Transoft International, Inc.

New Custodial Inventory And Cross Shipping Rules Bring Big Changes to Major Banks

A White Paper from Transoft International* – September 2007            

The American public has a love affair with debit and credit cards, and electronic payments in their many forms are a ubiquitous part of our culture and the U.S. economy.
Yet it is not time to count out cash just yet. Don’t forget that predictions of a cashless society have been floating around since the 1960s. But the facts tell a different story: over
the past three decades, the value of U.S. currency in circulation has grown dramatically - from $93.4 billion in 1977 to $783.2 billion in 2006. The number of pieces of currency in
circulation also has increased during this time - from 7.5 billion to 26.4 billion. 
 
At the heart of this enormous cash distribution network sits the twelve Federal Reserve Banks (often called “the Fed”). The main arteries are represented by the money center
and super regional banks, perhaps numbering fifty to one hundred and fifty of the largest financial institutions. With so many billions of dollars floating around, some people may
think that it the Fed’s job to store all of this cash and dole it out as needed. But in reality, the Fed essentially exists for three purposes: 1) manage the quality and integrity of the
nation’s cash; 2) remove bad (commonly called unfit) and counterfeit currency from circulation; and 3) supply good (commonly called fit) notes for the banks’ and ultimately
the public’s use.
 
Day in and day out, the Federal Reserve Bank cash offices keep the money flowing - receiving, counting, and processing currency from and paying out currency to depository
institutions. The Fed ensures that cash is readily available when and where it is needed, especially during times of crisis, and that the public is confident that currency supplied by
banks and merchants is genuine. Over half of the banks, savings banks, and credit unions in the United States work with Federal Reserve Bank offices for their cash needs, while
the remainder work with the Fed indirectly via correspondent banks that use Reserve Bank cash services. In 2006, the Reserve Banks received and processed 38 billion notes,
destroyed 7 billion worn notes, and paid out 39 billion new and fit notes.

It is important to reiterate that the twelve Federal Reserve Banks were not designed as storage repositories of large amounts of cash that actually belong to the banks. Yet, for
many decades, the largest banks have used the Fed for this purpose. These mega banks have ‘Money Desks’ and ‘Vault Departments’ specifically dedicated to maintaining
enough cash on hand to meet federal regulations, along with being tasked with managing their cash in transit and the daily balances in their Federal Reserve accounts. Becky
Stanton, Vice President at Los Angeles-based Union Bank of California and Manager of their Monterey Park Cash Vault, explains that “cash on hand is a non-earning asset so the goal of every bank is keep their cash balance in their vault as low as possible at all times.” Michael Lambert, Assistant Director, Division of Reserve Bank Operations and
Payment Systems at the Federal Reserve Board, adds that "the opportunity cost of holding excess vault cash is the lost income that an institution would otherwise earn from
investing those funds. When an institution deposits currency into a custodial inventory, it receives a credit to its account at the Reserve Bank. That institution can then earn a
positive return on those funds by lending them to another institution, such as in the federal funds market."
 
Another important issue to consider besides the interest bearing aspect of this massive movement of cash from the banks to the Fed is the fact that the banks have long asked the Fed to be responsible for the onerous task of sorting/determining fitness/bundling denominations and sending fit currency back to the banks when ordered. Unfortunately
for the Fed – and the American taxpayers – this activity known as cross shipping is very expensive and inefficient. The Fed had tried the ‘carrot’ approach for many years with
strongly worded recommendations that were essentially ignored by the banks because they were receiving these services for free. Lambert notes that “back in the 1990s we did
not have very good tools in place to monitor cross shipping, but increasingly it put a strain on our resources. When we put better vault cash management tools in place, we
could more closely measure cross shipping volumes.” Mark Mullinix, Executive Vice President and Product Manager of the Fed's National Cash Product Office in San
Francisco, states that “we have no intention of getting out of the cash business; it is just that we are trying to curtail the overuse of essentially a free service.” Bo H. Holmgreen,
president at Transoft which is a leading provider of currency supply chain management solutions, agrees “the Fed was never designed to be a vaulting or sorting service for the
banks and these ongoing cross shipping activities have really grown to become a major issue of the Fed.”
 
By some estimates, approximately fifty banks were accounting for about ninety percent of cross shipping activities. Working closely with these major players, the Fed developed
new policies and procedures designed to reduce the use of Federal Reserve Bank cash-processing services. This ‘stick’ approach entails fees. Stanton, who worked at the Fed
for seventeen years before moving over to Union Bank, points out “that the new rules went into effect in July of 2007 and pertain to $10 and $20 bills. Essentially, the Fed is
working in partnership with banks to discourage patterns  of depositing tens and twenties and then turn around and order those same denominations again within the same business week and within the same zone or sub zone.”
 
The goal of these new regulations was to reduce the practice of churning currency and its unnecessary cash processing and storage costs, and Lambert says that “the provide an
incentive for institutions to choose the lowest cost solution for re-circulating currency to their customers.” Stanton believes that “the penalties are substantial enough for many
banks to justify hiring more vault cash employees and permit them to budget for the purchase of more sophisticated currency sorting and handling equipment.”
 
The new rules have also been a boon to companies like Transoft and Carreker Corporation who offer sophisticated cash management software packages to large banks
around the globe. Holmgreen points out that “our OptiVault module can help financial institutions assess the true costs of processing and transporting cash and determine when
it might be less expensive to return cash to the Fed and take a penalty.” For example, Transoft’s solutions are quite robust and help automate cash forecasting, cost balancing,
ordering, monitoring, expense tracking and more. Banks can manage their vaults and comply with Federal Reserve cash re-circulation policies by utilizing cost optimization
technology that applies sophisticated mathematical algorithms to historical, event and cost data. Holmgreen likes to use the analogy of a GPS (global positioning system): “the
software tells you exactly where you are with your cash, where you are going, and where you need to be. It anticipates your cash needs and makes specific recommendations as
conditions change.”
 
Even before the cross shipping penalties went into effect, the Fed had tried the ‘carrot’ approach one more time with the launch of their Custodial Inventory (CI) program in
2006. Some industry observers believe that this represented the first concrete move by the Fed to emulate the position of central banks in many foreign countries around the world which have been even more aggressive than the Federal Reserve in reducing their subsidies of commercial banks’ cash operations. With custodial inventories, banks are
allowed to temporarily store currency that is expected to be needed later in the week. The Fed estimates the cost of administering this program will run about $400,000 annually,
but could save them somewhere in the range of $35 million a year. The Fed’s Lambert admits that “the banks that participate in the custodial inventory program will most likely
have to make an investment in more currency handling equipment.” However the ability to put these cash inventories on the Fed’s books and thus make the money ‘liquid’ and
available for lending purposes should help offset their new hardware expenditures.
 
Again, the currency will be owned by a Reserve Bank - even though it will physically remain at the bank's facility. Barbara Bennett, Vice President of Policy and Product
Development for the System Cash Product Office of the Federal Reserve Bank in San Francisco, highlights the three main requirements of the CI program: “in the event of
loss, the banks must indemnify the Federal Reserve bank for the cash that they place into the CI; they must agree to our operating requirements; and they must meet our vault
requirements for security issues such as cameras, physical access, etc. We don’t feel that these requirements are too burdensome for the benefits that they will receive.” Yet she
does add that “the participating banks must now manage two cash inventories and learn how to integrate the Custodial Inventory into their daily operations.”
 
Over at the Union Bank of California, Stanton characterizes the CI program as “a nice compromise for getting a handle on the cross shipping problem.” But she is quick to point
out that the program also “brings lot of necessary reporting with it and requires that we closely track incoming and outgoing cash. However, this practice is consistent with what
is in place when we use third party processors. We require the same from them since they are handling our money.” Holmgreen concurs with Stanton and emphasizes that “just
because the Fed allows the bank to keep a certain amount of cash in the CI doesn’t necessarily mean that the institution wants to keep the maximum amount parked in the
CI. It is very important to consider daily and weekly cash fluctuations in order to minimize the wasteful movement of cash.” Bennett says that “we have nearly seventy CI
sites in operation right now and about a dozen more in the pipeline, and many of them are using some sort of cash management software to assist with their modeling and tracking.” 
 
While managing the CI and the vault cash is critical, it is just as important to merge those activities that are often handled by the Money Center into other departments such as
ATM and General Bank and Finance. The savings can be substantial. Case in point: when Charlotte, NC-based Wachovia Bank implemented Transoft’s suite of applications they
were able to not only reduce tens of millions out of their financial center vaults, but also enjoy millions of dollars in savings in their branch and ATM networks by optimizing
cash deliveries. Plus they benefited from labor savings by combining four different areas within the bank that had previously handled the day-to-day operations of cash into one
much more efficient group. Holmgreen puts it succinctly when he concludes that “everyone is searching for ways to lower their overall currency costs and the real key is
to be able to apply cash intelligently across every single one of the bank’s departments and activities.”