5 Critical Issues in the Design and Management of Payment Systems

Omotunde Johnson, Jean-Marc Destresse, Nicholas Roberts, Mark Swinburne, Tonny Lybek, and Richard Abrams
Published Date:
March 1998
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Various social efficiency and organizational issues arise in the design, management, and reform of payment systems. This chapter briefly surveys some of the critical issues involved. In this context, a basic objective of the public sector agent(s), in the payment system, should be to ensure that there are in place appropriate institutions, economic organizational structures, and policies of public organizations/entities: both to facilitate general efficiency of resource use by the payments services sector(s) and to foster socially efficient innovations and endogenous change in the payment system. Implementing and sustaining necessary institutional changes to meet these objectives entail costs associated with the process of planning, introducing, monitoring, and enforcing the changes.

Payment System and Social Efficiency

An important underlying principle in assessing both the functioning and the wisdom of certain designs of the payment system is that they promote social efficiency of resource use and the efficient supply of payment services and products. This general principle is very often violated in practice when decisions are taken about the payment system. This is mainly because it is very easy to appreciate—and often to overestimate—benefits but to ignore or underestimate costs of reforms. Similarly, it is easy to become preoccupied with technical (or operational) efficiency and not continue on to evaluate economic efficiency.

An important principle in social efficiency is that, given the total amount of resources actually being used in the payment system, the marginal unit of resource used in one part of the payment system must yield no less in benefit to the society than if that unit of resource were used in another part of the payment system. Thus, efficient intrasectoral allocation of resources in the payments sector is promoted if the marginal unit of resource spent on, say, wire transfers would not produce more value to society if that resource unit were spent on activities related to some other payment instrument; this principle applies whether the marginal unit of resource is utilized for making the instrument; for enhancing reliability, reducing transaction costs; or for risk control activities.

The payment services sector is only one among numerous sectors in the economy. It should, therefore, be borne in mind that resources used in the payments services sector could have been used in other sectors. Formally, this means that the benefit to society of the marginal unit of resource being spent within the payment services sector should be no less than the benefit to society if that marginal unit of resource were spent in another sector.

Cost-Benefit Analysis and Rational Choice

What has been said so far implies that, when decisions on payment system design are being made, it is recommended that some form of cost-benefit analysis be done;42 but it is not the intention to underestimate the difficulties of the task. Cost-benefit analysis involves projecting the flow of benefits and costs associated with an investment (the reform) over some period of time (the time horizon), discounting such streams of benefits and costs to their present values by utilizing some discount rate (interest rate, social rate of time preference), and calculating the ratios of present values of the benefits and costs of the investment (reform). The benefits under consideration include reduced transaction costs, reduced risk, increased reliability, and new types of instruments. The diligence with which the cost-benefit calculations are typically made tends to depend, even for best practices, on the magnitude of the costs, the existence of choice among alternative approaches (institutional, organizational, technological) to attain some desired end, and the complexity of the type of reform/investment involved.

Several difficulties arise in valuation, both for benefits and for costs. On the benefit side, the important task is estimating the effective demand for the services or arrangements (including institutions)—namely, the value to the society. This value is what members of the society would be willing to pay for the benefits when there is a way of letting persons truthfully reveal this information. The basic problem, from a societal perspective, becomes how one measures accurately the flow of benefits over time, given uncertainty as to the demand for (hence the social valuation of) the service or arrangement. The uncertainty arises from changes in taste, relative prices, and technology. The last, especially, emanates from the unpredictability of the emergence of competing products or services likely to come onstream during the time horizon of the analysis.

The ranking of alternatives can be greatly influenced by the length of the time horizon and the rate of discount used in the analysis. The shorter the time horizon—that is, the time period over which the benefit-cost calculations are made—and the higher the discount rate, the higher the benefit-cost ranking of alternatives yielding their benefit streams mainly in the near future relative to those alternatives that yield their benefits in the more distant future. This can be important, especially when the gestation period (the period before the investment begins to bear fruit) or the time pattern of flows of benefits and costs differs markedly between the choices under consideration.

Rational choice on the basis of benefit-cost ratios is made more difficult by indivisibilities. These are a problem especially for some technological choices, but they could also arise in the case of institutional choices such as major legal reforms. In essence, choices must be made among units that are lumpy and often very expensive, since it may not be optimal or technologically possible to split up such units into smaller less expensive components among which only some need be acquired.

Two approaches used in practice would appear satisfactory from the viewpoint of systematic cost-benefit analysis, especially where indivisibilities are important. The first approach is to fix the maximum amount available to be spent on the “project”; this is the budget constraint. Then a specification can be made of the requirements of (that is, the effective demand for) the project. These so-called user requirements will include the payment instruments desired and the minimum requirements, features, or attributes for reliability, financial risk management, and transactions. The option chosen for the project then becomes the one judged best with respect to product and product quality (the latter being related especially to reliability, risk, and transaction costs). In this first approach, the value of the project to the investor in present-value terms is at least equivalent to the budget constraint. The budget is fixed and the product and product quality come out of the selection process. The second approach fixes the product and product quality (user requirements) and selects that option for the project that meets these requirements at the lowest cost to the investor or purchaser (for example, the central bank).

Path Dependence

Rational choice is complicated by what is known as path dependence. Incremental changes in technology, once begun on a particular track, may lead one technological solution to win over another, even though ultimately (that is, in a present-value sense) this path may be less efficient than the abandoned alternative. Alternatively put, path dependence is the consequence of small events and chance circumstances determining solutions that, once they prevail, effectively impel the decision maker onto a particular path. Situations of increasing returns to scale are especially susceptible. Path dependence is relevant not only for technological change but also for institutional change.

There are several self-reinforcing mechanisms generally at play in path dependence: (1) large set-up or fixed costs; (2) learning effects that improve products or lower their costs as their prevalence (or dominance) increases; (3) coordination effects, which bestow advantages to cooperation with other economic agents taking similar action; and (4) adaptive expectations, where increased prevalence on the market enhances beliefs of further prevalence (see Arthur, 1988). Indeed the existence of the phenomenon of path dependence helps to explain why suppliers can spend large sums in order to get the first major contract to supply a commodity or service.

Domestic Organizational Aspects of Reform

Various organizational issues arise in payment system reform. Some of these do so in two significant contexts that will be briefly discussed here: the role of national coordination bodies, and competition policy.

National Coordination Bodies

In payment system design, difficulties arise in estimating demand for different services (user requirements), and there is often a desire of the central bank to have a consensus on crucial institutions and various aspects of public policy in the payments area. Many countries have found that a forum within which the central bank can obtain the views of the private sector can prevent serious errors in policymaking. Such a forum has, in those countries, often taken the form of some kind of National Payments Council (NPC), comprising at least the central bank and the commercial banks, and probably also other financial organizations that actively participate in the payment system. Within such a coordinating body, ideas can be openly discussed, information on demand for payment services obtained, and consensus reached on important public policy issues related to institutions, competition policy, and the role of the central bank, as well as technological and other choices for major payment system initiatives. In addition, at the implementation stage of major initiatives, support from the NPC can greatly enhance cooperation, thereby lowering implementation cost.

The organization and the working methods and procedures of the NPC can be varied according to the needs, politics, and culture of the country. The NPC does not have to be a tightly structured or bureaucratic organization. But when many reforms are under way, one approach found useful is to have an NPC board with representation from suppliers and users including the central bank, as well as a number of committees or working groups, with each addressing specific aspects of the payment system design.43

Competition Policy

Good public policy will strive for coherence and explicitness in competition policy; in addition, such policy should be continuously reviewed to ensure that it appropriately evolves in the light of changing real world economic forces and community values. Competition is generally subject to the constraints imposed by the institutions of the country. Thus, formulation of a coherent competition policy is greatly assisted by a clear institutional framework. For instance, freedom of entry in many areas of payments activity is subject to licensing. Similarly, financial firms often would like to create organizations and arrangements to which access is denied to some demanders and suppliers, and this may be allowed under the institutions for property rights and contracts agreed in the country. In brief, “competition” will tend to mean “open competition consistent with the legitimate institutions of the country.”

Public sector actions to sustain competition tend to be regulation of the private sector to maintain the integrity of the market process, and public sector intervention to influence (shape) market structure. As regards regulation, one objective would be to prevent unfair advantage being gained by one competitor vis-à-vis others. “Unfairness” would imply that the advantage was not being obtained in consequence of a superior product or cost or price advantage. Another objective could be to protect users of payment services from attempts of payment suppliers to gain unfair transacting advantage and vice versa. Typically, then, with the objective of ensuring open competition, public policy in the payments area must define and have a policy toward: (1) price collusion, (2) price discrimination, and (3) disclosure of information (including truth in advertising).

Public sector intervention to influence market structure tends to focus on branching, mergers, and acquisitions. Indeed, public policy in virtually all countries pays particular attention to horizontal, vertical, and conglomerate mergers44 involving firms and organizations supplying payment services; the effect of such mergers on the efficiency of the payment system can be an important consideration in the decision to approve such branching and mergers. The general point here is that a country benefits from having, in place, coherent policies regarding branching, acquisitions, and mergers as they relate to a number of firms and organizations in the payment system, including banks, clearinghouses, LVTSs, check processing centers, and issuers of credit and debit cards.45

Typically, where banks are involved, the public entity with authority in the banking supervision area would have some responsibility in this process. But such authority is typically constrained by the general laws of the country as they relate to mergers and other aspects of “industrial organization.” A general recommendation is for clarity in the legal framework. Another is that—unless shown to be somehow not in the public interest—branching, acquisitions, and mergers should not be discouraged, especially when, from a banking supervision perspective, sounder banking firms emerge.

Other Public Policy Issues

The Central Bank as a Competitive Supplier of Services

A question that arises is whether, in the presence of economies of scale (particularly in clearing operations), there may not be a legitimate case for giving the central bank monopoly rights to provide certain payment services. In addition, standardization may be easier to achieve with a monopoly supplier, especially one with the authority of the central bank, than if competition were permitted. For instance, the Banca d’Italia by law (Decree Law of May 6, 1926) has responsibility for managing the clearing system for payments (see BIS, 1993b, pp. 201–46). Apart from historical factors, which often explain institutional and organizational arrangements, expectations of large social gains from economies of scale in supplying payment services could lead countries to grant such monopoly rights to central banks.

This must, nevertheless, be weighed against the efficiency cost of subverting competitive forces. In addition, if a monopoly is created, it does not have to be a central bank monopoly. Indeed, the process of granting such monopoly rights could be efficiency enhancing: for instance, the monopoly rights could be auctioned in an open market. Moreover, before monopoly rights are granted, the evidence should be clear that the optimal-sized firm for providing a particular payment service or set of services is so large relative to the size of the market that a natural monopoly situation exists. Thus, for a country newly developing certain payment services, the best recommendation would seem to be to permit competition and to violate this principle, in favor of granting monopoly rights, only after serious empirical investigation and careful cost-benefit analysis have demonstrated that such an approach constitutes socially efficient public policy. Even then, the monopoly rights do not necessarily or automatically belong to the central bank.

Pricing of Central Bank Noncredit Services

There is growing consensus that the central bank should charge for its payment-related services and that these charges should cover marginal costs (in general, long-run marginal costs). Admittedly, the central bank will have difficulty applying this principle in practice, owing to overhead costs distributed over a large number of central bank services and the problem of allocating variable costs among joint products or services (see Miller, 1977).

Nevertheless, central banks performing clearing and transfer services, as well as other functions such as coin rolling or check sorting or confirmation, increasingly aim to charge prices that, at a minimum, cover the variable costs. Where feasible, full cost recovery is sought: the aim is to cover also the fixed costs, with a view to earning a rate of return on their investment in the payment services at least equivalent to competitive rates in private markets, after adjusting for risk. A basic reason is to promote efficiency by: (1) discouraging excessive use of the services provided by the central bank; (2) ensuring that the central bank does not, by implicit subsidization, create competitive advantage for itself even though it may not be the least-cost provider of a service; and (3) forcing the central bank to make socially efficient decisions about what to produce and how it will invest its own resources.

In reasoning about pricing, the central bank could, for instance, divide each service into its component parts (or routines) and price each component with the aid of certain standard guidelines or benchmarks (for example, standard processing times). This procedure works well in fixing the variable cost portion of the price. The fixed-cost portion could be fixed by procedures and formulas that could differ widely—using criteria related, for example, to time or space used up, the complexity of the decision making involved, or the cost of the necessary equipment to perform the service. Naturally, the central bank will typically aim to price using objective, quantifiable formulas. For RTGS or clearinghouse systems, there could also be an entry or access fee as relevant.

Cost recovery has become enshrined in practice in some countries (for example, the United States and Germany). In the United States, the Monetary Control Act of 1980 requires the Federal Reserve to charge prices for its payment services to recover the full fixed, variable, and imputed costs of providing the services (especially services such as check processing, automated check clearing, and large-value funds transfer). Imputed costs—the so-called Private Sector Adjustment Factor—are based on an estimate of the taxes and cost of capital the Federal Reserve would incur were it a private firm (see Federal Reserve Bank of New York, 1995, p. 14). In Germany, until 1991 the Bundesbank charged only for special services associated with cashless payments (for example, the telegraphic execution of a credit transfer), but now it charges for all its payment services (see BIS, 1993b, pp. 151–200).

There is, nevertheless, the view that the central bank may price below cost to compensate banks for having to hold minimum reserves without interest compensation. The subsidy is then in lieu of interest on reserves. But this would seem a second-best approach when the first-best is available—namely, to pay interest on reserves and charge long-run marginal cost for payment services.

Suboptimal Structure of Payments in Market Equilibria

Distortions can exist in the market, producing a suboptimal structure of payments (including use of payment instruments). For instance, there is some evidence in the United States that, compared with the social optimum, checks may be overused relative to other instruments such as debit cards (and even cash) as means of making payments (see Humphrey and Berger, 1990). Float also creates distortions in addition to engendering social costs, the latter arising mainly from the procedures used by agents to generate and reduce float in reaction to its distributional effects. Typically, underlying these circumstances are marginal social costs and benefits of certain decisions and outcomes that are not properly internalized, so that they accrue to the economic agents producing them. This would mean, for example, that the social costs associated with using various instruments, or with the systemic risks and resource costs in trying to benefit from or guard against the distributional effects of float, do not fall directly on the economic agents taking the actions involved. Fostering greater competition and appropriate pricing of central bank services, in addition to improving the institutional framework (that is, more clearly defined property rights, greater freedom of contract), can greatly assist in bringing about better internalization of costs and benefits and thus enhance general economic efficiency.

Incomplete internalization of costs and benefits can arise also in relation to backups and emergency plans. Inadequate backups or emergency plans can lower reliability of a system, with frequent breakdowns and disruptions that impose large costs on others not internalized by the system operator(s). Similarly, using poor procedures, communications facilities, and transfer methods, rather than safer alternatives, in order to save on business costs can make profitable certain fraudulent activities, with effects not internalized by the sending banks. In such cases, it is again possible to introduce arrangements and devices that internalize the externalities, including minimum standards for operators and financial firms (entry requirements, an element of regulation), effective competition (that is, improved organizational structure) to “drive out” unreliable and unsafe firms, and ex post (and rigidly enforced) liability rules (punishment via a better institutional framework).

Some of the divergences of private and social marginal costs and benefits, at the quantities chosen, may, of course, reflect inappropriate pricing policies by the central bank. This can be especially true for the effective pricing of risk. In such circumstances, the direct approach to reducing the distortion is obviously to find a way to assess and properly price the risks involved.46

If incomplete internalization is due to the high cost of internalization, then this “distortion” may not be socially suboptimal; internalization costs have to do with the costs of making changes in institutions and in organizational structures as well as the cost to agents of using the current institutions and organizational structures to internalize costs and benefits. In addition, there are unquantifiable and nonpecuniary elements of private benefits that need to be taken into account in assessing true social optimality; for example, it may not always be possible for the price mechanism to fully capture the value placed on “convenience” associated with certain instruments or methods of transfer.

In short, a practical approach to facilitating social optimality might have to be content with simply ensuring institutional and organizational arrangements that tend to promote social optimality and then to conclude that any residual divergences observed between private and social (marginal) costs and benefits, at the equilibrium point of private choice, reflect the impact of unquantifiable and nonpecuniary factors and of internalization costs. In other words, given appropriate institutional and organizational arrangements, the ratios of social marginal costs to social marginal benefits, including the unquantifiable and the nonpecuniary elements, can be taken as indeed equalized across the payment instruments and services, or else economic agents find it socially inefficient to effect such equalization, and this cannot be done by socially efficient institutional and organizational changes.

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