to the rapid growth in the number of book-entry securities eligible for the system in the last few years and to other business needs, such as the Federal Reserve's program for reduction of risk in the payment system.

Definitive Safekeeping and Noncash Collection Services

During 1988, the number of definitive safekeeping issues averaged approximately 137,700 a month, 15 percent fewer than in 1987 (table 2). The number of noncash collection items decreased 12.2 percent to 3.3 million. Bearer and coupon municipal securities have not been issued since the 1983 revisions in the tax law, and volumes are projected to decline steadily in the 1990s. Responding to the 1988 decline, the Reserve Banks have emphasized cost-control measures.

Six Federal Reserve Districts raised their prices in 1989 to offset declining volumes in both definitive safekeeping and noncash processing, and two other Districts raised prices on noncash processing to offset anticipated declines in volumes. Full cost recovery for the combined service is planned for 1989. To achieve this objective, adjustments to operations and cost-control measures will be pursued, with further consolidation of the service where possible. [Tabular Data 1, 2, 3, A.1, A.2 Omitted]