The Check Business
By Betty Joyce Nash
Consumer habits die hard. Although plastic is gaining power over paper in the retail payments world, people in the United States cling stubbornly to the familiar paper and ink and cancelled checks, writing more than 15 times the checks of people in most European countries.
But after peaking at about 49.5 billion in 1995, check use started declining. By 2000, checks had fallen to an estimated 42.5 billion, a decline of about 3 percent a year. During the same period, electronic payments grew by about 15 percent annually, according to research by Geoffrey Gerdes and Jack Walton of the Federal Reserve Board of Governors.
The Federal Reserve System processes a hefty chunk of the checks written in the United States at 45 offices around the country. In the waning 1990s, the Fed gained a bigger share of checks processed, despite declining check use. In 1995, the Fed cleared some 15.4 billion checks out of the 49.5 billion written (31 percent); in 2000, the Fed cleared almost 17 billion checks of the estimated 42.5 billion (about 40 percent). The Fed's check volume began falling in 2000, however, by 0.5 percent a year. Volume fell by the same percentage in 2001. In 2002, volume to date has dropped more sharply, by about 3 percent systemwide, according to Bill Tignanelli, who heads up the Richmond Fed's Baltimore office and oversees the Fifth District's check operations. The Fed could start picking up some market share because some banks are exiting check services, says Chicago Fed economist Bob Chakravorti. Since the Fed is a provider of last resort, it could receive more check business than anybody else in the short run, he says.
Navy Federal Credit Union in Vienna, Va., a $17 billion credit union with about 2.3 million members, has processed its members' checks since 1978. "It's more efficient for us to do it ourselves than to outsource it," says comptroller Don Chapman. "We review it on a regular basis and haven't really come up with a level at which it would not be profitable.
"Check volume at Navy, the world's largest credit union, has fallen about 2.4 percent a year over the past four years, but the number of checking accounts has continued to grow, according to Chapman.
The Fed's role in check clearing is controversial and unusual because it competes with its own customers, other depository institutions. The Fed's check business goes head-to-head with its competition, given its 1980 congressional mandate — the Monetary Control Act. The act requires the Fed to price its payment services to recover all direct and indirect costs, including a rate of return comparable to that of private firms. The act also stipulates that the Fed extend its services to all financial institutions.
The Fed's biggest asset is its reliability and quality, says Burise Bittle Jr. of the Fed's Richmond office. "Whether there's 10 feet of snow outside, torrential rains, or whatever, we're still open for business."
A substantial number of checks clear in the Fifth District, about 1.7 billion in 2001, in its Richmond, Baltimore, Charlotte, Charleston, W.Va., and Columbia, S.C., check processing centers.
Of the Federal Reserve System's 45 regional check processing centers, the Baltimore Fed ranks 14th, clearing 483 million items in 2001. Volume is down by about 1.5 percent over 2001 in the Fifth District, but revenue is up. Tignanelli explains that price changes have helped. "We have to look at our products and make sure we have acceptable margins. [We must] price products so people will buy the business," he explains.
To improve efficiency systemwide, the Fed embarked on a wide range of initiatives to streamline check operations.
"It starts with the fact that the 12 Federal Reserves, acting independently of each other, have different software, different hardware to run, in essence, the same service," explains Tignanelli. The four-pronged effort — known as check modernization — will standardize hardware and software supporting the 45 centers. The project will also standardize the error research and resolution process, the imaging and archiving system, and provide secure remote electronic access to check services via the Internet.
The imaging and archiving system will ultimately eliminate the need to transport paper checks, since all transactions will be electronically archived. This check "truncation" depends on congressional approval allowing the printed image to serve as legal equivalent to original paper checks.
The Fed's long history in check clearing, since its founding in 1914, nevertheless raises questions about whether it needs to be in the same business today. The issue of the Fed's role in payment systems is periodically revisited. Originally, the idea was to provide a unified clearing system back when federal law prevented nationwide banking and regional interstate banking. As Federal Reserve Board Vice Chairman Roger Ferguson Jr. has written:
"In an era of rudimentary communications and a fragmented banking system in the early part of this century, the Reserve Banks' involvement in check collection helped to improve the workings of the national economy, spur trade, and overcome some of the structural impediments that had contributed to the financial panics in the late 1800s and early 1900s."
But efficiency wasn't the only motivation for providing check services. Fed founders were seeking stability, too. They wanted to ensure survival of the fledgling organization by giving it a practical, everyday purpose — such as check clearing. By providing those services, the Fed was more likely to attract member banks. A 1915 report to the Reserve Bank Organizing Committee stated: "(T)he domestic exchange business of the Federal Reserve system must be so arranged as to offer constant inducements to non-members to enter the system."
In 1996, a committee chaired by Alice Rivlin, then-vice chair of the Board of Governors, reassessed the Fed's involvement in the business of checks. The committee concluded that the Fed needed to stay in check processing to serve small, remote banking institutions. According to the report: "The Federal Reserve should remain a provider of both check collection and ACH [automated clearing house] services with the explicit goal of enhancing the efficiency, effectiveness, and convenience of both systems, while ensuring access to all depository institutions."
More recently, in February 2002, the United States General Accounting Office reported on the changing role of central banks worldwide in payment systems. The GAO report notes: "The degree to which a central bank should be involved in the payment system has been the subject of controversy. Views on this issue have evolved over time and therefore are likely to remain open to debate."
And debate is ongoing. Economists George Benston of Emory University and David Humphrey of Florida State University have argued for privatizing the Fed's retail payments system. Even though many small, remote banks could pay higher prices for check services under that scenario, the pricing would more accurately reflect the true cost of service to those customers, according to Benston and Humphrey.
Besides, check use is on the wane, say Benston and Humphrey, and market forces will ultimately erode the need for check processing. And that brings up another question that looms large in the payment literature. Why do Americans still write so many checks? John Weinberg, an economist at the Richmond Fed, explains that many countries have reduced check use through coordinated efforts.
"Other countries have banking industries that are much more concentrated," he says. "A small number of banks control the whole industry. And if three banks say, 'Let's all promote electronic payments,' then they all do it by increasing the fees for checks, so transition is easier than in a less concentrated industry."
Despite the wave of bank mergers in the United States, eased by the Gramm-Leach-Bliley Act, it's unclear whether the consolidation will have a big impact on check writing at a consumer level, says economist Chakravorti.
"Some observers have claimed that antitrust concerns prevent banks from getting together on pricing issues in the United States," he says. "However, some have claimed that fewer banks would lead to more uniform standards for electronic payments. We have been told by industry participants that large mergers often require significant time to merge electronic platforms, so the impact would not likely be immediate."
In the United States, where about 19,000 banking or credit union institutions operate, coordination is difficult. And consumers lack incentive to change their habits, since check fees are few. In other countries, Finland and Norway, for example, financial institutions have curtailed check use by imposing hefty fees, according to Chicago Fed economists Chakravorti and Timothy McHugh, who wrote a study entitled, "Why Do We Use So Many Checks?" They suggest that people, merchants, and financial institutions will ultimately migrate to electronic payments in a big way once market-based incentives favoring electronic alternatives are in place.
"Forty-one billion pieces of paper are a lot of pieces of paper," says Chakravorti. "But unless there are major changes in the way checks are priced, I don't see them going away unless the customer sees the need to get away from them."