Small Banks' View of the Fed: Then vs. Now

R. Alton Gilbert

Last year, Federal Reserve Vice Chairman Alice Rivlin headed a committee that nationally solicited payments system participants on how they view the role of the Reserve Banks in providing payment services. Comments received confirmed that relatively small banks located in remote areas are among the strongest supporters of the Fed's payments services. These banks expressed concern about their continued access to check collection and automated clearing house services in the event the Federal Reserve withdrew from these services.

Such banks have not always had a rosy view of Fed payment services. In 1915, when Reserve Banks began their check collection service, the banks that opposed their collection practices most strongly were these same small banks. Many of them considered the Fed a threat to a major source of their revenue: exchange charges.

Banking law in effect prior to the formation of the Fed required banks to pay at par (face amount) for checks presented at their place of business. Banks were permitted to pay less than par, however, for checks presented to them through other means, including the mail.

The rationale for this deduction from the face amount, called an exchange charge, was that paying banks could incur certain expenses in remitting payment to out-of-town collecting banks, including the cost of transporting coins or bank notes to the collecting banks. While these nonpar banks paid collecting banks less than 100 cents on the dollar for checks drawn upon their depositors' accounts, they debited the accounts of their depositors at the full 100 cents on the dollar. This difference was revenue for the nonpar banks.

From the formation of the Fed, the Board of Governors perceived a mandate from Congress to establish a national system for collecting checks at par. Most banks located in large urban areas had been paying collecting banks at par on checks written by their depositors. The nonpar banks were located primarily in remote areas. In 1916, the Board required all banks that were members of the Federal Reserve System to pay at par for checks presented by the Fed, even if the Fed sent the checks to member banks through the mail.

The battle over par check collection involved state-chartered banks that were not Fed members and that refused to pay the Fed at par. To promote use of its collection system, the Fed decided to accept checks drawn upon all banks for collection, including those that refused to pay the Fed at par. The Fed then developed various means of collecting at par from these banks. In some cases, it enlisted the help of member banks with offices located near the nonpar banks; member banks presented the checks at the place of business of the nonpar banks and demanded payment in cash at par.

Nonpar banks strongly opposed these practices and accused the Fed of harassment. They filed several lawsuits against the Fed. In 1923, the U.S. Supreme Court ruled against the Fed, saying that since Congress did not require the Fed to establish a national system for check collection at par, the Fed could not compel banks to pay at par. After this ruling, the Fed ended the practice of accepting for collection checks drawn upon banks that refused to pay at par. The practice of nonpar banking persisted for several decades. The number of nonpar banks fell below 1,000 for the first time in 1968, but nonpar banking did not disappear until the 1980s.

Thus, comments by bankers to the Rivlin Committee illustrate an historic irony: those small, remote banks that once saw Fed services as a threat to their revenue now see these services as crucial in keeping the financial services field competitive.

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