For financial institu­tions of all sizes, real-time transfers are likely to be a competitive necessity. But small banks must work out how to balance operational headaches with potential advantages.

It has been generally acknowledged that real-time payments can provide some significant benefits to financial institutions. But for smaller FIs, they come with some very real challenges.

Unlike the case with the current standard for automated clearing house daily payment fulfillment, supporting real-time or near real-time payments requires a true 24x7x365 environment. In addition, companies need to have the appropriate reserves on hand and the necessary staff to support real-time payments monitoring and administration.

It is important for smaller FIs to understand the true requirements, costs, and solutions associated with real-time payments adoption. Additionally, they need to know what is available now for real-time payments, and what could be coming down the road.

The Landscape

Today, real-time payment networks are being deployed around the globe. These networks allow financial transfers to occur in near real time, permitting a recipient to have access to funds transferred by a remitter within seconds of transfer initiation.

An important aspect of this process is that the recipient will have unrestricted access to transferred funds. What this means is that after a remitter has initiated a funds transfer, possession of those funds is controlled completely by the recipient. In other words, the remitter cannot recall them. What’s more, settlement of the whole transfer operation is immediate.

This capability contrasts sharply with traditional settlement methods, which delay settlement completion for hours or even days after a transfer.

This is a model typically followed by most funds-transfer operations. For instance, payments via checks or most wallet based payment networks are settled via the ACH network. Historically, ACH settlement files are swapped among FIs on a nightly basis. Until this occurs and the involved banks or credit unions have adjusted their internal balances to account for ACH transactions, transferred funds cannot be used by recipients without restriction.

The main reason recipients can’t fully take possession of the funds is that, until those nightly settlements have occurred, remitters can implicitly cancel the transfers. A remitter could, for example, write a check to a recipient and then simply withdraw all funds from the source account. Thus, the nightly settlement for the associated transfer will fail because there are no funds available to support it.

This basic remitter cancellation feature is part of many funds-transfer approaches that cause delays in settlement for a period of time. There have been some attempts to shorten the delays. For example, NACHA is offering same day settlement, permitting ACH settlement to occur on the same day as the transfer initiation. NACHA has also proposed an additional daily settlement window to allow multiple ACH settlement operations to occur each day.

However, despite these efforts, there is still a delay that could possibly result in interrupted funds transfers.

The RTP Network

Until recently, the only “true” real-time funds-transfer network in the United States was the Real Time Payments (RTP) network. Created and operated by The Clearing House Payments Co., which is owned by most of the country’s largest banks, this solution provides customers of member institutions access to RTP services. These include support for real-time transfers and payments with immediate settlement of all transfer operations.

Rather than directly using ACH settlement, RTP member banks instead settle among themselves using a common general ledger. This ledger is, in turn, supported by a common reserve account maintained by the Federal Reserve, to which all member banks contribute. Its members are required to maintain minimum reserve levels. If these reserve levels fall below a certain amount, additional funds must be deposited.

Since most RTP member banks tend to have large numbers of deposit holders, a sizable number of U.S. customer banking accounts can participate in the real-time payment capabilities it offers.

However, there is a significant number of accounts associated with smaller FIs across the nation that are not affiliated with RTP. For these customers, access to real-time payments may not come as easily. While RTP does offer real-time payment services to smaller FIs that partner with one of its larger member banks or authorized portal organizations, its outreach efforts have been marginally successful at best.

Unsurprisingly, many smaller FIs have reservations about joining a network operated by their larger banking competitors. Though RTP has offered assurances to smaller FIs to further entice them to join, many continue to be reluctant to do so.

FedNow

Recognizing the need to extend real-time payment services to all of the nation’s FIs regardless of size, the Federal Reserve last year announced the creation of its FedNow network. Initial estimates by the Federal Reserve suggest the network will be available by 2023 or 2024, though some industry experts have been skeptical of this timeframe.

The FedNow announcement was greeted enthusiastically by most smaller FIs, as the Federal Reserve is generally considered to be more of an “honest broker” or impartial operator of the payments network as compared to a private company or group.

This helped alleviate the concern that smaller FIs would be disadvantaged if they allied with RTP. However, though the news was positively received, some smaller FIs were disappointed with the four-to-five-year projected lead time before FedNow would be available. As a related correlation, RTP announced an upsurge in interest from smaller FIs following the Fed’s announcement.

Although FedNow seems to provide a promising path forward for smaller FIs, banks and credit unions with fewer resources will be challenged to take advantage of the services provided by the solution.

One of the key problems is the issue of reserves. All FedNow settlement will be real-time gross settlement (RTGS), not net settlement. This means that every single transaction will be immediately and irrevocably settled by FedNow.

This is a stricter process than net settlement, which permits a financial institution to be deficient in required reserves for individual transactions as long as proper reserves are available at the end of a specified settlement window.

Thus, each FedNow participant must monitor its reserve level on a constant, round-the-clock basis to ensure reserves are adequately maintained at all times. If an FI does not have the reserves, the FedNow platform will automatically fail the attempted transaction.

For those FIs not currently required to maintain reserve accounts with the Federal Reserve due to their size, there is also an additional consideration. For these smaller FIs, maintaining a reserve account to support RTGS would be a new operational obligation with additional costs to acquire and commit the necessary funds to cover the new reserve requirements.

Staffing may also be a major issue. Maintaining the staff to cover both normal banking hours as well as the additional 24x7x365 operations will present an increase in workforce and attendant training.

To fully accommodate the FedNow processing demands, these institutions must not only maintain 24x7x365 monitoring staff, they must also have the authority to refresh FedNow reserves if or when those amounts drop below certain levels.

Additionally, there are service expectations to consider with the extended hours. For example, does 24x7x365 operations mean that customer support will also be extended for related issues? FIs will need to decide how they will handle this from both a staffing and training angle.

Anticipating that this would likely be a burden for smaller banks and credit unions, the Federal Reserve is planning to allow participating FedNow institutions to designate service providers that can act on their behalf. These third parties will be allowed to submit or receive payment instructions as well as settle accounts of correspondent institutions.

FedNow regulators have not issued any rules or requirements governing the types of organizations that would qualify to be service providers and the type of oversight that they would be subject to by the Federal Reserve. However, these guidelines will presumably be updated as the availability date for FedNow approaches. Regardless of the regulations ultimately issued, smaller FIs that choose to outsource their FedNow operations will also incur the additional fees associated with it.

Another key concern with FedNow is its proposed interoperability with other systems, like the RTP network. While the Federal Reserve has confirmed this is a high priority for the network, it has also admitted to its complexity and that it may be difficult to have this functionality available during FedNow’s initial release.

In addition, though the Fed has suggested it is open to exploring solutions for true interoperability between FedNow and other payment networks, The Clearing House has expressed its intention to continue expanding RTP to minimize the need for FIs to sign up for FedNow. Smaller FIs will need to keep this interoperability conflict in mind as they consider their long-term real-time payments strategies.

Do They Need FedNow?

Ultimately, each community bank or credit union will need to decide if FedNow makes sense for its institution.

The Federal Reserve has indicated that FedNow participants will each be assessed a portion of the network’s overall operating costs so it can run as a financially self-sustaining platform. Therefore, regardless of the other FedNow issues that smaller FIs must address, there will be additional costs to offer FedNow.

For some FIs, these additional costs could potentially price them out of the network, especially if they have current services that may help provide a semblance of real-time payment capabilities. For example, some FIs currently offer same-day ACH services as their “real-time payments solution,” with the expectation that account holders will be satisfied with unrestricted access to funds if they can be available on the same day as payment initiation.

What’s more, this service could become an even more compelling option after NACHA adds the additional settlement window to its daily processing. Some smaller FIs may determine that “reasonably fast payments,” while not truly real time, are good enough.

It is easy to see how smaller FIs that position themselves as service leaders or innovators may view FedNow services as a marketing advantage, one that distinguishes them in their local markets. However, it is also just as likely that the more conservative FIs may only embrace FedNow if their customers or members demand the service.

The Future

Many of the challenges associated with FedNow are still conjectural. However, it does seem safe to assume that the Federal Reserve is monitoring issues that could diminish its capabilities—or attractiveness—for those FIs that may wish to access FedNow services.

For example, the after-hours liquidity to support RTGS has been suggested as a possible stumbling block for smaller FIs. This could be addressed in a number of ways. One idea would be to use existing reserve accounts as sources to replenish FedNow reserve accounts.

The Federal Reserve has indicated that it may allow existing reserve accounts that currently must be maintained by FIs to be used as sources of funds to automatically maintain the FedNow minimum reserves. If approved, this arrangement could help smaller institutions cover the funds needed for after hours FedNow processing.

Additionally, relaxing the current RTGS requirements for those institutions deemed “well operated” could also provide relief for smaller FIs. As previously mentioned, the Federal Reserve has confirmed that all FedNow settlement operations will be based on individual transaction settlement, which requires FIs to always have the reserves to support each individual transaction.

But the Federal Reserve already allows those FIs with good operating track records to incur “daylight overdrafts.” These overdrafts occur when a bank or credit union is allowed to withdraw more money than it has in its Federal Reserve account to make a payment with the requirement that the overdraft be corrected by the end of a processing day.

With RTGS adopted as the standard for FedNow, offering a “nighttime overdraft” would ease the reserve burden on smaller FIs by allowing their FedNow reserves to temporarily drop below the minimum required levels. For this to occur, however, minimum reserve levels would have to be reset within a specified period of time.

Due to the costs and complexity, many smaller banks and credit unions will be unable—or uninterested—in providing their own additional after hours staff for maintaining 24x7x365 operations. If the Federal Reserve still wants to attract these institutions, a key question becomes who will provide the needed support?

If the Federal Reserve ends up only allowing FedNow processing to be outsourced to correspondent FIs, then the situation becomes very similar to RTP affiliation. That is, smaller FIs will be forced to outsource at least partial operational responsibility to their larger competitors—something that FedNow has otherwise alleviated.

FIs of all sizes outsource various types of processing to outside companies that are non-banks. Fiserv, Vantiv, Jack Henry, and FIS, to name a few, perform several different types of payment processing services for FIs of all sizes. These organizations are not FIs and, consequently, are also not direct competitors.

In turn, it is not hard to surmise these, and similar organizations, will most likely offer after-hours FedNow processing services if the Federal Reserve allows it. This will certainly be a Federal Reserve consideration when drafting final FedNow rules and regulations.

A Question of Value

As mentioned, there is some debate on whether smaller FIs actually need the real-time payments capability that will be offered by the FedNow network. The short answer is some will and some will not. Frankly, many community banks and credit unions are not seeing much demand for real-time payments from their account holders. However, a truly national banking system should provide the same service opportunities to FIs of all sizes competing in comparable market segments.

While the RTP network can provide similar services to those proposed for FedNow, RTP is not generally perceived as a neutral network operator. Many smaller FIs have serious concerns about whether it will treat all its clients impartially.

Real-time payments networks are becoming increasingly available throughout the world. The United States is virtually alone in not having a national fast-payments network operated or directly supervised by its national banking authority. FedNow addresses this imbalance.

This is perhaps the greatest value of FedNow to smaller FIs; namely, it will be a neutral, trusted provider of real-time funds transfer services to all financial institutions, regardless of size. Because of this, many smaller FIs will see the network as an opportunity to better compete with their larger rivals in the world of faster-payment service offerings.

However, for smaller FIs, making the jump to implement these services may not be an easy process. Rather than adopting real-time payments processing for its own sake, community banks and credit unions must look to their own specific situations—their strategic business plans, pain points and accountholder needs before making a decision.

Only by understanding the true costs and impacts of issues like 24x7x365 operations and increased administrative complexity can they best choose the right path for their institutions.

—Jack Baldwin is chairman of BHMI, Omaha, Neb.