John Hancock, the colonial merchant and patriot, used checks as they should be used, to transfer funds in generous amounts at a distance, as a part of his import export business.[1] Checks did not develop to pay small amounts where cash could be used, such as for a package of gum at the checkout counter. They are made out of paper and have to travel from the payee’s bank to the writer’s bank to fulfill their function, a sometimes perilous journey. At the time the Federal Reserve was founded in 1913, the collection (i.e. transportation and settlement) of checks was so slow and expensive in the US that the Reserve Banks (which are real banks) were given the authority to be intermediary collecting banks and speed up the collection process.[2] At that time, checks were often routed circuitously, in a roundabout path, by the payee’s bank to a friendly bank (one with which it had mutual accounts) located near the writer’s bank, so that the payee’s bank could be assured of getting payment in full. Local banks in the same town often agreed to exchange checks without fees in clearing houses. Otherwise, the writer’s bank might pay for the check by sending another check to the remote payee’s bank, with a deduction of exchange fees. The Reserve Banks were not authorized to pay exchange fees, and eventually those fees were eliminated (called par clearance), but check collection was still slow and expensive.
Checks must be delivered to the writer’s bank in original flimsy form to obtain payment. The writer’s bank is responsible for verifying that the writer’s signature is authentic before paying the check and charging the writer’s account.[3] This might work if the writer had a signature like John Hancock and checks were worth the trouble of comparing the signature with a signature card, but as checks decreased in value and increased in number banks did not bother to verify most signatures on small value checks, hoping for the best. Check forgery and other check fraud increased to well into the billions of dollars per year in the banking industry. Banks also offered free checking accounts to compete with each other and get what they wanted, your deposit. And they would return your original paid checks to you with your monthly statement, or charge you a fee for storing them. No one ever said banking was easy, certainly no banker at any rate.
The USA is a big country, and the number of banks exploded over time. Back in the 60’s there were as many as 40,000 banks, including what were called thrift institutions, like credit unions and savings banks. Banks can be chartered either by the states or by the federal government, and in some states a bank could not have branches but only a single office, because small banks wanted to avoid branching competition and were a powerful lobby in their legislatures. Continental Illinois Bank and Trust Co., one of the biggest banks in the country when it failed in 1984, had only one banking office. A lot of little banks grew up to serve local needs, including the need perceived by customers for checks, which are so much easier to carry around than cash. Originally, thrift institutions did not have checking accounts, only savings accounts. But to compete with the real bank across the street, they developed “negotiable orders of withdrawal,” which looked like checks but had a little legend that said the bank could impose a 30 day notice of withdrawal (although it never did so). These NOWs looked and functioned so much like checks that the courts called them checks, subject to all the perils of checks.[4] A revolution had occurred.
As checks and the banks on which they were written multiplied, the Reserve Banks continued to collect about a third of the checks written in the US.[5] At the peak, Reserve Banks processed upwards of 60 million checks per day. Although there are only 36 Reserve Banks and branches around the country, they eventually established a total of 47 check processing offices, and, under contract, an air force of small planes that would deliver checks to each of these offices twice each night, when the processing took place. The processing was labor intensive (the Boston Fed employed 250 people at night), but was automated to the extent of high speed reader-sorter machines that could sort and resort (at a rate of 100,000 checks per hour per machine) a bundle of checks into 24 pockets representing each bank endpoint, based upon the magnetic ink encoding at the bottom of the check. But the automation broke down because the checks had to be delivered in original form to the banks each morning by fleets of old automobiles, in some cases hundreds of miles away.[6]
To avoid this delivery delay, the Fed tried to promote electronic presentment, called truncation, where the paper check would be held by the Fed and just the information as to amount and writer’s account number would be presented for payment, by agreement with the writer’s bank. This was not particularly successful. The consumer lobby demanded that either the original check or a legible copy be presented. You wouldn’t want your bank to charge your account on some other bank’s say so, would you? Of course not. So the Reserve Banks experimented with attachments to reader-sorter machines that would create a legible image of the front and back of a check, as the checks whizzed through the machines. Much of the impetus for this came from the US Treasury, which wanted the Reserve Banks, which were the Treasury’s bank, to destroy the originals and keep copies of the millions of Treasury checks used for Social Security payments and the like. Yes, Social Security recipients still wanted to receive their payments by check in the mail.
No one ever seriously suggested changing check laws to make the payee’s bank, rather than the writer’s bank, responsible for the validity of the writer’s signature. That would probably have reduced the acceptability of checks to payees and their banks. But over the years, regulations and laws were changed in efforts to speed collection and reduce cost. To name a few: Payment for a check presented by a Reserve Bank to a writer’s bank was required on the day of presentment, rather than the next day, in 1974.[7] In 1980, Reserve Banks were required to charge banks for their check services.[8] In 1987, the Expedited Funds Availability Act required the payee’s bank to give credit to the payee according to a fixed schedule.[9] The Federal Reserve continues to try to improve this still-archaic payment system.[10]
Slowly but eventually, things started to change. In no particular order, the number of banks decreased through mergers, failures,[11] and branching; consumers got used to paying by plastic or preauthorized debit and credit; they even began to accept images in place of their own original signatures; and the cost of paper handling increased relative to electronics. But it took federal legislation, strongly supported by the banking industry, in the form of the Check Clearing for the 21st Century Act (Check 21, 2003)[12] to require all people to accept images in place of checks and do away with the Fed’s air force and check processing offices. Its better now, isn’t it? You can still write checks just like John Hancock, but for that package of gum.
[1] Called bills of exchange at that time, because not drawn on a bank. The House of Hancock, W.T. Baxter (1945), pp. 32, 206-7, 235.
[2] 12 USC 342, 360.
[3] Check law is found in the Uniform Commercial Code, a generally uniform state law, which provides that a check must be presented, or exhibited, to the writer’s bank to demand payment. Sections 3-501, 4-401.
[4] Consumers Savings Bank v. Commissioner of Banks, 282 N.E.2d 416 (Mass., 1972). As a result, some banks (so called) could pay interest on demand deposits, in contravention of Regulation Q (but that is another story). https://en.wikipedia.org/wiki/Negotiable_Order_of_Withdrawal_account .
[5] Community Bank vs. Federal Reserve Bank, 500 F 2d 282, (1974). Another third were on-us checks where the payee’s bank was also the writer’s bank, and another third were exchanged through local clearing houses.
[6] Because the checks were indorsed by a bank, they were considered non-valuable and not subject to theft, only to traffic accidents, breakdowns, weather delays, etc.
[7] Community Bank, above.
[8] https://www.federalreservehistory.org/essays/monetary_control_act_of_1980 . 12 USC 248a. Prior to the per check price competition brought about by this act, private collecting banks usually charged their customers by requiring correspondent balances.
[9] https://en.wikipedia.org/wiki/Expedited_Funds_Availability_Act .
[10] https://www.federalreserve.gov/newsevents/pressreleases/other20150126a.htm
[11] During a strong economic downturn, 200 banks a year would fail and be closed or merged.
[12] https://en.wikipedia.org/wiki/Check_21_Act