Electronic Banking: The Check Truncation Issue
Released: 2003-11-08T00:00:00

Introduction

The United States banking system processes approximately 42.5 billion checks annually, butonly a fraction of these checks is processed electronically by check truncation. Check truncationoccurs when the check is stopped before it reaches the paying bank and the check clearing processis completed electronically. (The term bank is used to include commercial banks, savingsinstitutions, and credit unions.) The Federal Reserve Board (the Fed) has proposed legislation thatwould authorize the creation of "substitute checks," an electronically produced instrument, thatwould allow banks to truncate the original check clearing process and complete the processelectronically with the substitute check. The customers would receive the substitute check, whichwould be the legal equivalent of the original check.

If all checks were replaced by electronic transactions, the exact cost savings would still be unknown, because estimates of the cost of using a check and the number of checks written each yearremain in dispute. Consequently, estimates of cost savings range from $1.4 billion annually fortruncation alone to $68 billion for replacing checks with electronic payments. A significant part ofthe savings comes from eliminating the handling, sorting, and physically transporting of checks tothe paying bank. To clear checks electronically, banks must negotiate processing agreements thatmake it unnecessary to physically present the paper check. Since the benefits are not uniformlydispersed among the participants, banks have found it difficult to obtain these agreements, thusconstraining the widespread adoption of electronic check clearing.

Legislation

On October 28, 2003, President Bush signed the Check Clearing for the 21st Century Act intolaw ( P.L. 108-100 ). The act is also known as Check 21 Act. The legislation behind it goes back tothe the 107th Congress. In December 2001, the Federal Reserve Board drafted the Check TruncationAct (CTA) and sent it to both the House Financial Services Committee and the Senate Committeeon Banking, Housing and Urban Affairs to be introduced in Congress. On October 2, 2002, theCheck Truncation Act of 2002 ( S. 3034 ) was introduced by Senators Tim Johnson andThomas R. Carper. Prior to that time, on September 25, 2002, the Subcommittee on FinancialInstitutions and Consumer Credit of the House Financial Services Committee held a hearing on theCheck Clearing for the 21st Century Act ( H.R. 5414 ), introduced on September 19 byRepresentatives Mike Ferguson and Harold E. Ford Jr. The bills, H.R. 5414 , and S. 3034 and the Fed's proposed bill, are almost identical. They would eliminate therequirement to physically return the original checks to the paying bank and therefore make it easierfor more banks to voluntarily adopt electronic check clearing instead of continuing to use the papercheck clearing process. The main difference between the Fed's proposal and H.R. 5414 was that the Fed's proposal had greater consumer protection against unauthorized debits. (1) After thehearing held on September 25, 2002, no further action was taken in the 107th Congress.

In the 108th Congress , on April 3, 2003, the Senate held its first hearing on the Fed's CheckTruncation Act proposal that was received in December 2001. The Federal Reserve Board's ViceChairman Roger W. Ferguson Jr testified that the board would like Congress to remove someconsumer protection provisions that were in its 2001 bill. "Upon further reflection, the Board hasnow concluded that the significant compliance burdens imposed by these provisions on banks thatreceive [the electronically produced] substitute checks outweigh the small incremental benefits thatthe provisions would provide to the consumers." (2) The vice chairman did not provide a new bill, butinstead pointed out that "Nonetheless, Congress may conclude that the expedited recredit provisionsfor consumers should be included in the legislation. In that case, . . . it should not go beyond theprovisions proposed by the Board." (3)

On April 8, 2003, the Subcommittee on Financial Institutions and Consumer Credit of House Financial Services Committee held a hearing on H.R. 1474 , the Check Clearing for the21st Century Act of 2003. The bill was introduced by Representatives Melissa Hart and Harold E.Ford Jr. on March 27, 2003. Substantively, the bill was not changed between the two Congresses. Vice chairman Ferguson's statement to the Committee was essentially the same as was the onepresented to the Senate Banking Committee. On May 21, 2003, the House Financial ServicesCommittee in its consideration and markup session amended H.R. 1474 and orderedit to be reported by voice vote. The amendment is a clarification amendment made byRepresentative Artur Davis. It would allow a consumer to make a claim for an expedited creditwithout possessing the substitute check.

On June 27, 2003, the full Senate passed the Check Truncation Act of 2003 ( S. 1334 ) and incorporated it in H.R. 1474 . At a markup on June 18, 2003, the SenateCommittee on Banking, Housing, and Urban Affairs approved S. 1334. Earlier, on June5, 2003, the Senate Banking Committee received H.R. 1474 , which was passed by theHouse of Representatives the same day and referred it to the Senate. The two bills are quite similar. The major differences between the bills are mainly in the area of consumer protection. The CTA ismore generous in its consumer protection provisions. For example, the CTA gives consumers 40days to file an expedited recredit claim, while H.R. 1474 would give only 30 days. In

addition, the Senate's CTA would shift the burden of documentation more on the banks and less onconsumers than the House's bill.

On October 1, 2003, House and Senate conferees reported H.R. 1474 ( Conference Report H.Rept. 108-291 ). The Conference Agreement adopted the House provision of 30 days tofile an expedited recredit claim providing that a consumer who receives a substitute check does nothave to have the check to make a claim for expedited recredit. On documentation, the ConferenceAgreement adopted the Senate provisions placing most of the burden on the banks, not theconsumers. A major sticking point was only indirectly related to the bills. It was between theFederal Reserve Board and the AirNet System Inc., the nation's largest check transportationcompany, over the Fed disclosure of its check transportation costs. The Conference Agreementrequires the Fed to disclose its expenses and revenues for shipping commercial checks betweenprocessing facilities. The Fed would have to publish the information in its annual report for 10years, but would not have to disclose specific prices. In addition, the act mandates a study on fundsavailability including the percentage of total checks cleared in which the paper check is not returnto the paying bank. The Department of the Treasury is mandated to do annual studies on depositoryinstitutions services efficiency and cost reduction. The Comptroller General of the United States atthe General Accounting Office (GAO) is also mandated to study and evaluate the implementationand administration of Check 21 Act and report the finding to Congress.

The Paper Check Clearing Processes

Figure 1 is a graphical representation of the existing paper check process. It begins withacustomer paying a store using a check; then the store deposits the check in its bank, which may bedifferent from the customer's bank. It is possible that the customer and the store have accounts inthe same bank, in which case the check would be settled as an "on-us" item. In the processing of anon-us item, the bank of first deposit would simply debit the customer's account and credit the store'saccount in the amount of the check. It is estimated that 33% of the checks written in the UnitedStates are on-us items. (4) Assuming this check is notan on-us item, there are a number of ways thatbanks may clear and settle checks among themselves by the rules of interbank check settlement. Therules for interbank check settlement are governed by articles 3 and 4 of the Uniform CommercialCode (U.C.C.) and by Federal Reserve regulations J and CC.

After the store deposits the customer's check in its bank, the bank of first deposit can return the check to the paying bank by mailing the check directly to the paying bank, or by sending it througha third party intermediary (private clearinghouse, (5) a correspondent bank, (6) or the Federal ReserveSystem). Whichever of these methods the store's bank selects, in most cases, the check must bephysically returned to the paying bank before it pays the check. This means that checks must bephysically transported to the banks on which they were drawn before they are settled. Consequently,the paper check clearing process is subject to transportation delays.

If the customer does not have sufficient funds in the account to cover the payment to the store, the check is sorted out in the bank's backroom operations, and is returned directly to the depositorybank or to the intermediary that returns it to the depository bank (Figure 1). Usually the depositorybank returns the bounced check to the store, while charging a fee for depositing a check withinsufficient funds in the account. The store then tries to collect from the customer. At the sametime, the paying bank charges the check writer a fee for having insufficient funds in the account.

Source: Federal Reserve of Boston.

Which Bank Pays for Collecting the Funds. Under the Federal Reserve rules, a large portion of the costs of the clearing process, those relatedto collecting funds, falls on the depository bank -- the bank in which the check was first deposited. The store's bank in the above example has to pay for any intermediary check clearing charges andfor transporting the check to the paying bank. The legal requirement is that checks presented forpayment must be paid at face value, even though the depository bank incurs cost in collecting thefunds. It should be noted that the paying bank also incurs cost in paying the checks that arepresented. However, if banks have an equal amount of collection and payment, these costs on netcould tend to equalize among banks over time.

Paper Check Clearing Is Inefficient. Economists have argued that the continued use of checks has made the society worse off, because it wastesresources such as transporting checks by planes throughout the United States for collection. A checkin the process of collection creates inefficiency, because it pays no interest (zero interest rate). Asa result, the greater the difference between the market rate of interest and the implicit interest rateof zero, the greater the income that can be earned by using checks. This income is called the float.The float is income earned by the check writer between the time a check is given as payment and thetime it is settled. The interest income earned from the float transfers income from the payee to thepayer. Even though the net benefit of the float between the payer and the payee is zero (the payee'slosses are the payer's gains), economists believe that the float is costly to society. Check usersemploy real resources to exploit the float for themselves. For example, the longer the plane takesto transport the check to the paying bank the greater the income the payer earns from the float. Ofcourse, from the view of the check issuer, the float is not an inefficiency, but a benefit.

By one estimate (Wells), the cost to all parties involved in a check payment could average about $1.60 (in 1993 dollars) more than the cost of a payment made electronically. (7) According to theFederal Reserve in 2001, government, households, and businesses wrote about 42.5 billion checks. (8) If the Wells estimate is correct, this might indicate a saving of $68 billion if checks were replacedwith electronic payments. A different study (Stavins) estimated a net benefit of $1.4 billion fromelectronic check clearing. (9) It is generally acceptedthat there are potential savings to be obtained byadopting electronic check clearing.

Electronic Check Presentation and Truncation

The electronic check clearing and settlement process is called electronic check presentation(ECP). Check truncation is a subset of the broader term ECP. Electronic check presentation is acheck collection process whereby a check is cleared based on information contained in an electronicfile or data, instead of the actual paper check. At a minimum, the file contains the amount of thecheck and the account number. The physical check may or may not follow the electronic file. Whenthe check is truncated, it is stopped before reaching the paying bank (the check writer's bank, whichis the bank holding the funds against which the check is drawn). Thus, under ECP with truncation,the writer of the check does not get his/her canceled check back. Instead, the transaction is indicatedon the monthly statement (Figure 2). A check returned for insufficient funds would be returned tothe depository bank electronically from the paying bank. The bank of first deposit would be ableto return the bounced paper check to its depositing customer, or merchant, to support appropriateaction against the paying customer.

Source: The Federal Reserve of Boston.

Truncation by an Intermediary

If banks could not reach agreements among themselves on sharing the cost savings of electroniccheck clearing, they could use an intermediary to do the check truncations (Figure 3). The FederalReserve currently truncates checks. In 2000, the Fed truncated 20% of the checks it processed. Theuse of an intermediary reduces the cost savings, since additional transportation, sorting and handlingcosts are involved when compared to truncation at the bank of first deposit. For these services, theintermediary charges fees that could be directly or indirectly passed through to the banks and theircustomers. Under truncation by an intermediary, the backroom operations of the first deposit bankwould be basically unchanged, and the paying bank's clearing and settling activities would bereduced, but not eliminated. The Federal Reserve's suggested legislation would make it possible touse electronic check clearing without agreements.

Source:

Table 1. Estimated Per Check Payment Costs and Benefits of Check Truncation Over the Paper Check Process In cents (ï¿½) and percent ofcosts (%) benefits (%)

Costs

Benefits

Source: Figures taken from Stavins' Appendix B and percentages added.

Under ECP process, the estimated distribution of costs and benefits between the banks and their customers seems to be the reverse of what it is under the paper check process. Under the paperprocess for example, the paying customer gets the float and the canceled check, while under ECP,the paying customer loses the float and does not get the canceled check back. That makes it difficultfor banks to adopt ECP without an explicit agreement about how they will share the benefits. Onnet, according to Stavins' study, represented in table 1, the paying bank's customers would sufferthe greatest cost from moving to the ECP process with the loss of canceled checks and the float. At the same time, the paying bank receives the greatest benefit. That benefit would be large enoughto compensate its customers for their losses if it so chose and still leave it better off after adoptingthe check truncation process.

For the depositing bank customers, their costs are unchanged and they benefit from not losing the float. The depository bank's costs and benefits are estimated to be closer to break-even, but thenet benefit is also positive. The higher infrastructure, storage, and operating costs are estimated tobe slightly less than the benefit from reduced risk of fraud, and return check handling.

Despite the net benefit of check truncation, only a small number of banks have been using it. This could be explained by table 1. It estimates that total costs of 6.69ï¿½ per transaction are exceededby total benefits of 11.66ï¿½. This clearly suggests that there are net benefits of 4.97ï¿½ per payment inusing check truncation instead of the paper check process. However, the distribution amongparticipants in the check truncation process is not as simple. The paying bank's customers incur78% of the costs and receive no benefit from changing from the paper check clearing process tocheck truncation. On the other hand, the depository bank's customers gain more than 14% of thebenefit. For the banks, the paying bank receives 61% of the benefits, while the depository bankreceives about 9% of the benefit. The intermediary benefits from the check truncation at the firstbank of deposit since the truncation process would eliminate its handling of the paper checks. Asa result, the intermediary accounts for 16% of the benefits.

There may be a concern that, to the extent that check truncation shortens the time for a check to clear, it may disadvantage those less wealthy individuals who live paycheck to paycheck and counton the float in paying rent and other bills. While such people would likely adjust to the new system,it may not be their preference. To the extent that truncation reduces the availability of the float,fewer checks may be written.

The Check Clearing for the 21st Century Act (H.R.1474, P.L. 108-100)

The main difference between H.R. 1474 and the Fed's Check Truncation Actproposal is that H.R. 1474 has less consumer protection than the Fed's proposal. Thislegislation would facilitate wider voluntary use of truncated checks, without interfering with thecheck clearing process of institutions that do not currently have truncation agreements. The Actwould enable this by creating a new type of paper document, a "substitute check," that would be thelegal equivalent of the original check. The substitute check would:

contain an image of the front and back of the original check;

conform to the industry standards for substitute checks;

contain the magnetic-ink character recognition (MICR) line that would permitthe substitute check to be processed on check-sorting equipment; and,

bear a legend that indicates that it is the legal equivalent of the originalcheck.

Using this substitute check, a bank would be able to truncate a check from a bank with which it has no electronic exchange agreement by sending a substitute check instead of the original check. Asa result, check truncation would remain voluntary. Banks that now use paper checks would be ableto process either the substitute check or the original checks without any modification in their checkclearing process or their back-office operations. The cost of check processing would be unchangedfor banks already using check truncation and banks that chose not to adopt check truncation.

Much of the draft legislation spells out in detail the legal similarity between the original check and the substitute check under the uniform commercial code. For example, it would create awarranty structure to protect against losses associated with the substitute check. The proposal wouldalso create an indemnity structure to address losses resulting from receiving a substitute check, ratherthan the original. In addition, the draft legislation would provide an expedited recredit procedure. Recredit is the act of giving credit to an account even though the documentation to do so is beingquestioned. In short, the recrediting procedure allows customers' accounts to be credited as soonas possible whether or not there are problems associated with the receipt of the substitute checksinstead of the original.

The expedited recrediting sections of the Fed's proposal and the Check Clearing for the 21st Century Act are different. The Fed's proposal would give customers involved in a transaction wherea substitute check was used a one day right to a recredit if they claim a check was improperly paid. That means that customer's account could be recredited the amount of the improper payment by theclose of the next business day. In contrast, the Check Clearing for the 21st Century Act provides fora recredit 10 days after a claim of an improper payment. Under both versions, consumers usingbanks that have signed truncation agreements would not get this recrediting right. Only customers of banking institutions that have not voluntarily agreed to check truncation would have this right. Furthermore, under the Fed's proposal, the time the consumer has to request a recredit of disputedfunds was 60 days. Under the Check Clearing Act ( P.L. 108-100 ), it would be 40 days.

Consumer Groups' Reaction to H.R.1474

At both the Senate Banking Committee and the House Financial Services Committee hearingson April 3, and 8, 2003, the strongest opposition to H.R. 1474 came from theConsumers Union. The views in its testimony were supported by the Consumer Federation ofAmerica, the U.S. Public Interest Research Group, and the National Consumer Law Center. TheConsumers Union argued that the Act would make it impossible for an estimated 45.8 million U.S.households who are currently getting their paper checks back to continue to do so. It states that theseconsumers would be less protected from fraud under the Act than under the existing check clearingprocess when there are disputes about errors in the check payment process.

Specifically, the Consumers Union argue that there is a loophole in Section 6 of the CTA that consumers could only see a recredit if they receive substitute checks from their bank. Banks couldavoid giving consumers the recredit just by refusing to return the substitute check to consumers.

At these hearings the Consumers Union made two recommendations to protect the consumersunder the proposed Check Truncation Act.

Because all consumers are equally susceptible to harm from processing errors, the recredit loophole in the proposed CTA should be closed. The right of recredit should beexpanded to apply in every case where the original check is not returned to the consumer and a checkmay have been improperly charged to the consumer's account; and

A comparative negligence standard is inappropriate to resolve harm suffered by consumers due to processing errors. Banks should not be able to use this standard to avoidliability, or to delay a consumer's action for improperly paid checks that result from processingerrors. Therefore, as it relates to consumers, the language relating to comparative negligencestandard should be removed from the CTA. (10)

At the hearing held in the 107th Congress on H.R. 5414 , the Consumers Union suggests changes in the proposed legislation that would significantly increase consumer protectionwhen checks are cleared electronically. These changes focus mainly on the recrediting procedure. (11) First, the Union would like to extend the recredit provisions in the Act to all checks where theoriginal checks are not returned to the consumer and there is a claim of improper payment or awarranty claim. This amendment would expand the indemnification coverage beyond the substitutechecks in the proposed H.R. 1474 . It could extend coverage to more than 20% of allbank checks that are currently not returned to customers and more than 80% of credit unions' draftsthat are also not returned to their members. Financial institutions are expected to oppose thisextension because it would significantly raise financial institutions' cost of handling disputed checksand drafts.

Second, the Consumers Union argues that 10 days is too long for consumers to not have access to the disputed funds due to the use of the substitute check. It prefers the expedited recreditprovisions in the Fed's proposal. That is by the close of business the next day, the disputed amountof the payment (up to $2,500.00) would be credited to the consumer's account. The purpose of theprovision is to reduce consumer inconvenience due to the use of the substitute check. However, H.R. 1474 provides for a recredit after 10 business days, which the banking industryargues is appropriate.

Third, Consumers Union would like to raise the expedited recredit amount from $2,500 to $5,000. In H.R. 1474 and the Fed's proposal, checks for less than $2,500 would berecredited by the next business day, if the check is being disputed. Consumers Union would like theexpedited recredit limit raised to $5,000 because the size of the amounts of these transactions isexpected to increase over time. In addition, the Union would like to shorten the number of daysrequired to complete the overall recrediting process to less than 20 days. Financial institutions, onthe other hand, prefer the longer time to clear up disputed checks in order to make sure thatcorrections are made accurately. In short, the Consumers Union's changes would protect consumersfrom the loss of the fraud protection provided by the right to have the original check returned tothem. This right is now protected by statute and regulations. These suggested changes, however,could significantly raise the cost to financial institutions to the point where it is no longer profitableto adopt check truncation. In P.L. 108-100 the expedited recredit amount stayed at $2,500.

A counter to the Consumers Union's argument for protection against processing errors is the fact that in cases where check truncations have been used for years processing errors are practicallynonexistent and when they occur they are quickly resolved. Asked by Senate Banking CommitteeChairman Richard Shelby (R-Ala.) how many complaints she has received from credit unionmembers about electronically produced copies of checks, Alexander, President and Chief ExecutiveOffice of the NIH Federal Credit Union, said that over a period of 14 years, she had received none. In response to a question from Senator John Sununu (R-N.H.) Ferguson, Vice Chairman of theFederal Reserve System, said that in his seven years on the Fed board, he has never heard of a casein which checks were double-debited. (12)

Possible Objections to Universal Check Truncation

Under the CTA, the adoption of check truncation or electronic check presentation would stillbe primarily voluntary, even though it could significantly reduce the cost of using checks. Manybanks are not making agreements, because while there might be substantial social benefits if mostor all checks were truncated, they and their customers may never be able to achieve sufficientbenefits over the present paper check system to justify expending the resources to adopt checktruncation. A major obstacle to universal adoption is the uneven distribution of costs and benefitsamong the participants in the process. Many observers believe this obstacle is unlikely to beovercome without a legally mandated cost distribution, as is currently provided for in the papercheck process. The proposed Check Truncation Act would make legal any distribution agreement(or non-agreement) the banks approve among themselves.