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Financial Regulation in the Information Age

R. Alton Gilbert
Vice President and Banking Advisor
Federal Reserve Bank of St. Louis
Box 442
St. Louis, MO 63166
(314) 444-8559

June 25, 1996

Several groups are attempting to develop new arrangements for making payments: stored value cards and payments over the Internet. This article examines the implications of these developments for the safety and soundness of the payment system.

One type of threat to safety and soundness involves the nature of the technology used in these new payment arrangements: reliability of the systems and vulnerability to fraud or attack over computer systems. This article does not deal with these issues raised by new payments technology. Instead, this article deals with the role of the government in limiting the vulnerability of the payment system to shocks resulting from default by providers of payment services on their payment obligations.

Some of the firms developing new payment arrangements are not banks. This article examines the implications of entry into the payments business by the nonbank firms those whose liabilities are used or will be used for making payments, if their plans are successful. The appendix describes the services of two of these nonbank providers of payment services. Entry of these firms into the payment business raises some important issues for public policy. Should the new providers of payment services whose liabilities are being used for making payments be supervised and regulated as banks? Is it important, for preserving stability of the payment system, that they be granted access to the discount window?

I investigate these issues by examining banking history. While the technology involved in processing payments has changed over time, issues involving the role of the government in ensuring the safety and soundness of the payment system have remained the same. Lessons drawn from history are still relevant for the entry by nonbank firms into the payments business.

Definition of Supervision and Regulation

Since financial institutions are subject to various forms of regulation, it is necessary to define what I mean by supervision and regulation. My definition reflects the practice of supervision in the United States.

1. Supervisors restrict the types of assets in which firms under their jurisdiction may invest.


2. Through examinations supervisors assess the quality of the firms' assets and the capacity of their managers to manage risk.


3. Supervisors have authority to require changes in the behavior of firms, including authority to require them to increase their capital or cease operations.

The Market Discipline Argument for Exemption from Supervision and Regulation

One argument for exempting nonbank providers of payment services from supervision and regulation rests on the assumption that market discipline will ensure the safety and soundness of the payment system. This market discipline argument rests on the following assumptions.

1. Market discipline will force the nonbank providers of payment services to hold cash to satisfy the demands of their customers who wish to cash out of their payment systems.


2. These nonbank firms will arrange credit lines with banks to guarantee that they always have access to enough cash to meet their commitments. The banks offering credit lines will impose market discipline on the activities of these firms.


3. Nonbank providers of payment services will limit their investments to high quality earning assets, to maintain the confidence of their customers.


4. Customers would be able to distinguish accurately among payment providers on the basis of the risk they assume. Failure of one nonbank provider of payment services would not undermine customer confidence in the other nonbank providers, would not trigger contagious runs by the customers of the other nonbank providers of payment services.

Are these assumptions valid? Is there evidence to support them? Such evidence must be derived from periods with a variety of experience with payment system stability, and a variety of relationships among providers of payment services. In the history of banking in the United States, the relevant period is that prior to formation of the Federal Reserve System in 1914.

Lessons from Banking History

Major institutions in this history are clearinghouses, which functioned somewhat like central banks (Timberlake (1984)). Banks formed clearinghouses for efficient clearing and settlement of payments. Operation of clearinghouses required a great deal of cooperation among their member banks, especially during periods of financial crises. Clearinghouses engaged in activities similar to supervision and regulation of their member banks, to ensure that the financial condition of each member warranted support during a financial crisis (Gorton and Mullineux (1987)).

During occasional financial crises, bank customers attempted to withdraw their deposits in the form of currency. Banks attempted to cope with these large cash withdrawals through mutual support coordinated through their clearinghouses. Banks loaned their cash reserves to the clearinghouse member banks experiencing the greatest difficulty coping with depositor withdrawals. Clearinghouses created special certificates during crisis periods (called loan certificates) that the members agreed to accept in settlement through their clearinghouses. This arrangement freed banks to use their cash reserves to meet the demands of depositors, rather than holding inventories of reserves for settlement at the clearinghouse. The discount window of the Federal Reserve was modeled after these actions of clearinghouses during banking panics. Clearinghouses were effective in limiting the effects of bank runs during some banking panics. On other occasions, actions of the clearinghouses were not adequate to deal with panics, and banks resorted to suspension of cash payments to their depositors, which were major disruptions in the operation of the payment system.

To understand why banks attempted to deal with panics through cooperative actions, it is necessary to understand the conflict between the interest of banks as individual organizations and banks as a group during a crisis. The best actions for an individual bank would be to meet the liquidity needs of its customers while keeping its cash reserves as high as possible, and refuse to lend to other banks. Loss of public confidence in a competing bank might drive the bank out of business. Actions by individual banks to guard their own cash reserves, however, would make the crisis worse. It is in the interest of banks as a group that each use its cash reserves to meet the demands of its depositors and lend to the banks having the greatest difficulty meeting the demands of their customers. Through such actions banks might be able to restore confidence of the depositors at all banks in the community.

I draw the following conclusions from this period of United States banking history.

1. Banks were vulnerable to runs by their depositors. Runs by depositors on some banks tended to undermine the confidence of the depositors of other banks.


2. Banks did not rely on market mechanisms to allocate reserves during financial crises. Instead, they worked together through their clearinghouses in attempting to deal with such crises. Each bank benefited if all banks in its community could meet the demands of their depositors for cash, since depositor runs that closed one bank were likely to induce depositors to run on other banks (Dwyer and Gilbert (1989) and Roberds (1995)).


3. Clearinghouses that included as members all of the providers of payment services in their communities were more effective in dealing with banking panics than the clearinghouses that excluded substantial numbers of payments providers (Tallman and Moen (1995)).


4. Speed of actions by clearinghouses in dealing with panics was essential to success. Government sanction made such actions more effective (Roberds (1995)).


5. Conflicts of interest among banks as competitors may have limited the effectiveness of clearinghouses in dealing with financial crises. In particular, conflicts of interest may have limited the willingness of the members of the clearinghouses to commit their resources to ensure that their competitors were able to meet the demands of their customers for cash. Conflicts of interest may have limited the speed of response by clearinghouses when banks faced contagious runs by depositors (Goodhart (1985)).

One basis for challenging these conclusions is that banking panics were more frequent and their effects more severe in the United States than in other countries. Bordo (1990) documents this difference in the frequency of panics across countries and attributes the relatively high frequency of panics in United States history at least partially to restrictions on branch banking in the United States. This perspective would tend to undermine the relevance of United States banking history as the basis for determining the validity of assumptions that underlie the market discipline argument. Another challenge involves evidence that free banking systems (those that operated without central banks or government supervision and regulation) were more stable than systems with central banks and government supervision and regulation (White (1984)).

While a thorough comparison of banking history in the United States and other countries is beyond the scope of this article, the following observations support the relevance of these lessons from United States banking history for current policy analysis. First, while banking panics were less frequent in other countries, they did occur. The last banking panic in England occurred in 1866, but after that episode, the Bank of England accepted its role as the nation's lender of last resort (Wood and Gilbert (1986)). Second, one explanation for the occurrence of banking panics in the United States long after they had ended in other countries is that, because of an unusual ideology involving the government and banking, the United States established the appropriate government policies for dealing with instability in the banking system long after other nations had adopted appropriate monetary arrangements. From this perspective, United States history is especially relevant for studying the ability of private firms to achieve stability in the operation of a nation's payment system through private arrangements. Third, evidence to support the claim that free banking systems (those without central banks or government supervision and regulation) were stable is subject to conflicting interpretations (Goodhart (1987)).

Implications for the Future

Now to apply these lessons from history to current issues. Banking history does not support the assumptions that underlie the market discipline argument. Experience indicates that providers of payment services are vulnerable to runs by their depositors. While market discipline of banks is important for enhancing the effectiveness of supervision, there are limits to what can be accomplished through market discipline alone. Market discipline and market mechanisms for allocating reserves are not effective in preventing crises in the operation of the payment system, or in dealing with crises when they occur. In addition, private associations of nonbank providers of payment services would not be effective in ensuring the stability of their operations.

Banking history illustrates the importance of a central authority for preserving stability of a payment system. To be effective, a central authority must be empowered to act quickly in injecting reserves into providers of payment services in an emergency situation. Its actions must not be hindered by conflicts of interest among providers of payment services. In our payment system that central authority is the Federal Reserve System.

On the basis of U.S. banking history, I conclude that all firms which offer liabilities used by the public for making payments should be required to obtain bank charters. They would be supervised and regulated as banks, and have access to the discount window to help them deal with occasional liquidity problems.

I don't think that it is necessary to apply this prescription at this time to all such firms. Currently, there is a lot of research and development in the payment system, and the dollar amounts of payments settled through the new arrangements are small. The government should limit its actions that would discourage this research and development. Stored value cards and electronic payments for households may become important elements of our payment system, or they might fail to attract the interest of substantial numbers of consumers.

While I don't know the outcome of these experiments, I can predict the nature of the relationship between the government and providers of payment services in the future. The firms whose liabilities are used for making payments will have bank charters, will be supervised and regulated as banks by government agencies, and have access to the discount window. This is my prescription for what this future relationship should be, and my prediction of what it will be. We may get to this future through deliberate planning, or through some future crises in the operation of new entrants to the payments business. History includes many examples of crises in the operations of firms that provide payment services leading to changes in their relationship to the government. The challenge for government policy involves choosing a path to this future that facilitates innovation while limiting the potential trauma for those who begin using the new arrangements for making payments.

Nonbank Providers of Payment Services

Firms that issue stored value cards encode the cards with monetary value which customers use for making purchases at vending machines and retail outlets equipped with card readers. Use of such cards for vending machines is common on university campuses. One of the nonbank providers of payment services is National CasheCard, of St. Louis, Missouri. This firm provides identification cards for students at Washington University, located in St. Louis. Students who wish to use the cards for purchases at vending, copying and washing machines first load value on the cards at terminals on campus. Value recorded on the cards is reduced each time a student uses a card in a machine.

When a student loads value on a card, by injecting currency into a terminal or debiting a transactions account at a depository institution, the transactions account of National CasheCard at a federally insured depository institution is credited. National CasheCard pays vendors and provides any student refunds out of that transactions account. Students and vendors rely on National CasheCard to honor its payment obligations out of that transactions account. Thus, National CasheCard offers payment services through a deposit account at a bank. The bank that offers the transactions account does not accept responsibility for honoring those payment obligations. National CasheCard offers to license its system to banks or their payment associations.

A service planned by CyberCash called "Electronic Coin" involves payments transmitted over the Internet. To receive electronic coins, customers send money to CyberCash and receive coins transmitted over the Internet that are stored in their computer, in the form of digits recognized in the Cybercash system as monetary value. According to the plans of CyberCash, customers of its Electronic Coin service will be able to make purchases over the Internet. A customer who sees a product on the Internet he wishes to buy will transmit the coins to the merchant over the Internet. The merchant, in turn, will transmit the coins to CyberCash.

CyberCash will deposit the money received from purchasers of Electronic Coins in transactions accounts at federally insured depository institutions, and make payments to merchants out of these accounts. Thus, CyberCash, which is not a bank, plans to offer payment services to its customers through use of deposit accounts at banks. The electronic coins, which will be assets of CyberCash customers, will be liabilities of CyberCash.

A rival system for payments over the Internet, Digicash, involves different relationships among this service provider, customers and banks. Digicash licenses its Internet payment system to banks. The monetary value in computers available for purchases over the Internet is the monetary liability of the banks that license the system from Digicash. Integrity of this part of the payment system does not depend on the cash management practices of Digicash.

References

Bordo, Michael D. "The Lender of Last Resort: Alternative Views and Historical Experience," Federal Reserve Bank of Richmond Economic Review (January/February 1990), pp. 18-29.

Boyles, David. Testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives, June 11, 1996.

Dwyer, Gerald P., Jr. and R. Alton Gilbert, "Bank Runs and Private Remedies," Federal Reserve Bank of St. Louis Review (May/June 1989), pp. 43-61.

Goodhart, Charles. The Evolution of Central Banks: A Natural Development? London School of Economics and Political Science, 1985.

Goodhart, Charles A. E. "Review of Free Banking in Britain: theory, Experience and Debate, 1800-1845, by Lawrence H. White," Economica (February 1987), pp. 129-31.

Gorton, Gary and Donald Mullineaux. "The Joint Production of Confidence: Endogenous Regulation and Nineteenth Century Commercial-Bank Clearinghouses," Journal of Money, Credit and Banking (November 1987), pp. 457-68).

Levine, Ezra C. "The Regulation of Check Sellers and Money Transmitters," National Association of Attorneys General (March/April 1993), pp. 12-13.

Roberds, William. "Financial Crises and the Payments System: Lessons from the National Banking Era," Federal Reserve Bank of Atlanta Economic Review (May/June 1995), pp. 15-31.

Tallman, Ellis W. and Jon Moen, "Private Sector Responses to the Panic of 1907: A Comparison of New York and Chicago," Federal Reserve Bank Atlanta Economic Review (March/April 1995), pp. 1-9.

Timberlake, Richard H., Jr. "The Central Banking Role of Clearinghouse Associations," Journal of Money, Credit and Banking (February 1984), pp. 1-15.

White, Lawrence H. Free Banking in Britain: Theory, Experience and Debate, 1800-1845, Cambridge University Press, 1984.