The Paper Check’s Death Began on September 11, 2001

Movement away from issuing paper checks for payments has steadily increased, especially since the tragic events of September 11, 2001 in the United States. The terrorist attacks on that day saw not only the deaths of more than 3,000 people and the collapse of the twin towers of the World Trade Center, but also resulted in the grounding of all commercial planes for three days. At that time, paper checks were shipped around the country, mostly by plane, to their final destinations. It became immediately and painfully clear that paper checks were a very inefficient way to process payments.

Writing in March 2013 issue of Business Insider Australia, Thomas Owen noted the following: On a normal day, about $6 billion was literally up in the air as checks flew to their destination. That amount grew to $47 billion after the FAA grounded planes in the wake of the 9/11 terrorist attacks. Those events played a major role in the successful passage of the Check 21 Act, allowing banks to make use of electronic images of checks rather than the physical paper checks themselves.

It’s been a runaway success: Almost no payments are settled between banks using paper checks anymore. Even substitute checks—paper checks from printed images, a workaround allowed by Check 21, were “practically zero” by 2011, according to a study published last year by the Federal Reserve Bank of Philadelphia.

After 9/11 Everything Changed in the U.S.-Payments World

Yet all this change is invisible to ordinary banking customers and small businesses, who still write and deposit checks the way they always have—unaware that the paper check has a short lifespan after it leaves their hands.The number of checks is dropping, but slowly. U.S. consumers and businesses wrote 28 billion checks in 2009, a figure that’s been dropping about 1.8 billion a year. At that pace, according to the Philadelphia Fed study, paper checks will take until 2026 to go away entirely.

One big trend that could accelerate the paper check’s death throes is the continuing shift to e-commerce. Banks are doing their part. Most offer features like mobile check deposit—which uses the provisions of Check 21 to route the image of a check capture by a smartphone right into the payments system.

How Digital Check Imaging is Saving $3 Billion Per Year

Timothy Taylor, Editor of the Journal of Economic Perspectives of Macalester College in St. Paul, Minnesota, gives additional information about check imaging from David Humphrey and Robert Hunt’s “Getting Rid of Paper: Savings from Check 21,” Working Paper 12-12 for the Federal Reserve Bank of Philadelphia.

“Although the technology has been available for almost two decades to digitize check images and collect checks electronically on a same-day basis, the legal requirement of physical presentment inhibited its adoption. The September 2001 disruption spurred the Federal Reserve to ask Congress to allow a paper representation of the digital image of the front and back of a check (called a substitute check) to be legally the same as the original physical item for purposes of collection and presentment. This legislation, adopted in 2003 and known as Check 21 (Check Clearing for the 21st Century Act), along with other initiatives, currently permits almost all of the 24.5 billion checks paid annually in the U.S. (worth $32 trillion) to be collected electronically on a same-day (or next-day) basis once they are deposited at a bank. The original check is imaged and transported electronically, and a substitute check is printed close to where the paying bank is located. The substitute check is then physically presented for payment. Since accepting billions of substitute checks is more costly than accepting and paying the electronic image itself, almost all paying banks now receive and pay the image.”

This is a huge change from how check processing used to take place, as described by Humphrey and Hunt: “The Uniform Commercial Code has long required U.S. checks to be physically presented to the banks they are drawn on for payment. The required physical presentment generated expensive air and land courier transportation costs. It also led to delays in check collection of from 1 to 5 days, averaging 1 day for local or within-city checks and usually 2 to 3 days for non-local items such as checks going from one city to another across the country.”

The Check 21 legislation has shortened the float, so that it often happens in the same day or in one day, and never in more than two days. Humphrey and Hunt’s study estimates that going electronic is saving the banking system $1.2 billion a year, with consumers and businesses getting $2 billion in benefits from faster payment processing.

The story of the transition from paper checks to digital checks isn’t a major economic episode. But it’s one more nice illustration of how digital technology and the Internet have been transforming the ways in which economic activity is conducted.

The Future of the Check

Humphrey and Hunt also note that the result of two decisions will determine the future of the check and Check 21. First, consumer payors have to decide to write a check or, instead, use a card at the point of sale or sign up for a pre-authorized ACH debit for a bill payment. Business payors make a similar decision, but their only alternative is to make bill payments and pay employees using ACH. Second, payees must decide to clear a check using Check 21 or to convert it to an ACH debit. But NACHA rules limit ACH conversion to checks written by consumers (not businesses).

The Payor’s Decision: To Write a Check or Not

The study also explains that Consumer-to-business checks (C2B) account for 45% of all checks written. Importantly, C2B checks have fallen by 4.7 billion over the last three years and they accounted for 90% of the benefits they received by being a paying bank for business checks. This is one explanation for the NACHA rule. There were 8.6 billion C2B remittance or bill payments in 2009 and 2.0 billion point-of-sale payments.31 With so many consumer remittance checks, there could be a big impact on future check use if consumers switched rapidly to preauthorized ACH debits (or the Internet) for bill payment. This large potential is unlikely to be quickly realized, however, as the growth of pre-authorized ACH debits has been slow in the past. These payments are cumbersome to set up and hard to stop, and the biller initiates the payment, so consumers have little control. While businesses have been interested in getting consumers to adopt pre-authorized debits to obtain faster funds availability and a more predictable revenue flow, this interest will likely slacken since checks can now be collected more rapidly via Check 21.

The Payee’s Decision: How to Clear Checks Received

Humphrey and Hunt note that checks written can be cleared or paid using Check 21, which currently accounts for 88% of checks written (24.5 billion items). Alternatively, a payee can collect a check using ACH POP, ARC, or BOC, which together account for the remaining 12% of checks written (3.3 billion items). While both ACH check conversion and Check 21 reduce float, Check 21 can provide slightly better funds availability at a similarly low cost. During the years 2006-2009, 0.7 billion additional consumer checks were converted to ACH debits. Since there is now little difference in funds availability between ACH debits and Check 21, the 6.0 billion downward trend in checks paid during 2006-2009 may be 0.7 billion less than before as the incentive to clear checks via ACH to obtain faster funds availability has been effectively eliminated. This could change, however, if NACHA rules are altered to allow same-day ACH debits.

Strategic focus for Federal Reserve Financial Services

Sandra Pianalto, President and CEO of the Federal Reserve Bank of Cleveland, attended the Federal Reserve Bank of Chicago Payments Conference in October 2012, where she noted the following:

The U.S. payments industry has undergone extraordinary change in a short period of time. Of course, we know what has replaced cash and checks: Credit, debit, and prepaid cards along with electronic transfers, that is, ACH. Together, these electronic transactions represent 40% of retail payments. At the Federal Reserve, we expect this migration to electronic payments to continue as end-user preferences change and as new products and services come on stream.

Check 21 is a model that demonstrates the Federal Reserve’s ability to change with the industry. As a consequence of Check 21, the Federal Reserve has reduced check-processing staff positions by about 5,000, and we have closed 44 check sites around the nation. We have eliminated our extensive air and ground-transportation network for paper check delivery. We built an infrastructure that last year moved 7 billion check images from collecting to paying banks. Check 21 reduced clearing time for consumers, businesses, and banks. It reduced costs for the banking industry. And it improved safety and security.

Let me now turn to the Federal Reserve’s vision for the U.S. payments system a decade from now. This vision is driving our plan of action, which includes organizational design, investments in technology, and industry outreach. Our vision has three key principles: First, the payment industry of the future will move transactions faster from origination to settlement. Second, the payment industry will function more efficiently. And third, the industry will develop the array of payment instruments that satisfy consumer preferences.

For decades, the check system had a deferred availability schedule, with some checks not settling for as long as a week, and no certainty of good funds for longer than that. With many improvements since then, all checks in the United States now clear either on a same-day or next-day basis.

I am certain that there will be a time when all ACH payments and the surviving check payments will clear almost instantaneously, or, at the very least, on the same business day that they are initiated.

What gives me confidence that we can accomplish this goal is Great Britain’s Faster Payments Service. Faster Payments went live four years ago and it demonstrates that it is possible to accelerate end-to-end delivery of individual payments from the next day to no more than an hour or two on the same day. This was a collaborative enterprise of banks, technology vendors, and regulators. The Faster Payments Service and Britain’s ACH system operate independently. The Faster Payments Service now carries payments traffic that is equivalent to 13 percent of all ACH volume in that country.

The Faster Payments Service, or something more far-reaching, is within our grasp. NACHA has been working toward a same-day solution for several years now. Although its work has spurred divergent opinions and healthy debate, there is progress.The industry has been working on reducing costs since the 1970s, when the first Electronic Data Interchange standards were developed. Later, in the 1980s, NACHA introduced a mechanism to carry invoice information along with each B2B payment. However, the vast majority of B2B payments are still not accompanied by trade information. Making use of the remittance fields in ACH and wire transfers could reduce exception handling costs by helping to match invoices with payments. Greater use of remittance information could also drive more B2B traffic from checks to electronic payments.

However, consumers often choose payment instruments on the basis of qualitative attributes, such as convenience, certainty, security, and privacy. Consumers are less conscious of the speed and cost of an individual payment. For instance, in the future, consumers will increasingly want to use their mobile phones and tablet computers to execute payment transactions, just as they already use those devices to make phone calls, surf the internet, and send text messages. Consumer payment preferences are shaped by qualitative factors that are difficult to foresee.

Mobile payments have yet to gain traction in the United States. But evidence from such countries as Kenya, South Africa, South Korea, and Singapore shows that the right combination of standards, teamwork, and marketing can yield strong demand for mobile and contactless payments. In the future, in the United States, you will be able to replace your leather wallet with a mobile wallet containing bank account data, linked to the ACH, check, and card networks. Your mobile wallet may also include personal identification documents such as your driver’s license, insurance cards, and health records. The Federal Reserve has been working with mobile industry stakeholders in the United States to help collect information on the direction of mobile payments, and to understand the potential barriers and risks.