RegionsNorth AmericaSeizing the Opportunity in Check 21

Seizing the Opportunity in Check 21

The events of September 11 clearly demonstrated the need to reduce the US payment system’s dependence on the physical transportation of checks. During the days following September 11, the Federal Reserve Bank had to deal with an incredible $45bn of processing float on account of all airplanes being grounded. The risks associated with such an unprecedented level of float become even clearer when one bears in mind that generally the Federal Reserve only permits between $600-800mn of float per day (Source: American Banker, January 2002). In response, the Federal Reserve Bank submitted the Check Truncation Act (CTA) to the United States Congress in late 2001. The legislation was re-introduced to the 108th Congress in 2003 as the ‘Check Processing for the 21st Century Act’ (Check 21) The President of the United States signed the bill on October 28, 2003, with the implementation date set for 12 months thereafter.

The legislation’s primary goal is improve the efficiency of the United States’ payment system and avoid a repeat of the high-risk scenario witnessed after the catastrophic events of September 11. Check 21 also seeks to foster innovation in the United States’ check collection system, without causing major disruption to the banking system and its end users. An important step towards achieving the twin goal of innovation and efficiency is to facilitate check truncation. The law aims to achieve this objective by authorizing for the first time the use of so-called substitute checks.

Overview of the Legislation

Following the enactment of the Check 21 legislation on October 28, 2004, United States’ banks are no longer required to physically exchange original checks. Although the legislation limits itself to making a ‘substitute check’ created from an image the legal equivalent of the original check, it is expected to also promote image interchange between financial institutions. By allowing image exchange, Check 21 creates an unprecedented opportunity to

  1. eliminate the dependency on the physical shipment of checks between financial institutions, and
  2. accelerate clearing cycles and increase the amount of investable funds.

At the same time, the legislation takes care not to disrupt the United States’ check clearing system. When Check 21 becomes effective, banks may continue to present and receive physical checks. However, they will no longer be able to insist on obtaining the original item and will have instead to rely on substitute checks. As mentioned before, Check 21 will make a substitute check the legal equivalent of the original. This substitute check is known as an image replacement document or IRD. As its name suggests, an IRD is a paper item that carries images of the front and rear of the original check. It includes the Magnetic Ink Character Recognition (MICR) code line from the original check as well as its legal legends and endorsements. In addition to featuring these elements, IRDs must be machine readable and compatible with current standards. They must also conform to the latest check processing equipment.

What requirements will a financial institution need to fulfill to implement Check 21?

From a regulatory standpoint, all that is required of banks is the ability to accept substitute checks. However, from the banks’ point of view there is much more involved. They first of all need to evaluate the operating environment to ensure safety and soundness of the new IRD processing and/or check image exchange. Managing image quality is critical to banks and their customers in the Check 21 environment. If the resolution of a check image is not of high quality, the electronic environment may ultimately prove even less efficient than primarily paper-based processes. Essentially, image quality must be such that it can be read and used throughout the entire clearing cycle. And, as the industry continues to evolve, moving toward Image Exchange and Image Share for Settlement, banks need to define multi-channel clearing strategies that make sense not only for their business processes, but also for their customers.

Banks will also have to analyze the impact image replacement documents and image exchange will have on their operations. This includes reviewing their deposit and disbursement processing/funds availability procedures as well as examining their current security measures to prevent fraud. From a contractual point of view, banks need to understand that IRDs carry their own sets of warranties and indemnities. This requires them to review their legal and commercial policies accordingly. In particular, banks will have to accommodate and educate their customers in this regard. The banking industry must also implement processes to handle return items and potential disputes regarding IRDs. Lastly, and most importantly for all their clients, it is imperative that banks put safeguards in place against any new avenues to perpetrate fraud.

Image Exchange

As the United States’ banking industry implements the basic regulatory requirement for Check 21, the most interesting aspect of the new legal framework will be the potential for image exchange. Though this is not a regulatory requirement of the legislation, the Check 21 Act provides the banking community the Federal Reserve and the Clearing House with the legal basis for the exchange of images instead of the original paper check or IRD. The economic opportunities for banks to exchange images in lieu of creating IRDs, may be compelling for both themselves and their clients. Those banks that are ‘image enabled’ will be able to present ‘image cash letters’ to the Federal Reserve Bank and The Clearing House member banks. The Federal Reserve Bank, acting, as a check clearing entity, in turn will present image files to paying banks that are image enabled. In the case of banks that are unable to receive and process check images it will print and present IRDs.

Future Developments

Looking ahead, the image exchange authorized by the Check 21 legislation opens the way for operating alternatives. Most importantly, it allows for the decentralization of image capture. In the long term, this may mean that all transportation will be eliminated. In addition to offering the potential for costs savings it also presents opportunities for developing new products such as remote deposit capture, be it for branch or USD international check deposits. Check 21 legislation will also contribute to a speeding up of the clearing cycle, which in turn will have an impact on the existing product range. Lockbox, controlled disbursement, reporting and positive pay services will all have to be revisited.

Given the important potential for efficiency improvement and cost savings, the check collection service market is likely to become more competitive. Corporate customers are likely to rationalize their bank relationships in favor of those banks that have the technical and logistical capabilities to achieve greater efficiency and lower pricing. However, even the most advanced banks will not be able to take advantage of all the benefits that image interchange can yield without standards that ensure full interoperability. It is therefore imperative that all participants work together to establish industry standards for image quality, security and usability within the United States’ banking system. Such standards will also ensure an orderly evolution towards the new check image based processing and settlement environment.


Unlike many other laws or regulations which have impacted the United States’ banking industry, where banks’ ambitions are limited to achieving compliance rather than see how these laws and regulations can benefit the banking industry and its client base, Check 21 legislation may bring a built-in opportunity to add value to their clients’ business through resulting product innovations. Banks should seize this chance with both hands. Ignoring or only partially exploiting the potential benefits of Check 21 legislation is not an option as corporate customers will rightly demand greater efficiency and lower pricing. HSBC, for its part, is ready to rise to the challenge.

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