National Check Payments Certification

Check Fundamentals and Check Processing

Copyright© 2014 by the Electronic Check Clearing House Organization

NCP 2015 Exam CycleCore Training Series

Session 1

2National Check Payments Certification

NOTICESThis training course may provide an introduction to or summary of various aspects of check payments and the legal and rules framework for check image exchange. Responsibility for compliance with image exchange rules, and/or the legal, operational and regulatory requirements applicable to check image exchange, remains at all times with the financial institution participating in check image exchange and/or the individual or company using a check image exchange service.

This presentation and the information contained herein is not intended as legal or compliance advice or recommendation to any person or company. This document could include technical inaccuracies or typographical errors and individual users are responsible for verifying any information found in this presentation and related “live” webinar or webinar playback. Financial institutions should consult with their legal counsel regarding legal and operational requirements applicable to any check image exchange program they may offer or in which they participate.

These program training materials may not be reproduced or published, in whole or in part, without the express permission of ECCHO.

Copyright© 2014 by the Electronic Check Clearing House Organization(Certain contributed content subject to third party copyrights)

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4National Check Payments Certification

Session Topics

• Check Basics–Definitions–MICR line

• Need for Rules–Paper vs. Image Exchange

• Check Payments System Overview• Other Payment Systems

Check Basics

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General Check Definitions• Section will cover common definitions related to the check including:

– Bank (general definition)Depositary BankCollecting BankPaying Bank (also called “Drawee” in the UCC)

– Drawer– Payee– Amount

Courtesy AmountLegal Amount

– MICR lineSelected MICR line fields

• Other definitions discussed in subsequent sessions related to specific topics

• For additional definitions, see 2015 NCPC P.R.E.P. Guide section titled “Glossary of Terms and Common Acronyms” – Available upon registration to all 2015 NCP exam registrants

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Bank

• Bank: Reg CC definition – Expedited Funds Availability (EFA) Act uses the term depository institution –Reg CC uses simpler term “bank”

Definition includes ALL depository institutions as defined by both the: o FDIA – Federal Depositary Insurance Acto FCUA – Federal Credit Union Act

– Includes:Insured commercial bank;Insured credit union;Mutual savings bank;Savings and loan association; orAgency or a branch of a foreign bank as defined in the

International Banking Act

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Blank Check Example

Basic Consumer Check

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Parts and Parties to the Check• Paying Bank: Bank by which check is payable, to which it is sent for

payment or collection– Federal Reserve Bank (FRB) / Federal Home Loan Bank (FHLB) by which check

is payable; or– Bank through which a check is payable, if check is not payable by a bank; or – State or unit of local government on which a check is drawn and to which it’s

sent for payment or collection

• Drawer: Person ordering payment; Person signing the check• Drawee: Bank / person ordered to pay the check• Depositary Bank: First bank to which check is transferred even though it

may also be Paying Bank of payee (Reg CC definition)– Depositary Bank or Bank of First Deposit (BOFD) and Paying Bank may be the

same bank for on-us items

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Parts and Parties to the Check

• Correspondent Bank: May conduct business transactions, accept deposits and gather documents on behalf of other financial institutions (respondents)

• Collecting Bank: Any bank handling a check for forward collection, except the Paying Bank

• Amount – UCC 3-104 requires a fixed amount for the item to be a negotiable instrument– Amount should appear twice on the check to help inhibit check

fraud– Both in numbers and words

Courtesy amount (or convenience amount) – Amount in numbersLegal amount – Amount in words

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Processed Check – Front

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Processed Check – Back

Indorsers Depositary BankD

O N

OT

WR

ITE,

STA

MP

OR

SIG

N B

ELO

W T

HIS

LIN

E

EN

DO

RS

E H

ER

E

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What is MICR?

• Magnetic Ink Character Recognition (MICR)–1956–Descriptive information comprised of numbers and

symbols–Magnetic ink printed characters that can be

recognized at high speed by automated processing equipment

–E-13B Font – Used in magnetic ink printing in USA, Canada and several other countriesConsists of ten numeric characters and four symbols

–MICR line at the bottom of physical check

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123.45 One hundred twenty-three and 45/100

– External Processing Code FieldOptional

Account Number and

Serial Number

12-5-09

Payee’s Name

Drawer’s Signature

ABA Routing Number- 9 digits, no spaces- bounded by transit symbols

DRAWER NAMESTREET ADDRESS

CITY, STATE

MICR Line of a Check

• Six-inch check–Generally used for consumer checking accounts

10 DIGITS

1 digit

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MICR Line

• Key Fields – Six-inch check–Amount

10 digit field–On-Us

Drawer’s account number Check serial number

–Routing NumberABA assigned routing number for Paying Bank

–EPC – External processing codeOptional, single-digit field

o Provides information for handling or routing of check/check data to financial institutions and other processors

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123.45

Aux On Us Field: Can optionally include serial number or other transaction or product code

12-5-09

One hundred twenty-three and 45/100Payee’s Name

MICR Line of a Check

• Large check (longer than six inches)–Generally used for business checking accounts

Drawer’s Signature

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MICR Line

• Key Fields – Business-sized check–Same fields as smaller six-inch check–Includes Aux On-Us (optional field)

To the left of the Routing Field on the MICR line–Used on commercial checks for

Consecutive serial numbers; orAccount control information; orProduct codes/information

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Routing Number

• Used for all financial institutions in the U.S.• Each FI has a unique number

–Some have more than one• Two forms are currently used:

–MICR form–Fractional form

• Both forms appear on most checks, although only MICR form is used in automated item processing

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Routing Number – MICR Form• Called the ABA Routing Number

–May be referred to as:ABA NumberRouting Transit (RT)Routing Transit Number (RTN)

– First two digits designate Fed District location of Paying Bank and Type of Institution– 3rd and 4th digits represent specific Fed bank or branch serving paying institution– 5th through 8th digits are ABA number for paying institution– 9th digit is RT number validation (Check digit)

Federal Reserve Routing Symbol (4 digits)

ABA Institution Identifier (4 digits)

Check digit (1 digit)

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Routing Number – Fractional FormNumerator includes a city (1-49) or state (50-99) prefix followed by the ABA institution identifier

• Denominator is the Federal Reserve Routing Symbol

• ABA and Federal Reserve numbers match corresponding numbers in MICR form without leading zeros

• Additional letters or numbers may be printed if paying bank wants

• May be printed in one of two forms as shown91-03/1221

91-03 1221

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Example: Fractional RT

• ABA routing number: 122100037

• In MICR form, shownon check’s MICR line:

91-03/1221

22

Example – Fractional RT

122100037

91

0003

1221

• To convert to fractional form• ABA routing number: 122100037

– Drop check digit - last number in ABA routing number

– Pick-up city or state prefix Assigned by ABA

– ABA institution identifier Drop leading zeroes Separate with dash “ – “

– Federal Reserve routing symbolSeparate with slash “/ ”

12210003

91-91-0391-03/1221

91-03/1221

Need For Rules

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Clearing Paper ChecksUCC & Reg CC Provisions[Statutory and Regulatory]

BOFD

UCC, Reg CC & Payee’s Deposit

Agreement

Paying Bank Drawer

Payee (Merchant)

UCC, Reg CC & Check Writing

Agreement

UCC & Reg CC & Correspondent Agreement

Paper Check

Paper Check

Paper Check

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Paper Check Law

• Applicable Laws and Regulations–Impose warranties on financial institutions when

transferring and presenting checks–Together with case law form boundaries for

most aspects of check processing• Complemented by large body of court

interpretations–Provide guidance and understanding in check

payment disputes

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Recognized Role of Rules

• UCC [4-103(b)]–Recognizes role of check clearinghouse rules and

Federal Reserve Operating CircularsMay set forth additional provisions for paper check

collection by financial institutions• Reg CC [229.37]

–Recognizes role of check clearinghouse rules and Federal Reserve Operating CircularsMay vary some provisions of laws and regulations

oHowever may not fail to act in good faith or exercise ordinary care

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Not Covered Under UCC or Reg CC

Key Considerations:– Are the images authorized payments?– When does legal presentment occur?– Can the images be dishonored?– Who is responsible for duplicates?– Who is responsible for data security?– What are the rights of the payee and drawer?

BOFD Paying Bank

DrawerPayee

(Merchant)

IMAGE

What Rules or Agreements Apply?

Remote Deposit

IMAGE IMAGE

What Rules or Agreements Apply?

What Rules or Agreements Apply?

Clearing Images

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UCC Updates

• UCC anticipated electronic check truncation/ image exchange –1990 revision (§4-110) permits electronic

presentment of items pursuant to an agreement for electronic presentment

–Agreement may be in the form of: Check clearing house rules and/or Federal Reserve regulation or Operating Circular

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What Did Check 21 Do?

• Designed to encourage check truncation by removing key barrier to truncation–No longer required to obtain agreements from all

parties to the transactionProvides for replacement of paper check with substitute

paper checkAllows unilateral decisions to truncate checks

• Does not mandate the receipt of electronic (image) transactions–Only applies to the substitute check

• Encourages image exchange–Use image technology to create substitute check

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Paper Check vs. Images

• Regulations vs. Rules–UCC and Reg CC provide statutory and

regulatory definitions for a paper check, – but. . .

• No default definition of image in current check law

• Where is the image of a check defined?

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Need for Rules

• There Are No Laws To Cover Exchange of Check Images–Exchanging images in the absence of

agreements exposes financial institution to an indeterminately large amount of riskPotential for consequential damages

• Check Image Exchange–Need agreements for exchanges through:

Federal Reserve or Private sector

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Exchange Channels and Rules

• Warranties/Indemnities Come From Different Sources– Federal regulations– State Laws– Rules and agreements

• To determine what rules apply, is the item:– Original physical check, a substitute Check (IRD), or an image

• For images, determine the presentment/clearing channel– Through the Fed – Reg J and OC3 apply– Through a clearinghouse – clearinghouse rules (i.e. ECCHO)– Direct bank to bank (Clearinghouse rules or agreements)

• Generally, warranties start at first bank that deals with substitute check or image

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Check Rules and Regulations

• Federal Reserve Regulations–Regulation J

Subpart A: Collection of Checks and Other Items by Federal Reserve Banks

• Image Rules–FRB Operating Circulars

OC 3: Collection of Cash Items and Returned ChecksOC 5: Electronic Access

–Private sector clearing house rules (such as the ECCHO rules)

• Rules and regulations will be discussed in detail in other sessions

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Check Rules and Regulations

• Uniform Commercial Code (UCC)–Developed with efforts towards uniform laws for sales

and other commercial transactions in all 50 states–Detailed Code Addressing Most Aspects of

Commercial LawSet of standardized state laws that govern financial

contractsEstablishes general duty standards for parties to act in

Good Faith and exercise Ordinary Care–Organized as Articles

Each deals with a different subject areao Article 3 covers negotiable instrumentso Article 4 cover bank deposits and funds transfers

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Check Rules and Regulations

• Code of Federal Regulations (CFR)–Codification of the general and permanent

rules published by the executive departments and agencies of the Federal Government

–Title 12 - Banks and BankingPart 229-Availability of Funds and Collection of

Checks (Regulation CC)–Reg CC implements legislation relative to:

Funds availability (EFAA)Substitute checks (Check 21 Act)

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Eliminating Barriers to Image

• Prior to Check 21–Number of barriers made transition from paper

checks to electronic check payments slowDifficult to accept and implement

–To truncate paper check and replace with image, all parties with interest in check had to agreeWith thousands of FIs and millions of customers,

task was impossibly large

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Image Exchange

• Today – Items defined as “checks” under Reg CC and “items” under UCC eligible for image exchange– Covered by Fed OC3 and private sector rules such as

ECCHO’s rules• US savings bonds now transmitted via image exchange• Noncash items not eligible for exchange

– ECCHO Rules permit “imperfect image” to be exchanged• Foreign items currently not eligible

– Canadian items for image exchangeECCHO-hosted subcommittee discussing topic

o Canadian Payments Association (CPA) and Canadian banks participating Updates being discussed for ECCHO Rules

o Goal: Facilitate image exchange of Canadian items within U.S. prior to delivery to Canadian financial institution

Check Payments System

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Check Collection Process

Corporate Payor

Clearing Banks /Correspondent

Paying Bank

FederalReserve

Bank of First Deposit(BOFD)

On-Us Items

Individual Payee

Merchant or

Corporate Payee

Individual Payor

or

“Day in the Life of a Check” Forward Collection

Image

Image

Image Image

Image Image

Image

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Clearing Payments

• Various channels to move payments through system to final collection–May use clearing bank, correspondent or Fed

to present to Paying Bank–Depositary Bank wants to collect funds quickly

and at reasonable cost• Depositary Bank collects funds it has

provisionally credited to its depositor’s account

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Clearing Payments

• Clearing – Exchange of payment instruction data between financial institutions –Moves checks from banks where they are

deposited to banks where they are drawn• Clearing process includes:

–Data collected from multiple transactions–Sent to FIs core processing system–Affects accounts of the FI’s customers

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What is Settlement?

• Settlement – Exchange of value between financial institutions for payments–As shown in previous example:

“Clearing” involved exchange of payment instructions (data) between two financial institutions

–Settlement: Exchange of fundsSeparate event based upon agreement between

the two exchanging parties

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Settlement – Federal Reserve

• Settlement typically occurs at the Federal Reserve Bank

• All banks designate accounts for settlement at the Federal Reserve Bank–May have own Fed account–May use that of a correspondent

Some banks utilize both and designate which types of settlement occurs at each account

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FRB National Settlement Service

• Owned and operated by Federal Reserve Banks • Service is offered to depository institutions that:

–Settle for participants in clearing houses–Financial exchanges–Other clearing and settlement groups

• Settlement agents electronically submit settlement files to Federal Reserve Banks–Files are processed on receipt–Entries are automatically posted to depository

institutions' Federal Reserve Bank accounts

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Designated Settlement Accounts

Federal Reserve

Bank A’s Fed Account

Bank Bs Correspondent Account at

Bank A

Wires, TT&L, Treasuries

Checks, Credit Cards, ACH

+/- $ +/- $

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Settlement – Clearing House

Data Data

Clearing House

• Each member financial institution presents payment instructions to clearing house―Clearing house facilitates presentment to each paying

bank for “clearing” ―Settlement occurs as a separate event

Data Data

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Gross vs. Net Settlement

• Gross Settlement–Exchange of value for a single payment

• Net Settlement–Exchange of value for multiple payments–“Net effect” of all payments is settled to each

financial institution

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Gross Settlement• For the value of a single payment; one financial institution

receives credit and other receives debit• DFI sending wire receives a debit on FRB books; DFI receiving the

wire receives the credit

Federal Reserve

Debit Bank A’s Account on Books of the Federal Reserve

Credit Bank B’s Account on Books of the Federal

Reserve- $ +$

Bank B’s Fed Account

Bank A’s Fed Account

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Net Settlement• Multiple payments are grouped together

– Net effect settled to the designated account on books at Federal Reserve

Federal Reserve

Bank A’s Account

All debits / credits are combined for single bank; Net effect reflected ondesignated settlement account at the Fed

Net settlement: Settle between participating banks in a clearing network

+/- $

Bank B’s Account

Bank C’s Account

Bank D’s Account

+/- $ +/- $ +/- $

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Float Overview

• Float–Time between the deposit of a check and final

collection and funds availability to the customerDollar value of cash balances created by the time

lag in processing unpaid checksoChecks outstanding in the process of collection

Conditional credits in a depositor's checking account until the checks are collected/paid

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Float Overview

• Float–Banks receive checks for deposit and

provisionally credit the account of the check depositor

–Timing of clearing (collection / settlement of funds from bank upon which check is drawn)Check clearing results in checks in the process of

collection appearing briefly in the accounts of both Depositary Bank and Paying Bank

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Types of Float

• Bank Float (Incurred float)–Non-earning asset created through delay in the collection

of deposited funds–Correlates to calendar days elapsing between posting of

customer ledger credit and bank receipt of usable funds• Customer Float (Allocated float)

–Sum of dollars credited to a demand deposit account but not available for immediate withdrawal/earnings credit

–Correlates to calendar days elapsing between posting of customer ledger credit and funds made available to customer

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Positive and Negative Float

• Negative float occurs when:– Customer Float billed is greater than Bank Float

incurred

• Positive float occurs when– Bank Float incurred is greater than Customer

Float billed

Other Payment Systems

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Multiple Channels / Options

• Check Can Be Cleared via Multiple Channels–As a physical check –As an image–Convert image to substitute check (IRD)– As an ACH debit (if check is eligible for

conversion)ARC – Accounts Receivable entryPOP – Point of Purchase entryBOC – Back Office Conversion entry

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Automated Clearing House (ACH)• Funds transfer system governed by NACHA Rules

– Provides for inter-financial institution clearing of electronic entries for participating financial institutions

– Generally considered “batch and forward” next day payment system where: Day 1: Files originated / Day 2: Files settled

ORIGINATOR ODFIOriginating DFI

ACHOPERATORS

RDFIReceiving DFI

RECEIVER

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Ineligible Items – ACH

• Following Do Not Qualify for Conversion to ACH Transactions–Checks containing Aux on-us field–Greater than $25,000–Third-Party checks/share drafts/money orders–Demand drafts/3rd party drafts with no signature–HELOC checks–Money Market Checks–FI Obligations

Traveler’s checks, official checks, cashier’s checks–State/local Gov’t checks–Checks/money orders in a foreign currency

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Other Payment Systems

• Debit Card – Generally use the shared ATM networks that offer payment services associated with a financial institution’s DDA systems

• Credit Card –Issued by a company to allow the user to purchase goods and services from merchants who accept the card

• Wire – Electronic payment service for transfer of funds–Characteristics include:

Large dollar transactionsImmediate availabilityIrrevocable payments

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Questions

??? ?? ?

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Recommended Resources

• Uniform Commercial Code (UCC)

–Article 3 – Negotiable Instruments–Article 4 – Bank Deposits and Collections

• CheckImage Central Website: www.checkimagecentral.org

–White paper on “Need for rules”:– http://www.checkimagecentral.org/pdf/RoleOfPrivateSecRulesAndFRSRules.pdf

• ECCHO website: www.eccho.org

• Federal Reserve website: www.frbservices.org

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Recommended Resources

• ECCHO website: www.eccho.org

• Federal Reserve website: www.frbservices.org

• Uniform Commercial Code (UCC):www.law.cornell.edu/ucc –Article 3 – Negotiable Instruments–Article 4 – Bank Deposits and Collections

Thank You!

Check Fundamentals and Check Processing

Electronic Check Clearing House Organization3710 Rawlins Street; Suite 1075

Dallas, Texas 75219

NOTICEThis NCPC Program document contains copyrighted materials of its publisher.

These program training materials may not be reproduced or published, in whole or in part, without the express permission of ECCHO.

Ellen Heffner, NCPDirector and Education Manager

eheffner@eccho.org214-273-3211