| Booklet:
Retail
Payment Systems Section: Payment Instruments, Clearing, and Settlement Subsection: Check-Based Payments |
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Until recently, consumers used checks more often than any other retail payment instrument in the United States other than cash. Checks are very convenient payment instruments. Consumers can use them at the point of sale, for bill payments, and for person-to-person transactions. Nonetheless, checks comprise a decreasing percentage of the total non cash payment volume in the United States.
In recent years, check-clearing associations, financial institutions, and the Federal Reserve have introduced or participated in various electronic check presentment (ECP), electronic check conversion (ECC), and check imaging initiatives supporting the conversion, or truncation, of checks to electronic form. Consumers will no longer have a float period when using electronically converted checks for purchasing goods and services and paying bills.
ECP improves the speed of collection and return of checks. It enables check truncation by using magnetic-ink character recognition (MICR) line information to present checks electronically to the paying institution for payment. ECP eliminates the need to forward the paper check physically. Check imaging technology supports ECP and the creation and use of “substitute checks” stored on secure electronic media for retrieval when needed.
Increasingly, using ECC, payees convert checks to ACH or EFT transactions. Once the payee converts the check at the point of sale through ACH or EFT, or in a lock box environment through ACH, the transaction is governed by existing regulations for whichever electronic payment network is used.
In
the past, financial institutions have agreed among themselves to use various
forms of check truncation, such as using a check image or MICR information
from a check to substitute for the original check. The Check 21 Act (CTA)
declares that a qualifying substitute check shall be the legal equivalent
of an original check even in the absence of institution-specific agreements.
Such
substitute checks must meet certain specified requirements to be treated
as a legal equivalent, and the truncating institution must indemnify other
parties for losses that result from their receipt of a substitute check
instead of the original check. Financial institutions should consider
the implications of the CTA on the institution’s risk profile. Examiners
should stay current with anticipated supervisory guidance that will address
the significant risks that can arise from implementation of the CTA.
Check
Clearinghouses
A check includes the names of the payer and the payee, the account number,
amount of the check, and the name of the paying financial institution.
The MICR line at the bottom of the check enables high-speed reader/sorter
equipment to process checks. Before financial institutions process checks,
they encode the amount of the check in magnetic ink at the bottom of the
check. Check formats are governed by standards developed by the Accredited
Standards Committee (ASC) on Financial Services, X9B Committee, which
works under procedures sanctioned by the American National Standards Institute
(ANSI).
Financial institutions clear and settle checks in different ways depending on whether the checks are “on-us” checks (checks deposited at the same institution on which they are drawn) or interbank checks (the payer and payee have accounts at different financial institutions). On-us checks do not require interbank clearing or settlement. Interbank checks can clear and settle through direct presentment, a correspondent bank, a clearinghouse, or other intermediaries such as the Federal Reserve Banks.
Under
direct presentment, depositary financial institutions can present checks
directly to the paying financial institution. The paying financial institution
may settle with the depositary financial institution through a pre-arranged
settlement agreement or settle by sending Fedwire® funds transfers
through the Federal Reserve Banks.
Correspondent banks, acting on behalf of other depository financial institutions, can settle the checks they collect for other institutions, known as respondents, by using accounts on their books or using their Federal Reserve Bank reserve account.
Financial
institutions can also clear checks through a Federal Reserve Bank or an
independent clearinghouse, where they have formed voluntary associations
that establish an exchange for checks drawn on those financial institutions.
Typically, financial institutions participating in check clearinghouses
use the Federal Reserve’s National Settlement Service to effect
settlement for checks exchanged each business day.
There
are approximately 150 check clearinghouse associations in the United States.
Smaller depository institutions typically use the check collection services
of correspondent banks or the Federal Reserve Banks.
Figure
2: Check Clearing and Settlement |
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Figure
2 depicts the typical interbank check clearing and settlement process
through a Federal Reserve Bank or clearinghouse. In step 1 the consumer
uses a check to pay a merchant for goods or services. The merchant, after
authorizing the check, accepts the check for payment.
At
the end of the day, the merchant accumulates the checks and deposits them
with its financial institution for collection (steps 2 and 3). Depending
on the location of the paying institution, the funds may not be immediately
available. For deposited checks payable at other financial institutions,
the merchant’s financial institution uses direct presentment for
processing or sends the checks to a Federal Reserve Bank, clearinghouse,
or correspondent bank (steps 4 and 6). The check or an electronic presentment
file is sent to the consumer’s financial institution, and the financial
institution’s account at the correspondent, clearinghouse, or Federal
Reserve Bank is debited (steps 5 and 7).