Nyu – Leonard N. Stern School of Business Operations in Financial Service – B60. 2315. 030

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NYU – Leonard N. Stern School of Business

Operations in Financial Service – B60.2315.030

Professor Michael Pinedo

Check 21 – The Federal Reserve’s Perspective

Group Names:

Jeremy Dorin – jsd241

Euston Maynard – erm237

This paper does not contain confidential or proprietary material and is suited for public viewing.

Table of Contents

Table of Contents 2

Overview 3

Figure 1 3

Figure 2 3

Background - The U.S. Federal Reserve 4

The Federal Reserve Financial Services 4

Figure 3 4

The Federal Reserve Check Clearing System – Electronic Check Processing 5

Check 21 5

Figure 4 5

Organizational Structure 6

The Board of Governors 6

Competitive Environment 7

Economies of Scale 7

Economies of Scope 7

Name Recognition 7

Federal Regulation 8

Innovation & Standardization 8

Traditional Check Processing 9

Figure 5 9

Operational Details 10

Productivity Analysis 10

Check 21 12

Figure 6 12

Operational Details 13

Productivity Analysis 14

Figure 7 17

Simple DEA Analysis 19

Operational Risk Issues 20

Service Disruptions 21

Presenting Banks 21

Paying Banks 21

Business Continuity and Disaster Planning 22

Balance Score-Card 22

Strategic Planning Processes 22

Conclusion and Challenges 24


Paper checks make up a large percentage of the total number of non-cash payments used by U.S. consumers, businesses and government entities. As shown in figure 1, the US Federal Reserve handled about 28% of all paper checks or approximately 12 million US paper checks in the year 2000. Handling here primarily involves the process

Figure 1

of sorting, crediting accounts and delivering checks to originating banks. In addition, the US Federal Reserve may also need to process returned checks as well as allow for account adjustments in the event of processing errors. This all occurs at one or more Fed check processing facilities located in Federal Reserve Banks, Branches and dedicated processing facilities.
In general, the total number of checks written and those processed by the Federal Reserve has been declining since the late 1990s while during the same period, the dollar value of these checks has been rising. This trend is clearly depicted in Figure 2 and is expected to continue as the new Check 21 legislation is poised to reduce the volume of

Figure 2

paper checks even further. The Federal Reserve is required under the Monetary Control Act of 1980 and the Expedited Funds Availability Act, enacted in 1987 to recover expenses spent on transactional services provided to the private sector. This creates a dual role for the Federal Reserve which competes with specialized private clearing service providers, but must serve its mandate of providing service to all legally defined member banks. Under this environment and new rules, the Federal Reserve must be prepared to adjust its internal operations in order to maintain operational efficiency and contain costs.
This paper delves into the details of check processing and how it will be affected by Check 21 from the perspective of the U.S. Federal Reserve. After a brief organizational background into the Federal Reserve and its services, a more detail analysis of the check processing system will follow.

Background - The U.S. Federal Reserve

The United States Federal Reserve System was created by the Federal Reserve Act of 19131 to provide the nation with a safer, more flexible and stable monetary and financial system – in essence, it acts as the central bank for the United States. It is responsible for:

  • Formulating and executing monetary policy

  • Supervising and regulating depository institutions

  • Providing an elastic currency

  • Assisting the federal government’s financing operations

  • Operating the nation's payments systems

  • Protecting consumers' rights in their dealings with banks and

  • Promoting community development and reinvestment.

The Federal Reserve Financial Services

The FRB Financial Services acts as a fiscal agent to the federal government by providing financial services to the United States Department of Treasury, depository institutions and the general public. It is responsible for overall leadership of the twelve Federal Reserve Bank’s financial services activities and related support functions. Products and services include:

Figure 3

The Federal Reserve Check Clearing System – Electronic Check Processing

Since the early 1990s, the Federal Reserve has incorporated and enhanced electronic check clearing though their Electronic Check Presentment (ECP) services. This is a process in which checks evidence a one-time electronic payment from a specific account – the check itself is not the method of payment; rather a check represents a transfer of a bank obligation from a depositor to a payee. The MICR and dollar amount information are extracted and transmitted through the ACH clearing network for payment.

Check 21

The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28, 2003 to become effective on October 28, 2004. The legislation was designed to facilitate banks’ move to processing more checks electronically instead of the traditional physical transfer thereby making check processing faster, more efficient and less costly (in the long-term). This is primarily done through the introduction of a new negotiable instrument called a substitute check – see figure 4. A substitute check is the legal equivalent of the original check and includes all the information contained on the original check.

Figure 4

As a result of these characteristics, banks receiving a substitute check, both physically and electronically, are able to process them to the same extent that it could process the original check. The law however does not require banks to create substitute checks.2

Organizational Structure

The Board of Governors

The Federal Reserve has indices of both private and governmental structure. The Federal Reserve is fundamentally a government-run organization, chartered to promote the public good rather than maximize profit. The seven members of the Board of Governors are appointed for 14 year terms by the President of the United States and confirmed by the U.S. Senate. The Chairman and Vice-Chairman are appointed for four years, but may be re-nominated for more than one term. The Federal Reserve System is comprised of twelve districts represented by a Federal Reserve Bank and headed by a board which with the consent of the Board of Governors chooses a president for five year terms.3 Five of those presidents (along with Board of Governors) serve on a rotating basis on the Federal Open Market Committee, the body responsible for federal monetary policy.
However, the commercial banks within a Federal Reserve district hold stock in the Federal Reserve Bank of that district. Unlike holder of private equity, holders of Federal Reserve Banks may not exercise control over that bank. The shareholders have the ability to elect 6 of the bank’s nine board members. There are many functions that are financed not through governmental means, but through service-based fee collection. Section 11a of the Monetary Control Act of 1980 both increased the power of the Federal Reserve to operate financial services and created a mandate that the provision of those services be financed through user fees.
The Federal Open Market Committee has the primary responsibility for the Federal Reserve Payment Systems. The Federal Reserve offers three services through FedWire, the National Settlement Service, Fedwire Securities Service, and Fedwire Funds Service. The National Settlement Service is used by large clearing institutions such as check and ACH clearinghouses for large settlement transactions. These transactions are end-of-day net settlements, settling all of the daily transactions between institutions in a single transaction. These institutions may serve as an alternative to other Federal Reserve transactional services including FedWire. Insofar as the users of National Settlement Services are large transaction aggregators, there are very few users (less than 100). FedWire Funds Services, on the other hand, provides a transaction-level service for thousands of banks, credit unions, and other commercial financial institutions while FedWire Securities Services provides for similar transaction-based services dealing in securities rather than monetary instruments.
Each Federal Reserve Bank is given operational power to provide financial transaction services with guidance and supervision from the Board of Governors. Each Federal Reserve Bank issues a copy of the Federal Reserve Operational Circulars and the Account User Manual which both dictate policy of the individual banks as well as have the power of regulation.
There are a few (mostly jurisdictional) requirements for financial institutions to hold accounts with the Federal Reserve. However, non-qualified institutions, such as foreign banks, may enter into an agreement with a account-holding bank (called the correspondent) to run the transactions through that account. In such a relationship, the correspondent holds funds for the non-qualified bank (the respondent”) in a bank-specific sub-account which is held on the ledger of the correspondent, but does not appear on the books of the Federal Reserve. However, the correspondent must cover the reserve requirement of all monies in their account including that held for respondents. Thus, correspondents make relationship-specific agreements with respondent banks regarding security interests and other risk-management instruments.

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