by Paul M. Connolly, Retail Payments Product Director, Federal Reserve Bank of Boston
Atlanta, Georgia
November 18, 1996

     I really appreciate this chance to speak with you at the annual Treasury Management Association Conference. We in the Federal Reserve spend a lot of time with the bankers who serve your needs, but not nearly enough time with what I might call the end users of the U.S. payments system, including corporations. The Reserve Banks provide payment services only to depository institutions, so naturally we tend to talk mostly with them, as our customers. But increasingly we are recognizing that you are the customers of our customers, and if we want to understand what goes on in the payments system, and what the opportunities and obstacles are to improving that system, we need to know more about the practices and needs of the end users.

    My own belief is that the more we understand about you and your companies, the better a job we can do in serving our customers and helping them to serve you. Speaking with you at this conference, therefore, is an important way for me to try to get some dialogue going with corporate America. I hope that some of what I talk about this afternoon will be interesting enough for some of you to want to have some follow-on involvement with the Federal Reserve.

    My focus today is on the retail payments system of the country. By retail I mean most of the payments we make. In the Federal Reserve we classify the large value payments, such as those made over FEDWIRE and through CHIPS, as wholesale. They represent most of the dollar value transferred between parties, but a tiny portion of total transactions.

    By contrast, retail payments, particularly checks and the automated clearing house, or ACH, constitute nearly all of the payments made by means other than cash. While their dollar values are relatively low, retail payments, and checks in particular, dominate the system in terms of transaction volume.

    Although the largest single operation performed by the Reserve Banks is check collection, our strategic goal is to help move toward a mostly electronic U.S. retail payment system. We want to work with the banking industry and end users such as you to replace most of today's checks with electronic alternatives. Wherever that is not feasible, we want to collect the checks electronically rather than by paper presentment. A mostly electronic payments system will reduce costs, reduce risk, and collect funds faster. These are important objectives for the payments system and for the financial system which payments support, and we are paying a lot of attention to determining how best to move toward this strategic goal.

    While that is the goal, I have to admit that we seem to be a long way away from it. Where are we now? In a nutshell, we have about 60 to 65 billion checks being written in the United States annually, and that number still is growing, although at a pretty low rate. We may have 5 or 6 billion electronic payments in all forms, including the ACH, debit cards, and home banking systems. So far the migration from paper to electronics has been very slow.

    We know that there are many issues and obstacles impeding the migration to electronics. In the Federal Reserve we are trying to analyze the total picture by looking at various segments of payment activity and seeking as much knowledge and insight as we can get about each segment. About 40 percent or so of those checks are written by corporations. Nearly all of the rest of them are written by consumers, and most of those checks are written to pay bills to corporations. It's pretty obvious, then, that if we want to understand what needs to be done to move toward a mostly electronic retail payment system, we must learn as much as we can about payments by corporations and to corporations.

    Here are a few of the issues that we see when we look at corporate payments. First, we are amazed that the use of ACH Direct deposit to pay wages and salaries still has not reached 50 percent of American workers. After 20 years with ACH Direct Deposit in use, estimates of its penetration range from less than 30 percent to more than 45 percent; all agree that the majority of American workers still are paid by check. Since direct deposit seems so beneficial to the employee and the employer, we have to dig deeper to understand why adoption of direct deposit is taking so long.

    Most checks written by consumers are written in the home to pay bills. Nearly all of these consumer-to-business payments are made by check. If we are to have a mostly electronic system, we must have electronic solutions for these bill payments. And evidently we will need more and better solutions than we have today.

    Most payments by businesses to other businesses still are made by check. No doubt there are many reasons why this is so. The automated systems used by many businesses and their banks are built around the use of checks, and corporations may not have the infrastructure readily available to convert large portions of their payments to electronics. Support for electronic data interchange, or EDI, to enable electronic delivery of payment information along with the payment, has been slow to evolve in most places.

    We in the financial industry simply may not yet understand sufficiently what you and your businesses really need to move more rapidly into electronic payments.

    And check float remains a barrier to increased use of electronic payments. The current dynamics of the check clearing process give the initiator of a payment some incentive to use a check, because the several days of delay in the mailing, processing, collection, and presentment of a paper check allow the issuer of the check to enjoy the use of the funds for a longer time. Meanwhile, the check collection costs are borne by the recipient of the check, not the issuer. Some have said that the significance of float has diminished dramatically in recent years with much lower interest rates than we had in earlier periods. This ought to be so, but float still seems to be an important consideration to some significant portion of businesses. I really would like to get your perspectives on float, and on these other corporate payment issues as well.

    So, progress toward electronics has been slow, and we have a lot of issues to address. Nevertheless, we can see some positive signs for the future.

    New electronic payment options seem to be on the threshold of explosive growth. This is particularly true for consumer transactions at the point of sale. Just a few years ago it was unusual to see machines in supermarkets to support electronic payments. Now, in most areas of the country a card machine is literally in your face as you come through the checkout line. You are encouraged to pay with either a debit card or a credit card. The ability for consumers to use their ATM cards as debit cards has been a key factor in people's migration to this form of payment. You see these point of sale machines more and more in gas stations, department stores, and other retail establishments. Clearly they are having some impact on the use of checks and cash.

    The diffusion of PC technology in households and small businesses also is a positive sign. It is evident now that some swath of consumers will change their behavior, and use their PC's instead of their checkbooks to pay their bills with the new home banking systems. Small businesses also seem attracted to PC banking as part of their efforts to put much of their record-keeping and other business functions on PCs. By some estimates close to 40 percent of American households now have personal computers, and this number is certain to grow substantially. I do not have a number for small businesses, but my perception is that the overwhelming majority of them have at least one PC. As banks and other providers bring forward more attractive and convenient options for financial management, including bill payment, with PC software, the use of this mechanism in place of checks will grow.

    Of course, it is ironic that most of the payments now initiated electronically through PC banking systems are completed with paper checks. We've managed to do the hard part, which is to change consumer behavior. But thus far we have not been very successful at what ought to be the easier part, adapting the banking and corporate payment systems to accept electronics instead of paper. Over time, though, this will change. And by the way, we in the Reserve Banks are interested in helping that change to occur, if you and your banks would like us to try to bring all of the key parties together to address this concern.

    And demographic changes seem likely to play a role in moving us along toward electronics. You read a lot about younger people being so much more comfortable with PCs and computer technology than their elders. I think some of this is overstated. For instance, the percentage of retired people who accept their social security payments through ACH direct deposit is greater than the percentage of younger, working people who accept their salaries through ACH direct deposit. Nevertheless, today's high school and college students and very young adults seem more disposed to conducting more of their personal business electronically than prior generations were.

    One illustration of this trend to think about is the proliferation on college campuses of stored value card systems and similar mechanisms to enable students to make all of their purchases with a single card and avoid the use of cash and checks. Pretty soon we will have millions of young workers in the labor force who will be very comfortable, perhaps even demanding, of electronic payment mechanisms. You may find more demand from them for electronic alternatives to pay their bills to you.

    We have some reason for optimism, therefore, as we look ahead. Still, there are many needs that must be addressed. We will need more electronic payment options which in some combination can displace most of today's checks and a fair number of cash payments as well. And we need diffusion of electronic options. There is something of a chicken and egg issue here. It is hard to have any particular payment mechanism accepted by businesses and retailers until many people show signs of using it. But it is hard to encourage people to use a payment mechanism until they see that most businesses will accept it. Diffusion, meaning universal or close to universal acceptability of a mechanism, is essential for its broad and sustained growth. Today checks and cash are accepted almost everywhere. Tomorrow we hope to see some number of electronic options accepted almost everywhere.

    Two major payment areas where more electronic options clearly are needed are bill payment from the home and payments by corporations, as I mentioned earlier. We have barely moved away from paper in both of these areas, which together account for a majority of today's checks.

    All of us have to address the float issue. If float provides incentives to use checks and disincentives to replace checks with electronics, we have to do something about that. Maybe we have to find ways to charge the float to the check-writer's bank. That bank in turn may decide to recover those costs from its check-writing customers. If so, we might expect one of two outcomes. The check-writers may have more of an incentive to look for electronic payment alternatives. Or, the check-writers may decide to accept those costs and continue to write checks. In this latter case at least the costs of using checks would fall more on the parties making the decisions to use checks. How to make such a change is a complex question, and here again your perspectives would be helpful.

    And at a very fundamental level we need much more education and promotion about electronic payments in the United States. It is remarkable to go to most of the major industrial countries in the world and find that neither businesses nor consumers rely on paper checks to nearly the extent that we do. In England, for example, the number of payments made through the ACH exceeds the number of checks written, and annual check volumes are declining. Households in England pay all of their utility bills through ACH direct payment. Consumers who write checks do not receive their cancelled checks from their banks. Other European countries have a very similar look. In England and elsewhere, bank associations, utilities, and corporations have strongly supported the use of electronic payments with mass advertising and sustained promotion in their communications with their customers. All of us in the United States have a long way to go to match that corporate commitment to electronic payments. This is a real need, and another area where we in the Federal Reserve are keenly interested in working with your banks and you.

    Well, taking all of this together, here are my expectations. I believe the future will be different from the past. Up to now, every prediction for a checkless society, or even a "less checks" society, has been proven wrong. This experience leads some observers to say that checks will continue to grow for the foreseeable future. I cannot predict when check volumes will level off and begin to decline. But I do believe that will happen, and will happen sooner than past experience alone would suggest. The very recent emergence of new convenient electronic options for consumers, the demographic trends I discussed, and other factors persuade me that check volumes will be declining sometime in the not too distant future.

    While I say that the future will differ from the past, I would also observe that most changes in the payments system are evolutionary rather than revolutionary. Change tends to happen over time, and interestingly, we tend to adopt new payment mechanisms without abandoning the older mechanisms. So we will have very significant change, but there will still be many paper checks around us for some time to come.

    This expectation for gradual change supports the case for pursuing electronic check presentment, or ECP. The essence of ECP is to collect the payments without collecting the paper. At some stage in the check collection process, extract the payment data from the paper and transmit that data electronically through the collection stream to the check-writer's bank. Leave the paper behind.

    You might think of ECP as an intermediate stage between the current system and a mostly electronic system. The current system depends upon repetitive handling, processing, and delivery of the paper checks through the hands of one, two, three, four or sometimes even more banks, as well as the recipient of the check, and ultimately the check-writer's bank and even the check-writer when he receives his cancelled check. Ideally, we will replace most of those checks with electronic initiation of the payments. If we believe that we can move swiftly from a world of over 60 billion checks to a world of, let's say, 6 billion checks, than ECP may not be worthwhile to pursue. However, if we believe that the checks will decline gradually, then taking steps to make that check collection process more electronic is worthwhile. And the longer we expect to have many billions of checks used annually in the United States, the stronger the case for ECP becomes.

    The Reserve Banks have been focused on ECP for some time, because we see it as about the best thing you can do to improve upon the current paper-bound check collection process. If most checks can be collected with ECP we can reduce costs, accelerate check collection, accelerate the return of bounced checks, and deter some of the growing check fraud.

    For these reasons Reserve Banks have been promoting ECP, or check truncation as it is sometimes called, for several years. We actually are truncating over 300 million commercial checks annually right now. That is a very small fraction of the 16 billion checks collected by the Reserve Banks each year. However, we have been increasing this number fairly rapidly and we aim to grow this truncation volume much more rapidly in the near future.

    For many years we also have provided check truncation services to the U.S. Treasury. The Reserve Banks truncate more than 400 million government checks annually. Over the next few years most of these checks will be converted to electronic payments in keeping with the recent federal legislation mandating electronics for most government payments, and in keeping with the Treasury's longstanding commitment to replacing checks with electronics.

    During the past few years we have begun to use image technology in place of microfilm for the long term storage and retrieval of copies of truncated checks. Image provides higher quality copies. Image also enables us to retrieve and deliver copies electronically, and even to allow banks using our services to make direct inquiries into an image data base to look at or retrieve copies of particular checks.

    Besides truncation, we have other electronic check services which enable banks to try out the use of the check payment information in electronic form while continuing to receive the paper checks, either on the same day or a number of days after we deliver the electronics to them. Some form of electronic information replaces or accompanies about 20 percent of the checks we present to banks, and here also we expect this percentage to grow more rapidly as we move forward.

    Over time, working with the banking industry, we want to convert most checks to electronic collection. To pursue this direction we recognized the need to get perspectives other than our own Federal Reserve views. So, about a year ago, we organized our industry advisory group on ECP. This is an ambitious effort to bring the banking industry and the Reserve Banks together to address very important issues of common concern. We have a group of somewhat more than a dozen senior bankers, representing large banks, community banks, some major clearing houses, and other associations, all sharing our conviction that we need to improve the check collection system with electronics.

    We believe this collaborative effort will help to bring together our best thinking to chart a course toward comprehensive ECP. We are sharing information about market research and operational experiences with truncation and other initiatives. We are collaborating on some hands-on tests and some analysis of the costs, benefits, and other issues pertinent to ECP.

    In September I spoke with the TMA's Government Relations Committee about the work of this advisory group. Your committee was very interested and expressed interest in having some corporate participation in some of the analytical work, and in some form of a test or experiment with electronic presentment of some corporate payments. We intend to talk more about that, and if you would be interested in some kind of involvement with this groundbreaking work, please let me know and please let your committee know.

    The more we work on complex payment issues such as ECP, the more we realize how much we do not know. Certainly we in the Reserve Banks do not have nearly enough knowledge about corporate payment needs. I wonder if even your banks really understand all of your needs and your perspectives on how you send and receive payments today and how you might like to do so tomorrow. I think all of us need more of your corporate perspectives. And in closing, I want to point to a number of subjects for which we Reserve Bank people need your input and would like to work with you and your banks.

    On ECP, what corporate needs must be met? How will you benefit if the checks you receive can be collected faster with electronics? If you are a retailer, does truncating the checks at your point-of-sale make sense to you? If the checks you write are to be presented to your bank electronically, without the paper, what problems does that pose for you, and how can we solve them? Are there particularly serious problems with larger-value checks, but significantly fewer problems with smaller-value checks? Your input on these issues will help us. I will only ask that you come at these issues and others with a willingness to change the archaic paper-bound system we have today.

    Earlier I mentioned that we are baffled by the slow adoption of ACH direct deposit for paying wages and salaries. From your perspectives, how can we convert most of today's paychecks to direct deposit? What more must be done with the ACH product itself, or in other facets of the payroll process, to get from 30 or 40 or 45 percent to 90 percent?

    In a similar vein, how can we apply direct deposit to dividend payments, and to other payments which on the surface would lend themselves very well to electronic rather than paper form? Shouldn't corporations want to pay their shareholders as quickly and reliably as possible with ACH rather than with checks? Why does this not happen very much today, and what can all of us do to convert many of these checks to ACH?

    The other side of ACH direct deposit is ACH direct payment, in which consumers can authorize businesses and utilities to debit the consumers' bank accounts each month for the payment of bills. But bill payment through the ACH has not caught on for very many payments. We can see limitations in this mechanism. The consumer may feel a loss of control over the timing and the amount of the payment. Still, this mechanism ought to be used more than it is for some bill payments. Where do you believe ACH bill payment is most viable? What enhancements to the ACH do you believe would make it more viable?

    Another frustrating situation which I mentioned earlier is the "back end" of PC banking. How can we complete these payments electronically rather than with paper drafts? As recipients of many of these payments, what do you need to be able to accept the transactions electronically? Do you need standard formats from the PC banking providers? Do you need more information to be carried in the electronic record? Do you need your banks, and perhaps do they need the Reserve Banks, to perform any conversion or standardizing operations to funnel these payments to you in ways that will support your efforts to process them efficiently?

    Those are some specific payment practices and issues where we would like to get your corporate perspectives. There are some broader questions where again your insights would help us considerably.

    What are the essential characteristics for new electronic means of payment? For your businesses to convert most of your checks to electronics, what would you have to have in the electronic systems you would use? What is missing from today's world of ACH and EDI?

    As another broad issue, what would change if check writers incurred check collection costs or float costs? If the costs of the collection process were charged to the businesses and individuals writing the checks, do you believe that would change behavior?

    And most generally, what do corporations need to move more payments to electronics? This applies both to the payments you make and to the payments you receive. Some of us may see only the interbank flow of payments, and may look too narrowly at what you confront as you evaluate payment practices. Are you stymied by a lack of robust electronic payment services from your banks? Are you constrained by your internal systems? Or are the obstacles to electronic payments more in the broader arena of the payments system itself? That is, do we just not have electronic payment mechanisms with enough of what you need to convert your checks to electronics, and to be eager to promote the use of electronic payments by consumers making payments to you? To reach our goal of a mostly electronic payments system, we really need to know what holds you back from moving more rapidly in that direction, and what would help you to move more rapidly.

    If I may give you just one more area where we could use your help, it is in understanding the current uses of large-value checks, and what might accelerate their conversion to electronics. You may know that very recently the Reserve Banks announced that they no longer will accept for collection checks with a value of $100 million dollars or more. There are not many of these checks, but an amount of that size cannot even be encoded on the check, so these checks require special manual handling. They carry a higher float risk because of this requirement for special handling. Moreover, in our view a transfer of such a large value should not be subject to the delays and uncertainties of the paper check system. So, we won't take them anymore, and over some period of time we hope that these huge payments will move away from the check system into secure electronic systems with immediate or same-day finality.

    We intend to go further and take steps to discourage the use of checks with values less than $100 million dollars, but still very large values, in the millions of dollars. We want to discourage these large-value checks for the same reasons that we don't want checks above $100 million dollars.

    However, we know that checks are used today to make payments of, say, $10 million dollars or $20 million dollars. We also know that the parties initiating and receiving these payments are fully aware of FEDWIRE and CHIPS and other electronic alternatives. So we need to understand why today's business practices incorporate the use of checks in the millions of dollars. Why are they used in preference to electronic payments? What kinds of business transactions are most likely to require or prefer check payments in these amounts? What would you want us to know about your use of them before we take further initiatives? I know that you know much more about this subject than the Reserve Banks know, and we welcome your information and advice.

    Well, I've cited a number of broad and specific issues where we really would benefit from the best thinking you and other corporations can give to us. I hope you will take to heart my theme this afternoon. The Reserve Banks want to help to improve the retail payments system with electronics. We will be very active in pursuing our strategic goal of a mostly electronic retail payments system. We know that to be effective in pursuing this goal, we need to learn from and work with the banking industry and the end users of the payments system. We are seeking your help. We hope that you will talk with us, work with us, and share our commitment to building the best payments system America can have. Thank you.