The Law Checks Tyranny, But Law Can Also Become A Tool Of Tyranny

When you and I write checks, we tend to pay up if the check goes through despite an insufficient balance. In 2008, the Federal Deposit Insurance Corporation released a study of overdraft fees charged to bank consumers. This study found that overdraft fees averaged close to $27, which amounted to a huge effective interest rate on the credit extended when compared to the amount overdrawn (one estimate drawn from this study called it over 3000%). And a more recent study, released in early 2011 from the Pew Charitable Trusts, found that the average overdraft fee came to $35, with total overdraft fee revenue for banks of $39 billion, up from $20 billion in 2000.

You and I use banks when we pay each other money. Banks pay each other money, too. They use private and public ‘wholesale’ or interbank payment systems. This is a dry but fascinating area of research, given the public policy and risk management issues and the large dollar amounts involved.

Many people immediately associate the Fed with monetary policy, and a smaller subset of the population understands that the central bank also performs a ‘lender of last result function’ along with supervisory and regulatory roles. But the Fed’s payment system responsibilities are another leg of the stool, and an important one. For example, the Federal Reserve’s “Fedwire” wire transfer system moves over one trillion dollars every day among banks with access to it.

The Federal Reserve frequently refers to Fedwire as an efficient payment system. It is certainly popular, and ‘efficient’ from the point of view of the users, but whether it is efficient when it comes to the general welfare is another matter. In turn, the Federal Reserve’s pricing of this service raises some questions about the meaning of the rule of law.

Back in 1980, amidst accelerating inflation and tumult in the financial services industry, Congress passed the Monetary Control Act. This comprehensive legislation included provisions requiring the Federal Reserve to price the payment services it provides to fully recover their costs. And since then, the Fed has annually produced accounting statements listing the revenue and costs of these services, which assert that the services fully recover their costs as required by the law. Fed leaders have frequently testified to their compliance with the law in citing these estimates, and asserted that Fedwire is not a source of subsidy to banks.

But in the late 1990s, leading up the Gramm-Leach-Bliley banking legislation, while the Fed was trying to make a case for itself as the lead supervisor for new financial services holding companies, Fed leaders were regularly referring to their concern for the subsidy banks enjoy from public services, and also cited Fedwire access as part of this subsidy, in part because of the way the service can shift risk to the public.

How can a subsidy fully recover its cost?

Well, when looking at Fedwire historically, it sure looks like a source of subsidy. When the Fed processes payments over Fedwire, it guarantees the funds to the recipient – even if the sending bank has insufficient funds on its account. This ‘finality’ feature is uniquely provided by the monetary authority. But it also exposes the Fed to the risk from daylight overdrafts, which may become a loss if the bank incurring them can’t pay the Fed back at the end of the day.

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