Addressing the Fed’s conflict of interest on payments

In addition to monetary policy and bank regulation, the Federal Reserve has a third, lesser-known function. It operates a payment system that competes with private-sector payment systems to process payments between banks. 

In doing so, the Fed regulates the payment systems with which it competes, and also regulates the customers of both payment systems. The Fed is poised to expand its role in payment systems with a real-time payment initiative that it should abandon while it takes steps to clean up its conflicted practices.

The Federal Reserve has created regulations that govern how quickly banks must process checks, and unlike private payment systems, when the Fed adopts rules for the operation of its payment system, they take the form of regulations. 

Thus, the Fed can generate its own artificial demand for its payment system services by issues regulations on the banking sector that encourage banks to use its services. 

The Federal Reserve purportedly has internal controls in place to ensure these roles do not intersect. Yet, the members of the Federal Reserve Board who oversee the payment system committee also vote on regulatory issues. No matter what internal controls are put in place, the same Fed Board oversees everything the Fed does.  

Would consumers trust Facebook to serve as regulator of other social media with which it interacts, like Google, and other social media with which it competes, like Snapchat? Of course not. 

First, we would be suspicious of a government regulator that also has a private-sector role in generating revenue.  Second, we would be suspicious that Facebook might use its regulation of Google to encourage Google to prefer Facebook in some way.

Third, we would be suspicious Facebook might use its regulation of Snapchat to gain an advantage over that competitor service. The Fed has engaged in all three dubious practices. 

Congress created a cost-accounting framework to use internally generated cost estimates to price Fed payment services. Cost estimates generated by Fed employees are no substitute for the discipline of the private sector. 

This is the reason cost accounting is not used to generate financial statements for public companies, but instead Generally Accepted Accounting Principles accounting is utilized to create market-based estimates.

The Federal Reserve has not conducted an audit of its cost-accounting processes for payment systems since 1984. Many private-sector institutions have also criticized the Federal Reserve for not including comparable costs from the private sector into its analysis, including compliance costs associated with anti-money laundering rules.

The Federal Reserve is exempt from these rules (you get to exempt yourself when you regulate payment systems and operate one at the same time!). 

The Federal Reserve has an inherent bias that would discourage it from adequately incorporating an estimate for private-sector compliance costs into its cost-accounting for payment systems.

If the Fed admits that compliance costs are high, those estimates may conflict with the cost estimates the Fed generated to adopt the initial regulations in the first place.

For example, the Federal Reserve regulates financial market utilities designated by the Financial Stability Oversight Council.

Were it to admit compliance costs associated with those regulations are high for the private sector and include an estimate for those costs in its cost calculations for the Fedwire system, the Fed would have to admit compliance costs are high. 

Yet, the best way to ensure new regulations cannot be challenged in court is to offer cost estimates that lowball the compliance estimate or to refrain from estimating compliance costs at all. 

The inherent conflict of interest is also seen in another way, in that the Federal Reserve is not required to develop a process to orderly wind down its payment system in the event of financial panic. The Fed’s private-sector competitors by contrast are required to develop a wind-down plan. 

The reason is that the Fed says it will simply bail out it own payment system in the event of financial stress. Private-sector competitors will never be able to make a similar claim to avoid regulatory wind-down requirements.

The Federal Reserve is doing a poor job managing conflicts of interest in payment systems. Private-sector competitors are subject to unfair competition from their regulator. 

The Federal Reserve should abandon its project to further expand its role in payments with a real-time initiative and instead open a public comment process to consider the ways in which it is currently impeding the private sector from improving payment systems.

J.W. Verret is an associate professor at the George Mason University Antonin Scalia School of Law & a former chief economist for the U.S. House Financial Services Committee