A comparison of social costs and benefits of paper check presentment and ECP with truncation - Electronic check presentment

New England Economic Review, July-August, 1997 by Joanna Stavins

Each year, about 60 billion checks are collected in the United States. Paper checks account for about 80 percent of noncash transaction volume.(1) While the shares of electronic payments methods such as the automated clearing house and credit and debit cards have been growing in recent years, the volume of checks has grown by more in absolute numbers during the last 20 years than all electronic payments methods combined. Partly because of their convenience, checks remain an extremely popular way to carry out transactions. Since it seems that checks will be around for the foreseeable future, it makes sense to try to improve the process of their collection.

For most checks, the forward collection process occurs roughly as follows: The person or firm to whom the check is made out (the payee) deposits it in his or her bank (the bank of first deposit or the depositary bank). If the check writer's (the payor) account is in the same bank, the check is "on-us" and it stays at that bank. Otherwise, the physical check then travels, often via a financial intermediary, to the payor's bank (the paying bank), and finally to the payor, on a monthly basis. An interbank transit check can be handled by multiple institutions, with several processing steps at each point. If the payor has insufficient funds or the check is not honored by the paying bank for other reasons, the check travels back to the depositary bank and the payee. That so-called return process is much more costly, as it is more labor intensive.

As this description makes clear, considerable costs are incurred at several stages in the collection process for sorting and transporting of physical checks. Collection takes place within tight schedules. The paying bank has only one to one and a half days from the time a check is presented to decide whether to return the check and recover its payment before the check is final. In addition, the payee may lose interest for each day's delay in the collection process. In case of severe weather conditions, the difference between the time of credit and the time of debit could increase and generate additional "float."(2)

Some of these costs could be reduced or avoided entirely by a system of electronic check presentment and truncation. Electronic check presentment is a check collection process whereby a check is cleared based on information contained in an electronic file instead of the actual paper check (also called the physical item). At a minimum, the file includes the account number and the dollar amount. The physical check may or may not follow the electronic file. If the check is stopped before it reaches the paying bank (the check writer's bank, that is, the bank holding the funds against which the check is drawn), the process is called check truncation.(3) Whether the check is truncated or it follows the electronic file, the process is intended to improve on the traditional method of paper check presentment.

Electronic check presentment (ECP) and check truncation have been promoted by the Federal Reserve System and by some financial institutions as a more efficient payments method than the processing of paper checks. However, no estimates are available of costs and benefits of ECP or of truncation relative to paper check presentment. Before any definite recommendations are made, it is important to find out whether ECP with truncation is indeed cost effective. The purpose of this study is twofold. First, it compares the costs and benefits of traditional paper check collection to those of electronic check presentment with truncation. Because very little is known about the costs of the transition to ECP, it is a static analysis that does not include any transition costs, even though they are likely to be significant. Second, the paper addresses the question of why the private market has not so far adopted check truncation.(4)

Since so far only a fraction of checks are processed with ECP and a smaller fraction are truncated, the data sources are very limited in scope and several assumptions had to be made. Therefore, this study should be viewed as a first attempt to quantify the costs and benefits of ECP, and not as the last word on the subject. Given the data limitations, conservative assumptions were made throughout so as not to overstate the benefits.

Previous studies that compared various payments methods have focused exclusively on the cost side.(5) But even though one payments instrument may be cheaper than another, it is more efficient only if its net social benefits are higher than those of the alternatives. To determine whether that is the case, benefits must also be taken into account. For example, even though bicycles are cheaper than cars, one would not recommend that bicycles be substituted for cars without evaluating the relative benefits of each mode of transportation. Omitting consumer preferences from an analysis of the costs and benefits is likely to yield biased results. While comparing consumer valuation across the various payments methods is difficult, the consumer valuation of ECP can be assumed to be similar to that of the paper check - ECP is in many ways a close substitute for traditional checking.