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https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis THE COST OF THE PAYMENTS MECHANISM TO THE NATION'S COMMERCIAL BANKS Richard H. Freed July 1971 Special Studies Section Division of Federal Reserve Bank Operations Board of Governors of the Federal Reserve System CONTENTS I. II. INTRODUCTION . . . . . 1 THE PAYMENTS MECHANISM 2 METHODS OF MAKING PAYMENT. 4 Demand Deposits . . Check Collection Exception Items Other Related Expenses Econumies of Scale III. IV. 4 Wire Transfers. 11 Other Payment Methods Currency and Coin Money Orders Preauthor1zat1on Bank Credit Card Plans Food Stamps 12 CHECK PROCESSING WITHIN A BANK 16 DETERMINATION OF THE COMMERCIAL BANK CHECK CLEARING EXPENSE 22 Cost of the Demand Deposit Function 25 SUMMARY AND CONCLUSION . . . . . . . . 28 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 11 TABLES Page Estimated Distribution of Money Transfer Within the Banking System and Dollar Amount. 2 2. Check Writer/Receiver Interrelationships . 6 3. Transit Items Returned Unpaid. 9 4. Cost of Money Room Products. . . 13 5. Different Types of Proof Machines Used by Commercial Banks . 20 6. Bank Statistics by Bank Size. 24 7. Expense of Check Processing to Commercial Banks. 26 1. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis FIGURES Page 1. - 2. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Annual Check Volume. . . . . . . . . . . . . . . . . . . . . - Check Processing Within a Commercial Bank . . . . . . . iv ~ 5 21 INTRODUCTION For research purposes, the cost of the present payments mechanism can be studied in five parts (1) the cost to commercial banks, (2) the cost to nonbanking businesses, (3) the cost to individual consumers, (4) the cost to the Federal Reserve System, and (5) the cost to the Federal Government. Research already completed on the cost of the present payments mechanism showed that the payments mechanism expenses for the Federal Reserve System were $205.7 million and those relating to the Federal Government were in excess of $179 million in 1970.l/ The purpose of this study 1s to determine the cost of the present payments mechanism to all of our nation's commercial banks. cost analysis is divided into four sections The problem of Section I briefly defines the present payments mechanism, Section II explains in more detail the various components of the payments mechanism, Section III describes some of the processing points of the check clearing mechanism, and Section IV determines the approximate cost of the present check clearing system to all of the nation's commercial banks. This paper will concentrate mainly on the functions of the check clearing mechanism, as check payments account for most bank money transfers and because both descriptive and cost data on the other payments mechanism components relating to commercial banks are limited. 1/ Current Federal Reserve Payments Mechanism Expenses, John Thomas Whetstone, III and Jens Hugh Hutchens, Jr. (Board of Governors of the Federal Reserve System, September 1970) and A Study of the Cost of the Government Payments Mechanism, Eugene E. Snyder (Board of Governors of the Federal Reserve System, March 1971). https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -2I. THE PAYMENTS MECHANISM Commercial bank's payments mechanism refers to the transfer of monetary assets that begins when a buyer makes payment for the purchase of goods, services, or financial assets. This transfer of money from consumer to vendor may be accomplished in a number of ways, all of which generally fall under the concept of the payments mechanism. Table 1 ESTIMATED DISTRIBUTION OF MONEY TRANSFERS WITHIN THE BANKING SYSTEM AND DOLLAR AMOUNT.!/ Type of Money Transfers 1. 2. 3. Average Daily Number of Money Transfers Checks Wire Transfers Miscellaneous Source - 74,900,000 34,500 265,000 Per cent 99. 6-0.1 0.3 Average Daily Dollar Value of Money Transfers (in billions~ Per cent $29.2 25.2 0.6 52.8 46.1 1.1 The Check Collection System, Bank Administration Institute, 1970, p. 1. Table 1 shows the results of a study which intended to verify that checks are by far the maJor component of bank money flows, accounting for over 99 per cent of the average number of daily money transfers within the banking industry. Wire transfers comprised only 0.1 per cent of total bank transfers while 0.3 per cent are accounted for by miscellaneous methods. Those important components of the payments mechanism labeled as miscellaneous include currency and coin transfers, debit and credit advices from correspondent banks, bank credit card sales slips, and certain small volume transfers. Table 1 also shows that while wire transfers are a small component of the total volume of money transfers, they comprise almost 50 per cent of the dollar value of these transfers. This situation arises because the large commercial banks and the Federal Reserve System both make extensive use of wire communication facilities to transfer very large surns of woney. Wire l/ Information in this table was taken from a 1967 survey and a series of interviews with officials of commercial banks, Federal Reserve Banks, and clearinghouses in various cities. Data here refer only to money transfers within https://fraser.stlouisfed.orgthe banking system. Federal Reserve Bank of St. Louis -3- transfers of money have important° implitations' for 'fufure~aut'omationof tne payments mechanism because they greatly accelerate the availability of funds. The miscellaneous methods of money transfer previously mentioned play a relatively small role, both in volume and dollar value, in the nation's payments mechanism. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -4II. -METHODS OF MAKING-PAYMENT The following section will describe the various components of the payments mechanism, concentrating on the transfer of funds through demand deposits. Demand Deposits A check is a paper document which contains legal authorization to withdraw a specified amount of money from one's demand deposit account and to pay it to someone else. The check contains formatted information to identify who is to be paid, how much is to be paid, who is making payment, and where the check must be delivered in order that payment may be made. No precise count of check volumes is made due to the many checks issued and the many routes of collection, but it has been estimated that over 62 million checks are written each day, and that the same number are deposited or cashed at the nation's commercial banks.1/ With approximately 21.5 billion checks written in 1970, and with a proJected annual growth rate of approximately 7 per cent, 33 billion checks can be expected to be written in 1975. In addition, it has been estimated that a check is handled more than 10 times by clerks and machines in more than 2.5 commercial banks before it reaches its final destination. Thus, 21.5 billion checks written in 1970 turns into 230 billion check- handlings during that year.11 Figure 1 shows the Annual Check Volume from 1945 to 1968. According to research done by the Bank Administration Institute, individuals are the maJor check writers, accounting for about 52 per cent of all checks written, while businesses are the prime receivers of checks, 1/ The Story of Checks, Federal Reserve Bank of New York, 1970, p. 13. 11 The Check Collection System, p. 17. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -5Figure 1 ANNUAL CHECK VOLUME 1945-68 (in billions) (20.2) 20 15 10 5 1945 Source· https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 50 55 The Check Collection System, p. 3. 70 -6accounting for 55 per cent of all checks received.l/ Table 2 gives a further breakdown of check writer/receiver interrelationships. Table 2 CHECK WRITER/RECEIVER INTERRELATIONSHIPS (Per cent of Total Checks Written) w Receivers Individuals Businesses 35.9 14.7 Individuals Government 1.1 Totals 51. 7 r i Businesses 27.0 18.7 0.9 46.6 Government 1.1 0.4 0.2 1.7 42.8 55.0 2.2 100.0 t e r Totals s Source· The Check Collection System, Bank Administration Institute, p. 7. These funds are transferred into different accounts, whether within the same bank or across the country, by means of a diverse and complex check clearing mechanism. This clearing mechanism consists of a network of pro- cessing points tied together by a transportation and communication system. The processing points consist of the approximately 14,000 commercial banks and all their branches, 248 city clearing houses, and the 12 Federal Reserve Banks and their 24 Branches. Most of the checks are processed through about 400 large commercial banks and the Federal Reserve Banks. Check Collection The primary function of the check collection mechanism is to clear a check through the bank of first deposit and carry it ultimately to the bank on which it was originally drawn. About 30 per cent of all checks deposited for collection are payable at the bank of first deposit.1/ These checks are known as home debits or "on us" items and have a relatively short Journey through the 1/ The Check Collection System, p. 7. l! The Payments System· Problems, Fantasies, & Realities, Federal Reserve Bank of New York, Monthly Review, May, 1971, p. 109. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -7connnercial bank mechanism as they are already at their final destination. Home debits need only travel through the internal department of the bank of first deposit to complete the collection cycle. The remaining 70 per cent of all checks deposited are not drawn on the bank of first deposit and must be sent to the drawee bank, wherever it may be located, through either a local clearinghouse, a correspondent bank, the Federal Reserve System, or the drawee bank itself. Consequently, these transit or "on others" checks are the items that present the most problems of time to the check clearing mechanism. A clearinghouse is an organization established by banks in the same locality through which checks and other instruments are exchanged and net balances settled. Messengers from each bank bring bundles of checks, one bundle for each of the other banks inthe clearinghouse, and a list of the amounts due their banks from each other bank. When the drawee bank is not in the same locality as the bank of first deposit, a correspondent bank or the Federal Reserve System is used to clear the check. A correspondent bank serves as a depository and performs banking functions for other banks, usually out-of-town banks. Transactions are settled at the Reserve and correspondent banks by crediting the sending and debiting the receiving bank's deposit accounts. Federal Reserve Banks in turn use the Interdistrict Settlement Fund to settle their net balances through the Board of Governors of the Federal Reserve System in Washington, D. C. Federal Reserve Banks do not charge for check clearing services, while correspondent banks usually require deposit balances of their bank customers in payment for their services. The decision by bank officials as to which clearing technique to use is an important one, for any delays to the clearing mechanism cause a loss in opportunity to use those funds represented. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -8- Exception Items Besides those check items already mentioned, cormnercial banks also handle checks that are labeled exception items. Basically these include all items that cannot be handled in a routine way such as nonpar checks, envelope drafts, noncash items, and return checks. Nonpar checks are those that are paid by the drawee bank at some amount below face value. Recent years have seen a rapid decline in nonpar banking, resulting in fewer handlings, easier processing, and fewer routing problems. It has been estimated that within a few years there will be fewer than 200 nonpar banks in the United States.1/ Envelope drafts are those items in the check clearing mechanism that have irregularities, usually in the form of attachments, and therefore cannot be processed through regular channels. Noncash items such as maturing notes and bonds do not call for immediate payment and thus, cannot be collected through the regular check clearing mechanism. Return checks, while only accounting for a small portion of exception items, are the portion which affect handlings and float, and which in turn increase the expenses of the check clearing mechanism. Return items are checks returned unpaid because of insufficient funds, improper or wrong endorsement, being sent to the wrong bank, being misdated, or having a signature problem. In addition, some are checks written on nonexistent accounts and payment has been stopped on others. These items obviously require much time and effort which increases the processing costs for most commercial banks. l/ The Check Collection System, 1970, p. 25. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -9In 1967, approximately .75 per cent of all items presented for payment were returned unpaid. Thus, on the average 562,000 checks were returned unpaid each day amounting to 140 million items during the whole year.1/ Approximately one-half of all returned checks are eventually made good for pay' ment but the extraordinary processing costs are still incurred. Table 3 below shows some of the reasons for check returns and the percentages they account for. Table 3 TRANSIT ITEMS RETURNED ill~AID (average daily 1952) Source Reason for Return Per cent Insufficient Funds Endorsement Mis-routing Signature Uncollected Funds Other Total 54 19 11 3 3 10 100 The Check Collection System, p. 24. Most States permit direct return of unpaid items causea by insufficient funds, the greatest cause of returned checks. Thus, unpaid checks would be sent directly to the bank of first deposit rather than being routed back through the Federal Reserve System and all other endorsing banks. Other Related Expenses Two other results of the check payments system may also be looked upon as an expense to our nation's commercial banks. bank float and check kiting. check clearing mechanism. Both are a result of the time involved in the Commercial bank float is the dollar volume of items 1/ The Check Collection System, 1970, p. 24. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis These are commercial -10credited to customer accounts but not yet collected from the bank on which they were drawn. this commercial bank From the standpoint of the individual banks, float lowers their earning assets for, although the checks have been credited to the individual customer accounts, these new deposits cannot be invested until the funds are actually received. With check kiting, a drawer writes a check which he has insufficient funds to cover but the bank has no knowledge of his "insufficient funds" position due to the time involved in the check clearing mechanism. The law makes check kiting a criminal offense, but the law is difficult to enforce. Commercial banks must undergo a considerable amount of work in keeping accurate records of float ~n order to prevent check kiting operations. Economies of Scale Some research has indicated that larger banks enJoy an inherent cost advantage over smaller banks with respect to the demand deposit function Frederick Bell and Neil Murphy, in a 1967 studylfof banks in the Boston, New York and Philadelphia Federal Reserve Districts, found that the average direct demand deposit cost curve was in fact downward sloping and thus unit costs were decreasing with an increase in deposit volume. The results of the study revealed that a 10 percent increase in total number of accounts resulted in a 9.1 percent increase in total cost when all other cost related factors were held constant. Economies 0£ scale result from a more efficient use of input to achieve a greater output per unit of input. These economies may arise 1/ Economies of Scale in Commercial Banking, Frederick W. Bell and Neil B. Murphy, Federal Reserve Bank of Boston, 1967. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -11- in the demand deposit function in two ways. First, increased size permits greater specialization of tasks and thus a more efficient organization of resources. Large banks have the opportunity to assign labor and capital to a certain facet of work while smaller banks must use the same input factors for various Jobs. Second, certain types of computerized equipment that permit increased efficiency in the demand deposit function are economically feasible only for large scale operations. In spite of the fact that larger banks may realize certain cost advantages within the demand deposit function, it was nevertheless found that their per unit processing costs were actually higher than those of smaller banks. This can be explained by two factors First, branching, more apparent in larger banks, tends to increase costs mostly due to a greater labor requirement. Second, and more recently discovered, larger banks usually hold those accounts having a greater amount of activity thus further increasing processing costs. More recent research in the area of corrnnercial bank economies of scale has suggested that previous economies may no longer exist with respect to the demand deposit function. Wire Transfers The individual member banks, upon request, may transfer funds through the Federal Reserve's wire transfer system to member banks and nonmember clearing banks in the same area and in other territories. Wire transfers, as mentioned earlier, account for a small percentage of total volume of money transferred, but account for a substantial portion of total dollar amount transferred. This results ,from extensive use of the wire system by large banks for transferring large sums of money. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ·12- The computerized switching center for wire transfers between Districts at Culpeper, Virginia, is run by the Federal Reserve Bank of Richmond. Wire transfers increase the availability of funds and are a step in the direction of a changing payments system. Other ~ayment Methods Currency and Coin Today's money supply consists of nearly $57 billion in currency and coin in circulation and about $190 billion in demand deposits in the nation's connnercial banks. Although most of the total dollar volume of payments today are made by check, it has been estimated that approximately 40 per cent of the American people deal almost exclusively in cash.l/ Currency and coin deposits received by connnercial banks are either sent to their respective Federal Reserve Banks for deposit or kept on hand for customer withdrawals. In contrast to the demand deposit function, there is very limited descriptive and cost data on connnercial bank handlings of currency and coin. One study, however, on certain types of currency and coin operations and their approximate costs is reprinted in Table 4. Cost figures for currency and coin operations are not included in the final section of this paper. Money Orders Approximately 90 per cent of all postal money orders are cashed at connnercial banks, and the remainder eventually end up there via postmasters' deposits. After the correct accounts have been debited and/or credited, all postal money orders are then sent through the Federal Reserve System where they are processed. Corrnnercial banks also issue money orders and other special l/ Electronic Money and the Payments Mechanism, Federal Reserve Bank of Boston, 1968, p. 4. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -13- Table 4 COSTS OF MONEY ROOM PRODUCTS Products Approximate Standard Time (in minutes) Approximate Unit Cost (in dollars) 1. Payro 11 order 3- 4 1.00 2. Coin order 6- 8 3.00 3. Money 10.00 a. activity cost/hour b. cost per $1,000 .02-.08 .01 1.00 - 2.00 4. Customer Deposit 3- 5 5. Prepacking 1- 3 .50 10-28 3.00 7. Currency order 4- 6 2.00 8. Envelope deposits 1- 3 .so 9. Rolled Coin 6- 8 1.00 6. Proving Coin ($1,000) Source· Unpublished Federal Reserve System staff study. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -14purpose payment orders such as drafts, cashier's checks, and special signature checks (on which the bank fills in the date and amount and the purchaser fills in the payee's name and his own signature). Preauthorization Preauthorization is a method of money transfer by which the account holder, with one signature, authorizes the bank to transfer funds from his account whenever certain conditions exist. Thus, the debtor's bank will pay his bills, whether fixed or variable in amount, without recurring action by him. Preauthorization can reduce the number of checks in the system, however, any-cost benefits from preauthorization seem to accrue from accounts that engage in a large volume value of transactions, such as insurance firms and corporate payrolls. This concept has been struggling to gain a general acceptance for some time now,but present factors suggest that preauthorization plans may receive increasing use and attention in the near future.l/ In addition, response authorization and direct authorization may be relied upon when the requirements for preauthorizations do not exist. Response authorization may occur when the bank receives a request to transfer funds in a situation when it is unauthorized to do so. The bank may then go to the account holder for the needed authorization. Direct authorization is a single order given from the account holder to the bank naming a specific party to which funds are to be transferred. This procedure occurs mostly in payroll disbursing, bill paying and wire transfer services. Such plans, by reducing the check volume, may eventually have important cost saving implications with respect to the demand deposit function. l/ The Payments System Problems, Fantasies, & Realities, Federal Reserve Bank of New York, Monthly Review, May, 1969, p. 112. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -15- Bank Credit Card Plans While checks are very convenient as a way of making remote payments, bank credit cards have been developed for customers to make "on site" payments. The widespread adoption of bank credit cards may have served to slow the growth of check volume slightly, and consequently might have some cost saving implications for the commercial bank demand deposit function. Increased paper work and processing from the credit card plans, however, has most likely cancelled any saving from fewer checks being in the system. In addition, bank credit cards may be deferring payments ~or goods or services that would have otherwise been made in cash, thus increasing the number of checks written and the resulting processing costs. Food Stamps The U. S. Department of Agriculture issues food stamp coupons in denominations of 25 cents, 50 cents, and $2.00. They are traded at grocery stores which turn over the stamps to conrrnercial banks for credit to their accounts. Member banks obtain payment through their Federal Reserve Bank while nonmember banks forward the coupons to their correspondent banks who in turn present them to their Federal Reserve Banks for payment. Figures are not available on the cost to the conrrnercial banking system of food stamp processing. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -16III. CHECK PROCESSING WITHIN A BANK This section describes the various processing points of the check clearing mechanism within an individual commercial bank. Checks come into a commercial bank via customer transactions and from other parts of the banking system. Customer transactions take place over the counter, in the form of checks cashed and deposited, and through mail and night deposits. These checks are taken by the receiving teller who may sort the checks into home debits and transit items. Items in transit may arrive at the bank either directly from other banks (including correspondents), a local clearinghouse, or a Federal Reserve Bank. way back to the original drawer, are included Return items, _now on their with those items in transit but are kept separate from the other checks. All checks received by the bank must undergo various input control functions. Input control is a general concept describing those control tech- niques that take place in teller operations or in the proof department. The more labor intensive operations, such as examination of checks for proper signature, are usually performed by the teller while the more capital intensive functions are performed in the proof and transit department. Proof and transit operations are the nucleus of the check processing system within a commercial bank. Most checks are processed in these departments before they can be sent to their final destination. All exception items, including return checks, must be processed separately with exact processing procedures varying from bank to bank. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -17The three main proof and transit operations are proof of deposit, check encoding, and document sorting. The first two are categorized as proof operations and are performed on proof machines in most commercial banks. In contrast, document sorting is considered to be a transit operation and may be performed either on a multipocket proof machine or a reader-sorter linked to a computer. Proof machine sorting is referred to as low-speed processing while sorting by computer is referred to as high-speed processing. process checks through a high-speed system.l/ Most larger banks A high-speed process distinctly separates the proof and transit departments while a low-speed process, because all three operations are performed on a proof machine, does not. These proof and transit operations are described below Proof of Deposit The total amount of a batch of checks entering the proof department must be verified by adding up the values of the individual checks and comparing them to the total. proof machines. This process is done mechanically on most First, the individual check amounts are punched into the adding machine keyboard and listed on a control tape. These amounts are totaled and the total on the control tape is compared to the total of the batch. The machine then compares the two figures and if they do not match up, the machine locks. Encoding All checks and deposits are encoded in the proof department. If checks are not qualified (i.e., encoded as to bank identification number1 they are corrected at this point. Encoding is accomplished when the dollar amount is entered in the lower right-hand corner of the check. The value of the check must be typed into the adding machine keyboard of the proof machine. The imprinter is activated simultaneously when the check is dropped into the chute. lf A recent study made by Arthur D. Little, Inc. reports that banks with deposits of over $25 million usually sort checks under a high-speed processing system. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -18- All encoding, both bank identification number and dollar amount, is done by magnetic ink for magnetic ink character recognition (MICR) equipment. MICR, developed around 1956, is simply a method of putting this vital information on the check in a form which the computer can read. Thus, MICR encoding is only necessary when the individual bank uses a high-speed sorting process. Low-Speed Document Sorting The individual checks entering the proof and transit departments must be separated according to destination. Some checks will be home debits, and others will be clearing and transit items. Clearing items may be collected locally while transit items may not. Proof machines - with a sorting capacity may have anywhere frow 8 to--40 different pockets. Each pocket is designated to receive a particular type of check by depressing that specific key on the machine. The sort is accomplished after the checks have been encoded. After a check is dropped into the machine, it is fed mechanically to the selected pocket. Simultaneously, the amount of that check is printed on an individual pocket tape which eventually lists the total amount for all the items in each pocket. There are basically three types of proof machines and they differ according to function. They are listed by function 1.n Table 5. High-Speed Document Sorting Document sorting under high speed processing produces the same results as if a proof machine were used except for an obvious difference in processing speed. Under this system, the reader sorter may read, sort, and tabulate the MICR information as speeds of 1,500 II checks per minute.- l/ An Electronic Network for Interbank Payment Communications, Bank Administration Institute, Park Ridge, Illinois, 1969, p. 6. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -19Once the transit (and clearing) items are sorted, they are grouped into batches of checks by destination. Attached to each batch is a cash letter which lists the total amount of all the checks. These batches are then forwarded to an output control center before being shipped. The function of the output control center is to make certain that the dollar amounts of the individual batches of checks add up to the total amount originally entering the proof department. These batches are then sent by the transportation department either directly to the drawee bank, a local clearinghouse, a correspondent bank, or a Federal Reserve Bank. The bank gives less immediate concern to its own checks for they only have to travel through the internal network of that bank. These items are sorted again by computer into debits and credits and the respective entries are mechanically posted to the individual customer accounts. With the individual accounts now updated, the checks are hand filed, according to account number, for purposes of statement preparation and mailing. Some large banks have recently installed automated statement preparation equipment. Thus, the cycle within an individual commercial bank is completed with all home debits winding up in the customer's hands and all transit items on their way to the drawee bank. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -20- Table 5 DIFFERENT TYPES OF PROOF MACHINES USED BY COMMERCIAL BANKS MACHINES FUNCTIONS Proof, Encode, Sort Prook, Encode Proof, Partial Sort https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis IBM 1201 24 or 32 pockets NCR 482 8-16 or 24 pockets NCR 450 32 or 40 pockets IBM 1203 1 pocket NCR 481 2 pockets Burroughs P703 1 pocket (in limited use) IBM 1260 8 pockets Figure 2 CHECK PROCESSING WITHIN A COMMERCIAL BANK Entry ti Customer Deposits ! 1. Over the Counter 2 Mail & Night ~ - - - - - - - - - 1 Receiving Teller Home Debits 1-----11 Customer Input Control 1 ~1 Items in Transit 1. Federal Re,serve Banks 2. Clearinghous 1-........- - - - - ~ 3. Corres. Banks ,:I' 4. Bank of PreI vious Handling I 5 Return Items I https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 0 Clearing Proof ':' ,I & Transit Transit Return Items l I I :I --i----1 Output Control I I 'I Other Parts of Banking Industry 1. Local Clearinghouse 2. Correspondent Bank 3. Drawee Bank 4. Federal Reserve Bank -22IV. DETERMINATION OF THE COMMERCIAL BANK CHECK CLEARING EXPENSE This final section will consider the cost of the check clearing mechanism to the nation's commercial banks. on individual bank demand deposit Because the amount of cost data functions is limited, an exact cost figure cannot easily be determined, however, some light may be shed on the subJect through data approximation. The cost figures relied on here are taken from the Federal Reserve's 1970 Functional Cost-Analysis. This analysis is compiled annually and was based in 1970 on data furnished by 951 participating banks in the 12 Federal Reserve Districts. The banks are arranged according to deposit size--up to $50 million, $50 million - $200 million, and over $200 million--and expenses relating to the demand deposit function are listed for each deposit size range. In addition, unit costs for processing home debits, transit checks, and other items are derived based on the total expenses of the demand deposit function adJusted by a measure of activity defined as total weight units. The different weights--transit items and home debits are assigned values of 1 and 2.73, respectively--reflect the differences in processing costs associated with these different types of transactions.1/ These unit costs can be used to derive an approximate overall cost to commercial banks for dealing with these items. The cost of the check clearing mechanism to commercial banks for 1970 can be estimated by summarizing the total cost of processing both home debits and transit items. The cost of processing deposits (credits to customer 1/ The difference in processing costs are based on standard time studies conducted by the Bank Administration Institute. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -23accounts) is not included because this function is less dependent on the method of making payments. For 1970, the per unit costs of processing a home debit in each of the three bank deposit sizes--up to $50 million, $50 million to $200 million, and over $200 million--were 7.20 cents, 8.38 cents, and 10.60 cents, respectively. The per unit costs of processing a transit item in each category were 2.64 cents, 3.07 cents, and 3.88 cents, respectively. These unit costs are based on those commercial bank expenses--both direct and indirect-related to the demand deposit funct:Dn. In the 1970 Functional Cost Analysis, demand deposit expenses are separated into two sections, processing wages and expenses, and administrative and overhead expenses. Listed in the first section are tellers' salaries and wages, transit and bookkeeping wages, fringe benefits, furniture and equipment, computer service expense and/or computer expense, printing, stationery, and supplies, postage, freight, and delivery, telephone and telegraph, and fees (legal and other). The second section includes officers' salaries and fringe benefits, publicity and advertising, FDIC insurance, share of occupancy costs, and all miscellaneous expenses. The distinction between direct and indirect expenses relating to the demand deposit function is rather hard to make, but based on the breakdown given in the 1970 Functional Cost Analysis, the indirect expense (administrative and overhead) for participating banks in each deposit range amounted to approximately 25 - 30 per cent of the direct expense (processing, wages, and expenses) for 1970. In order to determine a total cost figure from those unit costs previously mentioned, the amounts of checks--both transit and home debits-processed by all banks in each deposit size range must be known. During 1970, an estimated 21.5 billion checks were written and deposited or cashed at all the nation's commercial banks.1/ Of these, about 70 per cent (15.1 billion) 1/ The Outlook for the Nation's Check Payments System 1970 - 1980, Arthur D. Inc., December 1970, p. 4. Little, https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -24were transit items that had to be sent to one of the approximately 14,000 drawee banks directly or indirectly through clearinghouses, correspondent banks, or Federal Reserve Banks. All 21.5 billion were home debit items to the bank on which they were originally drawn. However, data on the portion of these 21.5 billion home debits and 15.1 billion transit items processed by all commercial banks in each of the three deposit size ranges previously mentioned are not available. However, data are available from a Bank Administration Institute study on the percentage of home debits and transit checks processed for banks in the deposit size ranges of up to $50 million, $50 million to $100 million, $100 million to $500 million, and over $500 million. Using these data, two cost figures, a high and low estimate, can be determined. Table 6 BANK STATISTICS BY BANK SIZE Bank Size (millions of dollars) Number of Banks Per cent of total checks processed $0 - 50 12,948 33.4 50 - 100 335 2.4 100 - 500 320 21.5 over 500 90 39.4 Source An Electronic Network for Interbank Payment Communications, p. 5. According to the above table, banks in the $0-50 million deposit size range process 33.4 per cent of the total volume of checks or 7.181 billion home debits and 5.027 billion transit items. From here an approximation of the percentage of checks processed by those banks in both the $50 million to $200 million and over $200 million deposit size ranges must be made. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis This can be accomplished by using the figure -25- for the percentage of checks processed by banks in the $100 million to $500 million deposit size range first as a part of the large deposit size range (over $200 million) and again as a part of the middle deposit size range ($50 million to $200 million). Due to higher per unit processing costs in the large banks, the first estimate will contain an upward bias while the second estimate will contain a lower one.1/ The two different estimates of the expense of check processing to commercial banks appear in Table 7. The total costs to all commercial banks of the check clearing mechanism in 1970--i.e., processing of home debits and transit items--is somewhere between $2,393 million and $2,502 million. Cost of the Demand De~osit Function The preceding estimates of the cost of the check clearing mechanism to commercial banks consider only those demand deposit functions that are directly related to the method of making payment. There are, however, other demand deposit functions that are indirectly related to the payments mechanism and consequently could be affected if a change were to occur in the payments system. The costs of processing deposits, for example, were excluded from the previous cost illustrations, but are indirectly incurred as a result of making payment. Therefore, in order to add a degree of perspective to this cost analysis, it is appropriate to consider the costs incurred by commercial banks as a result of the total demand deposit function. The 1970 Functional Cost Analysis, using the expenses of the demand deposit function listed earlier in this section, derives the cost per $1,000 of demand deposits for the commercial Although some studies have shown the pnesence of economies of scale with respect to the demand deposit function, both increased branching and higher account activity in larger banks more than compensate for any cost advantage they might have over smaller banks. In addition, more recent ~tudies have suggested these economies do not exist. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -26Table 7 EXPENSE OF CHECK PROCESSING TO CO:MMERC IAL BANKS High Estimate Home debits by deEosit size range $0 - 50 million 50 - 200 million over 200 million Total home debit cost Transit items $0 - 50 million SO - 200 million over 200 million Total transit cost· checks 2rocessed 7.1810 1. 2255 13.0935 5.07670 .85785 9.10545 X X X X X X cost Eer unit 7.20 8.38 10.60 $ 2.64 3.073.88 517,032,000 102,696,900 1,387 1 911 1 000 2,009,639,900 132,704,880 26,335,995 3551619,460 494,660,335 Total Cost (high estimate) 2 1502 1300,235 Low Estimate Home debits by deEosit size range $0 - 50 million 50 - 200 mil hon over 200 million Total home debit cost Transit items $0 - SO million SO - 200 million over 200 million Total transit cost Total Cost (low estimate) https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis checks Erocessed 7.1810 5.8480 8.4700 5.0267 4.0936 5. 9397 X X X X X X cost Eer unit 7.20 8.38 10.60 2.64 3.07 3.88 $ 517,032,000 490,062,400 897 1 820 1 000 1,904,914,400 132,704,880 125,673,520 2301072 ,360 488,450,760 2,393,365,160 -27banks in each of the three deposit size ranges. If these costs are multiplied by the dollar amount of the nation's demand deposits (in thousands), a cost for the total demand deposit function can be determined. As an approximation, however, only the cost for the larger banks--$25.40 per $1,000 of demand deposits-will be used as these banks hold most of the dollar volume of the nation's demand deposits. The amount of demand deposits held by commercial banks during 1970 was $181.5 billion.l/ Consequently, the total cost of the demand deposit function to the nation's commercial banks for 1970 was slightly over $4.6 billion. Again, however, remember that this estimate includes those expenses of the demand deposit function that are indirectly related to the method of making payment as well as those expenses measured in the previous section. 1/ This figure is taken as of July 1970, for purposes of approximating the Year's average and excludes Government and interbank demand deposits. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis -28SUMMARY AND CONCLUSIONS The purpose of this paper was to find and expense the components of the payments mechanism with respect to all commercial banks. It has concentrated mainly on the commercial bank check collection system, because checks account for by far the greatest number of banking system money transfers, and they consequently, explain the greatest part of the cost of the payments mechanism to commercial banks. In addition, both descriptive and cost data on the other components of the commercial bank payments mechanism are very limited. Table 7 shows the costs of the payments mechanism components of the commercial bank demand deposit function to be somewhere between $2.39 and $2.50 billion. This figure includes only the expenses of processing home debits and transit items and excludes those demand deposit costs--such as the processing of a deposit--which are less dependent on the means of making payment. Both the direct expenses of processing checks and the indirect administrative and overhead expenses related to the demand deposit function are included in this aggregate cost figure. The $109 million difference between the high and low cost estimates derived in the last section, while absolutely large, is a small amount relative to the more than $2 billion represented here. Such an aggregate cost figure may prove useful when compared to the approximate costs of changing to and operating a new system of payments in our nation's commercial banks. Again, however, one should iemember that these final figures represent only the expense of check processing and ignore other relevant payments mechanism expenses incurred by commera.al banks. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis These figures therefore can -29be regarded as very conservative estimates, with the total no doubt exceeding $2.5 billion. In addition, a cost analysis which adds those demand deposit functions which are only indirectly related to the method of making payment produced a figure in excess of $4.6 billion for 1970. Contirrued study of the costs of the payments mechanism to corrnnercial banks may lead to more exact results and better understanding of the need for possible changes in the payments system in the near future. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis
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