Telecommunication Versus Processing Cost and The Consolidation of the Payment System

Diana Hancock
David B. Humphrey
James A. Wilcox

         The advent of nationwide banking raises the issue of whether consolidation of back-office operations reduces total costs.  Whether centralized or distributed processing of payments will be most cost efficient will depend on the size and range of scale economies and on the costs of inputs like telecommunications services and data processing.  Though consolidating operations into fewer sites may reduce costs as economies of scale are achieved, those cost savings may be more than offset by the associated increases in telecommunications costs.

        We use the experience of the Federal Reserve in consolidating its Fedwire electronic payments operations form 1979 through 1996 to estimate the extent of payments processing scale economies, technical change, and input substitution in the face of substantial changes in relative input costs.  Previous research based on cross-sectional or panel data extending over five years suggested both that the potential for realizing scale economies in Fedwire processing were minimal and that observed declines in average Fedwire costs were largely attributable to technical advance.

        Our estimates suggest more nearly the opposite:  We estimated that Fedwire has experienced large scale economies, but that the average amount of technical change was very small.  One possible reason for the difference is that we used 18 years of time-series and panel data.  Another possible reason is that our data processing and telecommunications input prices were already adjusted for embodied technical change.  Thus, we attribute technical change not to the production function that produces Fedwire output, but rather to the production function that produces the intermediate inputs used to produce Fedwire transfers.

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