Anthony M. Santomero, President of the Philadelphia Fed, discusses the evolution of our payments system. The history starts at a time in the U.S. when each bank issued its own checks and currency and banks are chartered and regulated by individual states rather than by the federal government. He talks about some of the problems that arrangement causes for transactions, particularly over long distances, and how the federal government attempts to solve this by introducing a national currency and check clearing system.
The focus here is on the evolution of checks, credit cards, and debit cards. There's more to the history of our dual banking system than can be written here, this post is long enough already, and the more general history can wait for another day:
The Evolution of Payments in the U.S.: Paper vs. Electronic, by Anthony M. Santomero, President FRB Philadelphia: Historically, U.S. banks tended to provide services — including payments services — to the broad spectrum of people and businesses... In early America, the geographical expanse of the country encouraged a fragmented system where state banks issued their own notes. Entry into the banking business was relatively easy, but bank branching was very restricted. Banks were prohibited from branching outside their home state, and in many states, branching was restricted still further. As a consequence, a region would be served by a relatively large number of banks, but there were no banks operating nationwide.
To effect transactions, people paid one another with paper checks drawn on their bank or paper currency notes issued by their bank. The banks would then clear these checks and notes among themselves. As you might imagine, with so many individual banks spread out across such a big country, effecting transactions outside the local area was cumbersome. Thus, banks would discount the value of deposited checks or notes based on the cost of presenting it to the “drawn on” bank for payment and some assessment of its creditworthiness. The farther away the bank, the less familiar its financial condition, and the greater the transportation cost associated with clearing the instrument — so the greater the discount...
By the turn of the 20th century, it was clear that the U.S. needed a better integrated national payment system. One of the main reasons Congress established the Federal Reserve System in 1913 was to create a national clearing system in which checks could exchange at par value. To achieve this, the Federal Reserve offered check clearing services free of charge to banks that joined the Fed System. However, the Fed did not become the sole provider of check clearing services, despite offering its services for free. First of all, not all banks chose to join the Fed System, primarily because of some of the regulatory implications. In addition, large correspondent banks offered smaller respondent banks an array of services including check clearing. Also, banks could take advantage of local and national clearing house arrangements. Nonetheless, the Fed established a large market presence, providing a baseline level of national check clearing services accessible to all banks, large and small, anywhere in the country. Thus, the Fed contributed to the viability of both the paper check and the small community bank.
In the 1960s and 1970s, U.S. banks and the Fed applied advances in technology to check processing, increasing the efficiency of their operations. Banks found the paper check payments business to be profitable, and consumers were quite comfortable and confident in their use of checks. In short, checks were the dominant form of noncash payment, and there was little momentum for change in the payments system. In the early 1970s, the Fed introduced its Automated Clearing House, known today as Fed ACH. To date, ACH has not developed into the dominant form of electronic payment, in part, because, traditionally, only banks — not individuals — could initiate ACH payments... While Fed ACH has had some success as a means to effect, and convert, routine payments, it was the credit card that proved most instrumental in moving payments from paper to electronics at the point of sale. As we all know, the credit card actually was the first ubiquitous consumer-based electronic payments instrument to emerge. Credit cards were introduced in the 1950s, and their use grew rapidly over the next three decades.
The infrastructure of credit cards in the U.S. is, or at least has traditionally been, fairly simple. The two major credit card associations, Visa and MasterCard, operate nationwide and are not subject to the anti-trust laws that prohibited collaboration among banks. ... In the 1990s, when the tech boom made information processing and telecommunications more powerful and less expensive, credit card companies were well-positioned to take full advantage of these developments... Of significance for the future, this technology has made the credit card a viable means of payment for e-commerce as well. Some card issuers even offer free consolidated bill payment on their sites, incorporating a variety of settlement mechanisms.
After the credit card, the debit card is the second most popular electronic instrument for making retail payments in the U.S. today. The debit card arrived on the scene relatively recently — during the 1980s. But since its arrival, growth in usage has been dramatic. At first, the debit card emerged as ... automated teller machine (ATM) systems, but then it moved beyond being solely a mechanism to access currency... bank customers had the option to simply present the card to the merchants and have their bank account debited directly. It was not long before the credit card networks responded to the growing use of these cash access cards with debit card products of their own. Visa and MasterCard already had an infrastructure in place for processing credit card transactions at the point of sale. They leveraged that infrastructure to establish offline debit card networks. Indeed, purchase volumes with these so-called “signature” debit cards are greater than those of the original “PIN-based” cards...
Santomero continues his talk and discusses what is expected to happen to the payments system in the future here.
