2003 Annual Report

Flexible Check 21 Law Sets Stage for Innovation

Commonly known as Check 21, the Check Clearing for the 21st Century Act became law on October 28, 2004. Check 21 requires banks and other financial institutions to accept substitute checks in place of original checks if these substitutes are presented to them by another bank. These substitute checks are paper copies of the original checks.

Check 21 establishes the legal validity of these substitute checks, mandates that paying banks honor substitute checks in the same way as original checks, and specifies technical standards to which substitute checks must adhere.

Despite its fairly modest scope and goals, the law's crafting and passage is the result of impressive cooperation from lawmakers, Fed officials, representatives of industry standards bodies, and industry participants throughout the payment system.

Speeding Toward Electronic Exchange of Check Information
The law is an effort to speed the move toward electronic exchange of check information rather than physical exchange of paper checks. In the long run, such arrangements will reduce costs and risks associated with handling, sorting, processing and returning checks, because electronic methods of accomplishing these tasks are easier and cheaper than current methods using paper checks. Additionally, banks adopting electronic exchange will gain more control over the location of their branches and ATMs, since they will no longer need to be geographically confined to check collection areas.

Because many banks will face transition costs associated with supporting dual infrastructures if they choose to process substitute checks, these banks may find it more attractive to enter into arrangements with other banks for electronic exchange. This will further accelerate movement toward electronics.

Technical Specifications
The new law requires the substitute check to contain an accurate and legible front-and-back image of the original. It must display the text, "This is a legal copy of your check. You can use it the same way you would use the original check." The MICR (magnetic-ink) coding on the substitute check must match that on the original, be machine-readable, and meet industry standards.

Flexibility for Financial Institutions
The scope of the act is revealing in the flexibility it affords banks. Banks currently present and return original checks unless they have entered into an agreement with another bank to process the checks electronically. Check 21 does not mandate that banks present checks electronically. It simply allows banks to send a substitute check instead of the original. This affords banks greater flexibility even if they do not enter into an arrangement for electronic exchange. For example, a bank can send an electronic image to its branch closest to the destination bank, then print the image and locally deliver it. In other words, the legislation does not mandate the electronic exchange of checks, but facilitates check processing by creating a standard format that allows banks to choose between paper, paperless, or some combination of the two when exchanging check information.

Why choose a policy option that values flexibility over specificity? Why risk a slower transition to electronics? These are difficult questions, but they relate to the same underlying theme: a faith in the ability of markets to foster transitions from one technology to another, through innovation and "creative destruction" - the process through which successful new technologies supplant older, more costly ones.