Federal Register, Volume 62 Issue 57 (Tuesday, March 25, 1997)

[Federal Register Volume 62, Number 57 (Tuesday, March 25, 1997)]
[Notices]
[Pages 14146-14151]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-7396]

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FEDERAL RESERVE SYSTEM
[Docket No. R-0967]

Federal Reserve Bank Service Pricing

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Board has adopted guidelines for the Reserve Banks' use of
volume-based fee structures for their electronic payment services and
products. The Board has also approved the continuation of volume-based
fees

[[Page 14147]]

for certain electronic check products, pending completion of an
analysis showing that those fees meet the guidelines. Finally, the
Board has approved specific volume-based fees for the origination of
automated clearing house (ACH) transactions and a reduction in the fee
for the receipt of transactions.

DATES: The volume-based pricing guidelines for electronic payment
services and products became effective March 24, 1997. The ACH volume-
based fees become effective May 1, 1997.

FOR FURTHER INFORMATION CONTACT: Florence M. Young, Assistant Director
(202/452-3955), Jack K. Walton II, Manager, Check Payments (202/452-
2660), or Wesley M. Horn, Manager, ACH Payments (202/452-2756),
Division of Reserve Bank Operations and Payment Systems; for the
hearing impaired only: Telecommunications Device for the Deaf, Dorothea
Thompson (202/452-3544).

SUPPLEMENTARY INFORMATION:

I. Background

In 1993, the Board approved volume-based fees for the Reserve
Banks' noncash collection service and several check products. Under
certain conditions, volume-based fee structures promote the efficient
use of payment services by allowing Reserve Banks to set variable fees
closer to the incremental costs of providing the services. One of the
objectives of adopting volume-based fees was to encourage more
efficient use of payment services by permitting the Reserve Banks to
address the differences in demand for the services by high-volume and
low-volume customers through the fees charged for those services.
Reserve Banks serve customers that vary in size and that have very
different business needs. For the most part, the Reserve Banks have
tried to meet those differing needs by designing specialized products.
In some cases, however, it is difficult to meet the needs of both high-
volume and low-volume customers solely through specialized product
offerings. This situation occurs most frequently in the Reserve Banks'
electronic payments services and products because they tend to be
homogeneous. Thus, it is very difficult to develop specialized products
to meet the needs of both high-volume and low-volume customers.
Currently, volume-based fees are in effect for several electronic
check products. The Federal Reserve Bank of Minneapolis uses volume-
based fees for its check truncation product. In this case, truncation
customers may select from two sets of fees--a per-item fee of $0.015
with an $11.00 daily minimum or a per-item fee of $0.007 with a $25.00
daily minimum.^{1 The Federal Reserve Bank of Richmond uses volume-
based fees for its account total and account total plus products.^{2
Account total customers may select from two sets of fees--a per-account
fee of $0.25 with a $45.00 daily minimum or a per-account fee of $2.00
with a $15.00 daily minimum. Account total plus customers may also
select from two sets of fees--a per-account fee of $0.25 with a $50.00
daily minimum or a per-account fee of $2.00 with a $20.00 daily
minimum.
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\1\ In 1993, the Board also approved the use of volume-based
fees for the Minneapolis office's weekday other Fed, weekend other
Fed, and city fine sort deposit products. In November 1994, the
staff recommended that the Minneapolis office's volume-based fees
for paper check products be eliminated. Results of econometric
studies of the check service's cost structure indicate that the use
of volume-based fees is not appropriate for paper-based check
products. The Minneapolis office subsequently discontinued the use
of volume-based fees for these products.
\2\ The account total products provide information on the number
and the dollar value of checks drawn on the accounts of individual
customers of a depository institution and are typically used to
support the institution's cash management services. The account
total plus product provides additional information on each check
drawn on those accounts.
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In approving these fees, the Board requested its staff to recommend
principles or guidelines that would be used in the future to determine
when and how volume-based pricing might be used in setting fees for
Federal Reserve priced services (58 FR 60649, November 17, 1993).
The following discussion presents the Board's analysis of the
issues raised by the use of volume-based fees for electronic payment
services and products, presents specific guidelines for the use of such
fees, assesses the existing volume-based fees for electronic products,
and analyzes the use of specific volume-based fees for the ACH service.

II. Reserve Banks' Current Fee Structures

The Monetary Control Act requires the Federal Reserve to set fees
that, over the long run, recover all direct and indirect costs incurred
in providing priced services to depository institutions plus imputed
costs that would be incurred by a private-sector service provider, such
as interest on debt, taxes, and return on capital. These imputed costs
are called the private sector adjustment factor (PSAF).
In establishing fee structures to recover the total costs of each
payment service, in most cases, the Reserve Banks have implemented a
combination of fixed and variable fees. For example, the fee structure
for the ACH service includes a monthly account servicing fee, a file
fee, and per-item fees. The account servicing fee is intended to
recover from all ACH customers a portion of the high fixed costs
incurred in providing the ACH service; the file fee is intended to
recover costs, such as processing overhead and accounting costs, that
do not vary with the number of transactions contained in files
transmitted to the Federal Reserve; and the per-item fee is set to
recover all remaining costs.^{3
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\3\ The Federal Reserve also charges electronic connection fees
to depository institutions that establish an electronic connection
with the Federal Reserve to send and receive electronic payment
transactions and information about those transactions. The
electronic products available include ACH, Fedwire funds transfer,
electronic check presentment, accounting information, and so forth.
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The types of fee structures that have been implemented by the
Reserve Banks are similar to the fee structures used by other payment
service providers, which also use multi-part fee structures.^{4
Private-sector ACH and funds transfer service providers charge monthly
access fees, participation or membership fees, and per-item fees,
which, in some cases, include discounts for high-volume customers.
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\4\ The Reserve Banks only charge a per-item fee for their
Fedwire funds transfer service, although depository institutions
that use the service also incur electronic connection fees.
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The use of multi-part fee structures result in differential costs
for users of payment services. For example, the current ACH fee
structure includes a monthly account servicing fee of $25.00, a file
fee of $1.75, and a per-item fee for unsorted transactions of $0.01.
For a customer that transmits one file containing 1,000 transactions
each day of a typical month, the average cost per transaction would be
$0.013. For a customer that transmits one file containing 5,000
transactions each day of a typical month, the average cost per
transaction would be $0.011. Thus, multi-part fee structures result in
low-volume customers incurring higher average costs than high-volume
customers because the fixed fees are spread over fewer transactions.
The use of multi-part fee structures have also contributed to the
Reserve Banks' ability to recover the costs of priced services because,
in some cases, the fixed fees reflect the fixed costs associated with a
product. Nevertheless, the current fee structures for electronic
payment services and products have not permitted the Reserve Banks to
set transaction fees close to marginal or incremental costs because the
fixed

[[Page 14148]]

costs incurred in providing these services are very high and setting a
non-differential fixed fee to recover fixed costs fully would likely
cause low-volume customers to discontinue using the services or
products. As a result, transaction fees for electronic payment services
are set well above marginal costs and do not reflect the real resource
costs of providing additional levels of the services.^{5
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\5\ For example, the combined per-item fees that are currently
charged to originators and receivers for the ACH service are $0.020
per item for unsorted files. These per-item fees are greater than
estimates of the marginal costs of processing an ACH transaction.
Based on econometric studies for the period 1989 to 1994, the
marginal cost of an ACH transaction is estimated to be between
$0.006 to $0.008 per item. See ``Scale Economies and Technological
Change in Federal Reserve ACH Payment Processing,'' Paul W. Bauer
and Diana Hancock, Economic Review, Federal Reserve Bank of
Cleveland, vol. 31 (Quarter 3, 1995), p. 14-29.
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III. Guidelines for Use of Volume-Based Fees for Electronic Payment
Services and Products

Volume-based fee structures are an extension of multi-part fee
structures. Rather than creating implicit volume discounts for high-
volume customers, the volume discounts are more explicit. Volume-based
fee structures would allow Reserve Banks to set per-item fees for high-
volume users closer to marginal costs under certain prevailing market
conditions. Thus, the use of volume-based fee structures for the
Reserve Banks' electronic payment services and products potentially may
provide an opportunity to improve payment system efficiency.
Economic theory supports the use of volume-based fees when certain
conditions are met. First, economic theory suggests that volume-based
fees require the existence of economies of scale over wide volume
ranges.^{6 In multi-product industries, volume-based fees also may
be justified for products that exhibit economies of scope with a
product that exhibits economies of scale over wide volume ranges. The
Board's pricing principles, however, require the Reserve Banks to set
fees so that the total costs for each major service category are
recovered. Thus, the potential existence of economies of scope among
payment services offered by the Reserve Banks is not considered, at
this time, a sufficient guideline for using volume-based fees.
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\6\ Volume-based fees may also be justified by the existence of
network externalities. Network externalities arise when a good
becomes more valuable to a user when other users also choose to
consume that good. For example, telephone service becomes more
valuable to a user as the number of other users who are connected to
the telecommunications network increases. At present, we do not have
strong intuitive evidence nor do we have well-developed methods to
establish the importance of network externalities for use in
establishing pricing policies.
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The Board has determined that Reserve Banks must demonstrate that a
payment service or product exhibits economies of scale over current
industry processing levels. It is anticipated that volume-based fees
would be retained until there is evidence that increasing returns to
scale have been exhausted. The Reserve Banks may demonstrate that this
guideline is met either by using the results of an econometric study
or, if such a study has not been conducted, by presenting evidence that
the service or product exhibits technical characteristics similar to
those exhibited by a service or product for which increasing returns to
scale have been demonstrated.
Second, volume-based fees should promote the efficient use of
resources in providing payment services. The Board has determined that
the efficient use of resources can be demonstrated in one of two ways:
(1) There are incremental cost differences in serving high-volume and
low-volume customers or (2) there are differences in demand for the
service or product among its end users. To the extent that volume-based
pricing permits fees to reflect more accurately the costs of providing
a service or product to high-volume and low-volume customers, those
customers should make decisions that would lead to a more efficient use
of economic resources. Alternatively, the use of volume-based fees may
increase end users' demand by offering lower fees to customers with
high demand elasticities. To the extent that differences in demand
elasticities exist, the use of volume-based fees would improve the
scale of the Reserve Banks' processing operations and result in a
reduction in the average cost of serving all customers. The Board has
determined that Reserve Banks should provide evidence that there are
cost differences between serving high-volume and low-volume customers
that support the price differential being proposed or that demand
characteristics differ across end users.
Third, economic theory indicates that societal welfare can
potentially be increased only so long as a firm using differential fees
does not engage in predatory behavior. A number of pricing constraints
have been proposed in antitrust law that are intended to prevent
predation. One of the best known, the Areeda-Turner rule, specifies
that the incumbent's price must be no lower than its reasonably
anticipated short-run marginal cost.^{7 To the extent that
econometric studies have been conducted, their findings could be used
to satisfy this guideline. It is unlikely, however, that there will be
econometric estimates of the marginal costs for all products. Thus,
estimates of marginal costs for some products may have to be based on
available cost accounting data. The Board has determined that no fee
should be set below marginal cost or a reasonable approximation of
marginal cost. Moreover, the Board believes that this guideline along
with its current requirement that each major service recover its total
costs, including the PSAF, over the long run, would ensure that
proposed prices are not predatory, but competitive, in nature.
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\7\ See ``Predatory Pricing and Related Practices Under Section
2 of the Sherman Act,'' P. Areeda and D. F. Turner, Harvard Law
Review, 1975, p. 637-733.
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In determining when the Reserve Banks should be permitted to
implement volume-based fees, the Board has determined that thresholds
should be set to ensure that the Federal Reserve's dual objectives of
promoting efficiency and a competitive environment for payment services
are met. To the extent that markets are contestable, economic theory
suggests that established firms cannot set prices that yield profits
greater than profits that are commensurate with the risk of producing
the service.^{8 Because the markets for electronic payment services
and products are typically contestable, Reserve Banks would not be able
to adopt fee schedules that would lead to unusually high profits. Based
on the preceding analysis, the Board has determined that the following
guidelines will be used in determining when volume-based fees may be
appropriate for a Federal Reserve priced electronic payment service or
product:

\8\ In a contestable market, potential competitors may freely
enter the market and serve the same customers with the same
production technology as the incumbent firm(s). Thus, in contestable
markets where incumbent firms are earning profits that are greater
than the risk they are taking, competitors may enter the market,
earn normal profits, and make the incumbents' fee structure
unsustainable.
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1. The payment service or product must demonstrate economies of
scale over the current industry processing levels for a particular
service or product, based on either the results of an econometric
study or, if such a study has not been conducted, evidence that the
service or product exhibits technical characteristics similar to
those exhibited by a service or product for which increasing returns
to scale have been demonstrated. Volume-based fees may be retained
until there is evidence that increasing returns to scale have been
exhausted;

[[Page 14149]]

2. Reserve Banks should provide evidence that there are cost
differences between serving high-volume and low-volume customers
that support the proposed price differential or that demand
characteristics differ across end users;
3. No fee should be set below marginal cost or a reasonable
approximation of marginal cost; and
4. Consistent with the Board's pricing principles, the fees
established for the service should be expected to recover total
costs.

IV. Evaluation of Current Volume-Based Fees for Electronic Payment
Products

In assessing the use of volume-based fees for the Minneapolis
Reserve Bank's check truncation product, it appears that three of the
four guidelines are met. The Federal Reserve has not performed an
econometric study of the cost structure of the Reserve Banks'
electronic check products nor have the Reserve Banks provided evidence
that the cost structure for these products exhibits characteristics
similar to those of a product with demonstrated increasing returns to
scale. The Minneapolis Bank, however, has achieved significant unit
cost reductions in providing its electronic check products, which
include the truncation product. From January 1994 to November 1996, the
volume of electronic check products processed by the Bank increased 161
percent and its unit cost for the products declined about 42 percent.
There do appear to be differences in the demand characteristics of
customers. Following the introduction of volume-based fees, larger
community banks and third-party service providers began using the
Minneapolis Bank's truncation product. Previously, only small banks and
credit unions used the product. From January 1994 to November 1996, the
number of checks truncated by the Minneapolis Bank increased 253
percent. While this increase is only slightly greater than the increase
in the System's overall truncation volume, the Minneapolis Bank's check
truncation volume is the highest in the Federal Reserve System.
The marginal cost of electronic check products has not been
estimated. Cost data provided by the Minneapolis Bank's staff indicate,
however, that the fees charged to high-volume customers recover the
average variable cost for the products, which would likely be greater
than the marginal cost. In addition, the Bank recovered the total costs
of its commercial check service over the three years it has offered
this product.
The Richmond Reserve Bank adopted volume-based fees for its account
total and account total plus products, which were intended to meet the
needs of low-volume customers that offer cash management services.
Since offering volume-based fees for these products in 1994, low-volume
customers have shown limited interest in the products and only three
are using them currently. As noted above, studies of the cost structure
of electronic check products have not been completed and the marginal
costs have not been estimated.
The Board has determined that, as a condition of retaining their
volume-based fees, the Reserve Banks should demonstrate that economies
of scale exist for electronic check products or provide evidence that
the products exhibit characteristics similar to those exhibited by
products with increasing returns to scale. The Federal Reserve Banks of
Minneapolis and Richmond should also demonstrate that their fees cover
the marginal costs of the products they are offering. In addition, the
Federal Reserve Bank of Richmond should analyze the costs of providing
its account total products to high-volume and low-volume customers to
determine whether there are cost differences in serving various size
classes of customers or should analyze the demand for the products to
determine whether their are differences in demand elasticities.

V. ACH Volume-Based Fees

The Board has approved the volume-based fees depicted in Table 1
for the ACH service, effective May 1, 1997. Customers that deposit
files of less than 2,500 items will be assessed a file fee of $1.75 and
a per-item fee of $0.009. Customers that deposit files of more than
2,500 items will be assessed a file fee of $6.75 and a per-item fee of
$0.007. The fee for the receipt of ACH transactions will be reduced to
$0.009 for all customers. Because current presort customers will need
to make software changes to take advantage of volume-based fees,
through August 31, 1997, they will be charged the high-volume
origination per-item fee and one file fee ($6.75) when they transmit
presorted files to the Federal Reserve. Beginning September 1, all
depositors will be assessed fees based on the number of items in each
file.
Fees for the ACH service have been reduced twice in the last six
months, reflecting the efficiencies that are being realized as a result
of the centralization of ACH processing using the new Fed ACH
application software. In October 1996, the interregional per-item fee
was eliminated and all items in mixed files were assessed the local
per-item fee. At the same time, the presort per-item fee was reduced
from $0.010 to $0.009. In January 1997, there were additional price
reductions. Specifically, the premium cycle surcharge and addenda fee
were reduced and the discrete file fee was eliminated. At the time the
1997 fees were approved, the Board indicated that further fee
reductions would be sought during the first quarter of 1997 (61 FR
64087, December 3, 1996).

Table 1.--ACH Fee Comparison
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Current
fees New fees
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Origination Fees:
Per-Item (Mixed)............... $0.010 $0.009 (up to 2500).
$0.007 (more than
2500).
Per-Item (Presort)............. 0.009 0.007 through August
31, 1997.
Discontinued as of
September 1, 1997.
File Fees.......................... 1.75 1.75 (up to 2500).
6.75 (more than 2500).
Receiver Fees: Per-Item............ 0.010 0.009.
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On average, the new fees reduce the cost of originating ACH
transactions by 17 percent and of receiving transactions by 10
percent.^{9 The reduction in

[[Page 14150]]

transaction fees for various Federal Reserve customers is shown in
Table 2.
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\9\ There may be a small number of third-party sending points
whose fees would increase as a result of this proposal because
sending points are assessed the file fees while the originating
depository institution is assessed the per-item fees. The Reserve
Banks believe that the number of organizations affected would be
small. Further, those organizations may be able to use the lower
per-item fees as an incentive to attract more customers.

Table 2.--Representative Cost Savings
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Percentage
Selected customers \1\ decrease
-----------------------------------------------------------------\2\----
Small...................................................... 4.9
Medium..................................................... 10.0
Large:
Does not presort......................................... 29.1
Presorts................................................. 24.3
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\1\ The small customer originated approximately 100 items in one file
and received approximately 70 items. The medium customer originated
approximately 4,000 items in two files and received approximately
17,000 items. The large customer that does not presort originated
approximately 200,000 items in four files and received approximately
39,000 items. The large customer that presorts originated
approximately 190,000 items in 108 presorted files and received
approximately 44,000 items.
\2\ Includes originated and received per-item fees and originated file
fees.

The Federal Reserve believes that the volume-based fees may
stimulate increased use of the ACH service because the fees for high-
volume originators are set close to the marginal cost of processing ACH
transactions. To the extent that this expectation is correct, the use
of volume-based fees for the ACH service should further the Federal
Reserve's goal of moving to a predominately electronic payments system.
Retaining high-volume originators would enable the Federal Reserve
to continue to spread fixed costs over larger volumes and to serve low-
volume customers cost effectively. In addition, because the new ACH
fees reduce the cost of the ACH service for low-volume originators and
all receivers, they do not price small customers out of the market and,
therefore, preserve the benefits of a large network.
The Board has determined that volume-based fees for the ACH service
satisfy all of the guidelines for their use. First, the ACH cost
function exhibits economies of scale over more than 150 percent of the
current industry's volume level, as shown in Bauer and Hancock's
econometric study.^{10 While the study was conducted when the
Federal Reserve processed ACH transactions at twelve sites, the use of
a centralized application has not created any material changes in the
characteristics of the service. ACH processing continues to use large
amounts of computer resources with relatively few labor resources.
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\10\ Bauer and Hancock, Economic Review, p. 14-29.
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Second, the Reserve Banks analyzed Fed ACH processing costs and
found that the average per-item cost to process larger files was about
$0.002 less than the per-item cost for smaller files. The analysis
focused on the data processing costs to edit and sort transactions
contained in incoming ACH files, which comprise approximately 19
percent of total ACH processing costs. Because there are other fixed
costs associated with processing ACH files, it is likely that cost
differences for processing high-volume and low-volume files of ACH
transactions are greater than the difference that was demonstrated.
There also appear to be differences among end users'' demands for
ACH services. For example, individuals may be willing to pay slightly
higher fees for increased convenience, as in the case of electronic
bill-payment services. Corporations may choose a payment method based
on its cost-effectiveness and certainty of settlement. In addition,
according to the 1994-1995 Phoenix-Hecht Blue Book of Bank Prices,
banks frequently grant discounts to some corporate customers for ACH
processing services. It is reasonable to assume that the discounts are
granted, at least in part, due to differences in demand among end users
and/or due to differences in the cost of serving end users.
Third, the results of the Bauer-Hancock econometric study confirm
that the fees are above the estimated marginal cost, that is, the
combined origination and receipt fees of $0.016 or $0.018 are well
above the estimated marginal cost of $0.006 to $0.008.
Finally, the Board anticipates that the ACH service will be able to
recover its costs over the long term. In addition, the Board expects
full cost recovery for 1997 (see Table 3). The current 1997 cost and
revenue estimates for the ACH service reflect some slight refinements,
compared with earlier budget estimates. Revenue in the revised estimate
is below the final 1997 budget figure because the $0.002 per-item fee
differential is greater than the price reductions assumed when the
Reserve Banks prepared their budgets. In addition, the estimated volume
growth rate for commercial ACH transactions has been reduced slightly,
from 18.5 percent to 16.0 percent, to reflect more accurately
expectations based on actual 1996 performance. Operating costs and
imputed expenses are below the 1997 budget estimates, reflecting lower
data processing costs due to enhancing the performance of the Fed ACH
software. Based on these refinements, the Board now expects that the
ACH service's net income will be slightly higher than the original
budget estimate.

Table 3.--ACH Pro Forma Cost and Revenue Performance
[$ millions]

Special
Operating Special Recovery project
costs and project Total Net income rate after costs
Year Revenue imputed costs Expense (ROE) [1- Target ROE target ROE deferred
expenses recovered [2+3] 4] (percent) and
[1/(4+6)] financed
1 2 3 4 5 6 7 8
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1996 (Act)...................................... 79.8 63.5 9.2 72.7 7.1 3.6 104.6 16.7
1997 (Bud)...................................... 75.4 59.9 11.1 71.0 4.3 4.0 100.5 10.8
1997 (Est)...................................... 73.5 57.7 11.1 68.8 4.7 4.0 101.0 10.8
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VI. Competitive Impact Analysis

In assessing the competitive impact of a proposed, substantial
change to a Federal Reserve priced service, the Board must consider
whether there would be a direct and material adverse effect on the
ability of other service providers to compete with the Federal Reserve
due to differing legal powers or due to the Federal Reserve's dominant
market position deriving from such legal differences. If the Board
determines that

[[Page 14151]]

legal differences or a dominant market position deriving from such
legal differences exist, then the Board must further evaluate the
proposal to assess its benefits--such as its contributions to payment
system efficiency, payment system integrity, or other Board
objectives--and to determine whether the proposal's objectives could be
achieved with a lesser or no adverse impact.
The Board has determined that volume-based fees are not a
significant departure from the multi-part fee structures currently used
by the Reserve Banks. Nevertheless, it is important to assess their use
in the context of the service for which the fee structure is being
proposed.
The Board has determined that adoption of a volume-based fee
structure for electronic services would not have a direct and material
adverse effect on the ability of other service providers to compete
effectively with the Federal Reserve in providing electronic check
products and ACH services.
In the check service, the Reserve Bank's dominant market position
is likely due, in part, to legal advantages, such as the ability to
present checks later in the day and the ability to control the timing
and manner of settlement. The use of volume-based fees for Reserve Bank
electronic check products, however, should not significantly change the
Reserve Banks' competitive position relative to private-sector service
providers. Volume-based fees are used by a number of private-sector
service providers and would not represent a significant departure from
the multi-part fees that are currently assessed by the Reserve Banks.
In the case of the ACH service, the Federal Reserve's dominant
market position does not derive from legal differences. The Federal
Reserve generally abides by the rules of the National Automated
Clearing House Association (NACHA), which also govern the processing of
ACH payments by private-sector operators.

By order of the Board of Governors of the Federal Reserve
System, March 19, 1997.
William W. Wiles,
Secretary of the Board.
[FR Doc. 97-7396 Filed 3-24-97; 8:45 am]
BILLING CODE 6210-01-P}}}}}}}}}}