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The Green Sheet Online Edition

May 10, 2010 • Issue 10:05:01

Creating a place for checks at the electronic payments table

By Patti Murphy
The Takoma Group

David Walker isn't afraid to defend checks, the payment method that is much maligned by payment professionals but nonetheless used in billions of transactions every year. "We've been telling folks for 30 years now that checks are bad and that we ought to get rid of them," Walker said. "We don't need to get rid of checks; we just need to shed the inefficient aspects."

A former banker, Walker has led the charge toward electronic check presentment and image exchange as President of the Electronic Check Clearing House Organization (ECCHO).

The organization is a bank-owned rules group focused on electronic check exchanges, which now account for most interbank check clearing.

"This is not an insignificant payment system," Walker pointed out in discussing the future of checks. Indeed, the Federal Reserve Bank of Boston estimates that payments between individuals (known as person-to-person [P2P] payments) in the United States total about $2.9 trillion annually, and virtually all of these are transacted by checks or cash.

The Association for Financial Professionals estimates that better than 70 percent of business-to-business (B2B) payments are made by check. Even companies that have adopted check alternatives, like the automated clearing house (ACH) direct deposit application, continue to issue checks to cover employee expenses, customer refunds and the like, noted Oz Shy, a Senior Economist and member of the Consumer Payments Research Center at the Boston Fed.

The post-Check 21 landscape

One reason is the Check Clearing for the 21st Century Act - federal legislation commonly referred to as Check 21. Implemented in 2005, Check 21 made it legally possible to truncate checks, capturing electronic images of the paper, which are then cleared through electronic networks that mirror paper check-clearing processes.

These electronic check networks (or image exchanges) have slashed both the cost and time needed to complete check payments. According to the Fed, as of December 2009, 98 percent of all checks deposited by financial institutions with the 12 Federal Reserve Banks for clearing were received electronically.

But Check 21 has done little to help wean individuals and businesses from writing checks. "There's still a lot of paper; it's just that most of that paper isn't in the clearing system anymore," Walker said.

U.S. consumers and businesses, combined, write more than 20 billion checks a year, according to the Fed. Although most of these are truncated, check writers and banks can request delivery of image replacement documents, which are legal, hard-copy replacements generated from the original, imaged check files.

According to Shy, the typical American consumer paid by check for 28.6 percent of transactions in 2007; only 16.8 percent were electronic transactions (for example, online bill payment and ACH debits); consumers used credit and debit cards for 54.6 percent of payments.

It's an entirely different scene in Europe, where consumers rarely write checks, having grown up with giro transfers.

The most popular consumer electronic payment method in the region, giro transfer enables account holders to transfer money by instructing banks to directly transfer funds from one account to another. Giro payments represent credit transfers; checks are debit transfers.

Additionally, European central banks and industry groups actively discourage check writing.

In the United Kingdom, for example, checks are to be made obsolete by Oct. 31, 2018. And in Germany, 84.7 percent of payments by the typical consumer were done electronically in 2007, and 0.58 percent were made by check, according to the Bank for International Settlements, which keeps tabs on payment trends in the major industrialized nations.

The American check habit

Shy addresses this chasm in check usage in a recently released policy paper titled Person-to-Person Electronic Funds Transfers: Recent Developments and Policy Issues.

Among other things, Shy asks if it's appropriate for the Federal Reserve to take additional, bolder steps to wean Americans from paper checks.

For instance, he suggests the Fed could widen the pricing gaps between check and electronic payment services, like the ACH, as a signal that paper checks will be replaced eventually by electronic exchanges.

Today banks pay the Fed or a correspondent institution upwards of 15 cents to process a paper check and about 1.5 cents to truncate and clear that same check electronically. The base price for an ACH payment can run upwards of 0.25 cents each for sending and receiving banks.

"The Fed could also adopt other means of intervention, such as public education and promotion," Shy proposes in his paper.

Shy also feels it's time to put an end to free checking. "Had consumers faced the true cost of using checks, electronic P2P [payments] would probably have been able to gain market share" in the United States, he wrote.

Walker doesn't see the need. "Checks have been around for more than 300 years; the ACH has been around for just 40 years," he said. There are good reasons why checks have had such staying power, he added.

For example, despite the proliferation of ACH transactions intended to displace checks, there's been little growth in B2B payments via the ACH, and growth has slowed recently for several consumer-to-business (C2B) transactions, such as accounts receivables check conversion (ARC).

ARC transactions fell by more than 10 percent between 2008 and 2009, according to NACHA - The Electronic Payments Association. Back-office conversion payments saw the best growth, statistically, but there were only 160.5 million checks converted to ACH payments in this manner.

End-to-end electronic checks

In a paper published late in 2009 by the Federal Reserve Bank of Chicago, Walker and several Fed payment experts suggest that rather than eschew checks, banks and the Fed should create a new digital check instrument, which they're calling an electronic payment order (EPO).

"Our paper develops an exploratory proposal to digitally rejuvenate the check payment instrument in order to extend the beneficial properties that have made it a viable payment option for centuries," the authors wrote in their tome, Digital Checks as Electronic Payment Orders.

"It makes good sense; it's the next logical step to improve the system," Walker said. In fact, banks today already handle billions of like transactions, he noted, pointing to remotely created checks.

Remotely created checks (sometimes called "telechecks" or "preauthorized drafts") are used routinely by billers to collect late payments, as well as for other non-face-to-face transactions.

Customers authorize payees to draw checks on their checking accounts; in place of signatures, these drafts contain language indicating customer authorization.

These remotely created checks clear just like paper checks today, Walker noted - only they're electronic, from beginning to end. They are, in effect, EPOs.

So why not take the next logical step, and initiate all checks electronically?

In the report published by the Chicago Fed, Walker and his co-authors argue that a similar transformation took place 30 years ago when advances in technology made it possible for banks to introduce ATMs to take some of the workload off branches. Today, ATMs are ubiquitous and far more than mere cash machines.

"We believe a similar radical transformation for paper checks could be at hand using an instrument that consumers readily turn to more than their wallets - a smart mobile phone," the report states. The transformation doesn't require significant change, just the elimination of what Walker refers to as "that tiny sliver" of the check system that's still dependent on paper.

EPOs are, in effect, end-to-end electronic payments, but they're treated legally like checks.

"We believe the costs to operate such a new system would not be large and allow the new product to compete quite successfully in terms of price and convenience with both debit and credit cards," the report states.

A business case for going electronic

EPOs, with check-like data fields, could also sway the millions of businesses that aren't using the ACH for B2B and B2C payments to move to an electronic version of a payment format with which there's existing comfort: the check.

From a corporate treasurer's point of view, ACH transaction formats don't provide for sufficient remittance detail, certainly not as much as checks.

That's a deal breaker when it comes to paying multiple invoices with a single transaction, which is the case with most B2B payments.

The result is that two-thirds of all monies received by businesses in the United States (from consumers and other businesses) are in the form of checks, according to the AFP.

Aite Group LLC predicts that among the nation's estimated 27 million small businesses, 90 percent of payments to other businesses this year will be made by check.

Former banker Ed McLaughlin, Executive Director of RemoteDeposit Capture .com, describes EPOs as "logical." But he cautions that the transition from paper checks to EPOs is not a slam dunk. Among other things, he suggests that banks could have problems distinguishing between EPOs and remote deposit capture (RDC) items. (For more information, see "The next generation of the check," by Ed McLaughlin, reprinted in this issue of The Green Sheet, May 10, 2010, issue 10:05:01.)

RDC items start out as paper checks and get truncated by the payee or its agent bank; an electronic image is taken (typically in a back-office environment), and that digitized information is transmitted for deposit and/or clearing. Most RDC items clear as electronic check files.

The ACH is also an option, in which case the payments are legally considered electronic and thus subject to consumer protections spelled out in the U.S. Code of Federal Regulations, Title 12, Banks and Banking, Regulation E.

Mobile phones and RDC

RDC has great appeal, especially among the estimated 24 million merchants operating in the United States. It's convenient; it's automated; it helps slash bank fees; it accelerates cash flow.

Shy suggests that RDC is such a good deal that it reduces "the incentives of merchants to resist checks, and may also have influenced the banking industry against offering low-cost P2B and P2P electronic transfers via online banking."

John Leekley, founder and Chief Executive Officer of RemoteDepositCapture.com, estimates accelerated cash flow from RDC, alone, holds the potential to create 40 cents in added value for every $1,000 in daily check deposits a business makes. Spread that over the course of a year, and you're talking significant additions to revenues, he noted.

For financial institutions RDC offers an inexpensive way to boost deposits, Leekley added. "RDC is not just about checks," he said. "It has the potential to be a critical part of a bank's payments business."

Federal regulators came to this conclusion, too, and issued a joint document on risk management steps banks should take when implementing RDC. That document describes RDC as "a deposit transaction delivery system."

Leekley believes any risks identified with RDC are manageable. "There are so many ways to manage an RDC system that it really doesn't matter where the payment is captured and processed," he said. "Even a cell phone can become a payment capture device."

At a webinar last fall, McLaughlin suggested 90 percent of branch teller transactions these days are check related. By moving significant numbers of those to an alternative, electronic channel - like the mobile phone - banks could boost branch and personnel efficiencies.

"Banks need to be more flexible; they need to understand where the value is for their customers as well as for themselves" from RDC, Leekley said.

"There's much more value [for banks] in deposits than in fees." After all, deposits are the "lifeblood of banking," Leekley added. end of article

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