he Federal Reserve is poised to make some policy changes that will force many financial institutions to change the way they think about money. In an effort to reduce its cash handling costs, the Fed has announced its intent to introduce a custodial inventory program that will encourage FIs to hold currency in their vaults rather than shipping it to the Fed.

In 2006, it also plans to begin imposing fees on depository institutions that deposit currency and order currency from Reserve Banks within the same week, a practice it calls cross shipping.

Morris Menasche, Managing Director of the Americas for Transoft International, a provider of cash management software and consulting services, said the proposed changes "will force practically every financial institution to look at its downstream supply of cash and figure out how they can consume more of their cash inventories."

"The Fed is saying 'enough is enough,'" said Bob Blacketer, Director of Consulting for Carreker Corp., another provider of currency management software and consulting services. "It wants to get out of currency handling operations and focus more on policy making and risk management."

World View

The Fed's position is far from unique, Blacketer said. Central banks around the world are adopting a more privatized view of cash handling.

In Australia, the Reserve Bank has virtually exited the role of depository and distributor, leaving commercial banks fully accountable for cash on their balance sheets. As a result, three of the country's leading banks formed a shared utility called Cash Services Australia to provide currency transportation services for FIs.

In the United Kingdom, the Bank of England adopted a Note Circulation Scheme in which verified and sorted notes are segregated to specified NCS inventories, with banks receiving credit for balances placed in the NCS.

As a result, most British FIs began outsourcing cash handling operations or formed joint ventures with other FIs. Only one of Britain's largest banks continues to perform cash handling in-house, Blacketer said.

During 2002, U.S. Reserve Banks processed 34.2 billion notes at a total cost of approximately $342 million, according to the Fed. The number included 19.4 billion $5 through $20 bills, nearly 6.7 billion of which were followed or preceded by orders of the same denomination by the same institution in the same business week.

Most cross shipping, "probably 75% to 80%" occurs at the nation's 100 largest depository institutions, Blacketer said.

Based on the 2002 data, the Fed estimates that it could avoid currency processing costs of up to $35 million a year by cutting down on cross shipping of $5 to $20 notes, the only denominations that would be initially included in the new policy.

The Plan

The Fed's plan includes two parts. First, FIs will be allowed to transfer $5, $10 and $20 bills that they might otherwise cross-ship into custodial inventories. The currency will be owned by a Reserve Bank, even though it will remain at an FI's facility.

The second part is a proposed penalty of $5 to $6 for each bundle of cross-shipped currency in the $5 to $20 denominations. FIs would not pay a penalty for the first 1,000 cross-shipped bundles in a particular zone or sub-zone each quarter.

According to the Fed, the exemption will limit the impact of the cross-shipping policy on institutions that may not be able to justify investments in sorting equipment, and will help FIs deal with unanticipated customer demands for cash. To become eligible to hold a custodial inventory, an FI must commit to re-circulating a significant amount of currency. Participating FIs also must have facilities large enough to segregate the currency from their own cash.

It's possible, said Blacketer, that some large banks with well developed cash handling infrastructures may be able to provide cash processing services for smaller FIs and other customers, much as they have provided check processing services for years.

"Instead of a loss leader, they could break even or even make a small profit with their cash handling operations by providing cash products and services for customers like retailers, ISOs and credit unions," he said.

But Menasche said it may be difficult to eke profitability out of cash handling operations, particularly if transportation costs are included.

"More than anything else, this is a logistics issue," he said. "It's easy to underestimate the costs of transporting cash. They could end up transporting the same cash three or four times."

The good news for cash management software providers like Transoft, Menasche said, is that the proposed changes are driving an increased interest in their products.

"Our decision support tools can help financial institutions assess cash processing and transportation costs, and show them when it may be cheaper to send cash back to the Fed and pay a penalty," he said. "If they allow those decisions to become subjective and decentralized, they could get into serious trouble."

The ATM Effect

The tremendous growth of ATMs, from 200,000 machines in 1998 to some 370,000 machines today, has helped drive the increased demand for fit currency.

The Fed's proposed policy change could unduly impact FIs' ATM networks, particularly non-branch machines, according to Amy Dronzek, National Manager of Cash Vault Services for KeyBank.

"Most cross shipping of currency in our industry results from the need for currency fit enough for automation, such as for ATMs. Large scale need for this type of currency requires automated fitness processing to be cost effective, historically proven more cost effective in a centralized versus a decentralized environment," Dronzek wrote in a letter submitted to the Fed.

Some FIs will have to invest in more currency sorting equipment to support their ATM networks, Dronzek wrote. The alternative will likely be paying higher fees to ATM service personnel.

"If the armored courier companies obtain currency from depository institutions, then they will increase ATM service fees for the additional handling of the currency that will be required," Dronzek wrote, "as Federal Reserve currency is viewed as 100% accurate due to the state-of-the-art, high-speed currency sorting equipment which many depository institutions will be unable to afford."

In KeyBank's comment letter, Dronzek urges the Fed to exempt ATMs from the new policy.

"Enable depository institutions the opportunity for limited cross-shipping activity to support their ATM networks using a separate endpoint or other delimiter," she wrote. "This will minimize impact to the consumer by allowing institutions the opportunity to maintain existing ATM networks, especially those that are remote."

In its comment letter, Huntington Bank raised the possibility that "using re-circulated money that does not meet strict fitness levels could cause ATM downtime or additional costs for emergency cash transportation."

Alternative Approaches

Some FIs would like to see the Fed adopt an alternative approach.

In a comment letter, Greg Smith, a Senior Vice President at SunTrust Bank, encouraged the Fed to approach cash processing "in a similar fashion to check clearing and electronic payments types by helping to create a processing utility among the banks and armored carriers that would act as an intermediary between depository institutions and the Federal Reserve."

Jim Roemer, Senior Vice President of Cash Services for U.S. Bank, said in his letter that U.S. Bank is involved in discussions with other FIs to explore the idea of establishing a "cash clearing house," similar to Cash Services Australia.

"In order for the cash clearing house concept to be successful, the participating depository institutions will require some level of cooperation from the Federal Reserve," Roemer wrote.

In its comment letter, Wells Fargo also signals its intent to "proceed with the creation of a non-profit organization in conjunction with other financial institutions."

The Fed began a pilot of the custodial inventory program [in August 2004], with 14 pilot sites and 10 participating depository institutions. According to a Fed spokesperson, the pilot program will run for six months, however "the clock will not begin until the last pilot is set up," likely in September.

Original article: www.atmmarketplace.com/research_story.htm?article_id=20223&pavilion=99