Drawn on a U.S. Bank: The Curious Behavior of Retail Check Clearances in a Global Financial Environment

Journal of Economic Issues, Dec, 1999 by Zena A. Seldon

One World... One Currency... Visa.

Visa International, Annual Report, 1993.

Because banking and associated institutions (including rules and practices of central banks and payments systems) are intricate, it is difficult to disentangle outcomes from the organizations involved in their making. Organizations and institutions both are path dependent; for example, in the absence of Regulation Q, U.S. banks might never have developed money market accounts. The connections are necessarily complex, reflecting Richard Nelson's [1995, 85-86] assessment that:

... economics would be a stronger field if its theoretical framework were expressly evolutionary. Such a framework would help us see and understand better the complexity of the economic reality. That, I think, is its great advantage. But it will not make the complexity go away.

While most institutional analyses focus on existing organizations and institutions, this paper takes a somewhat different approach, investigating the absence of a structure--a North American cross-border check clearance mechanism--where one might have been expected to develop.

To further our understanding of adjustment costs within an evolving set of institutions and the resultant infrastructure, this paper considers the case of the small-denomination cross-border check clearance system between the United States and Canada. A comparison with the European experience is used to shed light on the possible causes and consequences of the lack of such a cross-border payment system. The conclusion is that because an alternative mechanism developed to fill the gap, by the time the Federal Reserve System offered the needed infrastructure, it could no longer effectively alter organizational development. The moral is that in organizational development, as in love, timing is everything.

Curious Behavior

Both Americans and Canadians take for granted the ability to pay for such items as memberships in professional associations or subscriptions to journals by personal check. Americans are unlikely to notice, let alone question, the reasons behind a rider at the end of most invitations to membership mandating that "non U.S. residents should [must] make payment by check or money order in U.S. dollars, drawn on a U.S. Bank." In contrast, Canadians wishing to make purchases directly from the United States are certain to take heed. They typically find themselves unable to make payment by personal check, even if they wish to carry out such transactions on a regular basis. The inability is particularly significant in that most Canadian chartered banks offer checking accounts denominated in U.S. dollars.

To an individual Canadian (retail) bank customer, the cost of holding a U.S. dollar checking account has been low and at the margin can be zero. While money orders are cheaper than electronic funds transfers (efts) or wire transfers, personal checks typically are cheaper still, especially for someone who makes frequent purchases in U.S dollars. Further, writing a check is substantially more convenient than queuing at the bank or the post office for a money order.

In spite of this seemingly artificial suppression of cross-border checks, between percent and 2 percent of all small-value, paper transactions are cross-border. Based on data supplied by the Canadian Payments Association, the total dollar value (in billions of dollars) of checks, travelers checks, gift certificates, and money orders flowing between Canada and the U.S. between 1992 and 1997 can be seen in Table 1.

In addition to paper transactions, cross-border transactions are also made using Visa or MasterCard. Visa refused to supply information on the fraction of their transactions that were cross-border. MasterCard Canada reported that between 8 and 15 percent of their total sales were cross-border. Using a fairly conservative estimate of 10 percent, the total annual cross-border dollar value (in billions of $Canadian) of Canadian credit card transactions can be estimated as seen in Table 2.

While customers clearly could make use of credit cards, the obvious question about checks still arises: if a check is drawn in U.S. dollars, why must it be drawn on a U.S. bank? The answer, presumably, cannot be one of differential risk. First, since the check is in U.S. dollars, U.S. sellers face no threat of currency revaluation. [1] Second, U.S. dollar checks received in the eastern United States and drawn on financial institutions in California surely are no less risky than those drawn on a big-six Canadian chartered bank in Ontario. The situation is particularly anomalous in light of the 1987 Canada-United States Free Trade Agreement and the subsequent North American Free Trade Agreement (NAFTA), both of which were supposed to lead to financial free trade.

The Unintegrated Payments Systems

At first glance, a possible explanation for the missing link seems to lie in the virtually complete separation of the U.S. and Canadian clearance processes. A more detailed examination suggests that while the separation may be symptomatic, it does not provide an explanation.