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By Will Council

The High Cost of Slow Payments

August 20, 2015

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As it stands today, the US payments system – which moves money between banks and between account holders – isn’t broken, but it can do better. Other countries are developing or have implemented payments systems that are faster, safer and less complex than the current U.S. system. Twenty-first century technology presents the opportunity for the U.S. to improve. As payments stakeholders discuss and plan a faster payments system, one of the key questions to explore is exactly how much the current one- to two-day delay for payment transfers costs. Answering that question will be crucial to figuring out what a cost-effective solution looks like. Stakeholders, including banks, regulators, business owners and consumers, should first begin to address the question by examining the costs associated with administration, financial inclusion across society (or the lack thereof), and barriers to payments innovation. While these don’t represent the total universe of costs, they are major sources of inefficiency in the current system.

Administratively, the U.S. payment system presents a variety of challenges and costs to administrators, businesses, and consumers. The inefficiencies within the payments system revolve around the ability (or inability) of banks to process and verify information on a payment’s sender, recipient, and the banks of both parties. The current process is manually intensive, which leads banks to process payments in batches. Banks collect a large number of payments to be dispensed at once and “net” out the payments (the process of figuring out the credits and debits and only transferring the net amount one bank owes another). This is more efficient than processing individual payments in real time but delays accessibility to funds.

For example, a person is given a check for $100 dollars, she deposits the check, she sees the check on her account balance but can’t access the funds for a few days. This delay is the float, the time between origination and settlement. The float exists because banks can’t verify whether the funds from the originator exist as quickly as the payment can be sent. If the banks were to settle transactions as quickly as they were made, they would take on the risk of fraud and overdraft. The inability of banks to access funds quickly, due to the relatively slow settlement process, creates the risk for leakage (money being taken out of the system), as well as costly inconvenience. Recent reports have shown that float risk accounts for as much as 80 percent of handling costs for originators (person initiating the payment).

While the delay caused by the float is effective in reducing credit risk (the risk that one of the participants won’t be able to meet the financial obligation) and verification risk (ensuring that funds are in the account before processing payment), it hurts consumers and businesses alike. A faster system addresses this problem by allowing banks to verify account information immediately. In the UK, the Faster Payments System is able to process and settle a transaction in 15 seconds. This speed allows banks to handle each transaction individually and process it immediately, without the fear of bearing loss due or overdraft.

The slow, manual system in the U.S. also limits how businesses can pay their employees. Because of the labor intensive nature of the current system firms usually process their payrolls as batches, handling them all at once at set intervals. Under the current system, if a firm wanted to process payments more quickly or more often, it would incur costs in the form of additional payroll staff. This would be more complex for larger companies with employees in multiple locations. In a faster and more automated system, like those being contemplated, a firm could pay its employees weekly or daily or in whatever way it finds optimal.

The loss of speed imposed by the float also makes it difficult to meet the needs of many consumers needing immediate access to their funds. Roughly 30 million people are unbanked, meaning they don’t have an active account with a bank. Some unbanked households have made an informed decision not to use a bank, favoring cash or other alternatives, while others are unable to use bank services due to past financial mismanagement, such as excessive overdrafts or poor credit history. However, many households are without a bank only because they are living hand-to-mouth, needing instant access to funds in order to meet obligations or provide for their family. Banks are usually unable to provide instant access to funds due to the slowness of the payment system.

Unbanked households often turn to payday lenders and check cashers, incurring great costs in order to obtain funds immediately. Studies done by the Federal Deposit Insurance Corporation have shown that in households earning less than $15,000 a year, one in five turn to money-order services in order to make bill payments on time.

Under a faster payments system, companies could serve many unbanked households by paying their employees weekly or daily, as opposed to the bi-weekly or monthly model currently used by most businesses. This could also be particularly helpful to the 27 million hourly or part-time workers in the U.S. because they often do not have the stability provided by full time employment and can’t afford to wait to receive funds. A faster payments system would allow banks and employers to empower consumers by giving them access to their pay in a way that they find most optimal. This allows employers and banks to compete with payday lenders, who charge high fees, and give consumers immediate access to their deposits and paychecks.

In addition to serving their domestic businesses, other countries’ faster payments systems mean the U.S. runs the risk of losing business abroad. Countries with faster payments systems are able to process online transactions faster and more efficiently, presenting U.S. online vendors with a competitive disadvantage. Thirty-five countries now either have a faster payments system or are developing one. While many payments innovations have been brought to the U.S. market already, they are hampered by the current system and limited in how they can operate. Many payments innovations may not be able to operate to their full potential or may go unrealized until the current U.S. system is modernized.

While the current U.S. system isn’t in crisis, it is outdated and limited in its capabilities. Even though a faster system will be challenging to craft and implement, it is necessary for allowing the current U.S. payments system to respond effectively to the 21st century economy. Improving financial inclusion, limiting costs and burdens to administrators, and opening the possibilities for technology and innovation are all worthy causes for stakeholders. A faster payments system can help achieve this.