In early March 2014, the UK Government proudly announced proposals to improve paper cheques as a payment instrument. A few years ago, the banks tried to kill off cheques and (rightly) were told off, but now, just when plausible alternatives are starting to emerge, the Government is suggesting that the industry should spend substantial sums investing in the use of digital images of cheques.
How Banks Work is unconvinced, read why.
Current UK Cheque Processing
To understand what the improvements are, one needs to understand the current way that cheques are processed. A previous How Banks Work article describes this in more detail (click here) but the essence of the current process is that the physical paper cheque moves around the country. Let us look at an example; Mrs Wilson who lives in Yorkshire and banks with the Yorkshire Building Society (in this case, in banking jargon, the paying bank) sends a £50 cheque to her nephew Ralph who is studying in London and who banks with Barclays (the collecting bank). Ralph would deposit the cheque in a London branch of Barclays who would send the physical piece of paper to Barclay’s Central Cheque Clearing operation who would get it (via a mixture of other clearing banks, couriers and post) to the Yorkshire Building society “up North”. If for some reason Mrs Wilson did not have enough money in her account, then the physical cheque would be posted back to Barclays to post back to Ralph with a rather shirty letter and a charge.
All this driving small pieces of paper around the countryside is clearly very old fashioned, time consuming, expensive and error prone (stories of cheques scattered along the motorway like confetti after a courier accident).
Why is the UK Banking industry still in the dark ages? The answer is in two related points:
1) The Fraud Risk is with the paying bank. I.e. if the bank pays the money out but it is later discovered that cheque was stolen or altered, the Paying Bank (not the collecting bank) has to swallow the loss. This is rational as the Paying Bank is in a better position to assess whether a cheque is fraudulent; it has copies of the customer signature, has history on what is normal cheque activity on the account and in extremis, it has the contact details of the customer so they could check with the customer if the cheque is ok. The collecting bank has none of these capabilities so cannot realistically do much to detect fraud.
2) Because of the Fraud Risk being with the Paying Bank, the current UK cheque legislation requires that the Paying Bank must have access to the physical cheque within a few days so as to have the option of inspecting it to detect fraud or other errors.
The Government Proposals
The essence of the Government proposal is to change the legislation so that banks do not need to send each other the physical cheques but rather interchange a digital image of the cheques (think smart phone photographs of the cheques).
The benefits of this are suggested to be:
- Lower costs to the industry all round because of no transport of physical cheques.
- Faster cheque clearing cycles, as electronic images can move in a few seconds rather than days, meaning customers paying in cheques get certainty about whether a cheque will bounce or not in two days rather than the current six days.
An extension idea proposed by the Government is that consumers would not even have to go to a bank branch to pay in their cheques but could create the digital images using smart phone apps supplied by the banks. This might prove convenient to consumers who do not live close to a bank branch or who have mobility problems.
The most controversial suggestion is that the fraud risk should be borne by the Collecting Bank, not the Paying Bank. The rationale being that they are the last person to see the real physical cheque and they have to be incentivised to make check whether the cheque has been altered and is a faithful image of the cheque. If the fraud responsibility were to remain with the Paying Bank, it is argued that “any old rubbish” might get sent as the cheque image from the Collecting Bank. They might use cheap cameras in their branches to create the digital images which create poor quality images.
Also the Collecting Bank is the best placed to detect and/or prevent any alterations either to the cheque or the cheque image before it enters the system. (For example, alterations which are clearly detectable because of different coloured inks may come out undetectable in a black and white image.)
The HBW opinion
We are unconvinced about these proposals as they stand, although at their heart is probably a major improvement.
1) We at HBW think that promoting the life of a fundamentally insecure payment instrument by making it even less secure is a bad idea. We recognise cheques are a convenient means of payment for many vulnerable and disadvantaged people but the time has passed for investing in them. The industry is about to launch a mobile payments scheme which will at last come up with something as convenient and easy to use as cheques and be a lot more secure.
2) If the scheme is to go ahead, we are strongly against the idea of the Fraud Risk moving to the Collecting Bank. So much of what is needed to detect cheque fraud (which is a very material problem for the industry) is in the hands of the Paying Bank.
3) Given the fraud risk staying with the Paying Bank, there needs to be a mechanism for dealing with poor quality images, either at an institution level or at a customer level if the customer sends in a cheque image. These would probably come in the form of scheme rules;
- Ability to reject an image of insufficient quality; this could be arbitrated by an independent party such as one of the cheque processing companies.
- Some rules for customers on not destroying originals of cheques until the funds have successfully cleared.
4) The Government is minded to force all the banks to move at the same time via a central digital exchange infrastructure. It argues that this would improve the options for small banks. HBW can’t see this, as the implication is that all small banks would have to implement digital image systems and processes to cope with the relatively small volume of cheques they handle. This would seem to be a barrier to entry for small bank competitors.
Where a good compromise might lie would be in a law permitting the interchange of digital images, but implementation is driven by cost savings. I.e. implementation only when these cost savings justify the investment costs. The customers could still get the benefit of shorter cycle times. Since the scheme would be justified by cost savings and investment priorities of individual banks, the ability of banks to not accept digital images will be required for those banks who do not want to afford cheque image processing systems and processes and rely on paper versions of the images.
If the aim of this legislation is to make payments easier for vulnerable groups such as the elderly or small businesses, HBW would prefer to see regulatory and investment effort directed at making more secure methods, such as phone-based payments, more accessible.