Payments Are A Utility. And Critical Infrastructure.

It is not at all clear that banks are the best way to deliver payments.

May 12, 2023

Dateline: London, 11th May 2023.

The economist John Kay wrote in a paper on “Robust and Resilient Finance” that while “many aspects of the modern financial system are designed to give an impression of overwhelming urgency… only its most boring part - the payments system - is an essential utility on whose continuous functioning the modern economy depends”. His choice of word — utility — is interesting. Just like the electricity network or the water system, not only are payments a utility but they are also critical infrastructure: If the stock market shuts down for a day, life goes on, but if salary payments stop because of a bank failure, customers cannot access their money because of bug-ridden software updates or debit cards stop working in supermarkets because of misplaced cost-saving on testing, there is chaos. Perhaps we need to think again how the payments system works.

Critical Infrastructure

Matthew Klein says that banks are speculative investment funds grafted on top of that critical infrastructure and goes on to suggest that the public sector should embrace the role because money and the payments system are public goods. As he sees it, banks could focus on (what should be) their core competency of identifying creditworthy borrowers and making profitable loans. I think this is a very interesting perspective that is brought into focus because of two imminent developments in that critical infrastructure: FedNow, which is coming along in the summer, and the Digital Dollar, which could well be coming along soon.

I mention both of these because I am a payments nerd, so I distinguish between the implementations of electronic money that lives in bank accounts and flows around banking networks and the implementations of electronic cash that lives in devices and flows over the Internet, Bluetooth, WiFi and other forms of communications network. They are chalk and cheese, apples and oranges. But in both cases, the idea that the underlying Federal Reserve product (money) could be delivered into the mass market by regulated organisations other than commercial banks is worth exploring.

It may be time for a reevaluation. Matt Stoller provides a robust criticism of the Fed in his newsletter “Fire the Fed”, noting that the The Fed sees banking as ‘innovative,’ which he says is "ridiculous and means we will always structure banks, and our economy, in unfair ways". Maybe we do not want innovative banks. Maybe as Matt says banking is a "public utility service” and we should start treating it that way.

with kind permission of Helen Holmes (CC-BY-ND 4.0)

Banks and Payments

But how? Well, Mihir Desai and Sumit Rajpal, writing in the Harvard Business Review, suggest that the U.S. should create a special class of bank called a “payment bank” that does nothing more than process payments and earn a safe return by holding deposits with the Fed at the federal funds rate or charging customers a very small fee for facilitating these large payments. Ideas of narrow banking and “flow accounts” are not new by any stretch of the imagination. Go back a generation and take a look at William Roberts “What’s really new about the new forms of retail payment?” in the Atlanta Fed’s Economic Review (First Quarter 1997) in which he writes that

Payment by transfer of bank debt therefore constitutes a natural solution to the two-dimensional conflict of interest between banks and depositors and between buyers and sellers. In this sense it is not surprising that the U.S. payments system historically evolved so as to emphasize transfers of claims on banks (such as checks as an alternative to cash payment. However, the term natural in this instance does not mean inevitable. (my emphasis)

Then go and read Lawrence Radecki’s “Banks’ Payment-Driven Revenues” from the New York Fed’s Economic Policy Review (July 1999) in which he writes that

In theoretical studies, economists explain the prominence of commercial banks in the financial sector in terms of lending and deposit-taking but neither explains why commercial banks provide payments services on a large scale, or why they perform payments services together with deposit taking and information-intensive lending.

His answer is that the skills required to succeed in the lending business—the ability to control losses efficiently—are also necessary for success in payments. It is certainly true that access to payments data helps in risk management but it is not at all clear to me that these functions need to be performed by the same financial institution that provides the credit.

In a post-Silicon Valley Bank world of embedded finance, tokens and digital dollars it seems some of those old ideas about the relationship between payments and banking should be re-examined. When it comes down to it, why couldn’t fintechs or techfins hold customer money in accounts at the Fed to create a risk-free payments layer for the wider economy while banks continue to provide credit.

Payment Utilities

Suppose, for example, that the Fed gave settlement accounts to properly-regulated fintechs so that they could exchange electronic money directly without having to go through banks. Crazy? Well, no. That’s what the economist George Selgin (Director of the Cato Institute's Center for Monetary and Financial Alternatives) and others have long argued for. This was the approach taken in the U.K., for example, when the Bank of England decided a few years ago to give accounts to fintechs. The fintechs who took advantage of this opportunity used it deliver a better and cheaper service to customers: They range from my favourite fintech Wise (which I use all the time) to the open banking startup Modulr (which counts PayPal Ventures amongst its investors).

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Similarly, suppose the Fed allowed anyone with an approved, security-certified wallet in their phone, car, USB stick or whatever else to hold digital dollars and send them to any other such wallet: Who knows what innovative new services might be built on top of this simple, device-to-device robust form of electronic cash!

Public Services

Banks as we know them are built on top of three “transfer functions”. These are transfers in space (payments), transfers in time (savings and loans) and transfers in scale (investments). But it is not a law of nature that these functions should sit inside the same institutions: Indeed, they could be implemented in entirely different organisations.

Perhaps it is time to be more radical in our rethinking of the infrastructure for the online age: allow more direct access to the pipes, provide digital fiat (dollars with an API) as a public good and allow non-credit creating payment banks/institutions/utilities to implement the transfers in space as a utility bringing value together (electronic money and electronic cash) to put in place robust, inclusive and sustainable pipes for the rest of the economy to use.

Let banks focus on creating credit and let them find other ways (eg, digital identity, data trusts and AI) to stay in the transaction loop.