The Future of Payments

91 BANKING PERSPECTIVES QUARTER 4 2018 system. As a matter of basic economics, increased competition should lead to increased efficiency. Moreover, non-bank firms have a long history of efficiency-boosting innovations in technology and operating models. There are, however, a couple of caveats to the argument for increased efficiency. First, there is no obvious, causal relationship between giving non-banks settlement accounts and incrementally increasing efficiencies above current levels. After all, non-bank payment firms have not needed direct access to bring about successful advances in efficiencies, technological innovation, increased competition, and other benefits they have created under the current system. Second, since they are not regulated as banks, some non-bank payment firms might achieve time and cost savings through externalization of risk, rather than increased efficiency. In other words, while many non- bank firms find innovative ways to make payments better, others may merely be cutting corners in managing credit, compliance, or operational risks. INTEGRITY OF THE PAYMENT SYSTEM This last caveat highlights the critical role of the Federal Reserve’s third policy objective – ensuring the integrity of payment systems – in considering direct access for non- banks. Integrity considerations are paramount because the current master account eligibility criteria – both formal and informal – are central to the Federal Reserve’s strategy for managing risks in the payment systems it operates. According to the Federal Reserve Policy on Payment System Risk, “controls to limit participant-based risks, such as membership criteria based on participants’ financial and operational health[,]” are “key features” of a payment system’s rules and procedures. 4 The Federal Reserve’s eligibility criteria do not, on their face, include any consideration of an account holder’s financial or operational health. Indeed, the Federal Reserve Banks, in their role as payment system operators, do not have independent mechanisms to evaluate or monitor the soundness of depository institution account holders. Instead, the Federal Reserve relies on prudential bank regulation to manage participant-related payment system risk. This reliance manifests itself most explicitly in the Federal Reserve System’s daylight overdraft rules, which use an institution’s supervisory ratings and prompt corrective action status to establish limits for the institution. Viewed in this light, the master account eligibility criteria contain implicit assumptions regarding the regulations and supervisory regimes to which eligible depository institutions are subject. While the criteria may appear on the surface to set the eligibility boundary based on the legal formality of charter or license type, the real boundary is based on the level of regulation and supervision that the charter or license types imply. This observation is realized in situations where legal formality does not match regulatory substance. Like other central banks, the Federal Reserve reserves the right to decline to open an account for an institution that technically meets the minimum eligibility requirements. Two recent high-profile cases have drawn attention to this fact, though they are by no means the only examples. Uninsured state non-member banks seem particularly likely to encounter situations where Federal Reserve Banks decline to open – or restrict – master accounts for facially eligible institutions. This is notable because, unlike other depository institutions eligible for master accounts, uninsured state non-member banks are not subject to federal prudential supervision or to key federal prudential banking regulations. Non-bank payment firms, likewise, do not have federal prudential supervisors and are not subject to federal prudential bank regulation. To be sure, some specific types of non-bank firms are subject to a variety of other regulatory and supervisory regimes. For example, state-licensed money transmitters and registered broker-dealers hold licenses and are regularly examined by their supervisors, while certain large processors are periodically examined by the federal banking agencies as technology service providers. But these oversight regimes