The Fed’s Perspective
By Pamela M. Green
For four days following Sept. 11, 2001, bags of checks sat on the floor at Federal Reserve banks across the country. With air travel suspended, the nation’s normal check collection process was virtually shut down. The Fed had to figure out a way to keep the check payment system relatively intact and avoid the burden that a disrupted system would surely have added to the national crisis.
Fed officials knew that some banks, uncertain of whether they could collect checks, might discourage deposits of checks from their customers. This in turn might discourage merchants from accepting check payments, and people receiving paychecks might not be able to cash them. To circumvent these problems, the Federal Reserve continued to accept checks as usual, including checks from banks that did not normally deposit with the Fed, and it passed credit according to normal availability schedules. In spite of knowing it would not be able to collect many of these checks, the Fed “passed credit anyway, and absorbed the float, so that the check payment system would not be disrupted, and consumers and businesses would not be subjected to the risks of a broken check collection system.” (See remarks of Paul Connolly of the Boston Fed, cited in Maine Community Banker, December 2001.)
The Fed was able to forestall a banking crisis, but knew the time had come to move toward electronic clearing.
Enter the Check Clearing for the 21st Century Act (Check 21), signed into law on Oct. 28, 2003, and effective Oct. 28, 2004. The Federal Reserve’s Web site says the purpose of Check 21 is “to foster innovation in the payments system and to enhance its efficiency by reducing some of the legal impediments to check truncation.” The law creates a new negotiable instrument called a substitute check, which would permit banks to truncate original checks, to process check information electronically, and to deliver substitute checks to banks that want to continue receiving paper checks. A substitute check would be the legal equivalent of the original check and would include all the information contained on the original check. The law does not require banks to accept checks in electronic form nor does it require banks to use the new authority granted by the act to create substitute checks.
The New Electronic
Fred Higgins, senior account executive at the Boston Fed, talked about Check 21 at MACB’s CEO Midwinter Meeting in February. According to him, “Check 21 is not about imaging or image exchange, nor does it mandate those. It created a new payment instrument—the substitute check.” In his view Check 21 will accelerate the continued decline of traditional check collection processes, although check writing is expected to continue as a preferred method of payment.
Still, check writing is declining each year. Higgins referenced a study of check usage and electronic payment usage published by the Federal Reserve in 2001. The conclusion showed paper checks trending downward by 3 percent per year. Current projections suggest a decline as much as 7 percent in 2003. (See “The Use of Checks and Other Noncash Payment Instruments in the United States,” online under www.federalreserve.gov/paymentsystems.) On the other hand, FedACH statistics show a 21 percent growth in point of purchase transactions.
Another ACH payment method gaining acceptance is the ARC, or accounts receivable check. In this instrument, the check comes back to the consumer’s account as an ACH debit, even though the consumer paid by check. ARCs are showing a whopping 550 percent growth. Check replacement methods also continue to gather steam: Web-initiated payments grew 232 percent from 2002 to 2003, and phone-initiated payments grew 138 percent in that time period. Electronic payments are coming of age.
Check Clearing Scenario Pre- and Post-Check 21
Higgins led the audience through a hypothetical of how checks clear today, using as an example a dad in Boston who mails a paper check to his daughter at college in California. The daughter deposits the check at an on-campus ATM of Washington Mutual. A truck then takes the check to Washington Mutual’s data processing center and processes it, using check sorting equipment. Then it goes to the Federal Reserve Bank in San Francisco to be sorted. Next it flies to Boston, being met at the airport by a truck, which transports the check to the Boston Fed, to be sorted again. Finally it goes to dad’s bank for the funds to be taken out of his account. Typically, this process takes about three days to complete.
Next Higgins traced the process in a post-Check 21 scenario. The check goes to the daughter, who deposits it in an on-campus ATM. The ATM images the front and and back of the check, captures the MICR information and transmits this electronic information to Washington Mutual’s data processing center. Next, the electronically converted check is collected through the Federal Reserve’s FedImage collection process and delivered electronically to the Federal Reserve Bank of Boston. The following morning a substitute check will be created by the Boston Fed and driven to dad’s bank for the funds to be deducted from dad’s account. (In most instances the check image would be presented to dad’s bank instead of a substitute check.) Typically this process takes less than 24 hours. No planes, no check sorting equipment. And no float.
The Check 21 Act mandates that banks develop a consumer awareness program that should include providing a notification and explanation to their customers about this new payment instrument, the substitute check. In addition, banks must ensure their staff is trained in the new rules. Banks might also be subjected to some additional risk. They are required to develop expedited recredit procedures, which might include paying damages to consumers who suffer losses because of the receipt of a substitute check.
Higgins suggests there may be opportunities for banks to gain efficiencies as a result of the new legislation. Are there new revenue opportunities for banks under Check 21? Is the bank positioned for electronic exchanges? Is new equipment needed? Should the bank outsource? These are just some of the things to be considered.
After the Check 21 effective date of Oct. 28, 2004, the Fed will still offer paper collection services. There will also be new services. For example, on the depositing side, the Fed will convert deposited checks to images for collection and present images or substitute checks on the depositing banks’ behalf. Also, depositing banks will be able to transmit a file of images to the Fed for collection. This will eliminate putting checks on a truck each night for delivery to the Fed in Boston. On the presentment side, collection could take the form of image presentments to banks agreeing to receive images or having the Fed print and deliver substitute checks to those unable or unwilling to accept image presentments.
The end game is clear, says Higgins. Eventually it will be an all-electronic environment. But when this all-electronic environment will occur is unclear. Will the electronic solution be more or less expensive? Nobody knows. While there are no transporting costs, there will be fees. One thing the Fed hopes is certain, however, the migration toward electronics will give the industry some protection against a banking disaster like the one that was narrowly avoided in September of 2001.