Central Bank Policy Making

in Competing Payment Systems

DAVID D. VANHOOSE"

This paper analyzes the interaction between two payment systems. Administrators of both
systems establish intraday credit interest fees, caps, and collateral requirements. Analysis of
the model indicates that if a central bank does not take into account the effects that its policies
have on its share of payment system transactions, then its efforts to contain risks associated
with daylight overdrafts on its wire system will require a loss in its share of total transactions
volume. If it does recognize the potential loss in its share of payments, then socially optimal
policy instrument settings are unlikely to emerge. (JEL E5)

Introduction

During the 1980s, officials at the Federal Reserve System became increasingly
concerned about the growth in banks' daylight overdrafts on large-dollar wire transfer
systems. In 1988, staff economists at the Federal Reserve System widely agreed that
significantly reducing daylight overdrafts of Fedwire accounts would require an interest
fee of about 25 basis points. Nevertheless, in April 1994, the Federal Reserve initially
set its administered price for intraday credit on Fedwire at only 10 basis points. The
following year, the Federal Reserve raised the fee to 15 basis points instead of the 25
basis points that it originally had announced publicly.
Why did the Federal Reserve backtrack from its original pricing policy? One answer
might be that it has determined that 15 basis points is the socially optimal interest fee,
given a multipart objective involving trade-offs among competing policy goals of
maximizing bank profitability while simultaneously minimizing payment system gridlock,
systemic risk, and the Federal Reserve's own risk exposure. Nevertheless, as Hancock
and Wilcox [1996] have documented, the real average and peak daily volumes of Fedwire
overdrafts have fallen only to the levels that existed in the mid-1980s when the Federal
Reserve first determined that the overdraft problem was serious enough to warrant close
scrutiny.
One purpose of this paper is to offer a possible explanation for the Federal Reserve's
pricing of daylight overdrafts on Fedwire. This proposed explanation is that

*Universityof Alabama--U.S.A. The author is grateful to Paolo Angelini, Craig Furfine, Alton Gilbert,
Jeffrey Lacker, JeffreyStelma,Ed Stevens,participants in seminarsat the Universityof Alabama, the Federal
ReserveBankof Atlanta, and the FederalReserveBankof Chicagofor commentson earlierdrafts of this paper.
Thepaperalsowas improvedby commentsreceivedat the FederalReserveBankof Chicago'sPaymentSystems
ResearchWorkshop. Any remainingerrors belongto the author.

117
118 AEJ: JUNE 2000 VOL. 28, NO. 2

noncooperative rivalry with the Clearing House Interbank Payment System (CHIPS) can
induce the Federal Reserve to price its intraday credit at a level that is inefficiently low.
Competition with CHIPS for sufficient payments volume to cover the costs of providing
Fedwire services can, in principle, lead to suboptimal fees on intraday credit extensions
by the Federal Reserve. At the same time, CHIPS's interest in maximizing members'
profits while maintaining sufficient payment volumes to cover system costs can induce
administrators of this private system to enact socially inefficient policies regarding pricing
and collateral, particularly in a noncooperative equilibrium with the Federal Reserve.
This argument is not based on any presumption that either Federal Reserve or CHIPS
officials intentionally seek to enact socially suboptimal policies. The fundamental point
stems from the standard game-theoretic result. That is, in the absence of other
complicating factors such as time inconsistency problems (which add further layers of
complexity in policy games), noncooperative policy interactions in settings characterized
by policy interdependence typically produce Pareto-inefficient outcomes)
A broader objective of the paper is to provide a starting point for consideration of the
interaction of payment systems in the U.S. and elsewhere. There has, of course, been
considerable work recently on central bank policy making in payment systems. Federal
Reserve studies on likely market responses to pricing, collateral requirements, and caps
include Lindsey et al. [1988], Meulendyke et al. [1988], Belton et al. [1987], Humphrey
[1989], Evanoff [1988], Gilbert [1989], and Stevens [1989]. More recent work on
payment and clearing system risks and policies by other central bank economists and
academics includes Angelini [1996, 1998], Angelini et al. [1996], Dale and Rossi [1995],
Rossi [1995], Schoenmaker [1995], Chakravorti [1996], Kahn and Roberds [1997, 1998],
and Lacker [1997]. While many authors touch on the relationship between Fedwire and
CHIPS or among alternative European wire systems, only a few provide analytical
models of payment systems and the effects of alternative policies. With very few
exceptions (notably, Chakravorti [I997]), however, all existing work presumes the
existence of only one payment system. This paper, therefore, aims toward opening new
ground by modeling the interactions between potentially competing payment systems and
the administrators of those systems.
The second section develops the basic framework, which builds on Furfme and Stehm's
[1996, 1998] model of the trade-offs faced by a central bank that supervises a single
payment system. The innovation of this paper is to extend their framework to a setting
with two systems that provide payment services to bank customers and with separate
policy makers--envisioned to be a central bank and a private-wire administrator--which
can, in principle, set prices, collateral, and caps for intraday credit extensions that they
make to banks. The third section examines the determination of optimal bank choices of
trading volumes and intraday credit utilization on the two systems. The fourth section
discusses the objectives of payment system administrators, which can be very
cumbersome to analyze in full. For this reason, attention is focused in this section on two
special cases of the model that, despite their simplicity relative to the general formulation,
can provide considerable insight into the interplay between payment system policies in
 VANHOOSE: CENTRAL BANK POLICY 119

interrelated payment systems. The fifth section discusses key policy implications and
potential extensions.

The Model

The theoretical framework builds directly upon Furfine and Stehm's [1996] model
(FS). Here, however, there are two potentially competing payment systems. One, called
"CB wire," is operated by the central bank. The real-world example in the U.S. is the
Federal Reserve's Fedwire system. The other payment system, called "private wire," is
operated by a private firm. CHIPS is a real-world analogue for the U.S. Another is the
Government Securities Clearing Corporation (GSCC), a netting system that banks use to
clear transactions in government securities.
In the model, both CB wire and private wire offer wire transfer services to banks.
Banks wish to make two types of transfers. Although banks could, in principle, use either
CB wire or private wire for both kinds of transfers, the model includes transaction-cost
differences in using the two payment systems. Ceteris paribus, this gives banks an
incentive to use both systems for their electronic payment needs. This currently is the
situation in the U.S. where banks typically use Fedwire for federal funds and book entry
security transfers (though the GSCC is now a major private alternative for securities
clearings) while directing the bulk of their foreign exchange and Eurodollar transactions
to CHIPS.
The administrators of both systems have mixed objectives. As in FS, they seek to
maximize objectives that include bank profits but that also account for the central bank's
broader, socially benevolent concerns with the social costs stemming from any payment
system gridlock, collateralized credit extension, and uncollateralized credit extension. In
addition, the administrators must cover the costs of operating the systems.
The Banking Environment
As noted above, banks may use either payment system. As in FS, the customer demand
for payment services faced by banks is assumed to be perfectly inelastic. On a given day,
each bank transmits and receives an exogenous dollar payment volume, which, for the
sake of expositional simplicity, is assumed to equal a normalized value of unity. It directs
a fraction of this normalized payment volume, z, to clearing on CB wire and the
remaining fraction, 1 - z, to transmission via the private wire system.
A bank also has an initial reserve account balance with each payment system. Its
reserve balance at the beginning of the day is denoted as R. As in FS, a key assumption
that may simplify the exposition is that this also is the desired end-of-day reserve
balances. If both systems use required real-time gross settlement, then as the bank
transmits payments during the day, it will have to:
1) increase its reserves in advance of payments;
2) obtain intraday credit from the central bank or~the administrator of the private wire
system;
3) employ cash management techniques to reduce its liquidity needs; or
4) apply some combination of 1) through 3).
120 AEJ: JUNE 2000 VOL. 28, NO. 2

Traditionally, CHIPS has been a netting system, but recently it has adopted procedures
that make it function more like a gross settlement system.
Let z Z cB be the total quantity of intraday credit borrowed by the bank from the central
bank in the CB wire system, under terms established by the central bank's policies
regarding the provision of such credit. For z -- 0, the bank makes no use of the central
bank's system and thereby requires no credit to cover overdrafts on that system. For
~c > O, Z cs denotes the portion of CB wire dollar payments financed by bank borrowings
from the central bank. In addition, let (1 - z ) Z vw be total intraday credit borrowed
through credit facilities offered by the private wire administrator (more on this entity
later), with Z ?w denoting the portion of private wire payments financed by such
borrowings.
At present in the U.S., the Federal Reserve provides intraday credit (which might also
be called "intraday outside credit," made available by the central bank) explicitly only by
permitting daylight overdrafts on the Fedwire system, according to policies it has
established for such overdrafts. The CHIPS system also permits overdrafts (a form of
"intraday inside credit") under its separate policies. In addition, in the current regime,
interbank intraday credit extensions are nearly nonexistent. Consequently, in the present
real-world environment, Z cB and Z vw typically are positive for a number of banks.
Consider first the problem faced by a bank that seeks to maximize its profit:

rc -- r t L + r Ss - r DD - rC81:Z cs - reW(1 - v)Z ew

(1)
- [ w ( Z cB) + s(ZeW) ] - z pC8 _ (1 - z)p ew - v(l:) - K(1 - ~)

where L - loans that earn the rate r L, S -= securities that earn the rate r s, D -= deposits
that entail the interest expense r D, r CS _ central bank rate on intraday credit that it
extends, and r ?w =-- rate charged by the private wire administrator on its extension of
intraday credit. As in FS, w ( Z cs) +s(Z ew) is a separable cash management cost
function, with w'(Z cs) < 0 and s'(Z ew) < 0, and with w'(Z cB) and s'(Z l"w) assumed
to be convex. Hence, funding larger portions of given volumes of wire transfers with
intraday credit reduces cash management costs. Specific functional forms for
w ( Z cB) and s(Z ew) are considered below.
Furthermore, 9 cs is the per-unit payment processing fee charged by the central bank
for use of the CB wire system, while pew is the per-unit fee charged by the administrator
of the private wire system. Banks must also devote real resources to processing wire
transfers, and V('c) and K(1 - z) denote real-resource cost functions, where v'(z) > 0,
v " ( z ) > 0 , ~ c ' ( 1 - z ) > 0 , and K " ( 1 - z ) > 0.
A bank chooses its loans (L), securities (S), reserves (R), deposits (D), intraday credit
borrowings from the central bank (ZCB), intraday credit borrowings from the private
wire administrator (zeW), and the portion of payments that the bank processes on the CB
wire system (1:). These choices are conditioned on parameters and constraints established
by the central bank and the private wire administrator.
 VANHOOSE: CENTRAL BANK POLICY 121

Central Bank Wire and Private Wire System Credit Policy Instruments
Both the central bank and the administrator of the private wire system have four policy
instruments to influence bank choices. The central bank sets its CB wire transfer fee,
pcs, and its borrowing rate on extensions of intraday credit, rcB . It also can set a
quantity limit, or cap, on the intraday credit that it is willing to extend, 2 cB. A fourth
payment system policy instrument available to the central bank is a proportion, rl cB , of
its intraday credit extensions that banks must back by pledging collateral to the central
bank.
Previous payment system studies (for instance, Lindsey et al. [1988]) have
acknowledged the possibility and importance of spillover effects that central bank
policies, which are on its own payment system, may have on other systems. To date,
however, authors in the literature analyzing the effects of alternative payment system
policies have focused nearly undivided attention on central bank policy making in a single
payment system.
In this model, there are two ways in which the CB wire and private wire systems are
linked. The most important is that banks can choose the fraction, ~, of payments that
they process on the CB wire system. Central bank policies intended to achieve broad
social goals or else narrower central bank objectives can influence this choice. Indirect
effects also follow from the banks' choice between payment systems, because how they
allocate payments between the two systems influences their decisions concerning from
whom they will borrow intraday credit and what quantities of credit they will borrow.
A second linkage arises because the administrator of the private wire system also has
its own payment system policy instruments, which the administrator can adjust in
response to changes in the settings of policy instruments by the central bank on its CB
wire system. The private wire administrator also has four instruments whose values it can
determine: the private wire transfer fee, pew; the rate on intraday credit from the private
wire administrator, reW; a quantity cap on such credit, ~?rv; and a proportional
collateral requirement on such credit extensions, rterr.
Banks take the settings of the central banks' and private wire administrators as given
when determining their own profit-maximizing portfolio and payment system choices.
The central bank determines values for these instruments with a recognition of the effects
of its decisions on bank behavior.
Actual policy outcomes also depend on the interactions between the central bank and
the private wire administrator. One possibility would be for the two policy makers to
coordinate their policy choices with a joint aim to achieve their goals. Another would be
for the two policy makers to behave noncooperatively. In such an environment, the
central bank would set its instrument settings with an aim to attain its policy objectives
while taking the instrument settings of the private wire administrator as given. At the
same time, the private wire administrator sets its instrument values to pursue its own
objectives, taking the central banks' choices as given (yet a third possibility would be the
Stackelberg leader-follower behavior, which is not considered here). Next, this paper will
address the objectives and possible interactions of the two payment system policy makers
after determining how banks respond to their policy choices.
122 AEJ: JUNE 2000 VOL. 28, NO. 2

Bank Behavior and the Effects of Payment System Policies

The end-of-~y balance sheet constraint faced by a bank is shown as:

L +S+R = D+K , (2)

where Kis the bank's equity capital. The bank faces two other nonpayment system-related
regulatory constraints: a reserve requirement constraint, R >_ 6 D , with 0 < 6 < 1, and
a capital adequacy constraint, K _> 6 (L + S + R), with 0 < 5 < 1.3 If both of these
constraints are binding, then D = (o-1 _ 1)K and R = 6 (o-1 _ 1)K follow directly. Also,
following FS, let A - L + S denote earning assets and let ~t be the portion of earning
assets held as securities. Then the objective relevant to the bank for its payment system
problem is to maximize:

n = [rL(1 -I~)+ rS~t]A - r C ~ z z C B - r e W ( 1 - z ) Z eW

(1 ')
- w ( Z cs) - s ( Z l'W) - r,p cs - (1 - z)pew _ v(z) - I<(1 - "c)

subject to the intraday credit cap constraints, Z cB <_ -~cs and Z eW < -~ew, and to the
collateral constraint, S >_.rlCBz c~ + rlewZ ew. As in FS, to implement a simple and
tractable reason for a bank to hold securities even in the absence of the collateral
constraint, it is assumed that other factors, such as risk-based capital requirements or
regulatory liquidity requirements, force the bank to satisfy an additional security holdings
constraint, S __ _gA.
Optimal B a n k Choices Within the Full Model
The Kuhn-Tucker conditions for this problem imply the following:

r ~-rs = )c+)s (3)

p e w + [ r e V + )~ctlPw + s,(ZPW)] ZeW _ v ' ( 1 - ~)

= pcB + [rCS + )CrlCB + w,(ZCB)] ZCS + K ' ( z ) , for ~: > 0
(4)
and pew + [reW + )~c~vw + s,(ZeW)] ZeW _ v ' ( 1 - z)
< pcB + [rCS + XCrlCB + w,(zCS)] zCB + K ' ( z ) , for z = 0

_ w , ( z C S ) = z(rCS + xcrlcB ) + )CB, for Z cs > 0 ,

(5)
and - w ' ( Z cs) < r.(r cs + xcrl cB) + X CB , for Z cB = 0 ,
 VANHOOSE: CENTRAL BANK POLICY 123

-s'(Z ev:) = (1 - ~)(reW+ )-cne~) + )-ev:, f o r Z eW > 0 ,

(6)
and -s'(Z ew) < (1 - r,) (r eve + )-crlew ) + )eve, f o r Z eW = 0 ,

)-C(gA - rlCBZCB - rleWz eW) = 0 , (7)

XC~(zCB - 2 c~) = 0 , (8)

)-eve(ZeW _ 2 e w ) = 0 (9)

xs(g-g) = 0 , (10)

where )-c, )-cs, )-pw, and )-s are the shadow prices associated with the collateral
requirement, central bank intraday credit cap, private wire intraday credit cap, and
security portfolio allocation constraints, respectively. Both the collateral and securities
portfolio allocation constraints cannot simultaneously be binding. Consequently, (3)
indicates that either )-c or )-s is equal to the spread between the loan and security rates.
Equation (4) implies that the bank will make transfers on the CB wire system provided
that the net unit cost of such transfers, pC~ + [rCB + )-C,qCB+wt(zCB)]zCB + K'('~) , are
equalized with the net unit cost of transfers on the private wire system,
9 ew + [ r pw + )-crlew + s,(ZeW) ] ZeW _ v'(1 - ~). The unit cost for each system is the sum
of the transfer fee (pCB or 9ew), the net marginal cost of the portion of transfers
financed by borrowings from the managing system authority, and the marginal real-
resource cost of transfers. The net marginal borrowing cost for each system is the sum
of the intraday credit rate (r c~ or rew) and the opportunity cost of meeting a collateral
constraint (if it is binding so that )-c> 0), less the marginal benefit derived from
borrowing funds rather than engaging in cash-management strategies to reduce the need
to better match receipts and outflows of payment transfers. As (4) indicates, if the unit
cost of sending payments on the CB wire system becomes too high, the bank could decide
to make sole use of the private wire system so that 1: = 0.
Equation (5) says that the bank will borrow positive amounts of intraday credit from
the central bank, provided that "c > 0, so that it uses the central bank-administered
system, and that it can equate -w'(ZCS), the marginal benefit (the marginal reduction in
cash management cost) otherwise entailed in reducing its need for daylight credit, with
the total marginal cost of such credit, ~(r c~ + )-cric8 ) + )-ca. This marginal cost of
central bank credit depends on the interest charged by the central bank, the opportunity
124 AEJ: JUNE 2000 VOL. 28, NO. 2

cost of the central bank's collateral constraint (again, if it is binding), and the shadow
price relating to the central bank's credit cap. If the marginal cost always were to exceed
the marginal benefit, then the bank would not run daylight overdrafts on the CB wire
system (Z cB would equal 0). Equation (6) is an analogous condition for the bank's use
of intraday credit granted by the private wire administrator. Finally, (7) through (10) are
the standard Kuhn-Tucker conditions associated with the payment system policy
constraints that the bank faces.
There are several possible cases that could emerge. For instance, it might be that the
collateral constraint binds but that only one, or both, of the cap constraints do not.
Alternatively, one, or both, of the cap constraints may bind, but the collateral constraints
bind. Finally, one, or both, of the cap constraints may bind while the collateral constraint
simultaneously is binding.
Although caps were a central component of the Federal Reserve's stated effort to
control the growth of daylight overdrafts during the 1980s, the Federal Reserve had
generally recognized by 1989 that its cap-based policy was not effective (see, for instance,
VanHoose and Sellon [1989]). Recent work by Hancock and Wilcox [1996] indicates that
the Federal Reserve's caps apparently were not binding as they did little to constrain
overdrafts. Consequently, the following analysis focuses attention on the case in which
collateral constraints are binding but cap constraints are not.
Bank Behavior with Overdraft Rates and Collateral Requirements
The general framework outlined above is not readily amenable to policy analysis. To
obtain more concrete solutions for optimal bank decision rules, it is useful to consider the
following functional forms:

w(Z cB) = -COoZcB + (col/2)(zC~)2, with co0/co1 > zcB, v Z cs ,

s(Z ew) = -OoZPW + (ol/2)(ZeVC)z, with o0/01 > Z ?rv, V Z eW ,

(11)
K('C) = K0"C+ (g1/2)Z2 ,

and v(1 - z) = %(1 - z)+(vl/2)(1 -1:) 2 ,

where all parameters are nonnegative constants. As noted, it is assumed that intraday
credit cap constraints are not binding so that ~cB = ~ew = 0. Imposing this assumption
and substituting the quadratic cash-management and real-resource cost functions in (11)
into (3) through (10) can ultimately yield reduced-form solutions for z, Z cB,
Z ew, and gt.
Discussion of payment system policies typically assume that the Federal Reserve and
CHIPS do not take into account the possibility that relative payment volumes on Fedwire
and CHIPS are affected by policy" settings. In the context of the model, this amounts to
an assumption that -c is exogenous.
 VANHOOSE: CENTRAL BANK POLICY 125

Under this assumption, and provided that intraday credit collateral constraints are
binding, the solutions for the portions of transfers financed via intraday credit are given
by:

zCB = (Dil{(.OO-[rCB+'IqCB(r'L-rS)]T,} , (12a)

and

: o:{o0-I
Hence, for a given allocation of wire transfers between the CB and private wire systems,
the extent to which banks desire to fund wire transfers via intraday credit depends
negatively on four variables:
1) the wire administrators' interest charges on intraday credit;
2) collateral requirement ratios;
3) the loan-security rate spread, which determines the marginal opportunity cost of
collateral requirements; and
4) the volume of transfers on the system, a rise that pushes up the net marginal cost of
borrowing, thereby requiring an offsetting reduction in intraday credit to increase
the associated marginal benefit.
Of course, banks may respond to policy decisions in part by shifting payment
transactions from one payment system to another so that z is a choice variable for b a n k s . 4
Solving (4) for ~, in terms of other parameters and choice variables, yields:

"1~ = (K 1 + VI)
-1{(V 0 + V I - K 1) +
(pPw- pCS)
(12c)

Therefore, if banks respond to payment system policies by altering relative volumes of

transfers on the two payment systems, then the optimal portion of transfers that banks
make on the CB wire system unambiguously declines in response to an increase in the CB
wire transfer fee, overdraft level and interest charge, and collateral requirement.
Increases in the private wire transfer fee, collateral requirement, and overdrafts induce
banks to substitute CB wire transfers for private wire transfers.
The reduced-form solutions for Z cB*, Z ew*, and z* may be computed from (12a)
through (12c). This is a system of nonlinear equations that yields very complicated
polynomial solutions for these bank decision variables. To maintain tractability while
continuing to capture the fundamental aspects of the policy problem faced by payment
system administrators, the analysis that follows is based on the following first-order,
linear (multivariate Taylor) approximations to these solutions in the neighborhood of zero
values for the intraday credit rates, collateral requirement ratios, and transfer fees:
126 AEJ: JUNE 2000 VOL. 28, NO. 2

Z CB* = (Dll-O~o-a[rCB+rlC~(rL-rS)] , (13a)

zpW* (13b)

and

(13c)

where:

and ~ -= (v 1+nI) -1 ,

are nonnegative parameters, and where ~ -: (v 1 + K 1 ) - I ( v 0 + V 1 - K1) 5

Equations (13a) through (13c) indicate that the first-order determinants of banks'
desired levels of intraday borrowings from the central bank are the central bank's explicit
intraday credit rate and the implicit rate resulting from imposition of a collateral
requirement. Likewise, the first-order determinants of intraday borrowings on the private
wire system are the private wire administrator's explicit intraday credit rate and implicit
rate owing to collateral requirements. Explicit intraday credit rates, implicit credit rates,
and the transaction fees established by the two-payment system administrators all have
first-order effects on the portion of payment transactions performed on the CB wire
system.

Alternative Policy Choices in Competing Payment Systems

Bank payment system decisions clearly depends critically on the policy choices made
by the central bank and the private wire administrator. These choices, in turn, depend
significantly upon whether these public and private policy makers take into account the
 VANHOOSE: CENTRAL BANK POLICY 127

effects that their payment system policy instruments have on transactions volumes as well
as volumes of intraday credit.
Objectives of the Payment System Administrators
It is assumed that the private wire administrator is an agent for the banks that own the
private wire system. Consequently, the private wire administrator desires bank profits to
be as high as possible. At the same time, the administrator of this system may wish to
recognize payment system externalities of the private wire system. In addition, the
administrator must earn sufficient revenues to cover the costs of its operation, which are
assumed to equal a fixed amount, C ?w.
In principle, therefore, the private wire administrator can set up to four policy
instruments, peW, reW, -7ZPW,and flew, with an aim toward maximizing:

XPrvn* -q~eWg(ZeW') - ~mh(rleWZl~z/*)-OeWk((1 - rl?W)ZeW') (14)

where Xew, Oew, ~?W, and q0ew are constant, nonnegative weights that the administrator
places on various nonprofit components of the administrator's objective (discussed
below). In general, the administrator maximizes (14), subject to the administrative
funding constraint (where the total number of banks is normalized at unity for simplicity):

(1-1:)(peW+reWZ?W'('))~ C Pw , (15)

where the left-hand side of (15) is the total revenue earned from making transfers on
behalf of banks that use the private wire payment system and from issuing intraday credit
at the rate r ew, which must at least cover the fixed cost of operating and administering
the system.
The private wire administrator cares about bank profits to an extent governed by the
magnitude of Xew. The nonprofit components are the same as those proposed by FS. The
function g('), assumed to be decreasing and convex in Z ?W*, is intended to capture the
cost to private wire members of private wire gridlock, which thereby approaches 0 if
sufficiently large amounts of intraday credit are provided by the administrator. The
relative weight of the gridlock cost in the administrator's objective is given by qoPw. The
function h(.), assumed to be increasing and convex, is intended to capture the broad cost
of collateralized intraday private wire credit to the banks who use the private wire system.
While collateralization of this credit protects the umbrella structure of the private wire
system from risk of loss, it transfers that risk back to member banks. The magnitude of
the weight ~ew indicates how important this cost is to the private wire administrator.
Finally, the function k(.), also assumed to be increasing and convex, represents the cost
to the private wire system of issuing uncollateralized intraday credit, and the parameter 0 ?w
measures the weight of this cost in the administrator's objective.
The central bank has an analogous objective. It has the capability to set up to four
policy instruments, pCB, rCS, 2cB, and ~cB, with the goal of maximizing:
128 AEJ: JUNE 2000 VOL. 28, NO. 2

(16)

For the sake of simplicity (and tractability), the central bank's perceptions of the
functional forms for g('), h(.), and k(-) are assumed to be identical to those for the
private wire administrator. What may differ for the central bank are the sizes of the
weights, Xcs, qocB, ~cs, and O cB , that it places on bank profits and on the costs of
systemic gridlock, risk transfers resulting from collateralization of intraday credit, and
direct credit risk to the central bank that arise from any uncollateralized intraday credit
it extends:
The central bank maximizes (16), subject to its own administrative funding constraint
required to ensure operation of the CB wire system:

-c(p c'e +rCBZCB*(.)) > C CB , (17)

where the left-hand side of (17) is the central bank's total earnings from making transfers
for banks that use its CB wire system and from issuing intraday credit at the rate rcB.
These earnings must be sufficiem to cover the central bank's fixed cost of operating and
administering the CB wire system, CcB .
Solving the general model is a daunting task whether or not the policy makers
coordinate their policy choices. Note, however, that in the general case of noncooperative
behavior on the part of the central bank and the private wire administrator, the general
procedure for solving the model is as follows. Each policy maker maximizes its objective
((14) and (16), respectively), subject to its funding constraint ((15) and (17),
respectively), taking the policy choices of the other policy maker as given. Following this
solution procedure would yield best responses (reaction functions) for each policy maker's
four instruments in terms of the four instruments of the other policy maker. A grand
solution for all eight solutions could then be computed, given specific parameter values
and functional forms.
Nevertheless, for purposes of this paper, significantly less complicated special cases
are considered. Such special-case solutions, it turns out, provide considerable insight into
the importance of the strategic interaction among payment system policy makers that
emerges in this model.
Optimal Intraday Credit Rates and Transaction Fees Without Caps and Collateral
In the special cases that follow, it is assumed that the payment system policy makers
use neither intraday credit caps (Z cB and ~ew) nor collateral requirements
(rlcB and B?w). They rely instead on transfer fees (pCB and p?W) and intraday credit
interest charges (rcB and f e w ) . 7
In addition, the objectives of the central bank and the private wire administrator are
to maximize bank profits while reducing exposure to risks resulting from daylight
overdrafts on Fedwire, subject to its administrative funding constraint. Thus, for the
central bank, X cB = 1, and ~CB __q~CS = 0 in (16). In addition, it is assumed that
 VANHOOSE: CENTRAL BANK POLICY 129

0 CB = (0cB/2), where 0 cB is a nonnegative weight, and that k ( . ) = (zCB*) 2 . Under

these assumptions, the central bank maximizes:

r ~ (1 - ~t) + r s~t ]A - r cs z Z cs - r ev:(1 - z ) Z eW - w ( Z Cs)

(18a)
_ s ( Z e W ) _ ~.pCS _ (1 - z ) p Pw - ( o C B / 2 ) ( Z C S * ) 2 - V('C) - ~:(1 - Z)

subject to (17), which is assumed to be a binding constraint. Likewise, X?w = 1, and

q2ew = q~e~v 0 in (14), and the private wire administrator places a nonnegative weight
equal to 0 err = (0ew/2) on daylight overdraft risk defined by k(.) = (Zee"*)2 . It follows
that the objective of the private wire administrator is to maximize:

rL(1 - ~t) + r s~t ] A - r CS v z cB - r P r V ( 1 - z ) Z e w - w ( Z cB)

(18b)
- s ( Z ? w ) - z p cB - (1 - ~:)pPW_ (0~'w/2)(Z?W*)2 ,

subject to (15), also assumed to be a binding constraint. Below, the focus is placed on the
central bank's choices because the private wire administrator's decision process is
analogous (though not identical because of different daylight overdraft risk weightings and
potentially different shares of total wire transactions volume).
O p t i m a l Central B a n k P o l i c y M a k i n g W i t h o u t R e g a r d to T r a n s a c t i o n S h a r e s
Standard analyses of central bank determination of intraday credit rates presume that
a central bank sets this and other policy instruments without regard to the effects that its
choices may have for the volume of transactions--and, consequently, revenues--on the
payment system it manages. In the context of the present model, this implies a
presumption that the central bank chooses its intraday credit rate and transfer fee to
maximize (18a), subject to (17), taking the portion of total transfers on CB wire, z, as
given. This mode of behavior yields:

r Cs* = [ a ( w l + o C S ) - 4 v ] - ~ { ( a c o l ) - l [ a ( w l + o c s ) - 2 z ] - l } C O o ' (19)

as the solution for the optimal intraday credit rate for CB wire.
The optimal central bank intraday rate depends positively on the weight, 0 cs , that the
central bank places on risks associated with daylight overdrafts on CB wire. In the
limiting case in which 0 cs approaches infinity, r cg*= (a~l)-lco0, which yields
Z cB* = 0. The central bank sets the intraday rate sufficiently high to induce banks to
curtail all intraday CB wire overdrafts?
The effect of a rise in CB wire transactions volume on the optimal intraday rate is
equal to OrCS*/Oz = 2COo[a(6o~ + 0 cs) - 4 ~ ] -2 ((D; 1 0 CB - 1). Thus, the key determinant
of how the central bank varies its intraday credit rate in response to increased CB wire
volume is the weight that it places on intraday credit risk. A higher intraday rate causes
a ceteris p a r i b u s increase in bank costs. Consequently, if the central bank's risk weight
130 AEJ: JUNE 2000 VOL. 28, NO. 2

is sufficiently small (0 cB < u>1 in the model), then its optimal intraday rate depends
negatively on CB wire volume. In this instance, a reduction in the intraday rate pushes
up bank profits. Thus, the central bank can maintain sufficient revenues to cover its CB
wire operating costs at a lower intraday rate in light of the higher transfer fee income that
a higher CB wire volume implies. If the central bank's risk weight is sufficiently large
(0 cB > oJ1), however, then for a given fraction of CB wire payments that result in
overdrafts, an increase in CB wire volume results in greater central bank exposure to
risk. Hence, the propensity for the central bank to respond to higher CB wire volume by
increasing the intraday rate is greater for larger values of the weight, 0 cB , than what the
central bank places on the risk associated with CB wire daylight overdrafts.
The solution for the optimal transfer fee, 9 cB , is a more complicated expression and
is not reported here. Nevertheless, the central bank's optimal transfer fee also depends
on CB wire payments volume and the central bank's risk weight.
An important feature of these optimal settings for the central bank's policy instruments
is that they are not influenced by the private wire administrator's policy choices. The
reason for this is the assumption that the central bank makes its choices taking the relative
transactions volumes on the two wire systems as given. As a result, the central bank does
not set its policy instruments in an effort to influence ~: and thereby affect the CB wire
share of total bank wire transactions.
Nevertheless, a key implication of these results is that if the central bank places a
higher weight on reducing daylight overdrafts on its CB wire system, its share of total
wire transactions will change. As noted above, an increased central bank concern about
CB wire risks, reflected in a higher value of 0 c8 , leads the central bank to increase both
its transfer fee and its intraday credit rate. As (13c) indicates, however, holding private
wire policies unchanged, these policy changes reduce the value of z*, the optimal share
of payments that banks process on CB wire. Thus, a unilateral central bank effort to place
greater weight on stemming risks associated with CB wire daylight overdrafts requires
central bank policies that ultimately tend to reduce its share of total wire transactions.
Optimal Policy Making When the Central Bank and Private
Wire Administrator Actively Compete for Transactions Shares
The optimal intraday rate reported in (16) is a semi-reduced-form solution. It indicates
the best setting, given the presumed central bank concern with bank profitability and
intraday credit risks in light of its own need to generate sufficient revenues to cover the
cost of operating the CB wire system. Most discussions of central bank payment system
policy making effectively halt at this point. Indeed, most ignore the potential interaction
between the central bank's setting of its intraday rate and the volume of payments that
banks make on the CB wire system.
Realistically, however, a central bank cannot ignore this interaction. While its CB wire
system may have a comparative advantage in processing transfers of reserves among
accounts of its bank clients for interbank lending transactions, it is less clear that such an
advantage necessarily exists for other payment transactions. In the U.S., for instance,
federal fund loans entail transfers among bank reserve accounts with Federal Reserve
banks, so the Federal Reserve may have a natural advantage in offering to perform such
 VANHOOSE: CENTRAL BANK POLICY 131

transactions on banks' behalf via the Fedwire system that it owns and operates. Book
entry security transfers, however, are more likely to be open to competition from CHIPS,
the U.S. analogue to the private wire system in the model. Further technological
developments undoubtedly continue to open the potential for substitutability among
payment systems for these and other wire payment transactions. 9
A key assumption of the model is that banks can choose between the two payment
systems, given potentially different costs and benefits (determined by the values of the
parameters co0 , co1 , o 0 , and Ol) and different fees and rates established by the payment
system administrators (the policy variables rcB, r eW, pCS, and p?W). Hence, from the
perspective of banks, the CB wire and private wire systems are imperfectly substitutable
means of accomplishing payment transfers, but banks may freely alter the relative shares
of payments that they place on these systems.
Determining these relative shares and their implications for the central bank's optimal
policy choices in the face of competition from the private wire system entails working out
reduced-form solutions to the model. Even given the linear approximations to the banks'
decision rules, the simple functional forms for policy goals, and the presumption that
collateral requirements either are absent or nonbinding, however, the model generally
yields nonunique solutions for all the relevant variables (the reduced-form solution for
rcB*, for instance, turns out to be a fourth-order polynomial expression). Nevertheless,
fundamental implications of the model for central bank policy making in the face of
payment system competition can be examined by considering first-order linear
approximations to the optimal choices of the central bank and the private wire
administrator. For the central bank, the first-order linear approximation to (19) is given
by:

rC~" ~ ~cs + A(0cB)(z _ ~) , (20a)

where:

and A(0Cn) --- 2COo[CX(col+oCB)-4~.]-2(coilO cB- 1)

The term A(0 c8) is the derivative of r cB', respect to z, evaluated at ~. As discussed
above, the sign of A(O cB) may be positive or negative, depending on the magnitude of
0 CB . Note, however, that A(0 CB ) - 0 as 0 CB - oo. Hence, r cB'- kcB ~ (col~x)-lco° so
that the approximate solution continues to yield Z cB = 0 in the limiting case in which
0 CB - oo.

Obtaining an approximate solution for the private wire administrator's policy choices
entails maximizing (18b), subject to (15), and computing the first-order linear
approximation to the optimal private wire intraday credit rate, given by:
132 AEJ: JUNE 2000 VOL. 28, NO. 2

r Pw* = F e w - l"(O?w) (z - ~) , (20b)

where:

and F(Oew) -: (2Oo)[[3(o, + 0 ?W) - 4 ( 1 - ~ ) ] - 2 ( o ; ' 0 c " - 1 )

The term I'(0 cB) is the derivative of rew*, respect to ~, evaluated at ~. As for the
central bank, the sign F(0 cB) depends on the magnitude of the private wire
administrator's intraday credit risk weight, 0 Pv'.
Equations (13c) and (20) together constitute a three-equation system that, holding the
payment transfer fees for both systems (9 cB and 9 ?w) constant for the sake of simplicity,
yields approximate linear solutions to the policy problems that the central bank and the
private wire administrator jointly face in determining optimal intraday credit fees. To
understand the policy interactions implied by these three relationships, consider Figures
1 and2.
FIGURE 1
Policy Making When the Private Wire Administrator
is Averse to Intraday Credit Risk
r CB

R PW
RC~,
f~ .... ~CB2. . . . . . . . . . . ~ " ' ~ ' "
/ / / S -~ R cB
B CB .~p ,.~ ~ , ~ i " 1~ A
f ~ - -I-.....
!
I
I
I
i reW

few,
. . . . . . . . . . /
C D
 VANHOOSE: CENTRAL BANK POLICY 133

FIGURE 2
Policy Making When the Private Wire Administrator
is Indifferent to Intraday Credit Risk
,cB

~" "RcB'
r2cB~ "~ , "" cB
B A

r l ~ w
:fI
:
I !
I I !
rPW
I ~ l r: W

few,

C D

,f
The schedule labeled R cB in panel A of both figures is the implicit central bank
reaction (or best response) function obtained by substituting (13c) into (20a). Its slope is
equal to [1 + ~,A(0CB)] -1 6A(0C~). The schedule labeled R ?w in panel A of both figures
likewise is the private wire administrator's reaction function obtained from substituting
(13c) into (20b). The slope of R ew is equal to [~/F(0ew)]-I [1 + 6F(0ew)]. Panel B of
each figure illustrates the inverse relationship between banks' CB wire payment volume
and the central bank's intraday credit rate implied by (13c). Panel C depicts a 45-degree
line that relates the CB wire payment volume to the optimal private wire intraday credit
rate in panel D. This is the relationship given in (20b).
In general, the central bank's and private wire administrator's reaction functions may
slope upward or downward, depending on the relative magnitudes of 0 cB and 0 ew and
of the other parameters of the model. Both Figures 1 and 2 are drawn under the
assumption that the central bank's intraday credit risk weight is sufficiently large to
satisfy 0cB> 601, in which case, the central bank's reaction function unambiguously
slopes upward, as illustrated in panel A of both figures.
In Figure 1, the private wire administrator's weight, 0 ew, on intraday credit risk is
assumed to be sufficiently large enough that OeW> o 1 so that the private wire
administrator responds to a reduction in CB wire payment volume (an increase in private
134 AEJ: JUNE 2000 VOL. 28, NO. 2

wire volume) by raising its intraday credit rate, hence, the inverse relationship between
r eve and z, displayed in panel B of Figure 1. In this circumstance, the private wire
administrator's reaction function also slopes upward, as depicted in panel A.
By way of contrast, Figure 2 shows a situation in which the private wire administrator
places a relatively low (0ew< Ol) weight on intraday credit risk. In this event, the
private wire administrator responds to a decline in CB wire payments volume (an increase
in private wire volume) by reducing its intraday credit rate because this action improves
the profitability of member banks and maintains sufficient private wire revenues to cover
system costs. Hence, there is a positive relationship between r e w and z in panel B of
Figure 2, and the private wire administrator's reaction function in panel A slopes
downward. 10
Each figure shows the effects of an increased central bank concern with intraday credit
risk, reflected by an increase in the value of 0 cs. The result in each case is an upward
rotation of the central bank's reaction function in panel A of both figures. That is, an
increased concern with risk exposure stemming from its extension of intraday credit on
CB wire induces the central bank to raise rcB* to give banks an incentive to reduce their
daylight overdrafts on the CB wire system. In part, banks also respond to this policy
change by transferring some of their payment transactions to the private wire system, as
depicted by the reduction in z* in panels B and C of each figure.
The ultimate responses of both payment system policy makers to the central bank's
heightened concern with intraday credit risks depends crucially on the private wire
administrator's concern about risks stemming from daylight overdrafts. On one hand, in
Figure 1, where the private wire administrator (like the central bank) gives considerable
weight to the risk associated with daylight overdrafts, the private wire administrator
responds to the increase in private wire payments volume by increasing the private wire
intraday credit rate, as shown in panels A and D. This action by the private wire
administrator tends to have a slight counteracting effect on CB wire payment volume
(depicted by the leftward shift in the z* schedule in panel B) that reinforces the central
bank's decision to push up its intraday rate, inducing a further rise in the central bank's
intraday rate.
On the other hand, in Figure 2, where the private wire administrator places very low
weight on intraday credit risks, the decline in CB wire payments volume owing to a
higher CB wire intraday rate induces the private wire administrator to reduce the private
wire intraday credit rate. This action reinforces the CB wire system's decline in payment
volume, which pushes the central bank's payment system revenues down further, thereby
inducing the central bank to undertake a net increase in its intraday credit rate that is
smaller than it would have enacted otherwise in response to the rise in 0cB.
Therefore, Figure 2 potentially explains the partial reversal of the Federal Reserve's
policy stance in 1995. In the absence of potential payment system interactions, the
Federal Reserve would otherwise have enacted an intraday credit rate of 25 basis points.
After taking into account the potential for bank substitution between Fedwire and
CHIPS--and, if the model is a reasonable depiction of the underlying behavior of the two
 VANHOOSE: CENTRAL BANK POLICY 135

payment system administrators, a lower CHIPS concern about intraday credit risks--the
Federal Reserve ultimately settled on an intraday rate that was 40 percent lower.
Clearly, this possible explanation for the Federal Reserve's behavior hinges on an
initially sizable Federal Reserve concern about intraday Fedwire credit risks and a
relatively meager concern about intraday credit risks on the part of CHIPS participants.
Both assumptions seem reasonable in light of the safety-net coverages available to CHIPS
participants through federal deposit insurance and the Federal Reserve's lender-of-last-
resort facilities.
The model above does not explicitly consider the moral hazard effects of the federal
financial safety net, which limits the potential for using the model to conduct welfare
analysis. Nevertheless, for the sake of argument, suppose that the central bank's weight,
0 c~ , is equal to the societal weight on intraday credit risk. If so, then the socially
optimal (or, given the distorting effects of safety-net guarantees, second best) outcome
would require:
1) inducing the private wire administrator to adopt the same social risk weight, 0 cB ;
and
2) developing a mechanism for achieving cooperative policy making by thb central
bank and the private wire administrator.
Under these conditions, neither Figure 1 nor Figure 2 would illustrate the truly socially
optimal responses to an enhanced concern about intraday credit risks. Nonetheless,
assuming roughly equivalent technologies and costs for the two systems and nearly equal
costs and benefits for bank customers of the systems, the result would be higher intraday
credit rates in both systems with little change in relative payment volumes.

Conclusion

Traditionally, the Federal Reserve has been regarded as a key participant in the U.S.
payment system. As Stevens [1996] points out, the founders of the Federal Reserve
intentionally anchored the Federal Reserve within the payment system to "weave [Federal
R]eserve banks' operations into the fabric of everyday financial market activity." In
today's altered technological environment, however, interrelated public and private
payment systems experience credit and systemic risks owing to daylight overdrafts.
This paper has sought to examine how these interrelationships can influence the
payment system policy choices of a public payment system administrator such as the
Federal Reserve. The key conclusion is that examining central bank policy making solely
within a single payment system may ignore important effects arising from interactions
with private payment networks. Optimal policies that a central bank otherwise might
pursue within an isolated payment system are unlikely to correspond to the policies that
it would find optimal to pursue if the central bank recognizes that banks can shift
transactions among both publicly and privately administered networks.
On one hand, if a central bank ignores potential shifts in transactions volumes from its
system to private systems, then efforts to reduce risks arising from daylight overdrafts
on its system are likely to reduce its share of total payments. On the other hand, if a
136 AEJ: JUNE 2000 VOL. 28, NO. 2

central bank takes into account relative transactions volumes on both a public system that
it manages and private systems that banks alternatively may use, then noncooperative
policy making is likely to yield socially desirable central bank policy settings, assuming
that the Federal Reserve's objectives match those of society as a whole.
There are at least three possible ways that the Federal Reserve might address the latter
problem. One, which it has pursued to some extent, is to work with CHIPS to attain a
cooperative and (if the weights in the Federal Reserve's objective function reflect societal
concerns with risk, gridlock, and so on) socially optimal outcome. The Federal Reserve's
objectives and risk weights may differ from those of CHIPS, however. Indeed, the
presence of the federal financial safety net undoubtedly assures that such differences will
exist. Furthermore, weights in the Federal Reserve's objective function may not reflect
societal weights, particularly if concerns about Reserve bank employment levels and other
matters of self-interest influence Federal Reserve officials. These potential mismatches
ultimately could doom efforts to achieve a cooperative, socially optimal outcome.
A second, related approach would be for the Federal Reserve to take a more active
regulatory role. Under this approach, which the Federal Reserve currently seems on the
verge of pursuing [Federal Reserve System, 1997, 1998], the Federal Reserve essentially
would create regulatory mechanisms that would force private payment providers to adopt
risk weights and policies mandated by the Federal Reserve itself. The scope for
independent decision making by a private wire administrator such as the one modeled in
this paper thereby would be curtailed significantly. Indeed, in such a regime, the only
choice variable for the private wire administrator would be the transfer fee (and, perhaps,
quality and convenience of service). Whether such an approach, which would further
broaden the Federal Reserve's involvement in the payment system, is socially desirable
is an open question.
A third approach is more radical. The Federal Reserve could exit the payment system
business. It could sell or lease its payment system hardware and facilities to private
payment system firms or associations and privatize the bulk of its labor force. Taking into
account the distorting effects of safety-net guarantees on private incentives, the Federal
Reserve could then regulate the functioning of these systems by setting performance
standards (for instance, minimal risk weights) and performing auditing functions, much
as it does as a bank regulator today. This may or may not lead to a preferable outcome.
Certainly, this paper provides no analysis of this alternative payment system structure.
Nevertheless, the results here indicate that this option might be worthy of more study than
it has received to date. 11
This paper has concentrated on wire transfer systems because of the unique policy
problems that they present. Nevertheless, similar problems of interacting public and
private systems arise in check clearings. A model such as the one developed here might
therefore be useful in examining the massive U.S. check collection system and the
Federal Reserve's role in that system. This paper has also adopted an insular, U.S.
perspective. However, European nations increasingly will confront problems of
interrelated public and private payment systems as the drive toward monetary union
 VANHOOSE: CENTRAL BANK POLICY 137

continues.12 Undoubtedly, a framework not unlike the one in this paper could assist in
evaluating these issues as well.
The analytical framework employed in this paper can justifiably be criticized for its
reliance upon a static framework, its consideration of arbitrary policy objectives, its
abstraction from payment netting arrangements used in private systems, and its failure to
explicitly model sources of risk. However, such modeling extensions lie well outside the
bounds of this paper, which has highlighted essential policy issues that arise in the
operation and regulation of interacting public and private payment systems.

Footnotes

1. See Walter [1998] for a discussion of this and other subsidies.

2. This is a basic conclusion, for instance, in the literature on international policy coordination
in two-country settings (see, for example, Oudiz and Sachs [1984], Rogoff [1985], and
Canzoneri and Henderson [1991]). This paper essentially shows that the same basic point
extends to an environment of two interlinked payment systems administered by separate policy
makers.
3. The parameter 6 is the effective reserve ratio, after accounting for the required reserve-
reducing impact of sweep accounts [VanHoose and Humphrey, 1998]. For the sake of
simplicity, the capital constraint is assumed to be nonrisk-based [Kopecky and VanHoose,
1999],
4. At present, most transactions on Fedwire entail federal funds-related and book entry security-
related funds transfers, and the bulk of transactions on CHIPS are Eurocurrency-related and
foreign exchange-related transfers. Nevertheless, there is no technological reason that many
of the transactions currently conducted on one system could not be accomplished on the other
system. Indeed, anecdotal accounts indicate that some large banks proposed to begin
transferring blocks of book entry security transfers from Fedwire to CHIPS if the Federal
Reserve had raised its intraday credit rate from 15 to 25 basis points as originally planned in
1995.
5. Sufficient, but unnecessary, conditions for [3 > 0 are K0 _> ~0 and o o > 1. The necessary
condition for a > 0 and "~> 0 is u0 + t~1 - K1 > 0.
6. In its role as a public policy maker, the Federal Reserve also may incorporate concerns about
CHIPS risks, collateral costs, and gridlock into its objectives. Thus, in principle, its objective
function could be much broader than the one displayed in (14). Below, however, only a special
case of (14) is analyzed in detail. The Federal Reserve's aversion to uncollateralized overdrafts
reflect concerns about both its own exposure to credit risk and the banking system's exposure
to systemic risk arising from potential interbank funds settlement failures. However,
simulations by Furfine [1999] indicate that past concerns about the latter may have been
overstated in previous payment system research.
7. CHIPS recently has made collateral requirements a central feature of its intraday credit
policies. Nevertheless, the essential conclusions are not altered by focusing on an explicit
intraday rate instead of a collateral requirement. The latter has identical effects, at least in this
one-period model in which the spread between the loan and security rates is constant.
8. There likely is an upper limit for the central bank's intraday credit rate, above which banks
would have an incentive to extend private intraday credit at a market-determined intraday rate
(see VanHoose [1991] for analysis of such a system). This model ignores this possibility.
138 AEJ: JUNE 2000 VOL. 28, NO. 2

9. Federal Reserve pricing of daylight overdrafts may have encouraged the growth of the GSCC.
More broadly, increased substitutability in other forms of payment is increasingly common,
leading some observers such as Wilke [1996] to question the Federal Reserve's long-term
viability in the face of increased competition from private payment system providers and in the
absence of significant efforts to reduce the costs of maintaining its own payment systems.
10. In this case, F(0 eze) < 0. The negative slope for R PW in Figure 2 follows, provided that
1 + 6I'(0 eW) > 0, the condition for a stable equilibrium.
11. Of course, another option would be to permit greater competition among Reserve banks as well
as among private sector networks while maintaining an overall regulatory umbrella. This wotdd
maintain the Federal Reserve's direct involvement in the payment system and save it from
having to undertake a full privatization of its payment system functions. See Toma [1997] for
an interesting analysis of competition among Reserve banks earlier in the Federal Reserve's
history.
12. For a useful review of some of these issues, see Folkerts-Landau et al. [1996].

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