The Check 21 legislation, which will take effect Oct. 28, will dramatically alter check processing by making imaging more attractive economically. This will soon reduce the number of paper checks passing through the payments system, creating substantial surplus capacity in the processing business.
The Federal Reserve can help trim that excess by shutting down its check processing over the next two or three years.
The Fed handles over one-third of all checks passing between banks. Nevertheless, it has fallen increasingly short of a requirement of the Monetary Control Act of 1980: that it recover all costs incurred in providing services to the banking industry and earn what it would have as a private enterprise.
Last year the Fed missed its profit target by $155 million, after having fallen $69 million short in 2002 and $51 million short in 2001. These shortfalls reduced, dollar for dollar, the amount the Fed turned back to the Treasury, adding to the budget deficit.
This year, as volume declines, the shortfall will be much higher than the $69 million the Fed budgeted. These shortfalls constitute a taxpayer subsidy of the processing business and enable the Fed to compete unfairly against other processors.
Check 21 will worsen this situation unless the Fed gets out of the check business.
The new law will prompt a rapid reduction in processing volume. It will give the bank in which a check has been deposited the right to present an electronic image or a paper reproduction - an image replacement document, or IRD - to the paying bank.
Until Oct. 28 the depositing bank must present the original check unless both have agreed to electronic presentment. From that date on the paying bank must accept IRDs, which can be printed locally. Transmitting images to a paying bank or a IRD printer will not require check sorters or check transportation.
Furthermore, the per-check cost of imaging will drop sharply and image clarity will improve as the per-check cost of handling paper will keep escalating. Consequently, though the volume of checks written will continue to decline as consumers and businesses convert to other payment methods, the volume sorted and transported by the Fed and other check processors will plunge even faster.
Not physically handling checks will save billions of dollars annually. Within a few years many businesses will image the checks they receive and deposit them electronically. Deposited checks will also be imaged at teller stations or inside ATMs.
The Fed has begun downsizing its check processing infrastructure; the closure of 13 of its 45 processing centers is under way. However, it still intends to operate a processing and transportation network paralleling the banking industry's.
It would be more efficient to shut down the Fed network. The industry could then rationalize its processing capacity as volume shriveled further.
The Federal Reserve's Board of Governors should initiate an exit from check processing by simply adhering to the Monetary Control Act.
To have met its profit target last year the Fed would have to have raised processing charges by 29%. But doing so would have reduced volume, requiring even higher prices, leading to even lower volumes.
As perverse as it may seem, that is exactly what the Fed should do - drive itself out of the check processing business by raising prices enough to meet its profit target. Higher prices would hasten the shift toward noncheck technologies and imaging, and that is precisely the public policy objective.
Small and remote banks would not be harmed by higher prices and the Fed's exit from check processing, because community banks are leading the transformation to imaging. In an age of electronic communication, no bank is remote, as ACH payments have demonstrated. The day of the nonlocal check is rapidly disappearing.
Though Congress did not intend to accelerate the shift from paper check processing and transportation when it passed the Monetary Control Act, rigorous application of the law would produce that result. Congress should prod the Fed to move quickly to boost its check prices to again be in compliance.
The outcome would be highly beneficial to all concerned.
