Operations in Financial Services

Operations in Financial Services


Prof. M. Pinedo


Gorka Briones

Cristina San Jose

May 2005

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Check processing in the 1960s

Nodaway Valley Bank, Northwestern Missouri

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In the United States, retail noncash payments are usually made using checks, credit cards, debit cards, and an electronic payment system called Automated Clearing House (ACH). Consumers, businesses and government entities made 70+ billion retail noncash payments in 2000. The total value of these payments in 2000 was $45+ trillion, more than four times the US GDP for that year. The Federal Reserve processes about 40% of the US checks while the rest are processed by big banks and private clearinghouses.

This paper analyzes the reasons behind the low penetration of electronic payment instruments in the US, and the potential benefits and likelihood of a change in the payment instruments mix. We have focused our analysis in Checks and ACH payments, as suggested by comparing the US payment mix with the one in place in other developed economies. Our conclusion is that compatibility issues between the Check and the ACH systems, as well as a lack of incentives for retail customers and banks to switch to ACH payments are in the roots of the problem.

To analyze the potential benefits of an increase in the penetration of ACH transactions, we assess the cost of each network.Ouranalysis shows thatbecause of its current mix of payment instruments, the US system might be incurring in much higher costs that its European counterparts, as an ACH payment is more than 50% cheaper than paper based instruments.

To analyze the likelihood of a natural increase in the demand of ACH transactions we studied the various incentives for stakeholders in the network (retail customers, business customers and banks) to switch to ACH payments. On the demand side, we found that there are no strong incentives for retail customers to switch to ACH, while both cost and revenue incentives are pushing business customers towards ACH. On the supply side, the importance of checking related revenues, the existence of network externalities and the fragmentation of the industry are preventing non ACH enabled banks to offer the service. Then, we analyze and propose several incentives to boost ACH as a more cost efficient payment system.

Additionally, we outline the DEA analysis for Check processing in a fully compatible payment system, as the asymmetric treatment of float and non sufficient fund fees create different performance indicators for the different instruments. The trade off between productivity and quality is highlighted in the analysis.

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a) Decline in the number of checks8

b) Downsizing of check processing facilities9

c) Check 21 Act 10



a) US dependence on checks12

b) Situation of credit/debit cards13

c) ACH, Credit Transfers and Direct Debits15



a) Check 21-enabled checking network18

b) ACH network19

c) Compatibility of Paper Checks’ and Image Checks’ Network20

d) Compatibility of Paper/Image Checks’ Network and ACH20

e) Detailed Compatibility Overview21



a) Processing costs22

b) Cost comparison across networks24



a) Check float vs. the predictability of ACH settlement25

b) The perceived price of check transactions27

c) Convenience28



a) The importance of checking related revenues30

b) The existence of Network Externalities31

c) The fragmentation of the US banking industry33 33




a) The need for additional incentives36

b) What are the potential incentives?39

c) Incentives proposal40



a) Check processing flow in fully compatible networks43

b) DEA Analysis of Step 2: Bank’s Central Processing Center (Collection from Branches/Sorting/Credit Customer’s Account/Delivery to the Clearing House) 44

c) DEA Analysis of Step 3: Clearing House (Collection/Sorting/Delivery to the Paying Bank) 46

d) DEA Analysis of Step 4: Paying Bank (Collection/Sorting/Check Availability of Funds/Debit Customer’s Account or Return Check to Collecting Bank) 48


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Recent years have seen dramatic increases in the use of electronic modes of payment in the US (a)

As check volumes decline, unitary costs go up, due to the fixed costs represented by processing centers. Both banks and the Federal Reserve are attempting to reduce these fixed costs by using part-time staff and consolidating the processing centers (b) However, given that these centers are built to process large volumes, any consolidation will necessarily remove processing capacity in large chunks, rather than matching the slow but steady decline in volumes.

With banks reporting checks declining from 3-8% a year, the need to move to electronic check processing has become acute. The October 28, 2004 effective date of the Check Truncation Act (Check 21 Act) has created a deadline on which banks and industry associations are focused (c).

a) Decline in the number of checks

The number of noncash payments in the United States has grown since 2000 at a 3.8% annual rate. Checks are the only payment instrument being used less frequently now than three years ago.

Electronic payments in 2003, including those made by credit and debit cards, exceeded check payments for the first time in the United States, according to the Federal Reserve. The Fed also estimates that credit cards and debit cards will both surpass checks in terms of total annual transactions by 2007. The number of electronic payment transactions totaled 44.5 billion in 2003, while the number of checks paid totaled 36.7 billion, down from 50 billion in 1995.

Check payments have decreased at an annual average rate of 4% from 2000 to 2003. As for electronic payment methods, they have increased at an average annual rate of 13% for the same period.

According to a survey by the American Bankers Association, consumers are increasingly shifting to electronic methods to pay regular bills. In 2003, 40% of bills were covered by either automatic deductions from bank accounts or through online bill payment. Electronic payment accounted only for 15% of the bills in 1979.

“People is becoming increasingly comfortable doing things online”, says a spokesperson from Bank of America, “Customers might start out looking at their monthly statement, then they might transfer money from savings to checking and then they might start paying a few bills. And once they try it, they see how easy it is and they love the convenience”

b) Downsizing of check processing facilities

As checks are phased-out, their earlier processing and sorting scale economies work in reverse and raise unit costs as volumes fall. In February 2003, even the Fed reported that “mainly because of declining check volumes”, its own financial performance had suffered over the past year. As a result of its dismal performance, the Fed has announced the downsizing of its check processing operations.

In August 2004, the Fed launched a second round of consolidation that will reduce the number of processing centers to 23 by 2006, from 32 at the end of 2004 and 45 in 2003, when it began restructuring its check operations. This latest round will cut a net of 270 jobs, on top of the 400 jobs cut in the first round[1]”

c) Check 21 Act

The Check 21 Act took effect in October 2004, and it is designed to be a flexible legislation, intended to speed the move toward electronic exchange away from physical transport of paper checks, facilitating check truncation. Interbank check truncation was pioneered in Germany, with the UK, France, Hong Kong and Singapore following close.

Check 21 gives banks the legal framework to accept digitized images of checks instead of hard-copy paper checks. The legislation was enacted for two reasons: as a post-Sept. 11 safety net for lost checks through business interruption and to cut costs for banks physically transporting paper checks.

Check 21 does not mandate that banks present checks electronically, but creates greater flexibility, which allows banks to choose between paper, image or a combination of both. Some banks feel, however, that Check 21 diverts attention away from other electronic payment initiatives, and does not deter customers from writing costly checks.

It is expected that Check 21 will reduce costs and provide increased flexibility to banks and consumers. Additionally, Check 21 will reduce overall risk, but it will also increase the vulnerability in certain areas, such as networks and IT systems, at least in the short run. As checks will clear sooner, the risk that a check will bounce back if funds are not in the account when the check is first written will also increased.


In spite of the steep decline in paper-based payment instruments in the US, the country is still heavily dependant on checks when compared to other developed economies like Japan or the European Union. The US is the country with the lowest penetration of electronic forms of payment relative to the volume of cashless transactions. Electronic forms of payment include debit and credit cards as well as ACH, credit transfers and direct debits. Additionally, the US is the country that writes more checks per capita (a)

If we focus in electronic payment methods only, the US is well ahead the European average in credit/debit card penetration relative to the total volume of cashless transactions. Only Denmark, Greece, Luxembourg and Portugal have higher penetration rates for these instruments. (b)

Therefore, the differences in check usage between Europe and the US must be mainly caused by electronic payment instruments other than credit/debit cards: Credit Transfers and Direct Debits. In fact, the rate of penetration of those instruments in Europe is 5 times bigger than ACH penetration in the US. (c)

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a) US dependence on checks

In spite of the recent decline, the extent to which electronic forms of payment have substituted for checks in the US is less than what is often supposed. Among developed countries[2], the US remains the most dependent on the use of checks.

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The US wrote an average of 125 checks per capita in 2003, which is more than 5 times the amount of checks written by the European Union average in 2001 (22 checks per capita). If we take into account the fact that this figure has been decreasing at an annual rate of 5% in the last five years (the average European wrote 27 checks in 1997 vs. 22 in 2001) the gap with the US would increase.

Among the EU members, France, UK, Portugal and Ireland are the heaviest check users, but still well below the US average. French write 6 checks a month, Britons write 4 and Portuguese and Irish write 2, while Americans write 10 checks a month.

Belgians, Danish, Germans, Spaniards, Italians and Austrians write less than 1 check a month, and Greeks, Luxemburguese, Dutch, Finesse, Swede and Japanese write no checks at all.

According to the share of checks in noncash transactions volume, the US appears as the most check dependant country, whit a penetration of checks (45% of total transactions) 3 times the European average (15%). Again, if we had available 2003 data for Europe the gap with the US may be wider, as check penetration has decreased 8 p.p in the last five years (check penetration in the EU was 23% in 1997 vs. 25% in 2001)

Other countries with a high penetration of checks are France (35%), UK (24%), Portugal (27%), Ireland (30%) and Italy (20%), all below the US average. These countries have been experiencing a steep decline in the usage of checks, with huge penetration loses between 1997 and 2001. In this period, Ireland lost 31 p.p., Portugal lost 15 p.p., France and the UK lost 12 p.p and Italy lost 10 p.p.

b) Situation of credit/debit cards

The US reliance on checks is not the result of a lower penetration of credit/debit cards as payment instruments. In fact, cards penetration in the US volume of transactions (42% in 2003[3]) is much higher than the European average (no data for Japan are available)

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The European average was 29% in 2001[4]. In the US, debit card transactions alone account for over half of all growth in electronic payments.

Especially interesting are the cases of Germany, Spain and Austria, were credit/debit card transactions account only for 11%, 26% and 15% respectively of all transactions (vs. 42% in the US) and still have very low rates of check penetration (2%, 7% and 1% vs 45% in the US)

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c) ACH, Credit Transfers and Direct Debits

From the data above we conclude that the differences in check usage between Europe and the US are mainly caused by electronic payment instruments other than credit/debit cards.There are three other instruments that we should consider: ACH in the US and Credit Transfers and Direct Debits in Europe.


The ACH is an automated system for exchanging electronic funds drawn against one another. The ACH system supports both debit (e.g., automatic payment of mortgages) and credit (e.g., direct deposit of payroll) transactions. Unlike the wire transfer, it is usually used to process higher volumes or small-dollar payments for settlement issues within 1 to 2 business days.

Developed in the 1970s, the ACH system was a banking industry attempt to replace the paper check. A collection of 32 regional electronic inter-bank networks is used to process the transactions electronically with a guaranteed one-day bank collection float.

Credit Transfer and Direct Debit[6]:

A Credit Transfer is a payment order or possibly a sequence of payment orders

made for the purpose of placing funds at the disposal of the beneficiary, like the deposit of an employee’s payroll. Both the payment instructions and the funds described therein move from the bank of the payer/originator to the bank of the beneficiary, possibly via several other banks as intermediaries or more than one credit transfer system.

A Direct Debit is a pre-authorized debit on the payer’s account by the payee, typically used to pay periodical bills such as utilities, telephone or rent.

We are going to compare the penetration of Credit Transfer and Direct Debit in Europe with the penetration of ACH in the US as its closest substitute.

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Germany, Spain and Austria, the countries with the lower penetration on both checks and credit/debit cards have the highest penetration of Credit Transfers/Direct debits, with 86%, 66% and 84% in 2001, compared with a penetration of 11% in the US in 2003. The European average is also well above the US, with a penetration of 56% in 2001. Actually, the average usage of Credit Transfer/Direct Debit has decreased slightly in Europe, falling from 63% in 1997 to 56% in 2001 as a result of the increase in credit/debit cards usage.[7]

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In this Chapter, we will address the compatibility among the Check and the ACH Network. As it is not mandatory for banks to accept ACH transactions, compatibility issues arise. Additionally, a recent piece of legislation (Check 21 Act) has added an extra layer of complexity, as the Check 21 forces banks to accept truncated checks from the Clearinghouses. Check 21 does not mandate that banks present checks electronically, but creates greater flexibility, allowing banks to choose between paper, image or a combination of both. A detailed overview of the different components of the Check 21-enabled Network and the ACH Network can be found in (a) and (b)

To analyze compatibility, first we analyze the compatibility between paper and image checks inside the Check 21-enabled Network in (c). Then, we analyze compatibility between the Check and ACH Networks, as for paper initiated ACH payments both banks need to work with ACH systems (d)

As a summary, we provide a detailed overview of the different compatibility issues among the various networks in (e)

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a) Check 21-enabled checking network

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b) ACH network

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c) Compatibility of Paper Checks’ and Image Checks’ Network

The Check 21 Act legally enforces compatibility between paper checks and image checks, by forcing the Paying Bank to accept substitute checks. Under the Check 21 Act, the Federal Reserve may send to the Paying Bank either an image or a printed substitute check. Banks can choose whether or not to accept and create images, but they must accept substitute checks.

Clearing Houses are in charge of melding both networks into one. This way of enforcing compatibility will result in two outcomes. First of all, customers will have to get used to not having their cancelled checks back. Secondly, every bank will have to invest in Check 21 Substitute Check Reading technologies to be able to process the files sent to them by the Federal Reserve. Otherwise, they will have to deal with them manually. The investment in Check 21 Image Creating technologies remains optional, so that every bank will be able to keep on sending paper checks.

d) Compatibility of Paper/Image Checks’ Network and ACH

An ACH transaction can be initiated either by a paper check or by an electronic payment order. When initiated by paper check at the Point of Sale/Lockbox, the check is converted into an electronic file and either given back to the Paying Party (Receiver) or destroyed. When initiated electronically, the Paying Party authorizes the Collecting Party to debit his account (online payment of utility bills, telephone). In both cases the Paying Party will receive an ACH report of the transaction.