The check float puzzle. (check collection in banking)

Although the last few years have seen a dramatic surge in interest in new electronic payment instruments, consumers and businesses in the United States still write checks in vast numbers. Nearly 63 billion checks were written in 1995 according to one estimate, representing 78.6 percent of all noncash payments (Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries 1995). Check use has continued to expand in recent years, despite the increased use of debit cards and the automated clearinghouse; the per capita number of checks written grew at an average annual rate of 1.3 percent from 1991 to 1995. Moreover, forecasts call for check use to remain around current levels for the foreseeable future (Humphrey 1996). Because the social costs associated with the use of paper checks constitutes the majority of the real resource costs of the payment system--65.4 percent according to David Humphrey and Allen Berger (1990)--it will be important to continue to seek improvements in the efficiency of the check system in the years ahead.

The efficiency of check clearing is affected by the arrangements governing presentment and payment. These arrangements have a feature that is, for economists, puzzling. Helen writes a check to John for, say, $100. When the check is ultimately presented to Helen's bank for payment, the bank pays $100, and deducts $100 from Helen's account. VAM is surprising, from an economist's point of view, is that the bank pays the same amount, $100, no matter how long it took for the check to be presented. This implies that John's bank earns an additional day's interest by getting the check to Helen's bank one day sooner. This feature is puzzling because it is difficult to identify any significant social benefits to Helen or Helen's bank from getting a check from John's bank one day sooner, certainly nothing approaching the magnitude of one day's interest.

Check float is the time between when a check is tendered in payment and when usable funds are made available to the payee (John in our example,).(1) Because John and his bank bear the opportunity cost of foregone interest until the check is presented, they have an incentive to minimize the float. But check float provides interest income for Helen and her bank. Under current arrangements Helen and her bank implicitly reward John and his bank for reducing check float. Helen's bank stands ready to turn over their float earnings. John's bank thus has an incentive to capture those float earnings by accelerating presentment. Another way to state the puzzle is that the benefits to Helen and her bank do not seem to justify the incentive provided to John and his bank to minimize check float. For this reason I call it the "check float puzzle."

The resolution of this puzzle is of more than intellectual interest. Because collecting banks forgo interest earnings on the checks in their possession, they have a strong incentive to present them as quickly as possible in order to minimize the interest foregone. Collecting banks are motivated to incur significant real resource costs to accelerate the presentment of checks. Check processors, including the Federal Reserve Banks, routinely compare the cost of accelerating presentment to the value of the float. Checks are sorted at night and rapidly shipped across the country. But if there is little or no social benefit of accelerating the presentment of checks, then much of the real resource costs associated with check processing and transportation would represent waste from the point of view of the economy as a whole. It may be possible to alter this puzzling arrangement and improve the efficiency of the payment system.

The check float puzzle can be directly attributed to the fact that the laws and regulations governing check clearing mandate par presentment; the payor owes the face value of the check, no matter when the check arrives. Par presentment implies that the real present discounted value of the proceeds of clearing the check are larger the faster the check is presented. Par presentment essentially fixes the relative monetary rewards to alternative methods of clearing, taxing slower methods of clearing relative to faster methods. As with any regulation that fixes relative prices, there is the potential to distort resource allocations. In this article I argue that the distortion appears to be significant. This is Only part of the story, however. There could be offsetting benefits that make par presentment a good thing. To justify current arrangements there would have to be social benefits of clearing checks quickly that payees and their banks--the ones deciding how fast to clear the check--do not take into account.

The check float puzzle is of interest to the Federal Reserve System (the Fed), both as payment system regulator and as the largest processor of checks. In the 1970s the Federal Reserve Banks established a number of Remote Check Processing Centers (RCPCs) around the country with the avoided goal of accelerating the presentment of checks (Board of Governors of the Federal Reserve System 1971; Board of Governors of the Federal Reserve System 1972). Critics have argued recently that Federal Reserve operations should be consolidated to take advantage of economies of scale in check sorting (Benston and Humphrey 1997). But closing down Fed offices could increase the amount of time it takes to collect some checks. Should this result be counted against the decision to close an office? More generally, when performing a cost-benefit analysis of alternative payment system arrangements, what value should be placed on changes in the speed of check collection?

Check Float

A few words about how check clearing works will be useful as background. Checks provide a simple arrangement for making payments by transferring ownership of book-entry deposits. Helen (the "payor") writes a check and gives it to John (the "payee"). John deposits the check in his bank, which then initiates clearing and settlement of the obligation. A check is a type of financial instrument or contingent claim. It entitles the person or entity named on the check, the payee, to obtain monetary assets if the check is exchanged in accordance with the governing laws and regulations. One noteworthy feature of the check is that the holder of the check is entitled to choose when the check is exchanged for monetary assets. In other words, the check represents a demandable debt.

John's bank has a number of options available for getting the check to Helen's bank for presentment. John's bank could present directly, transporting the check itself or by courier to Helen's bank. Alternatively, the check could be presented through a clearinghouse arrangement in which a group of banks exchange checks at a central location. Another option is to send the check through a correspondent bank that presents the check in turn to Helen's bank. Or the check could be deposited with a Federal Reserve Bank, which then presents the check to Helen's bank. These intermediary institutions could themselves send the check through further intermediaries, such as clearinghouses, other correspondent banks, or other Reserve Banks.

The length of time it takes to present a check depends on where the check is going and on how John's bank decides to get it there. First, the checks received by John's bank during the business day are sorted based on their destination. Sorting generally occurs during the early evening hours. Afterward, many checks can be presented to the paying bank overnight- A check drawn on a nearby bank might be presented directly early the next morning. A group of neighboring banks that consistently present many checks to each other might find it convenient to organize a regular check exchange or clearinghouse in which all agree to accept presentment at a central location. Checks drawn on local clearinghouse banks can generally be presented before the next business day.

For checks drawn on other nearby banks it might be advantageous to clear via a third party, such as a check courier, a correspondent bank, or the Federal Reserve. A third-party check processor posts a deadline, usually late in the evening, by which local checks must be deposited in order to be presented the next day. Third parties also clear checks drawn on distant banks. Often such checks can be presented by the next day as well, especially checks drawn on banks located in cities with convenient transportation links. For checks drawn on remote and distant locations, however, an additional day or two may be needed to get the check where it is going. For example, a check drawn on a bank in Birmingham, Alabama, and deposited at the Federal Reserve Bank of Richmond is usually presented to the Birmingham bank in one day, while a check drawn on a bank in Selma, Alabama, is usually presented in two days.

When does John's bank collect funds from Helen's bank? If the two banks do not have an explicit agreement providing otherwise, Helen's bank is obligated to pay John's bank on the day her bank receives the check, provided it is received before the appropriate cutoff time. If the check is presented by a Federal Reserve Bank, the cutoff time is 2:00 p.m.; if anyone else presents the check, the cutoff time is 8:00 a.m. Helen's bank is obligated to pay by transfer of account balances at a Reserve Bank or in currency; in practice Reserve Bank account balances are the rule. Checks presented after the cutoff are considered presented on the following business day.

A majority of the checks in the United States are presented in time for payment the next business day. According to a recent survey by the American Bankers Association (1994), over 80 percent of local checks are presented within one business day, while only about half of nonlocal checks are presented within one business day (Table 1). Over 90 percent of the dollar volume of checks cleared through the Federal Reserve are presented within one business day.

Table 1 Number of Days It Takes to Receive Available Funds on Checks Deposited through Banks' Check Clearing Network Average Percentage of Item Volume

                              By Bank Assets in Millions of Dollars 
                               Less than     $500 to    $5,000 
                                 $500          $4,999     or More 
Local Checks 
  Up to 1 business day           83.7          85.9         93.8 
  2 business days                12.7          11.0          5.9 
  More than 2 business days       3.5           3.1          0.3 
 
Number of banks responding      159            61           29 
 
Nonlocal Checks 
  Up to 1 business day           42.2          53.2         65.7 
  2 business days                40. … 

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