How Are Deposited Checks Processed?

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It’s likely that the development of digital payments platforms, such as PayPal, was due in part to the business owner’s dread of the phrase, “The check is in the mail,” and his awareness that “time is money.” Today, developing states and industrialized nations alike benefit from an instant economy whereby one click initiates the movement of money from one cash account to another. This is quite a contrast to the payment by check process that can require days for cash to be transferred from one checking account to another depending on the participating institutions and their modes of operation.

So, why doesn’t the payment by check transaction match the speed of business? The delay between check issuance and cash receipt is due in part to the payment infrastructure that underlies the payment by check transaction and which elements of that infrastructure are involved in clearing a particular check.

Check Processing Basics

Once you issue a check and it is in the hands of the intended recipient, they deposit it in their bank account. If you and the recipient use the same financial institution, the clearing process takes place within that institution, which makes the funds more or less immediately available to the recipient. If you two use different institutions, a check processing or clearing process takes place.

If a check is drawn on an account at one bank, but deposited at another institution, access to that cash takes more time because the check clearing process is handled by a third party, an intermediary bank. In this event, the check recipient’s bank asks the intermediary bank to contact the paying bank to confirm that the payor has that amount of cash in his bank, so the check will “clear.” At that time, the recipient’s bank converts the check’s value to cash, which is placed in his account.

Types of Intermediary Banks

The intermediary bank may be one of three types:

Federal Reserve Bank: The Federal Reserve Bank (FRB) is the central bank of the United States. The FRB consists of regional banks, each of which processes checks for its member banks, or those financial institutions that have accounts at that regional bank. The regional bank charges a fee for each check it processes as well as for other services, such as check collection, air transport of the checks to the regional banks and their subsequent delivery to the paying banks.

Correspondent Bank: A correspondent bank, in partnership with other banks, exchanges checks and payments directly, rather than involving a Federal Reserve regional bank in the process. One correspondent bank may serve as an intermediary to other institutions by accepting checks and payments from a non-partner bank and forwarding those to another correspondent bank. A correspondent bank may be a large commercial bank, a bankers' bank or a corporate credit union.

Unlike the FRB, the correspondent bank is one of a group of financial institutions that operate in the private sector and that are authorized to clear checks. Some correspondent banks join together to form a clearinghouse corporation, by which they can exchange a large volume of checks and payments simultaneously, rather than on a check-by-check basis.

Clearinghouse: A clearinghouse is an institution that stands between two correspondent banks to facilitate the electronic exchange, or clearance, of payments as well as securities and derivatives transactions. The participation of the clearinghouse in the transaction reduces the risk that either partner to a transaction will fail to honor its settlement obligations.

Each day, the clearinghouse collects the checks drawn on member banks and distributes them to the appropriate member bank. Following the exchange, the net difference in value, or net payments for the checks, can be settled through Fedwire, an electronic funds transfer system designed specifically to facilitate this large-scale check settlement process. Unlike the FRB, the clearinghouse operates in the private sector.

The Check Clearing Process

The check clearing, or settlement process, consists of nine steps:

1. The check recipient deposits the bank draft in his account.

2. The check recipient’s bank transfers the check and a corresponding payment request to an intermediary institution for verification and settlement.

3. The intermediary bank identifies the check’s paying bank by its routing number. That number consists of the nine digits printed on the bottom and far left corner of the check. The routing number is directly to the left of the payer’s account number. All U.S. banks are assigned one or more routing numbers.

4. The intermediary bank transmits the check and payment request to the paying bank.

5. The paying bank verifies the check, which approves the draft for payment.

6. Upon receipt of the paying bank’s verification, the intermediary bank settles the check by debiting the recipient's bank and crediting the payee’s bank for the check’s amount.

7. The payer’s bank debits the draft’s related checking account.

8. The account of the check’s payee is increased by the cash value of the check.

9. The payment of the check’s amount is documented as a credit in the payer’s checking account statement and a debit in the payee’s account statement.

More About Check Processing

This transaction takes place using the automated clearinghouse (ACH) payments system. According to the Federal Reserve Bank of New York, the ACH is a nationwide network through which depository institutions exchange batches of electronic credit and debit transfers. The ACH is operated by Reserve Banks and Electronic Payments Network (EPN)

The Federal Reserve’s Cash Products Office (FRCPO) says the number of transactions that used checks as a payment process in the year 2018 was about 14.5 billion, a significant decrease from the 42.6 billion check payments in 2000. In contrast, the FRCPO says the value of core noncash payments, made up of debit card, credit card, ACH and check payments, was $97.04 trillion in 2018. There’s little doubt that this phenomenon is due in part to how checks are processed and the time the process entails.