Who uses electronic check products: a look at depository institutions

New England Economic Review, Summer, 2002 by Joanna Stavins

Approximately 42 billion checks were written and collected in the United States in 2000. (1) The vast majority of noncash transactions continue to be settled with paper checks, which despite gains in efficiency and speed, still require costly and time-consuming sorting and transportation. An alternative--electronic check presentment--could save time and money. Yet, electronic services have been slow to take off, possibly because of the way the Federal Reserve prices them. If the pricing structure were revised, there might be more demand from banks (2) for electronic services, and a higher level of efficiency, theoretically, might be obtained.

This paper uses data on purchases of the Federal Reserve's electronic check services by individual banks and tests whether demand for these services varies among depository institutions. We find that small and large banks use the services differently--large commercial banks are more likely to use MICR Information and Image than are small or medium banks, but the opposite is true for the other electronic check services. Demand elasticities may vary as well, although few of our estimated elasticities are statistically significant, suggesting that demand for the Federal Reserve's electronic check services does not adjust with price shifts, probably because other factors (besides the Federal Reserve's prices) can influence banks' decisions on how much to buy. We find that small and medium banks have more elastic demand for MICR Information than the large banks. However, data matching limited our sample and prevented us from drawing definite conclusions. Our results presented in this article are not conclusive eno ugh to make policy recommendations, and should not be construed as such. Instead, this article is intended to raise the issue of differentiated pricing for electronic check products.

The paper is organized as follows: The next section briefly describes the check collection process and outlines the types of electronic check services that the Federal Reserve offers. Section II explains some features of the demand for these services. Section III focuses on the relationship between bank size and demand for the various products. Section IV describes the data used in this article. Section V shows the actual use of each electronic check service by depository institutions. Section VI specifies the econometric models used to estimate the use of the Federal Reserve's electronic check products, and Section VII presents the results of that estimation. Section VIII concludes.

I. Types of Electronic Check Services

Background

For most checks, the collection process occurs roughly as follows: The person to whom the check is made out (the payee) deposits it in her bank (the bank of first deposit or the depositary bank). If the account of the check writer (the payor) 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, on a monthly basis, to the payor. An interbank transit check can be handled by multiple institutions, with several processing steps at each point. Legal presentment takes place when the check is delivered to the paying institution or its designated processor. If the paper check is stopped at any time before it reaches the check writer, the process is called check truncation. (3)

Technology can expedite the collection process. During check sorting, paper checks can be processed such that information encoded in the magnetic image character recognition (MICR) line can be collected and sent in electronic files. This information is gathered when a check passes through a reader-sorter. Because at least one pass through a reader-sorter is typically required during the forward collection process, MICR information is a valuable byproduct of check processing that is created at very low or even zero incremental cost.

The MICR information can then be electronically delivered to the paying bank, and, with minimal change in the routine collection process, the paying bank can use this information in a variety of ways. For instance, MICR information can be used to verify that accounts hold sufficient funds before paper checks arrive. The bank can go a step further and clear the checks based on information contained in an electronic file, treating the electronic delivery of information as the presentment of the check, in which case the process is called electronic check presentment, or ECP.

The electronic process is intended to improve on the traditional method of paper check presentment. Using ECP could reduce not only time, but also cost--indeed, some forms of ECP may be less expensive than paper checks. (4) The number of electronic checks processed by the Federal Reserve Banks has been growing, and such checks now constitute over 20 percent of their total processed checks. However, usage of ECP services currently is not high, possibly because of how the Federal Reserve prices them.