Cost reductions in electronic payments: The roles of consolidation, economies of scale, and technical change

Unfettered nationwide bank branching raises the issue of whether consolidation of banks' ''back-office" operations, such as their payment processing, reduces operating costs. Whether centralized processing of payments reduces costs depends on the size and range of scale economies, the relative prices of data processing and telecommunication inputs, and changes in technology in addition to the number of sites operated. While consolidating payment operations into fewer sites may reduce average data processing costs, these cost savings may be more than offset by associated increases in telecommunications expenses. To investigate the potential effects of consolidation on future banking operations, we look at the experience of the Federal Reserve in consolidating its Fedwire electronic funds transfer operation over 1979 to 1996. Previous research suggested that scale economies in Fedwire payment processing were minimal and that the observed declines in average Fedwire production costs were largely attributable to technical advance. Our estimates suggest more nearly the opposite. We find that the Fedwire funds transfer operation exhibited large scale economies but little technical advance beyond that already embodied in the technology-adjusted input prices of data processing and telecommunication inputs. We also find that the consolidation of Fedwire into fewer offices contributed around one-fourth of the overall reduction in Fedwire average cost. (C) 1999 Elsevier Science B.V. All rights reserved.