Payment Services

One of the most important functions of banks is to provide the means of making payments within the economy. Most small payments are made with currency, but on a volume basis, most payments are made by transferring a deposit in a financial institution from one party to another. These transferable deposits are called demand deposits, or checkable deposits, and they form the bulk of the money supply by the most common definition of the term. (Currency makes up the rest.)

A bank check is simply an instruction to the bank by its customer to transfer funds from the customer's (payer's) account to that of a third party (the payee). If the payment system is efficient, those orders will be implemented swiftly, cheaply, and with certainty. About 70 billion checks are written annually in the United States, requiring a massive system for collecting and clearing checks. Operating this system is a substantial task for banks.

The simplest procedure for collecting checks takes place when the payer and the payee of the check have accounts at the same bank. The bank collects the check simply by reducing (debiting) the account of the payer by the amount of the check and then crediting the same amount to the payee's account.

When the check writer and the payee use different banks, the payee first deposits the check in his or her bank, which in turn collects the funds from the payer's bank. If both banks belong to the same clearinghouse (check-clearing organization), the banks may deal with one another directly. If not, the bank may send the check either to another bank that provides check collection services (a "correspondent bank ) or to its own Federal Reserve bank. All banks must maintain deposit accounts (called reserves) with their regional Federal Reserve bank. These banks in turn collect the checks sent to them by crediting the reserve account of the bank depositing the check and debiting the account of the bank on which it was written. The Federal Reserve bank also returns the check to the payor's bank, which usually returns it to the payor with his or her next monthly statement.

One of the chief reasons for the establishment of the Federal Reserve System in 1913 was to create a more effective check collection system. Before the system was created, the collection of out-of-town checks was slow and costly, although clearinghouses handled local checks efficiently.

Until 1980 the Federal Reserve provided its check collection services without charge to banks that agreed to maintain reserve accounts with the reserve. The Monetary Control Act of 1980 changed this system, however. It required all banks to maintain these reserves, made Federal Reserve services available to all depository institutions, and required the Federal Reserve to charge full costs for all services provided.

Clearinghouses

A clearinghouse is a meeting place where representatives of participating banks come at specified times each day with all the checks they have received that are drawn on other member banks. Some banks will have more checks drawn on other banks than those banks will have drawn on them, and vice versa. Rather than have each bank settle its accounts with other banks on a bilateral basis, (he clearinghouse arrangement allows the bank to settle only its net surplus or deficit. (Generally, the-clearinghouse notifies the Federal Reserve to credit the accounts of those of its banks that have a surplus in the clearinghouse, and to debit the accounts of those with a deficit. In a clearinghouse with ten members, for example, only ten adjustments to reserve accounts would have to be made on the banks' books. By contrast, if each of the ten banks had to settle with each of the other nine members, a total of 45 adjustments would be needed.

Electronic Funds Transfers

While most consumers still make their payments by checks, electronic wire transfer systems for household use are gaining popularity. The largest wire transfer system is the so-called Fed Wire, which links the nation's Federal Reserve banks with participating commercial banks. This system lets a bank transfer funds virtually instantaneously from its reserve account to the reserve account of another bank. All transactions on the Fed Wire are final, which means they cannot be reversed in the event a participating bank does not have adequate funds. By contrast, a bank receiving a paper check cannot be sure that the check is good. There are several private wire transfer systems, the largest of which is the New York Clearing Mouse Interbank Payments System (CHIPS).

The automated clearinghouse (ACH) provides a way to reduce the cost of handling paper checks by putting check information into a form that is machine readable. A typical ACH transaction might involve a large employer putting payroll information on magnetic tape that is then delivered to the ACH. The ACH combines the information on that tape with the information on tapes from other employers and sorts it by payee bank. Each bank then receives a tape with information on the amounts to be credited to the accounts of its depositors. The actual transfer of funds would be made by the bank of the employer. The ACH should lead to sizable economies of scale as volume grows and may reduce the cost of a payment transaction to less than that of a paper check. Point-of-sale (POS) systems have still greater potential to reduce the costs of making payments. These systems use a plastic card (a "debit" card) and a terminal at the merchant's checkout counter. The customer can electronically transfer funds from his or her bank account to the merchant's account. The technology is identical to that used in the automated teller machine (ATM), which allows a customer to use a card to withdraw funds or perform other banking transactions. The federal government uses POS technology to make certain welfare payments. Instead of receiving a monthly check, welfare recipients receive debit cards that allow them to draw on a specified amount of funds.

Some bank customers can make payments electronically using devices such as telephones, home computers (through internet), or interactive cable-television systems. The success of these various electronic payment systems will ultimately depend on their cost and convenience to the consumer.

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