Aaron Klein on Real-Time Payments and Financial Regulation

David Beckworth: Our guest today is Aaron Klein. Aaron is the director of the Center on Markets and Regulations at the Brookings Institution where among other things, he focuses on financial regulations and real-time payments. Aaron has written widely on real-time payments and joins us today to discuss this issue. Aaron, welcome to the show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

Aaron Klein: It's great to be here.

Beckworth: Great to have you on. Now, you have an interesting career that predates Brookings. You've been a chief economist on the Banking Committee in the Senate. You worked at Treasury as deputy assistant secretary. You worked at the Bipartisan Policy Center, but through all of these you've had a focus on financial regulation issues. Is that right?

Klein: Yeah, that is. My first major job in Washington was on the Senate Banking, Housing, and Urban Affairs Committee. I started as the economist. Most of the committee staff were lawyers, and I was running numbers, formulas, thinking about the economic incentives, focusing on things like the Federal Reserve, monetary policy, bank regulation, housing and transportation. These issues have come to dominate my career and due to timing, I think to a large extent dominated parts of the national discourse. When you think about the housing crisis, the banking crisis, the very beginning of my career, the accounting crisis, the…

Beckworth: Sarbanes-Oxley.

Klein: …My first boss, the great Senator Paul Sarbanes from Maryland who actually was the top Democrat on the Banking Committee for 12 years and the chairman for 18 months. I happened to be there for that 18 month period of his chairmanship when we passed multiple pieces of major legislation including the Sarbanes-Oxley Act.

Beckworth: Yes. Now, you were also involved in TARP, which is a big deal in terms of the banking system, 2008. You were also involved in Dodd-Frank, 2010, the huge reform of the banking system coming out of the financial crisis. Tell us about that experience.

Klein: I worked both ends of the financial crisis. I worked on the committee all the way through spring of 2009. We saw the buildup of risks in the system. We were actually holding hearings on predatory lending and subprime mortgages back in 2002. This crisis caught a lot of people by surprise, but we'd been hearing stuff on the Senate Banking Committee about this crisis building for a long time. When the crisis hit, we passed multiple pieces of legislation. The most famous being the Emergency Economic Stabilization Act, better known by section 101, the Troubled Asset Relief Program or TARP. Interesting side note, the original two-and-a-half page proposal from the administration called that program TARA, the Troubled Asset Relief Auction. And we sat around, we said, you know, names have meaning and during a financial crisis, there's a crisis of confidence. And TARA reminds you of what?

Beckworth: Terror.

Klein: Terror and the plantation in *Gone With the Wind*.

Beckworth: Yes.

Klein: That's not a story that's inspiring of confidence. Many of us on the committee were baseball fans. We said, what happens when there's a storm? You pull out the tarp, you hide underneath and when it's over, and it's more than just an acronym. The original proposal was only about these reverse auctions and we said, you know what? The Treasury Department, maybe these auctions aren't going to work. Maybe they're going to need to inject capital into the banks, and we're going to give the authority to give capital. That was not in the original proposal by the Treasury Department, so we expanded it into TARP, which I think is one of the most wildly successful programs in terms of stabilizing the economy at very minimal cost to taxpayers. Often it's reported in the media that was a $750 billion bailout. What that fact gets wrong is the bill authorized up to $750 billion to be injected into the banking system.

Klein: Actually little less than 700 was actually injected, and of the money put into the banking system, it was all paid back to the taxpayers with interest. That is, the money that was sent to capitalize the banks was fully returned with a profit to taxpayers. I'm not using fancy accounting of the profit of the economic contraction that didn't occur. I'm talking about actual dollars out and actual dollars in.

Beckworth: Okay. So you were deeply involved in TARP. Did you ever work with Neel Kashkari during that time?

Klein: I did. Neel was the primary negotiator for the administration. He was the point person coming over from the Treasury Department and frankly the White House ceded that authority, and we sat in the room and negotiated key provisions of the bill together. I have tremendous respect for him.

Beckworth: So you've probably have watched his career with interest now that he's at the Minneapolis Fed. Interestingly enough from that experience, he's now a big advocate of increased capital funding for banks. I think that the ultimate objective in mind is breaking up some of the bigger banks into smaller ones. But you guys cut your teeth together in that crisis. But looking at your career, I would call it sink or swim in the financial crisis. Right?

Klein: It was. After the crisis and we stabilized the system in TARP and then with the new Obama administration, I was fortunate enough to get an appointment as deputy assistant secretary for economic policy. I went over to the Treasury Department and helped implement portions of TARP. I served on the TARP investment advisory committee. At that point we were mostly looking at small bank capital purchase programs. But we forget most of the banks that received TARP money were small banks. I also helped work and continued my work that I'd started with Chairman Dodd and then transitioned to working for secretary Geitner on the team building the legislation that eventually became the Dodd-Frank Act in 2010, getting that passed.

Klein: Most of that implementation occurred within the financial regulators, but we did some work there. We did some work at Treasury. I moved on to the housing finance team. Another problem from the financial crisis, we actually passed a giant bill. It was the anniversary of that bill just the other day, here are the Housing Economic Recovery Act. People forget in 2008, we did GSE or Government Sponsored Enterprise reform as well as TARP. Then at the end of that, after a wonderful first term in the Obama administration, I moved into the think tank world at the Bipartisan Policy Center where we conducted a bipartisan review of Dodd-Frank. What was working, what wasn't working, what should be done differently.

Beckworth: Okay. Looking back now at Dodd-Frank since you're such an intricate part of the process of making that, how do you view it a decade out? What are its strengths, any areas you would like to improve if you could?

Klein: I'll give you one broad thought about Dodd-Frank, which is that the portions of Dodd-Frank that don't have another name all kind of makes sense and work together. Title One, the living will component, the Financial Stability Oversight Council, the higher capital requirements, the ability to designate systemically important financial institutions. You can think they're good or bad ideas, but they're coherent with title two, with other aspects, failure resolution authority. There are a bunch of other things in Dodd-Frank that have a name to it. You think of the Durbin Amendment, the Volcker Amendment, the Collins Amendment. There are all these other-the Lugar Amendment, et cetera and so forth. Whether these individual amendments were good or bad ideas, hold that aside. They often were not integral parts of the Dodd-Frank system and were added on. And they were added on in large part because the bill passed by the bare majority in the United States Senate. There wasn't a vote to spare.

Klein: That's unusual in banking legislation, both regulatory and deregulatory. There's usually a large bipartisan majority in favor in both directions. But when you don't have a vote to spare, you have to take every idea you can that comes along with a vote. So I think a lot of times I give three broad thoughts. One is, I think Dodd-Frank is working and it's worked pretty well. And the banking system has been pretty stable since then, confidence returned into the system. Two is, a lot of the more controversial parts of Dodd-Frank are actually another idea that was grafted onto Dodd-Frank. So sometimes when people have issues with Dodd-Frank, they actually have issues with somebody else's idea that rode Dodd-Frank into law.

Klein: The third part is, a lot of the things people criticize Dodd-Frank for are not in Dodd-Frank. They were another part of the banking regulatory or financial regulatory system that had nothing to do with Dodd-Frank. I'll give you a story. Once my mom called me up and said, "I got this news from my broker that they have to change how they charge my retirement account and it's all because of Dodd-Frank. What did you do?"

Beckworth: Thanks, Aaron.

Klein: Yeah, I said to mom, "Thanks. It's part of your retirement account." That's under ERISA, which for those of us in the financial services world, one is the Department of Labor and two is actually a different committee in the United States Congress. It's not under the banking committee's jurisdiction. It was not touched in Dodd-Frank. It was a Department of Labor ruling fiduciary duty. This is a big topic. Dodd-Frank didn't touch that account and didn't touch that rule.

Klein: But interestingly enough, the stock broker financial manager of the account clearly had received information from their company and was telling clients this was part of Dodd-Frank. So Dodd-Frank has become interestingly this catch-all for all financial regulation. Sometimes I think people are unhappy with parts of financial regulation. They blame Dodd-Frank. Dodd-Frank had nothing to do with it.

Beckworth: Okay. So the banking system is in a healthier state of affairs right now. Banks are funded with more capital. Are there still concerns with the US banking system that should be addressed?

Klein: There are concerns. I have a big concern that there aren't enough banks failing today. 2018 was the first calendar year since 2005 where we didn't have a single bank failure. By the way, there have only been three calendar years in American history where we didn't have a single bank failure. 2004, 2005 and 2018.

Beckworth: Interesting.

Klein: 2004 and 2005 were not the mark of a healthy financial system. In point of fact, if you look back at some of the bank regulators, they were crowing about how there were no failures on their watch. And that means regulation is doing a great job. I take a very different view of regulation. America has about 5,000 banks. If you had 5,000 restaurants and you came back a year later and none of them had gone out of business, would you conclude that was a sign of a healthy market?

Beckworth: Nope.

Klein: So banks need to take risks. That's actually what banking is. I'm making loans, I'm taking risks. That's fine. That should be encouraged. What we want from regulation is not stopping banks from taking risks, from pursuing different strategies, from trying to attract and spend capital in different ways. What we want is a system where when banks fail, one, depositors are protected and two, the knock on effects, the negative externalities, the run risks, the systemic consequences are contained.

Klein: If you've developed that system, then you've got to the right point. I fear that we've developed a system both in terms of regulation and in terms of banks’ actual practices where there isn't enough risk being taken in the system and there aren't enough bank failures. I was pleased when the first bank of the year failed because it showed that perhaps banks were taking more risks. Then it became apparent that it was more about fraud. This particular failure was more about just stealing money and fraud as opposed to taking risks that didn’t work out.

Beckworth: Kind of a shallow victory for you, you wanted one that occurred because a bank was taking on a risk and it didn't work out. So your argument is that both regulation is playing a role, but maybe even more importantly there's still hangover risk aversion by bankers. They’re still timid.

Klein: I'll give you a perfect example. One of the big problems is a lack of capital to small business, that's frequently repeated. But when you dive into it, there's actually two different things going on. There's small business and there's new business. All new businesses by definition start small. Banks are often hesitant to make a small business loan to a business that hasn't been in operation for three years. It's part of show me your records. Well, who hasn't been in business for three years? All new businesses. Historically, a lot of new business capital wasn't in the form of small business lending, but was credit card debt or home equity debt and personal savings. That helped start entrepreneurship and new business. Well, what do we know after the financial crisis?

Klein: One, home equity was wiped out and home equity loans were harder to have. The tight home equity loans had gotten too loose. Two, savings got wiped out. Three, credit cards were constricted. Another piece of legislation, I worked on the Card Act, which was a pretty big deal in 2009 because there were  tremendous abuses in the credit card system. You remember your dog getting a credit card and college kids getting these things handed out like candy and finding themselves in tremendous problems upon graduation or not even making it to graduation in some instances. So there were a lot of abuses in the system that got tightened. That was a good thing. But financial institutions are a little too reticent in my opinion on that, to give business loans. In addition, there's some legitimate questions about the impact of the stress tests on the ramifications on small business lending. If you assume all small businesses close during a recession, you're going to have an aversion to giving a loan to small businesses. We actually know that's not the case. Recessions hit lots of different firms.

Klein: That part has gotten me concerned. I do think there've been some advances, financial technology firms that have started lending on the basis of payments to newer businesses. People are filling the gap outside of the banking system. And this leads to another concern, which we'll see in the next recession when it comes. It's one thing to make the banking system more stable. The banking system is a subset of the financial system.

Beckworth: That's fair.

Klein: We're interested in financial system stability. One thing the financial crisis taught me that I will never forget is you can have a non-bank like AIG who is an integral part of the health of the entire financial system. So I am concerned that we have now reached a point where the Financial Stability Oversight Council, the kind of Jedi Council that was established in Dodd-Frank to have the regulators look beyond just each of their own narrow purview currently doesn't have any institutions designated as systemically important. Maybe that's an accurate picture. Maybe that's also the triumph of ideology over prudence.

Beckworth: That was an interesting story because there were firms listed as systematically important that slowly have been crossed off, which could be a whole other podcast. So let's hold off on that. But I do want to go back to the point you raised about, I think Fintech. Is Fintech the new shadow banking system? Because I've heard stories where some of the financial intermediation that used to be done through banks is being done through Fintech or is that too harsh of characterization?

Klein: Well, I'm not a huge fan of this term shadow banking.

Beckworth: Okay.

Klein: Because it implies something nefarious. I think words have tremendous meaning and power and shadow banking sounds like something I don't really want. Part of the problem is that our lexicon has not kept up with reality.

Beckworth: Okay.

Klein: We have a lexicon in which we use the word bank interchangeably between commercial banking and investment banking. Which used to be different businesses segregated. You could not have a commercial investment bank. They had to be separate. We changed that in Gramm-Leach-Bliley in the late 1990s, the so-called repeal of Glass-Steagall which separated commercial. But our lexicon now just refers to these things as a bank. So if I say a bank, do I mean Morgan Stanley or Goldman Sachs as a large investment bank or do I mean wells Fargo or US Bank, which is a large commercial bank or do I mean somebody like JP Morgan Chase or Bank of America, Merrill Lynch that does both? We don't know because we use this term banking interchangeably.

Klein: The term shadow banking tends to try to mean the intermediation of funds, not through the formal banking regulated system, either regulated by the Federal Reserve or by the SEC. Often that means hedge funds, private equity, financial technology firms that are not part of banking. Let me try to offer a different way to touch the same question, which is that America is a separation between banking and commerce. This is not always the case in the rest of the world. If you ask most Americans, what's Mitsubishi? They say a car company. But you and I think of Mitsubishi as one of the largest banks in the world. So in Asia and other places, banks run lots of other commercial companies, not in America. In America, we separate banking and commerce.

Klein: On the side of banking lies the payment system. That's been the case in large part because banks are very efficient at running a payment system and payment systems network where you keep money and is logical to put payments with banks. That's not actually related to the legal separation of banking and commerce. Legally, banking is tied to the taking of deposits from people and the making of loans and a series of charters and regulations, federal deposit insurance. Payments can be operated by banks or non-banks. You don't have to be a bank to run the payment system. What some of these new financial technology firms are doing, and it's really fascinating, is they're bundling their services in payments and the provision of credit. And what you're finding is payments is starting to [be] encroached upon by the commercial sector and the commercial sector when they're making payments, they're beginning to realize as a payment processor, I have certain informational and financial advantages in which I can lend you my own money. In banking, you're lending someone else's money. Lending your own funds is called investing.

Klein: Take a firm like Square. We've all seen those Square readers. Square has a program called Square Capital where they make loans to new businesses. Businesses could be in business as little as three months secured by your cashflow. They take a percent of every swipe you make from your square and they'll lend to you on that. And they have great information. They don't need to see three years of your records because they've seen in real-time the last six months of your credit card sales on their platform. So on the one end they're filling this gap, which is fantastic. But what are they doing? They're lending money on the basis of a payment system that's somewhat secured.

Klein: Technically, we'd call it an unsecured loan because it's just a promise to repay. But since you're using their platform, they take the money every day, every day they take a certain percent of your swipe. On one end I think this is great, on the other end, this is lending occurring outside of the banking system. It would meet the traditional definition of shadow banking. But it's a reminder about how the payment system is more up for grabs between banking and commercial companies than people truly appreciate.

Beckworth: That's very interesting. It's a nice segue into the core issue we want to delve into today. And that's the payment system. You've touched on some of these fintech firms that are providing payment systems. You mentioned Square, I mean Apple Pay, Google Pay, Venmo, PayPal. There's some other ones.

Klein: There are, although I'll put out Apple Pay is just your credit card in digital form. That's all it is, is Apple providing an easier physical way to access your credit. And I've been stunned as an Apple Pay user. I thought to myself, how much easier? Well, your phone tends to be in your hand. I can't tell you. I take my kids to McDonald's after a soccer game and they're grabbing my arms this way or that way. Trying to physically reach into my wallet to open it up and put in a credit card and have the joy of sticking it in the chip thing and watching chip malfunction. Versus just hitting one click because my phone's already up because I'm texting with my wife about where I'm going and then click, click. And Apple extracts 50 basis points. A half a percent are tacked onto the swipe fee.

Klein: McDonald's agrees to essentially give Apple half a percent of the transaction in exchange for that on top of whatever they're using on their credit cards. But it's often, I've seen even financial regulators say there's a difference between different ways of accessing the existing rails of our system, like the credit card rail, versus building a new or different rail, like a set of digital wallets. If I PayPal you or Venmo money from my Venmo account to your account not touching the underlying banking system, then we've transacted in a very different way.

Beckworth: Okay. Why don't we begin with some definitions for this discussion of real-time payments. What does it mean when we say real-time payments?

Klein: That's a fantastic question because it's important. To me it means that the money moves from my account to your account where you have access to that money in a reasonable number of minutes. Ultimately real-time would be instantaneous. You think of email as real-time communication. It can take a minute or two to go through the system. People can get hung up on how many seconds something's lasting. Today if I write you a check, by the time you cash it or deposit it even on your phone and it goes through the bank, you may not have that funds for three, four, five days. And if there's a weekend or a holiday, can stretch out two a week. That's our incredibly slow and antiquated system. In a real-time system, the money is sent, received and available for use. And the key to me is available for use. Even if the funds don't actually settle between our two accounts. As long as you are credited with the money and you can use it in a reasonable number of minutes, then to me that satisfies the definition of real-time.

Beckworth: Okay. And you've written a lot on this, so we'll have some of your pieces up, including a recent article about China, which has a real-time payment system. So help us understand why we are so behind and give us some counter examples like China and other parts of the world.

Klein: In 2007, the Bank of England adopted a real-time payment system. England said, we're going to take our banks. We have an antiquated system, not too different from America’s system and we're going to update it and the technology was there. Mexico had done it in 2004 and we're going to give a real-time payment system so that the funds transfer immediately. Why is this so important? Well, here's a fact. Friday is going to be August 30^th. if you get paid at the end of the day on Friday, August 30th and you take the money into your bank, it can take you four or five, six days before that money's available to use. Remember first Monday in September is Labor Day. So the bank can hold, even if you're a good customer, the first $5,000, even if you're a longstanding customer, the first $5,000 can be held for three business days. Which if Friday, if you're there at the end of the day could mean Tuesday, Wednesday, Thursday. It's not your money there for the next Friday. What are you going to do?

Klein: September 1st is rent, utilities, child support, car payment. All the other costs of life are coming due. How do you bridge that gap? Now, if you're one of the 50 percent of Americans who live paycheck to paycheck, this is a real issue.

Beckworth: It's a big deal.

Klein: If you're in the other 50 percent and there's always money in your account, you don't notice the delay. And I think there's one reason why policy makers have failed to notice this. In addition, over time this issue has gotten worse because the instability of income has grown, variants of wages have gone up, people are cobbling together multiple jobs, family structures have changed. So the system has grown more pernicious because how do you handle this gap? I'll tell you how people handle the gap.

Klein: One, they go to payday lenders. Payday lenders will front that money. Every payday loan is secured by a bank. Somebody who has a bank account. $25 billion are spent in payday loans. Two, you take them to overdraft. You know what? The check didn't clear in time or I thought it was coming through and it didn't. I thought it was going to be there by Friday and it got held up until Monday and over the weekend I spent things. 35 bucks per bank overdraft. In the aggregate, $35 billion a year go to that.

Klein: Now, I first got turned onto this in 2016 when after taking my kids ice skating, we go to our local bank, I put a little money from their piggy bank into their savings account and I do my own banking business. It was a Saturday morning and there are two women in front of me in line and I was waiting while one woman was trying to deposit a check at the teller. I hear her and the teller. She starts yelling at the teller, "What do you mean this isn't going to be available until next Thursday? Well, but I have bills to pay. Well, how much is that going to cost me if I'm out of my money?" "Thirty five dollars?" "What, was that just for one?" "No, it's for each bill?" And she's yelling and yelling at the teller and the teller saying, "Look, I'm sorry. This is how the system works."

Klein: I thought to myself, this is really interesting. And what blew my mind was what happens next, which is that the other woman in the line walks up to her and goes, "I can help you. Here's what you do. Leave the bank, go around the corner and go to the check casher, come back and bring cash." The woman goes on to the teller, "When's the cash going to clear?" She goes, "Instantly." The woman goes, "Oh my God. Well, thank you so much. You've saved me so much money." I thought to myself, she really has. She's going to go to the check casher and probably spend about 20 bucks. For one overdraft, that saves her $15. I know for a fact she had at least two. That's going to save her 50, maybe more, and it blew my mind.

Klein: People spend seven billion dollars a year cashing checks. The common narrative told is they're not banked. Well, the FDIC says seven percent of Americans are unbanked, but roughly three times those number of Americans are underbanked. Underbanked being defined as using a check casher, using a payday lender or using an international wire money transmitter. So you have three times as many people. So what are they doing? Well, the next narrative here is, well, the banks’ branches aren't convenient. Well, there's a woman sitting in the bank branch. Well, the hours are bad. Wait a second. Saturday morning she's physically there with their check and I'm watching her. Then the third thing you say, well, “Aaron, this is an anecdote. How prevalent can this be?” I flip it to you and say the following, "There are three people in a bank branch on a Saturday morning. One person has the problem, one person knows the solution and the third person says he's a banking expert."

Beckworth: So some of these cash checking businesses maybe filling a niche because the payment system itself is so antiquated. You were recently involved in a debate online with, my organization had a symposium on real-time payment systems and one of the participants, Jim Angel of Georgetown, he had this saying, I think it speaks to what you're ultimately getting at. He had this line that I found really, really on point. "The Fed operates on 20th century east coast banker hours." It's system, which is the highway I guess, the infrastructure behind this. Is that what drives the fact that that lady can't get her-

Klein: A hundred percent

Beckworth: Okay.

Klein: A hundred percent. She's sitting there on a Saturday. The Fed system closed. In fact, the Fed system last would've processed her batch in the same day if she'd shown up before 10:00 AM (1:00 PM Eastern, 10:00 AM Pacific, 8:00 AM Alaskan or Hawaiian. So forget that, right?) And on a Saturday, by the way, Monday was a holiday. So the Fed system was next going to open on Tuesday. And there's no reason for that. As I said, the Bank of England had technology in 2007 when the first iPhone came out. And here we are sitting here 13 years, I have an iPhone XR, we're in the 10th generation of smart phones and the Fed system has barely adapted. You can think about it that they're running maybe cassettes, maybe they've upgraded from a track to cassette or CD and the world is streaming. That's what's causing this woman's problem.

Klein: Now, a group of banks have created an actual real-time network because they appreciate the fact that they don't want to be the taxi medallions in an Uber world. As I said, non-banks are starting to fill this payment niche. This woman has a real problem. Her problem was solved by going to a check casher. Her problem was solved in a way that causes billions of dollars. And let me add up the numbers for you, because I think they're staggering. 35 billion in overdraft, 25 billion in paydays, 7 billion in check-cashing. So, that's $67 billion a year. Let's say that real-time payments solves 20% of those costs. One out of five. That's, I would say, a conservative estimate. That's $13 billion a year that would be saved by lower income people. These are people by definition that are out of the money that instead are going to profit. And this is a pure profit.

Klein: Sarah Van Hollen, at this Senate hearing yesterday, pointed out this news article that showed that TCF bank CEO named his yacht, Overdraft. That's where these fees are going. That's $13 billion a year. Suppose America had done this when England did it. That's 12 years ago. You're over $150 billion of wealth that would have been kept in the bottom half of the income. So one of the reasons my research has started to focus more and more on this and become more passionate is I think this is an income inequality issue. The lack of real-time payments doesn't cost people with money anything. It doesn't matter when the check clears to the top half of the income distribution; to the bottom half of the income distribution, you're talking about tens of billions over time, hundreds of billions of dollars that have been taken.

Klein: I believe that the growing income inequality is number one, deep rooted economic issue that faces our country and our democracy and people of different sides of the political aisle can have radically different perspectives on what government's role should be in terms of addressing the growth and income inequality. We shouldn't… Taxes, spending, investment in education, skills training. These are big picture issues. I have never seen anybody that says the government should run a payment system that exacerbates income inequality by creating a slow and inefficient technology that makes it expensive to be poor. I've never seen anybody defend that system. That's the system we have and if we fixed that, we can have a meaningful impact on income inequality without raising taxes, without spending, without waiting 12 years for teaching skills to come through.

Beckworth: Well, let me ask this question. Why has it taken so long? Because now we're going to get to, in a minute, discussion about the Fed's recent proposal to do its own real-time payment system versus the clearing houses real-time payment system. But why has it taken so long? And again, going back to that Angel quote, "The Fed operates on 20th century East Coast banker hours." I mean, there's the jokes about, maybe 20 years ago about the bankers, they go in late, they leave early to go play golf. It sounds like that same culture echoes to this payment system or reflects in it.

Klein: It's interesting. At the beginning of my career it wasn't so. The Fed was on the forefront of advancing our payment system for a reason that you would never guess: 9/11. When the payment system used to require planes to fly around, paper checks to be physically processed. And that was pretty outdated technology. We spent about a billion dollars a year flying these planes around in the year 2000. 9/11 happened and the planes were grounded for a week.

Beckworth: Were these Fed chartered planes?

Klein: There were two systems. There was a private system in Ohio and a Fed chartered system.

Beckworth: So pilots actually worked for the Federal Reserve System. Wow.

Klein: Well, I think there was a subcontract.

Beckworth: Okay.

Klein: Exactly. And the Federal Reserve would have a set of… and they would fly around.

Beckworth: Interesting.

Klein: And if you ever wondered what happened when you got your great aunt's birthday check and how did it make it back to her bank statement in California a month later, these checks were getting, were flying all around the country. 32 payment processing centers the Fed was operating. When 9/11 grounded the planes for a week, the Fed did some very creative and important things to keep the float in the system. Banks didn't really know where their balances were because there was all this money outstanding, and how did you clear this? They sent forward to Congress a proposal and they said, "We got to be able to take, to email pictures and send these checks and digitize these checks." We worked on this in a bipartisan fashion in Congress. We passed legislation the Check 21 Act and it is why today you can deposit your check on your phone. At the time, we didn't even envision that as a possibility. When we passed the law, we just merely thought you'd be able to put it in an ATM and you'd have that technology.

Klein: One thing we didn't do in that law that we should have is we didn't require the Fed to reduce the whole time that you have. Here's an interesting fact and one that I think is core to the debate we're about to have on how the payment system should be modernized. Under existing law, the predated, the Check 21 Act, it's called the Electronic Funds Availability Act from the '80s. The Fed has the authority to reduce bank holding times of year payments to as fast as technology allows. There's a maximum amount that you can hold a check and then there's a catch-all authority. Very common in the way our regulatory system works, which is the regulator can keep up with technology. In fact, should. When we were talking about reducing check holding times in the Fed's proposal, they said, "Look, you don't need to tell us that because we already have the authority to." So it just requires a study. What happened? The Fed modernized their technology so we don't fly these checks around.

Klein: Almost all checks are digitized and emailed. I think that's a great win for society. I'm an environmentalist. We don't need planes damage the environment. We don't need to fly paper checks around the country. But the Fed didn't prioritize passing those savings along to people. They get the float kept in the banking system and that is extremely pernicious to lower income people. I don't think they fully understand that. And to this day, I don't think they fully appreciate that because if they did, I would like to think they'd have the same passion on fixing the issue given the statements from Fed leadership about the problems of income inequality in America. So you had a system that used to be on the vanguard of this 20 years ago. They made an improvement and now they don't. Now, why don't they? I think they have a system that works and they're deathly afraid of having a new system in case there's a problem. It's like modernizing your stereo system.

Klein: Well, works well enough. But what the problem is, the payment system works well for the people who have money. It doesn't work well. It is deeply dysfunctional for those who approached the zero lower bound of their bank account. That's the constituency that we ought to be responding to. But it's not the constituency that's before the Federal Reserve. Before the Federal Reserve are the people that operate the system, the banks that profit from the float, the existing employees that manage the existing system that can tell you a thousand reasons why we shouldn't modernize it. Structurally, I blame the Fed for this.

Klein: Years ago when this was first ratcheting up, the Fed formed a faster payments taskforce. You may be familiar with this. It named 332 people to this task force. Now, in the history of humanity, have 332 people ever gotten together to figure out how to do something faster? Only in a Kafka novel. Would the protagonists create a 332 member task force with the goal to do something faster and everybody sits around and nod and goes, “well, this is a step of progress”…? No. Shockingly, after multiple years the task force didn't figure out how to do anything faster and had principles for how someone else should figure out how to do something faster. And three years and $50 billion of fees later, lower income people were left with the same system.

Beckworth: Well, now this issue's become a hot topic. One reason I've brought you on this show, it's been a lot of discussion. There's a bill that's been proposed by Senator Elizabeth Warren and some of her colleagues in Congress. But also what's made this very topical right now is that the Federal Reserve is proposing its own real-time payment system, it's taking comments right now as we tape the show. But what I guess makes that even more interesting in itself is that the clearing house has its real-time payment system already set up. And my understanding is it was set up in 2017, went online then, it's not fully connected in that not every bank, every account is connected yet. They're working on that. And there's some tension between those two developments, the clearing house. So maybe walk us through that story. Who is the clearing house? Why were they interested in getting into real-time payments in the first place? And why is the Fed now joining the party?

Klein: It's a great set of questions. Number one, the clearing house was America's central bank when America didn't have a central bank. So students of this podcast will recall the Federal Reserve is America's third attempt at a central bank, set up in 1913 because the prior central bank was politically unpopular and killed by President Andrew Jackson. Well, in-between the second central bank and the third central bank, banks had to clear payments between each other. So a group of big banks, big at the time, set up a house to clear each other's payments. And that house was called the clearing house. That functioned as the central bank for a long period of time through the 1860s, seventies, eighties, the banking panic of 1907, which is credited with creating the political will to create a central bank. This was the end of declaring that. They maintained private clearing of payments and they and the Fed have traditionally operated the two largest payment systems in the United States to this day. The clearing house is owned by essentially large banks, what today are considered the largest banks.

Klein: As I said, this technology issue about America's loan payment wasn't new to them because they saw England developing this system in 2007. The entire continent of Europe has rea-time payments. China, Japan, Mexico, Poland, South Africa. If you go around the world, we are the outliers. And if you look at the growth of technology and the tipping point phenomenon you've seen, payments could be up for grabs. And they said, we've got to modernize our system before somebody else comes along and Uber-izes this important situation. As I pointed out in China, they don't use banks for retail payments. They use WeChat and Alipay, their version of Facebook and Amazon and digital wallets that transmit money instantaneously without going through payment processors or banks at all. They developed this system and they've started rolling out the system. Any bank can join the system. There are 5,000 banks – you can imagine how, if I send you money for it to go in real-time, both our banks have to be part of the same system, so there are a lot of possible permutations.

Klein: The Fed has been studying whether or not they should build their own system. And let me just give one piece of technology predicate, which is, to build a real-time system you can't just advance your existing old system. It's like moving from tapes to CDs or CDs to MP3. It's a new technology. You have to build a new system from scratch. You can't just jerry-rig your old system to take these new technologies. That's just given. So the Fed has to either build a new system or not.

Beckworth: Aaron, let me ask this one question. What is the Fedwire and how does the Fed work?

Klein: That's a different. The Fed's payment system that connects to banks to banks on that is ACH. The Automated Clearing House. That's where our checks and payments go through.

Beckworth: And that's the Fedwire, right?

Klein: Fedwire is a separate system.

Beckworth: Okay.

Klein: That is more commercial banks, retail, investment banks, larger sums of money, not individual payments. For example, when you buy or sell stock, it takes now two days for that actual transaction to settle and close. It used to be three. Those large institutional funds...

Beckworth: Like a quicker clearing. Okay.

Klein: Well, this is even slower. Fedwire works nine to six, Monday through Friday. One of the lowest hanging fruits the Fed could do is make Fedwire just go 24/7. That's a system where you could just keep the lights on-

Beckworth: Just turn up the volume.

Klein: ... and operate it over the weekend. You don't need to actually build that system.

Beckworth: That would benefit commercial business-

Klein: Financial transactions.

Beckworth: Right, transactions. Okay. But we're focused on the-

Klein: Retail.

Beckworth: Retail level. Okay.

Klein: We're focused on your direct deposit. A lot of people mistakenly assume direct deposit means instant. When you get paid, if you're paid by direct deposit, your employer is sending a note to their bank, descend a fund directly to your bank that goes through the ACH system. That can take-

Beckworth: Which is automated clearing house.

Klein: Which can take days depending on when those notices go through. Some people may notice, depending on your employer, that your paycheck doesn't hit the same day every couple of weeks. That be can be because of these different timing delays.

Beckworth: So the Fed's ACH is where the core issue, the core problem lies.

Klein: Correct, correct.

Beckworth: It's antiquated, it's 20th century, it just needs to be updated.

Klein: It needs to be rebuilt from scratch.

Beckworth: From scratch. Okay.

Klein: The Fed can do one of a couple of different things and the Fed has been like Hamlet. “Should I build a system, should I not? I don't know.”

Beckworth: Nice analogy.

Klein: The Fed's last request for public comment closed 208 days ago. I submitted my 19 page comment letter. Comments were due 208 days ago. They've gotten however many comments they want there. When online, you can read them all. And for 208 days they've wondered, “Should I do this, should I not?” By the way, this is 12 years after the Bank of England did it. The Fed's 332 member faster payments task force set a goal of having real-time payments in America by 2020. They didn't tell us how to get there because 332 people can't. But they said we should have a goal of 2020. They did this years ago when that seemed so far out, who could possibly imagine we'd be that behind? Fed Chairman Powell in his most recent congressional testimony when asked by Congresswoman Pressley, “Will you meet your goal?” … Said “No.” So the Fed will not have a real-time payments program in operation by 2020, 13 years after the Bank of England. Years after the Fed zone task force set that as imminently achievable goal that all 332 people thought we could get to.

Klein: What is this Van Hollen, Warren, Congresswoman Pressley, Congressman Garcia put up the house companion? What does this bill do? This bill does two things. The first thing, which I think is the most important is it says, your funds have to be available immediately. It mandates real-time payments today. By taking that existing legal authority from the 1980s law that the Fed doesn't use. The Fed could mandate real-time payments today and it mandates it for them. The second thing it does is says the Fed needs to build its own system. Let's put that aside for a second, because what would happen on day one?

Klein: On day one, a bank would have one of two choices. The bank could make your funds available immediately and settle through the existing system. When the bank gets the notice that your direct deposit is coming, it knows the money's there. Gets the information with the payment, here's how much money your employer's giving you, and then it has to wait for the money to show up. They can give you the money. Different credit unions, some commercial banks give people immediate access to their funds. And again, we're talking about customers who've been there for at least six months in the first $5,000. So we're not talking about somebody who walks up and says, “Oh, look at this check. It's for a million dollars, can you give me a sack of money? I want to leave.” We're talking about our customers and their first sets of money. If you're lucky enough to have a check for over 5,000, most people are not. Then wait for the money to come for a couple of days. That's option number one.

Klein: Option number two is they can join the real-time payment network that's already available and settle the funds immediately.

Beckworth: The one built by the clearing house?

Klein: Yes.

Beckworth: Okay.

Klein: If the funds are coming from another member of that system, remember it takes two to tango, so those would be their choices while they wait for the Fed to build a system. But that's what solves the problem. What solves the problem is it’s “Who builds the system?” What solves the problem is having immediate access to your funds. Some credit unions and some banks provide immediate access today. There isn't really much settlement risk in this process. What that would do is it would canalize bank overdraft fees. The CEO of TCF banks, Dahl, wouldn't be named Overdraft. It would probably be a lot smaller.

Beckworth: Okay. Well, we're running out of time. I want to ask, what do you see as the next steps? And I want to mention to our listeners, we will have on our webpage the symposium that Aaron and George Selgin and Jim Angel were a part of as well as some of Aaron's other work because there was still this ongoing discussion about next step forward. But I want to hear your next steps forward.

Klein: If I were in charge of the world, my next step forward would be for the Fed to put out a new regulation under section 402 of the Electronic Funds Availability Act, their existing legal authority that says everybody gets real-time payments tomorrow. And the Fed could do that. I don't think they will and they won't because their own system couldn't comply with it and the Fed will not regulatorily do what's required under the law keeping pace with technology because they're conflicted as an operator of an antiquated system. Imagine if Congress told the Fed, you have to play music in the most efficient way technologically possible, and the Fed said, well, my six CD changer works pretty well, so I'm not going to require anything more advanced than a six CD changer while I debate: “Should I buy, should I get Pandora? Should I get Spotify? Should I get Apple music?” I'm going to think, I'm going to debate, debate, debate. It's been 208 days since they asked the entire universe, what system should I get or should I get a system?

Klein: Legislatively, I think there's a lot of momentum that's starting to build in Congress to address this system. The Fed, I think, eventually will announce its decision whether it will build its own system or whether it won't. What I fear is that in the debate about whether the Fed should build a second system, we're losing sight of the real problem, which is that people need access to their funds immediately and the simplest Occam’s razor solution, which is give it to them.

Beckworth: So Aaron, in that symposium where you, George Selgin, and Jim Angel were discussing matters, George raises a couple of observations. I wanted to get your feedback. First, he mentioned in this question of whether the Fed should set up its own system. That if it does go ahead and do that, it might impair the progress of the existing ones set up by the clearing house in that if I'm a bank and I know the Fed is going to set up a new system, I might wait and not join the existing one. And again, to make the existing one work, you've got to have everyone on board. So what do you say about that?

Klein: I think George has a very fair point. And I take George's point especially strong because whatever timeline the Fed says that they'll have their system up and running if they choose to build one, I add two years or maybe double their projection. We're all used to, whether it's the government or whether it's the contractor in your home. Deadlines tend to fall. I think the worst outcome is the Fed promises to build a system in four years, it takes them eight years. They don't increase regulation. Banks don't want to join the existing system and we have another decade where hundreds of billions of dollars is sucked out of working families in fees because of an antiquated payment system. So I think George has a very real and credible point. Part of the reason why I think my solution in the solution, in the proposed legislation addresses George's point is it requires the funds to be available immediately and then banks can have this choice.

Klein: Banks could choose an antiquated slower system if they like it for whatever other reason and just make the funds available. There isn't much of a cost in that process. Right. I'll give an example of how big a problem this is. Wells Fargo, as part of its mission to rehab its image, launched this thing called Operation Rewind. Which says, if you get an overdraft and 24 hours within the next 24 hours your direct deposit hits, which is a small sliver of the type of people we're talking about. Like you got paid, it just takes a day. We'll rewind and pay you back your $35 or however many overdrafts you got. Through operation rewind, their first quarter in their earnings call, they had a note, $73 million of less profit as a direct result of operation rewind.

Klein: Another couple other aspects of rewind of notification. That's a quarter. It cost one bank $73 million for just these 24 hours and only a direct deposit. By the way, people get paid in a lot of different ways. One point I wanted to make as this delay on the payment system can amplify for working people. Remember the story I told you about the person who gets paid on Friday, August 30th but the money doesn't hit their account? I talked about what their bills might be due on the 1st? What if they had a child support payment, and the child support payment gets automatically deducted when their money becomes available? So there are seven days and then it gets deducted on that following Friday and then it doesn't post to the other parent who is in charge of the kid until the following Monday or Tuesday.

Klein: These delays compound on each other in the real lives of working people. So now you have a single mom waiting on two different sets of bank delays until she can get her child support payment. In the interim, the kid has to eat, and they again need school supplies. How are people bridging this gap? Very expensive means.

Beckworth: So we must find the quickest, straightest path to immediate access to real-time payments. All right. Second question that George raised in his discussion with you was the question of ongoing innovation. How do you build a real-time network that has competition and incentive to innovate so we're not stuck with the eight track like we are with the Fed system?

Klein: It's a very good question, in fact, one of the things the Bank of England has done that's quite interesting. They're now leapfrogging us again and again, is they've started to open their payments system to non-banks. So I think transfer-wise, who provides international money transmission has now finally gotten rights to plug into the system and use the system. So there are people who have questions about who owns the system and who's going to be the most likely to innovate. There are areas where government can be incredibly innovative. There are areas where government can deeply lag the private sector. There are areas where government can provide a technological platform for others to integrate. Like GPS, I think is one of the greatest innovations in my lifetime. Those satellites were government satellites.

Klein: But it took, and I think the Clinton administration should get a lot of credit for this, it took their decision to open up their technology, which was defense based and proprietary. There were people in the room saying, “Don't open up GPS to commercial operations. What about the Chinese and the Russians? This is secret, we have to keep it secret and keep it closed.” Imagine if they'd won the debate? Think about all the platforms built off of GPS.

Beckworth: I'd still be using a map.

Klein: And you wouldn't have Uber.

Beckworth: Right. That's true.

Klein: I mean, all these other innovations that require GPS inside of it to work. So I think payment has that capability of transforming other aspects. Because if you think about almost any type of commercial activity, it requires a payment. That's why it's commercial. Electronic payments took a leap forward when eBay solved some of these online verification situations through PayPal. You couldn't have eBay, you couldn't have these online auctions unless there was a secure way for us to give money and a way for me to have rights of recourse in case you don't deliver the good that I bought online. So these trust issues. A payment system is in this way, this core underbelly of modern society and continuing advanced payments.

Klein: Now, the Fed to its credit, did a big advance in this Check 21 Act, which they proposed and Congress enacted, and they adopted so that we can deposit our checks from the convenience of our home. But they didn't then go the next step and give us the actual money so that people get these emails. I don't know if you've ever gotten it, your deposit has been approved?

Beckworth: Yes.

Klein: That doesn't mean your money's there. It just means that you clicked the buttons the right way. When the CFPB did a study on banking, what makes people upset about their banks, and they looked at complaints they'd received, the number two complaint by all Americans about their bank was real-time funds availability from this email about remote check deposit. Because what happened, people went out and got an overdraft because they thought their money was there because you get the email, it says your deposit has been approved. They didn't read the fine print, approved for processing. Because how could we develop a system where I can deposit a paper check through a cell phone at 3.00 in the morning from my house and get an email back saying it's been approved, and the money's still isn't there for four days. That's insane.

Beckworth: And real-time payment will solve that. With that, our time is up. Our guest today has been Aaron Klein. Aaron, thank you so much for coming on the show.

Klein: Pleasure. Thank you for having me as a devoted longtime listener, first time attendee. I'm looking forward to this and hearing what else is in store.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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