FRB: Appendix 2 to FRB Testimony, Rivlin -- The payments system -- September 16, 1997 The Federal Reserve Board eagle logo links to home page

Appendix 2 to testimony of Vice Chair Alice M. Rivlin
The payments system
Before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives
September 16, 1997

Appendix 2
Interdistrict Transportation System and Implications of H.R. 2119

Among the issues being considered at today's hearing are those raised by H.R. 2119, "The Efficient Check Clearing Act of 1997." The sponsors of this bill have stated that their intent is to require the Federal Reserve to treat its check transportation as a separate service subject to separate cost recovery under the Monetary Control Act of 1980 (MCA). We share the sponsors' objective to promote a competitive environment in the nation's payments system in order to improve efficiency in the provision of payment services. This bill, however, would hinder our ability to achieve this objective. Moreover, it fails to recognize that the transportation of checks is simply one of the inputs necessary for the Federal Reserve or any bank to provide check collection services.

The following discussion provides some background information on the Federal Reserve's check service, the transportation used to provide that service, and our concerns regarding H.R. 2119.

Overview of the Federal Reserve's Check Service
The Federal Reserve provides a comprehensive array of check collection services to banks throughout the nation.1 Federal Reserve offices collect checks drawn on paying banks located within their own office territory (local checks) as well as checks drawn on paying banks located in other Federal Reserve office territories (nonlocal checks). As is the case with any collecting bank, the Federal Reserve cannot demand payment of a check until that check is presented to the paying bank. Unless the paying bank has agreed to electronic presentment, presentment must be made by the physical delivery of the check to the paying bank. Consequently, the transportation of checks is essential to the Federal Reserve's ability to provide check collection services.

Each Federal Reserve office has established its own local transportation network to present checks to paying banks. This transportation consists of private-sector ground couriers, supplemented in many cases by private-sector air couriers. The Reserve Banks use a competitive procurement process to help ensure that the couriers with which they contract provide cost-effective service that meets their business requirements.

The Federal Reserve also has established a transportation network to ship nonlocal checks between Federal Reserve offices. This privately-owned but Federal Reserve managed transportation network is called the Interdistrict Transportation System (ITS). We would like to provide a more detailed description of ITS because consideration of H.R. 2119 appears to focus primarily on this aspect of our check transportation.

Interdistrict Transportation System--ITS is an integrated network of private-sector air and ground couriers that ties together the check processing operations of 45 Federal Reserve offices. In 1996, $35.5 million of the total ITS costs of $36.1 million consisted of contracts with private-sector firms.2 As in the case of the Reserve Banks' local transportation arrangements, ITS courier contracts are awarded to private-sector firms based on a competitive bidding process. ITS enables the Federal Reserve to provide a unified national check service that provides for very prompt collection of checks at a reasonable cost. Since 1983, the ITS network has enabled the Federal Reserve to accelerate the collection of checks substantially and to reduce the amount of float created in the collection of checks. These improvements have been achieved while holding the increase in average annual ITS operating cost during this period to under 1 percent.

The ITS network is a hub and spoke network that uses about 50 aircraft to make about 200 flight segments nightly, with dispatch and delivery schedules tied to deposit deadlines at the Federal Reserve offices. The network is configured into five geographic regions.3 Checks are flown from the airport serving each Federal Reserve office to the regional hub city serving the office. The check shipments are then sorted at the hub cities according to their final destinations. Those shipments destined for Federal Reserve offices served by the same regional hub are flown and delivered to those offices. Those shipments destined for Federal Reserve offices located in other regions are flown to the hub city serving those regions for eventual delivery to their final destinations.

All ITS activities are coordinated by a central control function. The central control function monitors the status of all 200 flight segments and innumerable ground courier pickups and deliveries. It uses information received from the air carriers' dispatchers, hub managers, and Federal Reserve offices to carry out its responsibilities. For example, the central control function makes time-critical decisions concerning the need to re-route scheduled flights and to release or hold flights on the ground awaiting a connecting flight. Because of the critical nature of the central control function and the need for that function to understand fully the Federal Reserve's check collection products, the Federal Reserve has begun to transfer the responsibilities currently performed by a contractor to Federal Reserve staff members.

The ground operations at each hub city are overseen by hub managers who supervise the loading and unloading of aircraft, the sorting of check shipments, and the ground transportation used to deliver shipments between Federal Reserve offices and local airports. The hub managers provide the central control function with information on weather conditions, aircraft mechanical problems, pilot problems, the status of flights, and so forth. Working together with the central control function and the carriers' dispatchers, the hub managers control the nightly activity of the ITS network.

To put into perspective the time-critical nature of the ITS network, during the course of eight to nine hours each night, there generally are at least two round-trip flights between each spoke city and its regional hub city. There can be six to eight flights arriving at each hub city within ten to fifteen minutes of each other. In many cases, the departure time for the critical flights between hub cities allows as little as fifteen minutes for the unloading, sorting, and reloading operation to be completed. In most situations, a failed connection due to a late arrival could result in a full day's delay in the collection of checks.

As discussed above, the primary purpose of the ITS network is to provide the transportation that is necessary for the Federal Reserve Banks to collect checks for their customers that are drawn on paying banks located in other Federal Reserve office territories. Because the ITS network must be designed to handle peak load volumes and there is typically excess capacity on flights, the network is also used to ship other materials between Federal Reserve offices. These materials include government checks and savings bonds, which the Federal Reserve handles as fiscal agent of the United States, and inter-office mail.

The costs of the ITS network are allocated among the activities that use it as is the case with other shared Federal Reserve expenses. The Federal Reserve allocates the costs of the network to each type of shipment based on shipment weight. In 1996, about 69 percent of ITS costs was attributable to commercial check shipments; the remaining costs were attributable to other Federal Reserve activities and were allocated to priced services (9 percent), fiscal agency services (14 percent), and central bank services (8 percent).

The ITS costs allocated to priced services are recovered by fees for those services. The costs allocated to fiscal agency services that the Federal Reserve provides to the federal government and to the Federal Reserve's central bank activities represent costs that must be incurred to perform these responsibilities. Using ITS is a cost-effective means to ship non-check materials between Federal Reserve offices and is a prudent use of taxpayer funds.

The Federal Reserve's methodology for allocating ITS costs to the functions that use ITS is consistent with the principles that underlie its cost accounting system, called the Planning and Control System. While the specific methodology currently used to allocate ITS costs has not been reviewed by outside organizations, the General Accounting Office (GAO) and a public accounting firm have reviewed the underlying principles and found them to be reasonable. In its January 1985 report, titled An Examination of Concerns Expressed About the Federal Reserve's Pricing of Check Clearing Activities, the GAO concluded that "the procedures the Federal Reserve now uses for allocating costs and setting prices generally are reasonable." Further, during the same period, the Board contracted with Arthur Andersen to conduct an independent review of the Federal Reserve's pricing methodology and cost accounting procedures, in light of criticism that had been raised by several correspondent banks. Arthur Andersen concluded in its September 1984 report, titled Federal Reserve System: Report on Priced Services Activities, that "the System's methodology for pricing the services it provides to financial institutions is logical and complies with the priced service related provisions of the Monetary Control Act of 1980."

There is no one "right" way to allocate shared costs to benefitting activities. There are, however, a number of reasonable methods of allocating such costs. Although the Federal Reserve refines its specific allocation methodologies periodically, the principles underlying the Planning and Control System have not changed since they were reviewed in the early 1980s. The Federal Reserve believes that its current methodology for allocating the costs of the ITS network is reasonable.

Rationale for H.R. 2119
H.R. 2119 appears to be prompted by two concerns. The first concern is that the taxpayers "subsidize" the Federal Reserve's check transportation. The second concern is that, because of this perceived subsidy, the Federal Reserve's management of ITS adversely affects the ability of other air couriers to provide check transportation services to banks. The Board does not believe there is a basis for either of these concerns, as explained below.

Taxpayers do not subsidize the cost of the Federal Reserve's check transportation. It is understandable that whenever a public entity competes with the private sector in providing services, the issue of subsidies arises. 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. In addition, the MCA requires the Federal Reserve Banks to recover imputed costs, such as the cost of capital and taxes, that would have been paid and imputed profits that would have been earned had the services been provided by a private firm.

The Federal Reserve has complied with those requirements and has recovered 100.7 percent of the costs of its priced services, including imputed costs and profits, over the last ten years. In fact, because the Federal Reserve recovers imputed costs that it does not actually incur as well as imputed profits, the Federal Reserve's revenues over the past decade have exceeded its actual costs of providing priced services by almost $1 billion, which has contributed to the earnings the Federal Reserve has returned to the Treasury during this period.

The Federal Reserve has set a more rigorous standard for itself than required by MCA; specifically, the Board requires that each major priced service category, such as the check service, recover its total costs. The Federal Reserve has fully recovered the costs of providing its check service, including all costs related to the transportation of checks, over the past decade. In fact, the check service has been the primary source of excess revenue attributable to the Federal Reserve's priced services that has contributed to the earnings returned to the Treasury.

The question that has been raised, however, deals with a component of the check service, the ITS network, and whether that component is being subsidized. The Federal Reserve is not in the transportation business. The ITS network is merely a small component of the check service, accounting for only about 4 percent of the service's total costs. The ITS network is obtained from private couriers and permits the Federal Reserve Banks to collect nonlocal checks efficiently.

As a component of the check service, the Federal Reserve's staff does review the costs of the network, in the same way that the staff reviews the costs of all components of the check service. Based on these reviews, the staff determines whether the network as well as other elements of the check service should be modified to ensure that the service is operated in a cost effective way. The staff also reviews periodically the ITS surcharges that are assessed to banks collecting nonlocal checks through the Federal Reserve Banks. Again, all check fees are reviewed periodically. These reviews are intended to ensure that the check service continues to recover its costs and to ensure that no check fees are set below incremental costs.

For multi-product firms to ensure that individual products are not receiving a subsidy, each product should recover at least its incremental production costs. Because the cost structure of the ITS network is dominated by high fixed costs, its incremental costs are low. First, the costs of the air transportation contracts are essentially fixed, that is, the costs do not vary significantly with volume. Similarly, the costs of ground operations at airports and transportation between airports and local Federal Reserve offices are fixed. The incremental or marginal cost of shipping a check on the ITS network currently ranges from about $0.0004 to $0.0018. On the other hand, the per-check ITS surcharges range from $0.004 to $0.032 per check. Thus, ITS prices cover at least incremental costs and the ITS network is not being subsidized by other check products.

The Federal Reserve's management of ITS does not adversely affect the ability of other air couriers to provide check transportation services. Because the ITS network is designed as a component of the Federal Reserve's check service, only checks that are being collected by a Federal Reserve office are shipped via ITS. The first Federal Reserve office receiving nonlocal checks for deposit must sort most of those checks to the paying bank's Federal Reserve office before shipping them via ITS. For the remaining nonlocal checks collected through the Federal Reserve, the depositing bank has determined it is more cost effective to perform this sorting itself. It is only in these cases--where a bank has decided to collect nonlocal checks through the Federal Reserve and has sorted the checks to the Federal Reserve office of the paying bank--that the bank has a choice of shipping the checks to the paying bank's Federal Reserve office via ITS or by other means.

Banks that have the choice of shipping checks to distant Federal Reserve offices by ITS or by other couriers overwhelmingly choose non-ITS couriers. In fact, this trend toward the use of non-ITS couriers to ship checks to distant Federal Reserve offices has increased in recent years. In 1996, only about 13 percent of the approximately 4.8 billion nonlocal checks that were not processed by the depositing bank's local Federal Reserve office was shipped on ITS. The remaining 87 percent of those checks were shipped via other private-sector couriers. Banks often decide to ship checks on a non-ITS courier so that they can use a single courier to collect checks through the Federal Reserve as well as present checks directly to paying banks and/or collect checks through distant correspondent banks. In contrast, banks can only ship checks on ITS that they collect through the Federal Reserve, and must use an alternate courier for checks collected through other channels. Private-sector couriers have grown and prospered; one major provider of check air courier services carries more than twice the check volume than is carried on ITS, based on its publicly available cost and income data. Moreover, that courier's volume has grown rapidly over the last several years. This evidence does not support the contention that the Federal Reserve's management of ITS has impeded the growth of private-sector couriers.4

Implications of H.R. 2119
Designating Federal Reserve's check transportation as a separate service line subject to separate cost recovery raises a number of issues. First, it would unduly complicate the Federal Reserve's check service and make it less attractive to its customers. The Federal Reserve and other collecting banks must transport checks to paying banks in order to obtain payment. The transportation of checks is an integral component of the check collection process and the industry practice is for collecting banks to include the cost of check transportation in the collection fees charged to their customers.

The Federal Reserve may be required to disaggregate its current fees and establish transportation fees between Federal Reserve offices for all nonlocal checks as well as for local check deliveries to paying banks. This could result in a pricing structure with thousands of additional prices that would be complicated to administer, confusing to banks, and put the Federal Reserve at a competitive disadvantage in the check collection market. In the supplement to its January 1985 report, the GAO reached a similar conclusion. In its discussion of ITS, the GAO stated that "requiring the transportation surcharge to exactly cover the costs for each market area would be difficult to administer, is not required under existing law, and would not necessarily be effective."

Second, requiring separate cost recovery of check transportation rather than treating it as one of the many components of the check service would be inconsistent with industry practice not only in the check collection market but also in other industries where organizations do not separately recover the costs of the transportation component of the services they provide. For example, the U.S. Postal Service charges one flat fee to recover its costs of delivering a letter; it is not required to assess separate fees for its mail sorting operations, its local delivery service to each home and business, or its inter-office transportation system. If the provisions of H.R. 2119 were applied to the Postal Service, the postage for a letter mailed from New York to Los Angeles potentially would vary based on the cost of the local transportation to the Postal Service processing location in New York, the transportation from the New York processing location to the Los Angeles processing location, the transportation from the Los Angeles processing location to the addressee, as well as the mail sorting performed in both New York and Los Angeles. Just as it would be unreasonable to burden the Postal Service and its customers with such a complex price structure, it would also be unreasonable to burden the Federal Reserve and the banking industry with such a price structure.

Third, treatment of the Federal Reserve's check transportation as a separate service line subject to separate cost recovery would be inconsistent with the treatment of the Federal Reserve's electronic data communications network, Fednet. The Federal Reserve's check transportation network and its electronic counterpart serve similar functions. Whereas check transportation is used to deliver paper-based payments collected by the Federal Reserve, Fednet is used to transmit electronic payments, such as Fedwire transfers and automated clearing house transactions, and other data between banks and the Federal Reserve. As is the case with the Federal Reserve's check transportation network, the costs and revenues associated with the Federal Reserve's electronic network are allocated to the services that use it.

Fourth, as indicated earlier, the Federal Reserve does not consider itself to be in the transportation business; the Federal Reserve is in the payments business. If Congress were to determine that check transportation should be considered a separate service line subject to separate cost recovery, we would need to consider whether we would continue to restrict checks shipped by the Federal Reserve to those that are collected through the Federal Reserve. The Federal Reserve does not condition the provision of any of its major services on a bank's use of another service. Thus, the Federal Reserve would have to reconsider whether access to its transportation networks should continue to be conditioned upon the use of the Federal Reserve's check collection service or whether all banks should be permitted to use Federal Reserve contracted transportation to ship checks that they are collecting outside the Federal Reserve.

In summary, a requirement that the Federal Reserve treat check transportation as a separate service line for which costs must be recovered separately would complicate the Federal Reserve's management of its check service, would complicate the use of the check service by banks collecting checks through the Federal Reserve, would not be consistent with industry practice or with the treatment of other similar functions performed by the Federal Reserve to provide payment services, and may fundamentally change the scope of material eligible for shipment on Federal Reserve check transportation.


1 In this appendix, the term bank includes commercial banks, thrift institutions, and credit unions.

2 The remaining costs are attributable primarily to the staff at the Federal Reserve Bank of Boston responsible for contracting with and overseeing the performance of the private-sector firms providing services that constitute the ITS network. Currently, these private-sector firms provide air and ground courier services, ground operation services, and central control functions.

3 Currently, the hub cities serving these regions are Atlanta, Chicago, Cleveland, Dallas, and Philadelphia.

4 The Federal Reserve has actually taken steps that have improved the attractiveness of non-ITS couriers. As noted above, ITS only ships checks collected through the Federal Reserve, while other couriers ship checks that are collected both through and outside the Federal Reserve. By improving the presentment abilities of correspondent banks, the Federal Reserve Board's 1994 same-day settlement rule reduced the Federal Reserve's market share and also reduced the number of checks that were eligible to be shipped on ITS.

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Last update: September 16, 1997, 1:30 PM