This is part of an ongoing series.  For previous installments, go here.

Before we wrap up our tour, there is one more payment method we have to cover, which is the check.  The oldest non-cash payment method, it is also the only one that is on the decline, although its death is protracted and uncertain.  The 2019 Federal Reserve Payments study found that the number of checks written had declined from a 2000 peak of 42 billion to 14.5 billion in 2018.  This is shown in the figure below.  Note that “on-us” means checks between two accounts held by the same bank.  The legend “Converted to ACH” will be explained below.

Decline in Checks 2000-2018

Source: The 2019 Federal Reserve Payments Study, December 2019.

As you can see, the rate of decline has decreased over time, and 14.5 billion is still a lot of checks.  For reasons having to do with the network effect I discussed in Part 2, as well as other factors, checks have proven stubbornly resistant, especially now that most are processed electronically.  The value of checks written has occasionally gone up, because small-dollar checks written by consumers have converted more rapidly to cards and ACH, while large-dollar checks remained integral to corporate cash flows for a longer period.

We update our familiar model with some new terminology:

The five-actor model adapted to checks. Buyer and seller are payor and payee, buyer's bank and seller's bank are drawee and drawer banks, and the network is one of two clearinghouses: The Federal Reserve and The Clearinghouse.

Having their origins in medieval times, checks (or cheques, as they are called in Europe) are a debit product, because they draw funds from a bank account with the permission of the owner.  In this way, they are like ACH auto debits and payment cards – they “pull” funds from an account, as opposed to “pushing” funds to an account.

Since there may be some reading this who no longer use (or never used) checks, here is a quick explanation of how they work:

  1. The Payer, or buyer, fills out a check, and hands or mails it to the Payee.
  2. The Payee deposits the check with his or her bank, also called The Bank of First Deposit.
  3. The Bank of First Deposit sends it to the clearinghouse, which is operated by either the Federal Reserve or The Clearinghouse Payments Company of New York.
  4. The clearinghouse determines from the routing/transit number (the first set of numbers on the bottom of the check) which bank is the Drawee Bank, or the bank from which funds will be drawn. The Bank of First Deposit is also known as the Drawer Bank.
  5. The clearinghouse batches all the checks that are going to each Drawee Bank and sends them out.
  6. When the Drawee Bank (the Payer’s bank) receives the check, it refers to the account number (the second set of numbers on the bottom of the check) and debits the Payer’s account.
  7. If there isn’t enough cash in the Payer’s account to cover the check, the Drawee Bank may (more than one is possible):
    1. Return the check to the clearinghouse as unpayable. This is referred to as a “bounced check”.
    2. Cover the check, but charge interest for doing so (called an Overdraft Line of Credit).
    3. Charge an overdraft fee, which can be less than $10 or over $30 dollars, depending on the kind of account the Payer has.
    4. Return the check to the clearinghouse as payable.
  8. When the clearinghouse gets a check marked payable, it simultaneously debits and credits the reserve accounts of the drawee and drawer banks. Banks are required to maintain reserve accounts at the Federal Reserve sufficient to cover their usual daily traffic.  Note that this is net settlement, which evens out daily fluctuations and reduces the required reserves.
  9. When the Drawer Bank gets the transfer from the clearinghouse, it moves the amount of the check into the Payee’s account.

With so many parties involved, paper checks could take several days to process, and there were delivery delays caused by weather, or simply accidents like a delivery truck running off of the road. With electronic payments becoming more common, checks were becoming a real headache for banks and their customers.

Check 21

The answer to all this was a law called The Check Clearing for the 21st Century Act (Check 21), which went into force in October 2004.  Check 21 required banks to accept images of checks rather than the original paper.  As a stopgap while banks geared up to accept images, the law created something called a “substitute check,” or “image replacement document (IRD).” For a time, banks could opt to have a third party company close to them print out the images and deliver them to the check sorters.

By 2010, the transition was mostly complete.  In the interim, however, a number of enterprising bridge applications arose.  The most successful of these was NACHA’s ARC code, for Accounts Receivable Entries. also known as “check truncation.”  Banks now could accept just the key fields and use them to construct an ACH transaction instead.  This removed even the need to take an image, and to generate a substitute check.  For a time, ARC was the fastest-growth type of ACH transaction. Following the “check card,” which I covered in Part 4 on Debit Cards, the ARC was the second big example of enterprise payments strategy, where a payment made in one form factor was converted to another form factor without the underlying systems being aware of the change.

Overdraft Fees

As checks became digitized and the revenue from float dried up, banks started raising their overdraft fees in response.  Whereas a typical overdraft fee in 1998 was $21.57, by 2020 it had grown to $33.47, according to Statista. Banks also started to optimize their overdraft fee revenue by changing the order in which they processed the checks.  Before, a bank would use a “first in first out” (FIFO) process; now, it sorted the checks from largest to smallest, and processed them in that order.  While the official position was that this benefited customers by ensuring that their largest (and presumably most important) checks were processed first, in practice it made it more likely that a low balance account would be overdrawn on the first check.  By honoring the overdrawn check (called a “courtesy overdraft”), the bank could ensure that all subsequent checks were also overdrawn and charge the same high fee for each of them. Low income customers could be faced with fees exceeding the value of the overdrawn checks.  One “solution” the banks pushed was an overdraft line of credit; this would ensure that no checks were actually overdrawn, although some banks charged a (smaller) fee for using the overdraft line, plus interest every month that the line was used.  After a public outcry, the Federal Reserve responded in 2009 with new regulations that forced banks allow customers to “opt in” for overdrafts, and if they did not, simply refuse to honor the overdrawn check without charging a penalty.  However, litigation continues to this day, and has led in to the rise of so-called “neobanks,” which used a prepaid card platform to present a very simple transaction account with no overdraft feature and no overdraft fees.  While neobanks have evolved beyond this original concept, that is where they got their start.

Check Fraud

As noted, there used to be a long time between the time a check was written and the time the funds were deposited into the payee’s account.  Criminals took advantage of this time by engaging in a fraud scheme called “check kiting.”  The idea was to open a dummy checking account, deposit a sum of money, and then write a series of checks in excess of the deposit to fund additional checking accounts.  By the time the checks wound their way through the system, and were returned for insufficient funds, all the money in the original account would be gone, and the drawee bank would be stuck with the losses.  Setting up a series of checking accounts in this way would enable the fraudster to multiply their original investment without attracting attention.

Check kiting was a major driver of efforts to digitize checks.  It also drove efforts to verify customer identities more rigorously, and to share the identities of bad customers between banks.  Early Warning Services, now known popularly as the company behind Zelle, got its start providing these services to banks experiencing a high rate of fraudulent deposits.  Check kiting is also a reason banks will hold onto funds for a time after receiving them to allow time for the drawee bank to discover the fraud.

Another popular fraud scheme was to forge checks using a good copy, typically from a business.  This actually became easier as a result of Check 21, because the security features, such as watermarking, that were built into corporate checks did not survive imaging well.  Since all the relevant information (routing number, account number, etc.) was already on the check, it was easy to white out or scratch out the original payee and amount and write in new ones.  Banks offered a service called “positive pay,” which required corporate customers to send a list of the checks they issued to their bank.  When the bank received a check requesting payment, they would compare the check to the list the company sent over, and if it did not match, would reject it.  Banks also used new fraud scoring models based on data collected by a consortium of banks, to identify risk deposits in real time, so that they could be subjected to greater scrutiny.

The Future of Checks

In December 2009, the United Kingdom created a deadline of October 2018 to phase out checks altogether, but there was an outcry and the deadline was removed in 2011.  Other countries, such as The Netherlands and Sweden, were more successful, but the US and France are still the biggest users of checks in the world, with no firm plans to get rid of them.  However, in the UK cheques accounted for only 0.8% of total cashless payments volume in 2019, according to the Bank of International Settlements.  The arguments in favor of checks tend to be these:

  • Many people trust checks more than ACH or P2P services. As with the controversy over PIN vs. signature debit, this is a mistaken view; in fact, with the entire account number printed right on the check, checks are more vulnerable to fraud than ACH.  There is something, however, about the tangible paper check, as well as habit, that creates a sense of comfort that is hard to shake.  No doubt widely publicized data breaches of card and account data contribute to the feeling that purely electronic payments are not as safe.  Nevermind that checks cease to be paper once they are deposited, or that banks long ago stopped including the original check in payer’s bank statements (they do still print the images).
  • Checks are available to all people who have a checking account, and do not require access to the Internet, a mobile phone, or any other electronic device. Thus, in rural or underserved areas, they are still important.
  • Checks are universally accepted – as with other longtime payment methods, the network effect is powerful with checks, making checks difficult to dislodge. Other substitutes, like cards, still do not have the level of acceptance checks do, although a growing number of retailers no longer accept check, eroding this advantage somewhat.

As a banker once said at a conference I attended, “banks are great at creating new payment methods, and really bad at getting rid of them.”  I expect checks will eventually become one more format supported by enterprise payments systems, as imaging becomes universal and the paper artifact becomes less and less useful.  While you still need to know what checks are, for future generations they will be a trivia question like “what was VHS?”