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FEDERAL RESERVE BANK O F NEW YORK

I N E C O N O M I C S A N D F I N A N C E

Changing Technology and the Payment SystemJamie B. Stewart, Jr.

On September 11, 2000, Jamie B. Stewart, Jr., Fi rst Vice President and Chief Operati ng Off icer

of the Federal Reserve Bank of New York, delivered the fol lowing remarks at Sibos 2000,

the internati onal banking operations seminar sponsored by the payment network SWIFT

(Society for Worldwide Interbank Financial Telecommunications).

The Sibos 2000 conference provides an important forumfor discussion of the payment system and paymentissues. I believe that the payment system in the UnitedStateslike its counterparts elsewhere in the worldis

critical to ongoing confidence in our financial markets,to the competitiveness of our f inancial sector, and tothe continued health of our banking system. Allof us here todayincluding representatives of bothcommercial and central banksshare a common set ofvalues in that we are concerned about the continuedstrength and vitality of the payment system.

This year, we face a rapidly expanding set of oppor-tunities and challenges. We also face the need to actquickly. Indeed, I cannot recall a time of more funda-mental and pervasive change in the financial servicesindustry. Much of this changeand the pace at which itis taking placeis driven by extraordinary advances incomputing and telecommunications technology. Theseadvances in technology are not just evolutionary, theyare revolutionary, and they are transforming virtuallyevery aspect of commerce and banking.

Today, I want to talk about the implications of someof these developments for commercial bankers andcentral bankers. Both groups enjoy natural advantagesas trusted intermediaries and trusted agents. But bothgroups also face significant challenges in how they adapt

in a time of profound change. In this environment, Ibelieve that we will need to manage our organizationsin new ways to be successful.

The growing number of e-commerce products

offered and the unexpected alliances of business andtechnology announced each week offer ample evidenceof the revolution currently under way. In the banking

industry specifically, we see commercial banks usingtechnology and newly formed alliances to leveragetraditional account relationships with corporate cus-tomers into completely new service offerings.

Some banks, for example, have worked with cus-tomers to develop innovative distribution and supply-chain management systems. Other banks are joiningforces with aggregators to cut across traditional

October 2000 Volume 6 Number 11

I cannot r ecall a time of more fundamental

and pervasive change in the f inanci al services

industry. Much of this change . . . is driven

by extr aordinar y advances in computing

and telecommuni cations technology.

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C UR RE NT I SSU ES I N E CON OM I C S A N D F I NA N CE

in-house offerings, competitors services, and nonbankfinancial services to offer individual customerscomprehensive and customized financial informationservices. These banks see themselves as very activefinancial advisors and cash managers for customersnot just deposit takers.

Banks are thus moving into business areas that bearlittle resemblance to traditional bankinga develop-ment that regulators are clearly monitoring. For themoment, however, I want to consider not the regulatoryand supervisory implications of these developments,but rather the effects of these developments on thecompetitiveness of commercial banks. One of my mainconcerns is that as banks strive to innovate andtransform themselves, they could lose sight of theimportance that payment services continue to have forthemas sources of both their near-term revenues andlong-term competitive viability.

In my view, the importance of payment services as abusiness line for commercial banks is not widelyappreciated. To view payments as a cost center that

should be reduced is a strategic mistake. Even with allthe technological changes taking place in the financialservices industry, providing payment services remainsa signif icant source of revenue for commercial banks.

The largest banks in the United States, for example,derive approximately 40 percent of their total netrevenues from payment-related service offerings.

I find that payment services offered by commercialbanks are particularly useful as a source of steady, non-cyclical revenue. Moreover, many banks are able touse these payment services as an entry point to offer

their retail and wholesale customers a broader suite ofservices, including cash and portfolio management. Inthis way, the provision of payment services enhancescommercial banks abil ity to meet their customersneeds and develop profitable relationships.

Beyond their value to the competitive viability ofcommercial banks, payment systems and paymentservices play a broad role in the functioning of theglobal f inancial system, a role that is of special impor-

tance to central bankers. The ability of the paymentsystem to ensure that financial transactions are made inways that are timely, reliable, and secure is vital to themaintenance of market confidence and to the safe andsound functioning of f inancial markets. The efficientprocessing of payments is a necessity in a marketplaceas competitive as ours is in the United States today. This

last point is important because, in my view, we will seemuch more competition among financial centers in thefuture. Because financial centers are a source of high-paying jobs, cities around the world will increasinglycompete to be prime financial locations.

To date, however, payments and payment issues havereceived limited attention in the e-commerce revolu-tion, despite the fact that the settlement of payments isan essential element in any e-business transaction.Many of these otherwise highly automated transactionsstill result in payments that are made by paper checks.

This practice does not seem sustainable to me.Commercial banks clearly have much to contribute

to the evolving world of e-commerce. Their knowledgeof and experience with payment services and their repu-tations as trusted agents are valuable attributes in theuncertain and often untested arena of e-commerce. Forexample, banks have proven tools and techniques tomanage the risks associated with payment transactionsand to ensure the security and confidentiality of cus-tomer information.

Although recent advances in technology create newopportunities for commercial banks to leverage their

traditional payment services into valuable new offer-ings, pursuing such opportunities will not be easy forbank managers. Let me be more specif ic about a few ofthe challenges I believe commercial banks face.

The first challenge is simply how best to manage theuse of new technology in an environment where changeis occurring through increasingly rapid cycles of inno-vation. New tools and products leapfrog others thathave only recently been introduced.

One of my main concerns is that as banks

stri ve to innovate, . . . they could lose sight

of the importance that payment services

continue to have for themas sources

of both their near- term revenues and

long-term competit ive viabil it y.

Commercial banks clearl y have much

to contri bute to the evolvi ng world of

e-commerce. Their knowledge of and

experi ence wi th payment services and thei r

reputati ons as trusted agents are valuable

attri butes in the uncer tain and often

un tested arena of e-commerce.

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In the United States, PC (personal computer) bank-ing is a good example of this phenomenon. Before PCbanking over private networks had become established,it was superseded by PC banking over the Internet. Thisapplication of technology, in turn, may be supersededby wireless banking from cell phones and hand-heldelectronic organizers. This uncertainty about the long-

term value of technical investments creates discomfortfor any traditional business person.

Related to the challenge of how to manage the newtechnology are the many unknowns banks face withrespect to customer acceptance of the new productsthey introduce and the cost-effectiveness of the innova-

tions they put in place. How do bankers make choicesunder these conditions of constant change and unprece-dented uncertainty?

Some banks are responding by investing in multipleproducts and technologies in order to hedge their betsand stay in the game. To use this approach successfully,however, an organization must adopt a mind-set andmanagement style very different from those associated

with the relatively predictable environment of tradi-tional banking, in which branches have long life cyclesand corporate products are expected to last fordecades.

The approach called for today requires a portfoliomind-set and a venture-capital style of decision makingin which the organization makes investments in a vari-ety of products and tools. Projects that fail to showpromise are eliminated promptly in order to cut lossesand make way for new investments. This approachrequires, among other changes, a very different attitudetoward project failure than that held by traditionalbanking organizations. If banks are not experiencing

some failures in this environment, they are almostcertainly too conservative to succeed.

This method of making business decisions stands instark contrast to traditional processes in which bankmanagement selects each product and platform aftermuch consideration so as to achieve a careful deploy-ment and long life. Adopting a different approach todecision making will not be easy, but making thechange is important because the real competitors for

the next generation of payment service providers maynot be banks.

A second challenge for banks is to decide whatservices to provide. Changes in technology open newpossibilities that extend far beyond the cluster ofservices that have traditionally defined commercial

banking. These new service options range from simplyre-facing traditional service lines to offering com-pletely new services such as inventory management andlogistics.

Is there a downside risk to the banking industry inthis expanding variety of service options and strate-gies? I think there may be at least one. In the past,banks were able to come togetherin times of stress oropportunityto agree on common industry practices,standards, and even shared infrastructure. One examplethat comes to mind is the agreement on a common infra-structure and standards for automated teller machinenetworks. Cooperative efforts like this benefited theindustry as well as individual institutions, even asthose same institutions remained commercial competi-tors. Collaboration was possible because banks had agreat deal in commonstructure, services, processes,and goals.

As banks develop sharply different corporatevisions, organizational structures, and service offer-ings, the question is whether their ability to cometogether around common interests and to address

shared goals will be diminished. Yet it seems clear that,to remain viable, banks need to cooperate on standardsand related service and infrastructure issues now morethan ever as nontraditional competitors move quickly to

develop new networks and product offerings.

Of course, all of us in the financial services industryare familiar with the long-standing need for joint indus-try initiatives to address important systemic risk andefficiency issues. But here as well, we see such effortsposing new challenges as they are applied to ever moredifficult and complex issues. I am thinking here ofprojects such as the push for T+1the settlement ofsecurities transactions within one day of the trade

3

To remain vi able, banks need to cooperate onstandards and related service and in frastructu re

issues now more than ever as nontraditi onal

competi tors move quickly to develop new

networks and product offeri ngs.

Changes in technology open new

possibi li ti es that extend far beyond the

cluster of services that have tradit ional ly

def ined commercial banki ng.

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dateand the adoption of straight-through process-ingthe fully integrated electronic processing of finan-cial transactions. I also have in mind the importantContinuous Linked Settlement Bank project, which pro-vides a mechanism for the simultaneous exchange ofpayments in different currencies. Increasingly, ambi-tious efforts like these will require attention from all of

us because the stakes are very high.

A third challenge confronting banks is how to man-age a number of complex new business relationships.How, for example, will banks deal with newly formed

nonbank competitors, new technology partners, and anarray of service providers? I believe that organizationaland cultural differences will make these partnershipsdifficult.

Almost daily, it seems, we are bombarded byannouncements from existing technology firms andnew-economy start-ups of innovative productsdesigned to meet e-commerce requirements. Many ofthese new products cross over into traditional business

lines of banks.Why do I think the organizational and cultural limits

of many banks will be challenged by these changes?Because in my view it is becoming increasingly appar-ent that no single organization can go it alone andflourish in the current environment of rapid technologi-cal change. Despite traditions of solid self-suff iciencyand strict confidentiality, banks, like their customersand new competitors, are being forced to seek newservice partners and business alliances. The number andvariety of these alliances, partnerships, and servicemergers almost defy comprehension. Many of thesenew relationships will fail, but business partnership

has become a necessary hallmark of the e-world.Establishing and managing these new alliances will notcome easily to traditional bank managers accustomedto working within their own organizational walls,because in the past self-sufficiency was considered asign of strength.

These are just a few of the challenges confrontingthe banking industry as the global financial market istransformed by advancing technology. I have spent a

good deal of time talking about the challenges banksface, but how do these forces affect the U.S. FederalReserve? Like central banks elsewhere in the world, wemust grapple with most of these same challenges alongwith a few additional ones that stem from our role as asupervisor and regulator. Like many of you, we areworking hard to bring our own organization up to speed

to deploy new tools and function effectively in therapidly changing marketplace.

As a provider of payment services, we are workingon strategies to use the power of the new technologies toimprove and ultimately transform the services we offer.

To do so, we must listen carefully to our customers andattempt to understand emerging payment servicerequirements. These requirements are not clear or welldefined, but trends are beginning to appear.

We know, for example, that we operate within alinked international payment system whose require-ments are increasingly important for us. Accordingly,

we have made a number of enhancements to Fedwire,the Federal Reserves electronic funds and securitiestransfer system, in recognition of the fact that Fedwireis no longer just a domestic payment service, but rathera part of the global payment system.

For instance, at the end of 1997 we expanded the opera-ting hours of Fedwire, in large part to achieve greateroverlap with the hours of other nations payment systems.Also in the 1990s, we changed the format of Fedwirespayment messages to conform more closely to the SWIFT

message format, which is also used by CHIPS (ClearingHouse Interbank Payments System), a private networkthat specializes in the international transfer of funds.

Like commercial banks, we at the Federal Reserveneed to make certain that as we innovate, we maintainthe reliability and security of our payment services. Asthe operator of Fedwire and other important elements ofthe payment system, we have very special responsibili-ties to ensure that we do not compromise the safety andsoundness of the payment and banking system when weincorporate new capabilities and technologies in ourservice environment.

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We have made a number of enhancements

to Fedwir e, the Federal Reserves electroni c

funds and secur i ti es transfer system,

in recogniti on of the fact that Fedwire

is no l onger ju st a domestic payment service,

but rather a par t of the global payment system.

As a provider of payment services,

[ the Federal Reserve is] work ing on

strategies to use the power of the new

technologies to improve and ul timately

transform the services we off er.

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For example, as we automate payment transactionsmore completely by using distributed processing andthe Internet, we need to be sure that these technologies,oriented toward the mass market, are compatiblewith the requirements of high-value transactions.

Consequently, we are deploying new network configu-rations and infrastructures to verify identity and to con-trol accessmeasures that will help ensure messageintegrity and security of access. We must move forward,but with due caution.

This brings me to my final thoughts: a few ques-tions I want to pose and address briefly. First, whatrole does the Federal Reserve plan to play in the worldof e-commerce? Second, how does the Federal Reserve,as a provider of services, plan to interact with theprivate sectorthat is, with its customers and otherproviders of financial services here and abroad?

First and foremost, the Federal Reserve wants tosupport rather than limit innovation in the private sec-

tor. Although this has always been our stance, we see itas especially important in this time of unprecedentedtechnological change. I want to emphasize, however,that this policy stance should not be interpreted to meanthat the Federal Reserve plans to be a passive observer.

On the contrary, we are committed to enhancing ourrole as a constructive participant with our customersand the markets we support. Recent examples of thiscommitment include hosting an industry-orientedworkshop on electronic check presentment, drafting pro-gressive U.S. e-signature legislation, and participatingactively in the SWIFT user group in the United States.

Like commercial banks, central banks cannot go italone in this complex and demanding environment. Weneed to develop new partnerships and alliances with

private sector providers of services and with centralbanks in other countries.

One example of such an alliance is our work withSWIFT to develop closer working ties for the benefit ofour customers. A very tangible, near-term goal of thiscollaboration is to ensure that the message formats and

standards we use support straight-through processingand the creation of compatible operating systems. Atthis time, we are defining changes we must make toensure that messages can be transferred from one pay-ment network to another seamlessly. In the future, youwill see further evidence of these cooperative efforts.While this degree of collaboration will not always beeasy to maintain, we see it as a requirement in anincreasingly interdependent marketplace.

As I have noted, central banks, like commercialbanks, enjoy special advantages as trusted intermedi-aries. These advantages, however, will not guarantee

that central banks retain a vital role in the evolvinge-world unless we are responsive to the changing envi-ronment in which we operate.

One of our most basic goals at the Federal Reserve isto ensure that the payment system remains efficient andstrong. Let there be no doubt, we are firmly committedto the belief that a well-functioning payment systemis essential to the financial health of our economy.Moreover, we see commercial banks as the bedrock ofthe payment industry, and we plan to continue working

with you to make certain that the payment systemremains sound and secure as it responds to the changingneeds of our global economy.

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We [at the Federal Reserve] have very

special responsibil i ti es to ensure that we do

not compromise the safety and soundness

of the payment and banki ng system when

we incorporate new capabil it ies and

technologies in our service envir onment.

Centr al banks, li ke commercial banks,

enjoy special advantages as trusted

intermediari es. These advantages, however,

wil l not guarantee that central banks retain

a vital r ole in the evolving e-worl d unl ess we

are responsive to the changing environment

in which we operate.

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The views expressed in this publ icat ion are those of the authors and do not necessar il y reflect the positi on of the

Federal Reserve Bank of New York or the Federal Reserve System.

Cur rent I ssues in Economics and Financeis published by the Research and Market Analysis Group of the FederalReserve Bank of New York. Dorothy Meadow Sobol is the editor.

Editorial Staff: Valerie LaPorte, Mike De Mott, Susan Szarkowitz, Jacqueline DoyleProduction: Carol Perlmutter, David Rosenberg, Jane Urry

Subscriptions to Cur rent I ssuesare free. Write to the Public Information Department, Federal Reserve Bank of

New York, 33 Liberty Street, New York, N.Y. 10045-0001, or call 212-720-6134.Cur rent Issuesis also available at theResearch and Market Analysis Groups web site:http://www.ny.frb.org/rmaghome/curr_iss/2000.html.

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October 1999 -September 2000 Current Issues

Date Vol./No. Title Author(s)

10/99 5/14 Two New Indexes Offer a Broad View of Economic Activity Orr, Rich, Rosenin the New YorkNew Jersey Region

11/99 5/15 Credit Risk in Japans Corporate Bond Market Packer

12/99 5/16 Explaini ng the Recent Divergence in Payrol l and Household Juhn, PotterEmployment Growth

1/00 6/1 Are High-Quali ty Fir ms Also High-Quali ty Investments? Antunovich, Laster, Mitnick

2/00 6/2 Health Insurance Trends Point to an I ncrease in Uni nsured Rapaport, MurrayChildren in New York and New Jersey

3/00 6/3 The Emergi ng Role of Banks in E-Commerce Wenninger

4/00 6/4 The Unreliabili ty of Inflation Indicators Cecchetti, Chu, Steindel

4/00 6/5 New YorkNew Jersey Job Expansion to Cont inue in 2000 Orr, Rosen

5/00 6/6 Explaini ng the Gap between New Home Sales and Inventor ies Kahn

6/00 6/7 Rapidly Rising Corporate Debt: Are Fi rms Now Vulnerable Osler, Hongto an Economic Slowdown?

7/00 6/8 Understanding the Recent Behavior of U.S. Infl ation Rich, Rissmiller

8/00 6/9 Explaini ng the Rising Concentrati on of Banking Assets Stiroh, Poolein the 1990s

9/00 6/10 A Nati on of Spendthr if ts? An Analysis of Trends in Personal Peach, Steindeland Gross Saving

Documents

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