Check Processing

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The check as a payment mechanism is being replaced by the increased use of electronic payments. The number of checks written in the United States has been falling since the mid-1990s. At the same time, the number of checks being processed electronically is increasing.

Instead of transporting and sorting paper checks as was done in the past, financial institutions such as banks and credit unions and some businesses process the checks that they receive electronically.

In line with this trend, the Federal Reserve Banks reduced the number of places at which paper checks are processed. Before their restructuring initiative that began in 2003, Federal Reserve Banks processed checks at forty-five locations. Since February 26, 2010, the Federal Reserve Banks have processed all paper checks at just one location.

One of the initial pushes for the electronification of checks occurred when companies were first allowed in 2002 to capture the information on the magnetic ink character recognition (MICR) line at the bottom of a consumer check, keep an image of the check and process the payment as an automated clearinghouse (ACH) transaction. Companies that receive a large number of paper checks, such as credit card processors, public utilities and phone and cable companies, took advantage of this change.

The shift from paper to an electronic format moved forward in October 2004 when the Check Clearing for the 21st Century Act became effective. This legislation—commonly called Check 21—facilitated electronic check collection by introducing a new negotiable instrument called a "substitute check." A substitute check is a special paper copy of the front and back of an original check that is the legal equivalent of the original. Previously, to collect checks electronically, all financial institutions in the collection process had to agree to do so. Otherwise, original paper checks had to be presented to the institution on which they were drawn. Under Check 21, institutions that wish to process checks electronically may do so provided that if, in the process of collecting a check they encounter an institution that insists on receiving paper items, they provide that institution with a substitute check created from the electronic image file.

Today, the Federal Reserve receives almost all the checks it processes for clearing as electronic check images. Regardless of whether checks are processed as paper or electronic items, financial institutions have several alternative ways to receive payment for, or clear, checks deposited with them.

In 2009, interbank checks, which are checks that are deposited at and drawn on different depository institutions, accounted for about 74 percent of the checks paid that year. The remaining 26 percent of checks were "on-us" checks, which are deposited at and drawn on the same depository institution..

To clear on-us checks, the institution makes the appropriate entries on its books, by debiting the payor's account and crediting the depositor's account. To collect the remaining interbank checks, a financial institution may:

  • present the paper checks or transmit images of the checks directly to the paying bank,
  • forward the paper checks or images of the checks to a correspondent for collection,
  • exchange checks, in paper or electronic form, with a group of banks participating in a clearinghouse arrangement, or
  • forward the paper checks or images of the checks to a Federal Reserve Bank for collection.

Generally, smaller deposit-taking financial institutions either deposit checks for clearing with a Federal Reserve Bank or with a correspondent. A correspondent may be a larger commercial bank, a bankers' bank or a corporate credit union. Larger institutions may deposit exclusively with a Federal Reserve Bank or use a combination of methods to clear checks. All depository institutions, either directly or in conjunction with a correspondent, may deposit checks with a Federal Reserve Bank. Check deposits are received as either bundles of paper checks called "cash letters" or, more commonly, computer files of imaged checks called "image cash letters." The Federal Reserve Banks charge depositors a fee for check-clearing services.

When cash letters or image cash letters are deposited with Federal Reserve Banks, they credit the Federal Reserve account of the depositing institution or its correspondent. The Reserve Banks debit the Federal Reserve account of the paying institution or its correspondent when the checks drawn on the paying institution are presented to that institution for payment. A paying institution may choose to receive checks drawn on it in image files or in paper form. If the financial institution elects to receive check presentments in paper form, it will most likely receive substitute checks. The paying institution then charges the accounts of the customers who wrote the checks in accordance with its account agreement.

Regulation CC of the Board of Governors of the Federal Reserve System and certain state laws limit how long financial institutions may hold funds deposited by check before making the funds available for withdrawal by a depositor.

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