The death of paper checks has been predicted since the 1960s, but only recently has their use begun to decline. The end may be near, though, as two forces accelerate the trend away from checks: the growing acceptance of electronic payment instruments and the passage of legislation designed to reduce our reliance on paper checks.Checks ; Payment systems

Paul W. Bauer

English

Research Papers in Economics

Evidence from other sources suggests
that electronic payment instruments 
are making inroads against paper 
currency as well. The real value of
small-denomination notes in circulation,
the type most frequently used in retail 
transactions, has been falling since the
late 1980s (see figure 1). Except for a
brief surge just before Y2K, real per
capita currency holdings have fallen 
27 percent over the last 25 years, even
though real per capita personal con-
sumption expenditures have increased
68 percent.
Electronic payment instruments should
offer consumers and merchants better
features and cost less than paper checks.
These benefits will accrue much more
quickly than was anticipated just a few
years ago. The shift away from paper
payments, promised at the dawn of the
computer age, seems to be finally gain-
ing momentum. Two forces are working
to accelerate the trend. First, electronic
payment instruments, such as credit,
debit, and point-of-sale (POS) cards, are
becoming more and more widely
accepted, and network economies are
likely to lead consumers and businesses
to use and accept these competing
instruments more and more often. Sec-
ond, recent legislation, known as Check
21, helps set the stage for the day when
September 1, 2004*
Federal Reserve Bank of Cleveland
When Is Checkout Time?
by Paul W. Bauer
ISSN 0428-1276
*printed November 2004
The death of paper checks has been
predicted since the 1960s, but only
recently has their use begun to decline.
The end may be near, though, as two
forces accelerate the trend away from
checks: the growing acceptance of
electronic payment instruments and
the passage of legislation designed to
reduce our reliance on paper checks.
“They always say time changes things,
but you actually have to change them
yourself.”
—Andy Warhol (1928–1987), 
The Philosophy of Andy Warhol 
T he death of paper checks has been
predicted for many years. Starting in the
1960s, futurists thought that computers
and electronic networks would replace
paper checks, long the leader in noncash
retail payments. Yet in 2000, 42.5 billion
paper checks were still being written.
What such prognosticators forgot was
that economic agents have to have an
incentive to change their behavior
because there is always some cost for
changing it. 
Converting large-value payments turned
out to be fairly straightforward because
they generally occur among financial
institutions and large businesses. For
some time, the benefits of converting
these large-value transactions from
paper-based instruments to electronic
ones more than offset any transition
costs. By 1987, electronic payments,
mostly in the form of wire transfers,
accounted for 83 percent of the total
value exchanged in trade, while paper
checks accounted for only 16 percent.
Thus for large-value payments, the 
futurists essentially got it right. 
However, for retail payments, which are
far more numerous than large-value pay-
ments but for much smaller sums on
average, the best we can say is that
rumors of paper check’s demise were
premature. What was not understood was
how much more challenging it would be
to convert retail payments that take place
among millions of consumers and thou-
sands of small businesses from paper
instruments to electronic ones. This
process has only just begun to occur in a
significant way within the last 15 years. 
Estimates suggest that as recently as
1987, most transactions were conducted
with cash (83 percent), while a sizeable
chunk was still done by check (almost
15 percent). Electronic payments were
practically nonexistent: All forms of
electronic payments together totalled
less than 0.5 percent of all transactions
(“The U.S. Payment System: Efficiency,
Risk and the  Role of the Federal
Reserve,” by Allen Berger and David
Humphrey, 1990). Thus, while the value
exchanged in trade had largely gone
electronic by 1987, the vast number of
small-value transactions had not.
Over the last few years, the cost of pro-
viding electronic payment services has
fallen, so much so that, in many cases,
payment providers can offer consumers
incentives to use their electronic instru-
ments while still lowering merchants’
overall cost of handling these payments.
Consumers are responding. A comparison
of the shares of various payment instru-
ments in 1987 with those for 2000 shows
that the payments market has changed
significantly (the 1987 estimates are from
the Berger and Humphrey article cited
above, and the 2000 estimates are from a
survey conducted by the Federal Reserve
in 2001 of depository institutions, 
electronic payment networks, and card
issuers). In 1987, checks were the domi-
nant form of noncash payment,  account-
ing for 85 percent of all the transactions
that weren’t conducted with cash. By
2000, check’s share had taken a dive,
falling to 59.5 percent. Retail electronic
payments, a blip on the radar in 1987,
were starting to take over. In 1987, they
accounted for less than 2 percent of all
noncash transactions; in little over a
decade they had grown to 40.5 percent.
(Other forms of noncash retail payments
in 1987 were credit cards—then consid-
ered nonelectronic—travelers checks, and
money orders.) more banks will be willing to accept
electronic presentment of checks.
Because of this and other legal changes,
even when consumers do write paper
checks, they will be increasingly cleared
and settled electronically. 
■ Network Economies
and Technology 
Credit, debit, and POS cards are not new,
but their use has exploded over the last
few years. Part of the reason appears to
be the result of network economies. 
Network economies occur when the 
benefits of a good or service to an indi-
vidual increases as more people use it.
The classic example is the fax machine.
Fast, small, and efficient fax machines
became available in the 1970s, but they
did not take off until the late 1980s. As
more people owned fax machines, the
benefits to existing owners increased
because they could communicate with
more people. The benefits to carrying
credit and debit cards similarly increase
as more stores and businesses accept
them. Consequently, there is less need 
to carry cash or checks.
On another front, automatic electronic
bill payment of mortgages, car loans,
and utility payments by ACH (auto-
mated clearing house, an electronic sub-
stitute for checks developed in the
1970s) has become more common, but a
drawback to their acceptance has been
that many consumers do not like losing
the control over when their payments
are made. Currently, there is a pilot pro-
gram under way that may eliminate this
drawback. It’s called the Electronic
Billing Information Delivery Service, 
or EBIDS. EBIDS allows companies to
deliver billing information electronically
using the ACH. Consumers receive
notice of the bill through their online
account with their financial institution,
and they can then authorize the payment
when it is convenient to them. The spon-
sors of EBIDS hope that this approach
will eventually serve as a model for the
universal electronic distribution of con-
sumer bills to the 20,000 financial insti-
tutions that use the ACH network. 
Switching to an EBIDS-type model
offers potential benefits to billers, finan-
cial institutions, and consumers, so all
parties could have an incentive to incur
the transition costs required to make this
change.  Everyone could benefit from
the likely lower costs and increased con-
venience. Consumers, in addition to
retaining control over the timing of their
payments, would have access to more of
their bills at one location, and con-
sumers’financial institutions would be
able to offer enhanced online banking
services. Finally, billing companies and
their financial institutions should see
cost savings in processing payments, in
part because they would then be receiv-
ing nonrevocable ACH credit payments.
■ Legal Innovations
Two legal innovations are likely to speed
the shift away from paper checks. First,
beginning in 2002, a change in the regu-
lation that governs the way banks con-
duct electronic funds transfers—known
to bankers as Reg E—allows a variety of
consumers’check payments to be con-
verted to electronic items. For example,
many consumer bills are paid by mailing
checks to lockboxes, mail handling
facilities that accelerate the processing
of consumer payments for entities that
receive large volumes of consumer pay-
ments, such as utilities and credit card
companies. Under the new Reg E, with
prior notification, these lockboxes can
now convert paper checks to electronic
items. As more and more lockbox oper-
ations adopt this practice, more and
more payments that start off as a paper
item will be cleared and settled electron-
ically. Another example of a payment
originating as a paper instrument but
being cleared and settled as an elec-
tronic item is a point-of-purchase (POP)
transaction. With POP, a consumer
writes a check for a purchase and, with
his approval, the item is scanned at the
register and converted to an ACH item
for collection.
A potentially bigger change has just
taken effect. The problem of clearing
paper checks when all civilian flights
were grounded after 9/11 provided the
impetus for passing the Check 21 legis-
lation. As of October 28, 2004, this act
reduces some of the legal impediments
to check truncation, the conversion of a
paper check to an electronic debit or
image, and should help foster innovation
in the payments system, enhancing its
efficiency. The law creates a new nego-
tiable instrument called a substitute
check, a printed image of the front and
back of the original check. Such substi-
tute checks will be the legal equivalent
of the original check. 
For example, when a customer deposits a
check drawn on another bank, his or her
bank will be able to truncate the paper
check and process that check’s informa-
tion electronically. If the bank on which
the check is drawn insists on receiving
the paper check, the new, legally binding
substitute check could be printed at a cor-
respondent institution near the paying
bank. Lawmakers explicitly chose not to
force banks to accept electronic images,
choosing instead to let the market decide
how quickly banks adopt new practices.
The law is intended to induce voluntary
innovation to promote efficiency, as
under the law, banks will not be required
to accept checks in electronic form nor
will they be forced to create substitute
checks. 
Notice that with both of these legal inno-
vations, even when a payment begins life
as a paper check, increasingly the pay-
ment will be processed electronically,
thus speeding the processing time. 
FIGURE 1 REAL VALUE OF SMALL-DENOMINATION
NOTES PER CAPITA ($1, $2, $5, $10, AND $20)
250
270
290
310
330
350
370
1979 1984 1989 1994 1999
December 31 of each year
Dollars
SOURCE:  Board of Governors of the Federal Reserve System.■ Implications for Reserve
Banks
The decline in paper checks has impor-
tant implications for the 12 Reserve
Banks of the Federal Reserve System.
While the Reserve Banks have been
involved in check processing since the
system’s founding, not until Congress
passed the Monetary Control Act
(MCA) of 1980 were the Reserve
Banks required to price their services.
The act, which was intended, in part, to
increase competition and efficiency in
the market for correspondent banking
services such as check clearing,
required Reserve Banks to set fees that,
over the long run, recover all the direct
and indirect costs actually incurred in
providing priced services such as check,
ACH, and Fedwire (a large-dollar-value
interbank payment mechanism). These
costs include interest on items credited
prior to actual collection, overhead, and
an allocation of imputed costs that takes
into account the taxes that would have
been paid and the return on capital that
would have been provided had the ser-
vices been furnished by a private busi-
ness firm. This means that not only do
Reserve Banks have to recover their
actual costs across all priced services
over time, they must achieve the same
degree of profitability that private
providers do. Of course, the Federal
Reserve has other objectives that it must
simultaneously pursue, such as helping
to maintain the safety and soundness of
the payment system, so it must be care-
ful not to operate in a way that is disrup-
tive to the system.
Since 2000, Reserve Banks have strug-
gled to try to meet this standard of prof-
itability (see figure 2). If check process-
ing were a small sideline, its decline
would require a minor institutional
change, but check accounts for about 
40 percent of employment at Reserve
Banks, if one counts not only direct
check employees but also the support
staff they require.  In February 2003 
the Reserve Banks announced that
check processing at 13 of their 45 sites
would be discontinued and that check-
adjustment functions (resolving any
check-processing errors) would be con-
solidated at 12 sites, down from 43.
Nine more closings were announced
last August and scheduled to take effect
in 2005 and 2006, and more may be
required if current check volume 
trends continue.
The volume of checks processed by
Reserve Banks, which last peaked in
1999 (see figure 3), will certainly
decline further, but how much, how
fast, and when are not easy to predict.
A first approximation is to assume that
the Reserve Banks’volume will decline
at roughly the same rate as the overall
market. Determining this rate is some-
what tricky, because hard data on over-
all check volume is sparse. In 1979 the
Federal Reserve conducted a survey
that estimated the overall check vol-
ume, but the next survey for this pur-
pose was not released until 2001. In the
intervening years, the Board of Gover-
nors estimated check volumes using a
combination of discussions with check
printers and other industry experts and
later by looking at movements in real
personal consumption expenditures.
For 1995, for example, the estimate
was 63 billion items. When the 2001
survey found only 42.5 billion items for
2000, it came as quite a surprise. Geof-
frey Gerdes and Jack Walton, II, found
evidence that the decline had likely
begun during the late 1990s. Using data
originally collected for 1995 for a
report to the Congress on funds avail-
ability and check fraud, they estimated
there were 49.5 billion check items for
that year (Federal Reserve Bulletin,
August 2002). Thus, overall check vol-
ume had fallen about 3 percent per year
on average from 1995 to 2000 (see fig-
ure 3). We will have much more current
information when the Federal Reserve
releases its next survey of retail pay-
ments late in 2004.
But how valid is the assumption that
Reserve Bank volume will decline at the
same rate as the overall market? Until the
declines actually started, many believed
that Reserve Banks would not be too
affected by the eventual fall in overall
check volume, at least in the short run,
and that they might even benefit initially:
As overall volume declined, the Reserve
Banks might continue to gain volume
and market share as other providers left
the interbank check market. 
FIGURE 2 CHECK COST RECOVERY RATE
FIGURE 3 CHECK VOLUME
0.80
0.85
0.90
0.95
1.00
1.05
1.10
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
Revenue/(Costs+PSAF)
10
15
20
25
30
35
40
45
50
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Billions
Total market, BOG estimates
Federal Reserve
SOURCE:  Federal Reserve Bank of Atlanta.
SOURCE:  Board of Governors of the Federal Reserve System.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Material may be reprinted if the source is
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material to the editor.
Paul W. Bauer is an economic advisor at the
Federal Reserve Bank of Cleveland.
The views expressed here are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
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However, the smaller overall market
estimate first found in the 2001 survey
makes it nearly impossible that the
Reserve Banks’volume will increase.
Instead of the Reserve Banks having 
35 percent of the interbank market for
check clearing in 1995, as had been
supposed, they actually had 44 percent.
By 2001 their market share had risen to
56 percent. The higher market share is
significant because the Reserve Banks
do not have a very good chance of
attracting the remaining 44 percent.
Most importantly, roughly 29 percent of
all checks are “on-us” items, meaning
that the person writing the check and
the person cashing the check bank with
the same institution, so that these items
do not require outside processing. Also,
a significant number of checks are
cleared by direct presentment (for
example, two banks running a shuttle
van to exchange checks periodically).
Commercial banks have been merging,
so there will be more “on-us” items and
direct presentment will become more
attractive. Consequently, it is likely that
Reserve Bank volume will decline more
quickly than the overall market. 
In addition to boosting productivity, new
technology can sometimes cause some
painful adjustments to existing firms and
their employees, but the Monetary Con-
trol Act is working as legislators
intended. They wanted the Reserve
Banks to compete on an equal basis with
private providers so that technology and
consumer preferences would determine
the outcomes in payment markets. The
act gives Reserve Banks a clear yardstick
to measure their performance and prof-
itability. If they are failing to meet this
yardstick, the market is telling them they
need to do things differently. Reserve
Banks have been adapting rapidly, con-
sistent with their other goal of ensuring
the safety and soundness of the payments
system, and are likely to continue to be a
major payments player, albeit likely one
with fewer employees. 
So, “When is checkout time?” Rather
than dying out completely, checks, like
old soldiers, are more likely to fade
away, as fewer checks get written and as
those that do are increasingly settled
electronically.

When is checkout time?

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When is checkout time?

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