why do we use so many checks

44 3Q/2002, Economic Perspectives

Why do we use so many checks?

Sujit Chakravorti and Timothy McHugh

Sujit Chakravorti is a senior economist and TimothyMcHugh is a senior analyst in the Emerging Paymentsand Policy Department at the Federal Reserve Bank ofChicago. The authors would like to thank David Allardice,Ed Green, Harvey Rosenblum, and Fiona Sigalla fornumerous helpful discussions. They also thank EveBoboch, Tom Ciesielski, David Marshall, Ann Spiotto,Victor Stango, and Kristin Stanton for comments onprevious drafts.

Introduction and summary

The primary question we address in this article is whyconsumers, merchants, and financial institutions arereluctant to embrace electronic payments even thoughelectronic payment networks, such as the credit cardand automated clearinghouse (ACH) networks, haveexisted for more than 25 years. While most Internet-based transactions are primarily processed via creditcard networks, most noncash off-line payments byboth consumers and businesses in the United Statesare made with checks.

In the United States, there are over 15 checkswritten per month per person.1 This is more than threetimes the number of checks written per person inCanada or the United Kingdom and at least 15 timesmore per person than in Germany, Italy, Belgium, theNetherlands, Sweden, or Switzerland (Bank for Inter-national Settlements, 2000, and Federal Reserve Sys-tem, 2001).2, 3

In this article, we incorporate various strands ofthe payment literature to provide a more integratedview as to why payment system participants are reluc-tant to use electronic payments. Brito and Hartley (1995),Hirschman (1982), Mantel (2000), Murphy (1988),and Whitesell (1992) focus on consumer choice issues.Radecki (1999) and Wells (1996) discuss the revenueearned and cost to financial institutions from provid-ing check services. Food Marketing Institute (1994,1998, and 2000), Chakravorti and To (1999), andMurphy and Ott (1977) concentrate on the merchantsperspectives. McAndrews (1997) and Weinberg(1997) investigate the network issues. Connolly andEisenmenger (2000), Benston and Humphrey (1997),Green and Todd (2001), Guynn (1996), and Lackerand Weinberg (1998) discuss the Federal Reservesrole in the payment system. A more integrated analy-sis of the underlying incentives of various paymentsystem participants has been developed by Baxter

(1983), Chakravorti and Emmons (2001), Chakravortiand Shah (2001), Rochet and Tirole (2000), andWright (2000).

We study the incentives underlying the paymentnetwork to examine why, unlike several other indus-trialized countries, the United States has been slow toabandon checks. Many observers claim that electronicpayments are less expensive than checks. However,these social cost comparisons usually ignore transitioncosts and the underlying incentives to each paymentparticipant. Furthermore, the provision and usage ofpayment services exhibit network effects, more com-monly referred to as the chicken-and-egg problem,which may impede the adoption of new payment tech-nologies. Even if electronic payments are less expen-sive and they can overcome the chicken-and-eggproblem, consumers, merchants, and financial insti-tutions may still be reluctant to move to electronicpayments. We analyze why this is so. In addition,we explore actions by the Federal Reserve to improvethe check processing system and whether this couldpossibly hinder the migration away from checks.Finally, we discuss potential drivers to the adoptionof electronic payments.

Check usage

We use two different sources of check data in thisarticle. The first source is the annual payments datapublished by the Bank for International Settlements

45Federal Reserve Bank of Chicago

(BIS). The second source of data is a comprehensivereview of the retail payment systems by the FederalReserve System (Fed) (2001). The Fed study indicatedthat the total volume of check payments in the UnitedStates was significantly lower than previously estimat-ed. However, the data published by the BIS still pro-vide valuable insights into check usage in other countriesand check usage trends in the United States. We relyon the new Fed study for current check values andvolumes and use the older data reported to the BISby the Fed for trends in check values and volume.

According to the new Fed benchmarking studyreleased in November 2001, 49.6 billion checks werewritten in the U.S. in 2000, valued at $47.7 trillion(Federal Reserve System, 2001).4 Checks representedaround 60 percent of non-cash consumer transactions.The Fed study estimates that consumers wrote around51 percent of checks but only accounted for 19 per-cent of the total value. According to the BIS (19912000), per capita check volume grew at a compoundedannual growth rate (CAGR) of 1.13 percent, whileper capita check value grew at a 1.91 percent CAGRfrom 1991 to 1999.5

Unlike most other industrialized countries, theU.S. seems to have experienced growth in total checkvolume and value during the 1990s. For every Groupof Ten (G-10) country except the United States, thevolume of check usage (see figure 1) and value (seefigure 2) declined during the 1990s.6 Among the rea-sons that have been cited to explain U.S. check vol-ume growth are differences in financial institutionsper capita, cash usage, laws and regulations, and pric-ing of financial services (see BIS, 1999 and 2000,and Humphrey, Pulley, and Vesala, 2000).

By increasing the price of checks vis--vis otherpayment options, financial institutions in Scandinaviancountries have been successful in decreasing checkusage. For example, in Finland, during the mid-1980s,banks began implementing a small per-check fee ofabout 10 cents. Palva (2000) states that this pricingpolicy coincided with a drastic reduction in the useof checks (see figure 3).

Adopting similar policies, Norwegian banks alsosuccessfully decreased check usage. Humphrey, Kim,and Vale (2001) found that a 1 percent increase in theprice of checks resulted in a 1.07 percent decrease incheck usage. They also found that online debit cardswere a close substitute for checks at the point of sale.7As a result, check usage in Norway decreased from72 million checks in 1988 to only 6.2 million in 2000.Furthermore, the volume of payments made by pay-ment cards, primarily debit cards, was 62 times thatof checks in 2000 (Bank of Norway, 2000).

Other countries have used different approachesto reduce check usage. For example, Canadian banksgive check payees immediate credit and availability oftheir funds (see Humphrey, Pulley, and Vesala, 2000).Furthermore, checks are backdated to remove any floatbenefit to paying banks. In addition, corporations arecharged for the float when the distance is significantbetween the bank where the check is drawn and whereit is first deposited.

The decline in check usage across most countriesindicates that, given market incentives, there is a move-ment toward electronic instruments. Electronic alter-natives to accessing transaction accounts for purchasesare held to be less expensive than checks. Humphreyand Berger (1990) were the first to calculate the totalsocial cost of each instrument in the United States.Social cost is the sum of the real resource cost borneby each participant to convert a given payment intogood funds. They found the social cost of a cash trans-action to be the lowest at 4 cents and a credit card trans-action to be the highest at 88 cents. An ACH payment,an online debit transaction, and a check transactionhave social costs of 29 cents, 47 cents, and 79 cents,respectively. Wells (1996) updated Humphrey andBergers study and found that ACH payments costbetween one-third to one-half as much as a checkpayments but found significantly higher social costestimates for both checks and ACH payments.

A difficulty with comparing social cost amongpayment instruments is that a given payment instrumentmay not be preferred for both small and large trans-actions. While cash transactions outnumber all othertypes of transactions, the average transaction size isrelatively small compared with other payment instru-ments. Consumers tend to prefer checks for larger trans-actions. The average consumer check transaction isestimated at $364 (Federal Reserve System, 2001).Furthermore, consumers may not be able to use all pay-ment instruments for all types of transactions. Forexample, cash cannot be used for bill payment viamail and checks are difficult to use for Internet trans-actions. Additionally, these social cost calculationsmay not adequately adjust for the risk of not beingable to convert the payment into good funds that mayplay a role in the acceptance of certain payment instru-ments. Some characteristics of payment instrumentsare difficult to quantify, such as the convenience andcomfort levels enjoyed by the participants.

These estimates also ignore transition costs andnetwork effects. Consumers, merchants, and financialinstitutions may be unwilling to invest in emergingpayment technologies due to uncertainty about wheth-er they will be widely accepted in the marketplace.


FIGURE 2

percent

Source: BIS (19912000).

Percent change in check value (199099)

United UnitedBelgium Canada Germany Italy Netherlands Sweden Switzerland Kingdom States

FIGURE 1

percent

Source: BIS (19912000).

Percent change in check volume (199099)

-120

-100

-80

-60

-40

-20

0

20

40

61.2

24.722.9

89.796.7

72.2

11.1

22.7

6.8

-120

-100

-80

-60

-40

-20

0

20

40

76.55

42.14

71.78

90.4897.04

79.2075.03

18.64

34.85

United UnitedBelgium Canada Germany Italy Netherlands Sweden Switzerland Kingdom States


FIGURE 3

number in millions

Source: Finnish Bankers Association and Palva (2000).

Electronic payments in Finland

1984 85 86 87 88 89 90 91 92 93 94 95 96 97 98 990

50

100

150

200

250

Check paymentsDebit card payments

U.S. smart card trials demonstrated that consumersand merchants may not be willing to adopt new formsof payment rapidly.8

Lack of incentives

In this section of the article, we analyze the costand incentive structure faced by each participant inthe payment network. We address two fundamentalquestions for consumers, merchants, and financial in-stitutions. First, are electronic payment alternativesless expensive than checks for each participant? Sec-ond, if electronic payment forms are less expensive,are participants reluctant to abandon checks becausethey lack the right incentives to adopt alternative pay-ment instruments?

ConsumersWhile checks might be more costly to society as a

whole, several studies point out that consumers mayview the marginal cost to use a check to be zero.9 Re-cently, several banks have reintroduced free checkingaccounts to entice new customers.10 Humphrey, Pul-ley, and Vesala (2000) state that most U.S. consumersprefer accounts with fixed monthly fees or no feeswith minimum balance requirements to those withper-check transaction fees. Furthermore, merchantsrarely impose additional fees for check payments.

Moreover, some consumers still view check floatas a major benefit. Today, most checks are processedovernight and interest rates on transaction accounts,if they are offered, are quite low, resulting in low floatbenefits. Wells (1996) calculated that float is no longersignificant for consumer check payments. Nonetheless,some consumers still may perceive significant floatbenefits.

Ironically, checks do not have a built-in featurethat automatically declines a transaction if the custom-ers account does not have sufficient funds. Whilenon-sufficient-funds fees are relatively high and maylead to several other checks bouncing, most consum-ers seem to ignore these costs. However, non-sufficientfunds fee income is large for financial institutions,potentially reducing banks incentive to promotesome electronic payment alternatives.

Independent of the cost of check payments, wecan identify three key reasons consumers have resist-ed abandoning checks. First, checks are easy to use.The 1998 Survey of Consumer Finances indicated thatabout 87 percent of U.S. households had checkingaccounts, making checks the most accessible noncashpayment instrument.11 Checks are also one of the mostwidely accepted forms of payment by merchants atthe point of sale.12 For bill payments, checks are themost popular instrument because, unlike other formsof payment, they are almost always accepted by billers.13


Second, consumers are reluctant to switch to elec-tronic alternatives unless they offer superior benefitsto checks. While consumers may believe that electronicpayments are less expensive overall, they are reluctantto change unless they view the shift as beneficial tothem. Credit card issuers often offer additional servicessuch as extended warranties, dispute resolution servic-es, and frequent-use awards, along with interest-freeshort-term loans to those who pay off their balanceseach month.

Third, some consumers feel checks give them great-er control over the timing of their payments, leadingto better budgeting. Hirschman (1982) argues that someconsumers believe that checks may enhance their abil-ity to track, budget, and control spending better thanother payment instruments. Mester (2000) argues thatchecks give consumers more control over when to paybills than pre-authorized ACH payments and can moreeasily attach remittance information. Yet, consumerscan also access their checking accounts via their deb-it cards and maintain budgeting, tracking, and controlover their funds. When using debit cards, consumerscannot overdraw their accounts unless previous creditlines have been established. However, debit card us-age in bill payment is relatively low, given the slowadoption of the necessary infrastructure.

Because consumers perceive checks to be a low-cost payment instrument and are comfortable with them,they are reluctant to change unless there are strongincentives to do so. From a cost standpoint, checks arerelatively inexpensive if one ignores non-sufficient-funds fees. As we noted earlier, explicit per-check charg-es by financial institutions in other countries have beeneffective in changing consumers payment habits.

MerchantsA primary issue for merchants is the cost of pay-

ments. There are significant differences in the cost ofaccepting alternative payment instruments. The FoodMarketing Institute (FMI) (2000) estimates the mer-chants cost to accept each payment instrument (seetable 1). Online debit cards are the second least ex-pensive payment instrument for merchantsto accept at 80 cents per $100 of transac-tions. They offer merchants immediatefunds, low per-transaction fees, and little,if any, settlement risk. While cash pro-cessing costs are low at 90 cents per $100of sales, most consumers are reluctant touse cash for larger purchases. Credit cardand off-line debit card transactions costmerchants an average of $1.80 per $100 insales. The average check transaction costs

merchants 80 cents per $100 in sales, though this costvaries widely depending on whether the check wasverified.

Given the rapid increase in the use of check veri-fication systems during the last decade, it is importantto analyze check costs using this technology. Nilson(2001a) estimates that 9.14 billion checks were veri-fied at the point of sale. Using Federal Reserve System(2001) point-of-sale check numbers, we estimate thatbetween 75 percent and 97 percent of checks writtenat the point of sale were verified in 2000.14 The typi-cal cost for these services ranges from 2 cents to 20cents per check (Nilson, 1997b). Nilson reports anaverage cost of 3 cents in 1998.15

Merchants have found that check verification ser-vices significantly reduce the risk that they will notreceive good funds. As a result, they have been ableto lower their costs by over 23 percent and to reducelosses from exception items from 0.50 percent of thevalue of the check to 0.05 percent of the value of thecheck (FMI, 1998).16

According to FMI (2000), a verified check pay-ment is actually the cheapest form of payment for themerchant to accept, costing a merchant 60 cents per$100 in sales versus $3.00 per $100 in sales for anunverified check.17 Since the majority of checks atthe point of sale appear to be verified, it is importantto concentrate on the cost of verified checks. Accordingto FMI (2000), the cost of a verified check per $100 insales is significantly less than cash, off-line debit cards,and credit cards. Although FMI (2000) did not reporta cost for ACH-based debit card transactions, FMI(1998) reported an average cost of 82 cents in 1997.

The cost difference between a verified check trans-action and an online debit card transaction might alsobe growing. Between 1997 and 2000, FMI (1998 and2000) found that the cost of online debit cards increasedby 14 percent, or 10 cents per $100 in sales.18 Recent-ly, several networks have announced plans to increasetheir fees significantly.19

Even if checks are more expensive than electronicalternatives, merchants may continue to accept checks

TABLE 1

Merchant costs to accept a payment instrument

Cost per Checktransaction not Check Online Off-line(dollars) Cash verified verified Credit debit debit

Cost per$100 sales .90 3.00 .60 1.80 .80 1.80

Source: Food Marketing Institute, 2000.


for three reasons. First, the potential cost savings fromelectronic alternatives might not be large enough tojustify the transition costs to make this change and/orrisk movement to more expensive payment vehicles.Second, cheaper electronic payment alternatives atthe point of sale have only recently flourished. Last,checks might offer merchants some level of benefitsthat they are willing to pay for.

Given the slow movement away from checks,merchants, banks, and third-party providers have start-ed to convert check transactions to ACH transactionsat the point of sale to reduce costs.20 However, thismay involve high initial set-up costs related to imple-menting a new system, purchasing equipment, andtraining staff. Furthermore, merchants may be reluc-tant to make large investments in new payment tech-nologies with uncertain futures.

Furthermore, even though online debit cards area relatively inexpensive payment option, they have be-come widespread only recently. Annual per capita trans-action volume in the United States increased from 0.76transactions per year in 1990 to 11.3 transactions in2000 (BIS, 19912000, and Thomson Financial, 2001).Figure 4 shows the rapid increase in debit card trans-actions over the last five years. Figure 5 shows theincrease in online debit card terminals installed by mer-chants, indicating substantial growth in merchant ac-ceptance of online debit cards over the last 13 years.

Lastly, some evidence suggests that merchants arewilling to accept high-cost payment instruments be-cause they offer benefits not offered by other instru-ments. Credit cards generate sales to illiquid consumerswho may not otherwise be able to purchase goods andservices.21 In some instances, merchants may chooseto accept certain instruments because they are tied toother instruments that they choose to accept. For ex-ample, merchants accepting Visa or MasterCard creditcards are required to accept their off-line debit card prod-ucts. A large group of retailers led by Wal-Mart has suedthe credit card associations, alleging that this tying oftheir credit card and debit card products is illegal.

Available U.S. data do not indicate a significantcost reduction if merchants move toward electronicpayments. Furthermore, the benefits of acceptingelectronic payment instruments may not outweighthe investment that may be required. Merchants maybe willing to accept relatively expensive payment in-struments because they offer benefits such as the po-tential to increase sales and profits.

Financial institutionsAlthough electronic payments are generally per-

ceived to be less expensive than paper-based pay-ments for financial institutions, several U.S. studiesindicate the costs of processing ACH and check pay-ments are not very large for financial institutions.

FIGURE 4

millions of transactions

Source: Nilson (19962001), Nos. 737, 726, 705, 678, 654, and 627.

U.S. debit card use at point of sale

1995 96 98 2000 010

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9997

Other debit cardsOff-line debit cards


FIGURE 5

per 1 million inhabitants

Source: BIS (various years).

EFT point-of-sale terminals

1987 88 89 90 91 92 93 94 95 96 97 98 990

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

The Federal Reserve Boards 1994 Functional CostAnalysis estimated that the average cost per transactionfor an ACH payment was 14 cents and the average costfor a check payment was 14.6 cents. Wells (1996) es-timated that the cost of processing a check ranged from15 cents to 43 cents, while the cost of processing anACH payment ranged from 12 cents to 45 cents. Guynn(1996) questions whether ACH payments are really lessexpensive for banks to process than checks. However,evidence from Norway indicates that check transactionscost banks two to three times as much as electronicgiro services and electronic funds transfer point-of-sale transactions (Robinson and Flatraaker, 1995).

Furthermore, financial institutions earn significantrevenue from the provision of check services. On aver-age, they charge customers 21 cents and merchants 5cents to process each check.22 In order to spur adop-tion, online debit cards should offer financial institu-tions similar revenue opportunities assuming similarcost structures, or similar profit opportunities result-ing from offsetting cost savings. Online debit cardsprovide a potentially lucrative revenue stream in theform of the fee paid by the merchants bank to the cus-tomers bank, commonly referred to as the interchangefee. Yet, as of the end of 2001, no online debit cardnetwork had interchange fees higher than 20 cents.23Recently, a few online debit card networks have sig-nificantly increased their processing fees. Several in-stitutions have also implemented per-transaction fees

for using personal identification number (PIN) baseddebit cards at the point of sale.24

Financial institutions also earn significant revenuefrom fees related to overdrafts to checking accounts.According to Bank Administration Institute and PSIGlobal (1998), in 1995, banks earned $8.1 billion fromnon-sufficient-funds check fees. The Board of Gov-ernors of the Federal Reserve System (1996) estimatedthat banks losses from check fraud amounted to$615 million in 1995, $215 million of which was

FIGURE 6

Check verification and guarantee dollar value

billion of 1999 dollars

Source: Nilson, 2001a, 2000b, 1999b, 1997b, and 1996b,Nos. 742, 715, 691, 644, and 618.

1991 93 95 97 99 010

100,000

200,000

300,000

400,000

500,000

Verification

Guarantee


eventually recovered. Debit cards could significantlyreduce or eliminate overdrawn accounts, becausetransactions are only processed if funds are available.However, by promoting online debit cards, financialinstitutions would reduce their revenue from non-sufficient-funds fees.25

If electronic payment instruments were less ex-pensive than checks, financial institutions might beable to influence consumer usage and merchant accep-tance of electronic payments as evidenced in Norwayand Finland. However, U.S. financial institutions maybe reluctant to impose explicit per-check usage feesdue to competitive pressures.

Some financial observers have argued that the largenumber of payment providers in the United States mightprevent financial institutions from implementing priceincreases and cost-saving measures. One initiative bya Midwest bank to charge consumers for using banktellers initially met with consumer resistance and littlesupport from other financial institutions. Stavins (1999)found that regional competition prevented banks fromnot returning canceled checks because they fearedcustomers might switch to a rival bank that returnedchecks. Yet, some financial institutions were eventual-ly successful in implementing both of these policies.

Whether electronic payments are less expensiveto process than checks for financial institutions is de-batable. However, even if electronic payments are lessexpensive, the potential revenue from checks, especial-ly in the form of non-sufficient-funds fee income, isdifficult for financial institutions to forgo.

The Federal Reserve

Central banks differ in the roles they play in theoperation and oversight of their domestic paymentsystem (see Bank for International Settlements, 1999and 2000). Most central banks of industrialized coun-tries are involved in the settlement of retail paymenttransactions and some also play a clearing role. In theUnited States, the Fed is a provider of interbank checkclearing services and is the largest ACH operator.

Whether there remains a compelling need for theFed to provide check-processing services is debatable,given technological and regulatory changes. Whencreating the Fed, the U.S. Congress stipulated that itshould improve the efficiency and safety of the pay-ment system.26 At the time the Fed was created in 1913,checks were the primary means of interbank fundstransfer. Today, large-value domestic transactions areprocessed electronically via Fedwire, which is oper-ated by the Fed. In addition, electronic retail paymentalternatives, such as credit cards, debit cards, andACH payments, are increasing their market shares.27

The Federal Reserve has historically played an im-portant role in the development of check processing.However, some have questioned this role. Green andTodd (2001) argue that as the United States transitionsto the next generation of payment instruments, theFed should promote efficiency, integrity and acces-sibility primarily by means other than direct serviceprovisionsuch as participation in the setting of stan-dards, the drafting of model legislation and the regu-lation of payment services markets (Green and Todd,2001, p. 1). They further argue that encroaching onactivities that the private sector can perform efficientlyand equitably may erode the Feds reputation as atrustworthy and neutral institution.

The Feds role in check processing has declinedover the past two decades, partly due to regulatorychanges such as the Monetary Control Act of 1980(MCA), the removal of interstate branching restrictions,and changes to Regulation CC to allow banks to settlechecks in same-day funds. In the five years followingthe passage of MCAunder the terms of which theFed had to price its financial services and make themavailable to all financial institutionsthe Feds share ofinterbank check clearing decreased sharply.28 Summersand Gilbert (1996) claim that the Feds share of checkvolume decreased from 61.0 percent in 1980 to 49.8percent in 1985.29 For the same period, its share of checkvalue decreased from 48.5 percent to 31.7 percent.

The Fed also experienced a sharp decrease in thenumber of checks handled from 1993 to 1995. Giventhe lack of reliable non-Fed check volume data for thisperiod, it is difficult to determine the cause of this de-crease. Some financial observers claim that changesin Regulation CC and the removal of interstate branch-ing restrictions were at least partially responsible. In1994, Regulation CC was changed to allow banks tosettle checks in same-day funds. These changes mayhave resulted in more institutions using private clear-inghouses. We would also expect that as banks merged,the ratio of on-us transactions would increase. How-ever, most estimates indicate that on-us check volumehas remained constant at around 30 percent.30

Alternatively, total check volume may have de-creased during this period as a result of the adoptionof electronic alternatives. Therefore, the drop in Fedvolume would be attributable to a decrease in overallcheck volume and not a change in market share. Per-haps a more plausible explanation is that both a shiftto private-sector alternatives and substitution of otherpayment instruments were responsible for the reduc-tion in check volume. However, as stated before, inthe absence of reliable data, we can not determine themagnitude of each effect.


According to Federal Reserve System (1998), theFed processes a greater proportion of checks for smallerdepository institutions than private sector providers.During the Committee on the Federal Reserve in thePayments Mechanism (also known as the Rivlin Com-mittee) public forums, several community banks in-dicated that they feared that private entities wouldnot process checks at similar prices to those currentlycharged if the Fed left the check processing industry.Several banks and clearinghouses freely admit thatthey would charge more to clear these items than theFederal Reserve now does, citing the higher costs in-volved in serving these endpoints (Federal ReserveSystem, 1998). These institutions suggested that theFed subsidizes small institutions, especially those lo-cated in remote locations.

The Fed has denied cross-subsidizing across itspriced-services product. According to Rivlin (1997,p. 5), then vice-chair of the Board of Governors ofthe Federal Reserve System, each product in a multi-product firm should recover at least its incrementalproduction cost to ensure that no individual productis being subsidized.31 Using this standard, the Feddoes not subsidize any of its products. Similar argu-ments could be made about the allocation of fixed costsamong customers that may result in certain custom-ers paying a higher proportion of fixed costs. How-ever, some distributions of allocating fixed costsamong customer segments may deter competitorsfrom entering industries where economies of scaleand scope are present.

Chakravorti, Gunther, and Moore (1999) suggestthat private-sector providers could cherry-pick the prof-itable customers and leave the higher cost ones withthe Fed if low-cost customers pay more than the mar-ginal cost to serve them. They argue that as low-costcustomers find other less-expensive check processors,the price charged should rise for those remaining cus-tomers. Eventually, the rise in cost may result in anexit strategy for the Fed. Thus, these more expensive-to-serve customers may eventually choose to promotenon-check payment alternatives by charging highercheck fees to their customers.

However, if the Fed improves check-processingtechnology, such incentives would be reduced. Recent-ly, the Fed has made large investments in improvingcheck-processing technology to lower its costs.32 Itcontinues to promote electronic check presentment.33In 2000, the Fed electronically presented about 20percent of the checks it handled. From 1995 to 2000,the number of checks presented electronically grewfrom 1 billion to 3.5 billion, or a 28.5 percent com-pound annual growth rate (CAGR). Though the

physical checks still followed, this program allowedfor faster presentation of the check for payment. TheFed also participated in projects where the check wasimaged or truncated at either the payee bank or at theFed and no paper was sent to the paying bank. Morethan 7 percent of the checks the Federal Reserve han-dled were processed in this manner in 2000.

While these changes are aimed at decreasing check-processing costs, they may also affect the migrationto electronic alternatives. Specifically, a less-expen-sive check-processing system may reduce the incen-tives for financial institutions to migrate to electronicalternatives. Lacker and Weinberg (1998, p. 19) arguethat ECP (electronic check presentment) could beviewed as an attempt to stem the expected decline incheck use. By reducing the cost of paper checks, ECPcould slow the transition to fully electronic paymentinstruments that are even more beneficial.

Benston and Humphrey (1997) suggest that theFed may not have sufficient reason to continue in thecheck-processing business. Furthermore, they pointout that the Fed is virtually alone among central banksof developed countries in the provision of check-pro-cessing services to financial institutions. Bullock andEllis (1998) suggest that the heavy involvement ofthe Fed in check processing, along with its role in reg-ulating the industry, has kept the check competitivewith other payment instruments.

On the other hand, improvements in check pro-cessing may allow for the electronification of checks,while maintaining some features not presently avail-able in competing payment instruments in the UnitedStates, ultimately facilitating the movement to electron-ic alternatives. Connolly and Eisenmenger (2000) ar-gue that in some instances there is a need for the Fedto take an operational role to improve the processingof checks where the private sector may not be willingto invest the necessary funds initially to adopt thenecessary infrastructure. Guynn (1996) suggests thatcertain improvements in check processing may actu-ally improve the adoption of electronic instruments.

Drivers to change

Given todays underlying incentive structure, itwould appear that U.S. consumers, merchants, andfinancial institutions are not likely to change their pay-ment preferences in the near future. However, giventechnological enhancements and competition fromnonbank payment providers, the incentives for pay-ment system participants to use electronic alterna-tives will increase. Financial institutions, along withmerchants, have started to electronify checks byconverting them to ACH payments. Given the right


incentives, consumers may also increase their use ofelectronic payment instruments. In this section, we dis-cuss drivers that might aid the transition away fromchecks in the future.

U.S. consumers have only recently had electron-ic alternatives for different types of payments. Creditcards have surpassed checks as the most popular in-strument used for point-of-sale transactions.34 Debitcards are becoming increasingly popular at the pointof sale, and ACH payments continue to gain popular-ity for recurring bill payment and payroll disbursements.In addition, third-party providers are using new tech-nologies to deliver payment card products and ACHpayments to new market segments.

Debit cards show the greatest promise to decreasecheck volume at the point of sale. Debit cards offer con-sumers access to their transaction account like checksand allow merchants to receive their funds relativelyquickly, incurring little, if any, settlement risk. Mer-chant acceptance of debit cards and the number of con-sumers holding debit cards are growing rapidly. From1995 to 1998, the number of households with a debitcard increased by a 27 percent CAGR. The successof promoting debit card usage is partly due to the le-veraging of existing credit card and automated tellermachine (ATM) networks and financial institutionsability to easily put the product in the wallets of theirconsumers by increasing the functionality of theirATM cards.35

Earlier, we noted that financial institutions maynot have sufficient incentives to promote online debitcards. Recently, several electronic funds transfer net-works have consolidated. In the process, several ofthe largest networks have publicly stated that they in-tend to increase the revenue to financial institutionsfor participating in their networks (Breitkopf, 2001a).Two of the most prominent networks announced theirplans to almost double their interchange fees (Breitkopf,2001b). However, these plans were delayed more thansix months after several large retailers indicated thatthey would discontinue processing transactions overthe networks if the rate increases went through.

Off-line debit card usage has also increased rapidlyand these cards now outnumber their online counterpartsin the United States. These cards provide financial in-stitutions with similar levels of interchange fees to thoseoffered by credit cards, usually a percentage of thepurchase price. A few years ago, a group of merchantsfiled a lawsuit against Visa and MasterCard, challengingthe honor-all-cards rules of the card associations.36These rules stipulate that if merchants accept one ofthe card associations products such as credit cards, theymust accept all of the association-branded products.37

The merchants claim that few alternatives exist to thegeneral-purpose credit cards. Therefore, they are un-willing to stop accepting credit cards but want the abili-ty to decline the associations off-line debit cards.

A significant but not often discussed payment seg-ment is the person-to-person (P2P) payment segment.38The Federal Reserve System (2001) estimates that 11.2percent of total check volume and 6.7 percent of totalcheck value in 2000 were consumer-to-consumer pay-ments. Individuals are usually unable to accept ACHpayments or credit or debit card transactions. In thelast two years, banks and nonbanks have started toenable individuals to accept these payment instruments.39While the initial impact of P2P has been mostly lim-ited to the online auction community, recent initiativesby P2P providers have been geared toward capturinga larger share of the non-auction online transactions.40Some small businesses have begun to use P2P paymentservices as a means to accept payments both withinand outside the auction community.

In the bill payment arena, depository institutions(DIs) are facing competitive pressures from both third-party providers and non-depository financial institu-tions. Third-party providers began promoting the useof electronic payments to many of the most profitablecustomers for DIs. Brokerage firms and credit-cardbanks, which already have a connection to many ofthe DIs high-net-worth customers, have also beenactively promoting electronic bill payment services.Depository institutions risk losing these integral rela-tionships if they do not match or exceed the servicesoffered by these competitors. Thus, other providers ap-pear to have accelerated the incentives for DIs to pro-mote some forms of account-based electronic payments.

While checks continue to dominate the propor-tion of non-cash payments, we have discussed severaldrivers that should facilitate the migration to electronicalternatives. Leveraging existing networks, debit cardshave gained significant market share, and financialobservers believe that debit card growth rates will con-tinue to be higher than those of other established pay-ment media. As more commerce is conducted remotely,such as via the Internet, electronic payments share oftotal payments will also increase, since paper instru-ments may not be appropriate for these environments.Furthermore, new payment providers, especially non-bank providers, have started to leverage existing net-works, such as debit and ACH networks, to allowelectronic person-to-person payments. As consumersand merchants become comfortable with electronic pay-ments in certain payment segments, there will likelybe spillover effects to other payment segments thathave traditionally been dominated by checks.


Conclusion

In this article, we have examined why U.S. con-sumers, merchants, and financial institutions have beenunwilling to significantly reduce their check usage. Con-sumers lack incentives to change their habits. In theUnited States, credit card issuers have been success-ful in gaining point-of-sale market share by offeringincentives such as frequent-use awards and interest-freeshort-term loans if monthly balances are paid in full.However, in some environments, such as online pur-chases, consumers may have little choice but to useelectronic alternatives. Consumers may become morecomfortable with electronic alternatives the morethey use them, resulting in faster market adoption.

For merchants, the cost to process checks, includ-ing the risk of not being able to convert a payment togood funds, may not be significantly greater than forelectronic alternatives such as online debit cards. How-ever, merchants are also realizing the benefits of on-line debit cards as evidenced by the rapid deploymentof point-of-sale terminals and the merchants antitrustsuit against the credit card associations. Merchantsmay be gaining sufficient bargaining power with pay-ment providers to impact existing cost structures inways that may increase usage of electronic alternatives.

Financial institutions in Finland and Norwayhave been successful in convincing consumers to sig-nificantly curtail their check usage and increase theiruse of electronic payment forms by imposing per-checkfees. However, checks remain a substantial source ofrevenue for U.S. financial institutions, especially interms of non-sufficient-funds fees. Electronic alterna-tives, such as online debit cards, may not have been as

financially attractive, but new pricing policies by theonline debit card networks may entice financial insti-tutions to promote them more heavily.

Some have questioned the role of the Fed in theretail payments arena. While the Federal Reserve is ac-tively promoting electronic alternatives, it continuesto improve check processing. Such improvements maydistort the market incentives to move to electronic pay-ments. Even though the United States lags behind otherindustrialized countries in its continued high usage ofchecks, no studies to date have concluded that the mi-gration to electronic substitutes for checks is welfareenhancing in the U.S. context.

In this article, we have identified several poten-tial drivers of electronic payments, such as greater choiceof payment instruments for consumers for differentpayment segments, greater non-face-to-face shoppingopportunities, competition from non-bank paymentproviders, and a greater role by merchants to offer thelow-cost payment alternatives. Anecdotal evidence sug-gests that U.S. consumers are slowly changing their pay-ment habits, and we would expect this trend to continue.

Further research is warranted as to why the Unit-ed States lags other industrialized countries in adopt-ing electronic alternatives. We have suggested thatchanges need to occur in the underlying incentivestructure to convince all payment participants to mi-grate to electronic payments. U.S. consumers, mer-chants, and financial institutions are more likely tomake the transition to electronic payments, given thegrowth in remote purchases, developments in tech-nology, and greater market-based incentives to useelectronic alternatives.


1The number of checks written includes consumer, business, andgovernment checks. We focus only on consumer checks in this ar-ticle. We use U.S. check data for 2000 from the new Federal Re-serve System check survey and 1999 figures from BIS for theother countries (Federal Reserve System, 2001, and BIS, 2000).2The level of confidence in the payment statistics published byBIS is questionable. Therefore, a great amount of care should beexercised in interpreting them.

3A portion of the difference in per-capita check usage might beattributable to higher levels of cash use in some of these countries.Some countries with low check usage may have a high level ofcash usage, such as Japan. See BIS (1999) for a more detaileddiscussion of these differences.

4Determining the volume and value of checks is difficult. Whilethe Federal Reserve knows the number and value of checks it pro-cesses, it estimates the volume of checks processed by others. In1999, Nilson (19962001), BIS (2000), and Green (1999) esti-mated total U.S. check volume between 64 billion and 69 billion,accounting for $47 trillion to $83 trillion. Prior to the 2001 study,the Federal Reserves last benchmarking study was conducted in1979. For more recent years, non-Fed check volume was extrapo-lated from the 1979 study.

5We would expect that these numbers overestimate the growth ratein check usage, given the 2001 Fed study, but no reliable evidenceindicates that growth has been negative during this period.

6The G-10 countries are Belgium, Canada, France, Germany, Italy,Japan, the Netherlands, Sweden, Switzerland, the United Kingdom,and the United States. Japan is not included in the figure becausecheck usage in Japan is extremely limited, and France is not in-cluded because it did not report check data for 1999.

7There are two types of debit cardsonline and off-line. Onlinedebit cards use ATM networks to authorize and process transac-tions and require customers to use a PIN (personal identificationnumber) code. Off-line debit cards use credit card networks andare signature-based.

8For a discussion of why stored-value did not succeed in theUnited States, see Chakravorti (2000).9However, there are fixed costs such as the opportunity cost ofholding funds in a zero- or low-interest bearing account and po-tential monthly fees.

10Bank of America, Washington Mutual, Bank One, Harris Bank,and Fifth Third have recently started to promote free checkingaccounts (Thomson Media, 2001).11In comparison, 72.5 percent of households had a credit card and34.5 percent of households had a debit card in 1998 (a substantialincrease from 17.6 percent of households in 1995).12However, there are several types of merchants, such as gas sta-tions and restaurants, that do not usually accept checks.

13For more on bill payment, see Andreeff et al. (2001).14Federal Reserve System (2001) estimates that of the 49.6 billionchecks written in 2000, 19 percent were written at the point ofsale and 12 percent were written at either the point of sale or forremittance. Therefore, between 9.42 billion and 12.4 billionchecks were written at the point of sale.

15In addition, merchants used third parties to guarantee another 2percent of the total check volume. According to Nilson (1999b),the cost for check guarantee services averaged 1.56 percent of thevalue of the check in 1999. Note that guaranteed check costs aresignificantly higher than those of online debit cards and may bemore than off-line debit cards and credit cards.

16FMI (2000) does not break out the cost of fraud for verified andunverified checks, so we are using FMI (1998) for this portion ofthe analysis.

17We should note that based on the average cost per transaction,FMI (2000) shows that online debit cards are still the cheapest meansof payment. On a per transaction basis, online debit cards cost $0.34,verified checks cost $0.36, and unverified checks cost $0.38.

18Comparatively, on a per transaction basis, the cost of debit cardsrose from an average of $0.30 in 1994 and $0.29 in 1997 to $0.34in 2000.

19Both the Star and NYCE networks have increased their maximumfees for supermarkets to 19 cents, while Interlink has raised thisfee to 20 cents.

20In 2000, 32 million checks were converted to ACH payments atretail locations (National Automated Clearing House Association,2001).21For a theoretical exposition of credit extensions and their ben-efits to merchants, see Chakravorti and To (1999).22The Board of Governors of the Federal Reserve System (2001)states that the average per check fee was about 21 cents for inter-est-bearing accounts. Check revenue would be similar for accountsthat did not charge per-check fees if the average account holderwrote 9.5 checks. See FMI (1998) for merchants fees from checks.23As of the end of 2000, Interlink charged the highest online debit-card-processing fee of 20 cents for point-of-sale transactions. Af-ter recent price increases, Interlink still charges the highest feeswith a maximum of 45 cents for point-of-sale transactions.

24According to a recent survey by Dove Consulting and Pulse EFT,6 percent of financial institutions charge extra fees for using PIN-based debit cards at the point of sale. The study found that an av-erage fee of $1 is being charged to consumers because the low-interchange offered on PIN-based debit transactions does not ad-equately cover processing costs. See Breitkopf (2002).25Off-line debit cards offer issuers significant revenues in the formof interchange fees that could offset the decrease in insufficient-funds fees. This lucrative interchange revenue may be partly re-sponsible for the increase in popularity of debit cards since theirintroduction in the early 1990s (see figure 4).26For a historical perspective on the Feds role, see Gilbert (1998)and Summers and Gilbert (1996).27See Federal Reserve System (2001).28For a discussion of the private sector response to Fed pricingpolices resulting from the MCA, see Frodin (1984). For a histori-cal perspective on retail payment services and the MCA, seeKuprianov (1985).

NOTES


29The Feds share is taken as a percentage of interbank check vol-ume ignoring any changes in on-us volume.

30The last comprehensive study of the payment system by theFederal Reserve prior to the 2001 study placed the share of on-uscheck volume at 30 percent in 1979. The 2001 Fed study also putthe on-us check share at 30 percent.

31For more discussion of cross-subsidization, see Faulhaber (1975).32By mandate, the Fed must recover costs from the financial servicesit provides. Investments in equipment are amortized over years.Thus, it appears that the Fed expects the demand for its check-clearing services will not decline significantly in the near future.

33A number of other private-sector initiatives have also been un-dertaken to truncate checks at the point of sale and through lockboxes. In most cases, these initiatives take the magnetic ink char-acter recognition (MICR) information and turn the payment intoan ACH transaction.

34Some observers do not categorize credit cards as electronic pay-ments, because in most instances the statement is provided on paperand most payments are made by check. However, for most mer-chants, credit cards are processed, cleared, and settled electronically.

35There are differences in consumer liability across payment instru-ments. For a discussion, see Spiotto (2001). For a discussion of howevolving payment instruments and applications have leveraged theexisting payment infrastructure, see Mantel and McHugh (2002).36This case is currently awaiting trial.

37See Evans and Schmalensee (1999) for a discussion of networkrules and history.

38For more details on online P2P systems, see Kuttner andMcAndrews (2001) and McHugh (2002).39In some cases, P2P providers have created their own medium ofexchange, but most also allow consumers to easily convert thevalue into good funds.

40PayPal, the leading provider of electronic person-to-person pay-ments, indicated that 66.9 percent of its payment volume in 2001originated from online auctions. See McHugh (2002) for a discus-sion of PayPal and its services.

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Bank Administration Institute and PSI Global,1998, Profiting from Change in the U.S. PaymentsSystem, Chicago, IL: Bank Administration Institute.

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