1. Short-Term Financial Management
Chapter 8 – The Payment System and Financial Institution Relationships

2. Chapter 8 Agenda
Discuss the components of the domestic payment system, identify banking products that are important to treasury managers, describe the major paper-based and electronic-based payment systems, and explain the purpose of an account analysis statement.

3. Cash Flow Timeline The firm is a system of cash flows.
These cash flows are unsynchronized and uncertain.
The cash conversion period is the time between when cash is received versus paid.
The shorter the cash conversion period, the more efficient the firm’s working capital.

4. Historical Check Clearing Process
The numbers on the bottom of checks are encoded in special ink (‘MICR line’…magnetic ink character recognition) and include:
Routing Transit Number (Bank ID)
1, 2 - The Fed District/Office to which the ‘drawee bank’ belongs.
3 - The drawee bank identification number.
5 - Account number of ‘payor.’
6 - Check number of payor.
7 - Amount encoded on check by ‘collecting bank.’

5. Historical Check Clearing Process
Depending on the size and location of the bank receiving the deposit (and its geographic location and size relative to the bank on which it is drawn), the availability schedule and the clearing options for non- On Us checks includes the physical exchange of checks by:
Sending them directly to the other institution (direct presentment).
Delivering them through a local clearinghouse exchange (ACH).
Delivering them through a correspondent institution.
Using the check-collection services of the Federal Reserve Bank.
Most checks are collected and settled within one business day.
Federal regulations govern settlement processes, which we will not review.

6. Life of a Check – Customer View

7. Life of a Check – Bank View

8. Paper Checks
At the peak, 55 billion (+/-) paper checks per year were written in the United States.
This is higher than other countries, given our history of a national banking system which prohibited interstate banking from 1927 until the mid-1990’s.
Other countries have a handful of banks compared to the nearly 7,000 in the U.S.

9. Check 21 – The Checkless Age?
Until recently, clearing paper items continued to be the norm since firms nor banks were motivated nor required to move to a digital format.
The Check Clearing for the 21st Century Act (Check 21) removed barriers on the electronic collection of checks. Effective 2004
Check 21 allows banks to truncate paper items to either a digital image (of the front and back of the item) or a photo-copy substitute check, both of which are legal equivalents.
Check 21 has all but eliminated paper check processing, but it has not eliminated paper checks.

10. Checks/Other Noncash Payments
The Federal Reserve commissioned the 2010 Payment Study.
2010 Federal Reserve Payment Study
The 2010 Federal Reserve Payments Study is the fourth of a series of triennial studies conducted by the Federal Reserve System to comprehensively estimate and study aggregate trends in noncash payments in the United States. This study estimates the total number and value of payments that were made in 2009 by check, debit card, credit card, automated clearinghouse (ACH), and prepaid card from accounts domiciled in the US. The study also estimates the number and value of ATM withdrawals.
CAGR is compound annual growth rate.

11. Automated Clearinghouse (ACH)
ACH items are electronic, repetitive, pre- authorized transactions.
Electronic Data Interchange (EDI)
Direct Deposit (payroll, pension, Social Security)
Direct Debit (automated bill pay)
Check to ACH Conversion
Non-Bank eCheck
PayPal (owned by eBay)
Remotely Created Checks (RCC)
Online bill pay
Remotely Created Payment Orders
Remote Deposit Capture
Remote Image
Mobile Payments (smart phone, Square)

12. Distribution of Noncash Payments
Based on number of items

13. Checks/Other Noncash Payments
Electronic payments represent 78% of all noncash payments.
There were $72.3 trillion in noncash payments in 2009.
24% of the items were checks; (44% of the amount).
The number of checks written nationally has been declining since the mid-1990s; however, it is still very high.
6.1 billion fewer checks were written in 2009.

14. Checks Cleared Electronically
Firm usage of image deposit services (‘remote deposit capture’) and replacement of paper exchange with image exchange between banks (Check 21) has expanded.
Approximately 13% of checks were initially deposited as images by firms.
96% of items deposited as paper checks were subsequently cleared electronically between banks (up from 43% in 2006).
The Reserve Banks reduced the 45 check-processing locations in place in 2003 to a single location (Cleveland) in Effective 12/31/12, paper items are processed in Atlanta.
These changes are increasing the efficiency of the check clearing system and reducing float.

15. Automated Clearinghouse (ACH)
The number of ACH payments increased 9.3% from 2006 to
Some consumer checks are converted to ACH items, so the number of checks paid differs from the number of checks written.

16. Other Noncash Payment Systems
Phone Apps
ATMs
Electronic Bill Pay
Wire Transfer

17. Banking Relationships

18. Treasury Management Services
Selecting a banking partner considers, among other things, the cash (treasury) management services offered.
A plethora of bank services can speed collections, manage disbursements, or are related to short-term financial management:
Collection
Payment
Information
Credit
Investment
Most of these services are paid for in some combination of balances and fees.
Large firms select a bank through the RFP process.

19. Bank Balances Firms have several ‘balances’ at the bank: Book (Ledger)
Reflects all posted account activity.
Collected
Actual funds collected / disbursed.
Available (Investable)
Balance available for withdrawal (includes holds) and earnings credit (could include reserves, etc.)

20. Corporate Cash Management
Corporate checking accounts are subject to account analysis.
Since 1933, banks are not legally permitted to pay explicit interest on corporate checking accounts (Glass-Steagall Act).
Instead, the firm is credited with an implicit interest rate (set monthly and called the earnings credit rate (ecr)).
The ecr is usually based on the rolling average of the 91-day T-bill rate.
This earnings credit is based on average balances (collected or available, depending on the bank) and is applied toward services provided (analysis charges).
If less than the total charges, the difference is charged as a fee.
Can be viewed as the equivalent of a modest rate of return for firm.

21. Financial Reform (Dodd-Frank Bill)
As mentioned, banks are not legally permitted to pay explicit interest on corporate accounts.
The only way to earn interest is to “sweep” excess balances into an interest-bearing account overnight; the balances must be large enough to justify the bank charges.
Such accounts may not be FDIC insured.
The recently passed Dodd-Frank Financial Reform bill has a little known provision permitting reversal of the ban.

22. Net Analysis Position Example
Account Analysis
This firm incurred $5, in analysis charges for this 30-day month.
What is the net analysis position based on the balances maintained in the same month?

23. Net Analysis Position Example
Account Analysis
This firm incurred $5, in analysis charges for this 30-day month.
What is the net analysis position based on the balances maintained in the same month?
Value of Balances = Avg. Available Balance × [(ecr/365)(n)]
$3,899 of the fees were covered by balances (paid for by the bank in return for maintaining valuable balances on deposit); the remaining $1,842 was charged as a fee.

24. Federal Reserve Requirements
Reserves Requirements are the amount of funds that a bank must hold in reserve at The Fed against specific deposit types.

25. Compensating Balances
Firms can maintain balances to offset service (analysis) charges (RCMP, or required compensating balances).
Firms should not maintain balances in excess of that required.
Here, ‘required’ means the level of balances necessary to offset analysis charges.
It is usually not ‘required’ by the bank, unless it is tied to some other arrangement, such as associated with a borrowing relationship.

26. Compensating Balances
The formula for calculating the required compensating balances is:
RCMP = SC / [(ecr/365)(n)]
Where:
RCMP = Compensating balances to offset charges
SC = Monthly service (analysis) charge
ecr = Annual earnings credit rate
n = # days in month

27. Compensating Balances Example
Where:
RCMP = Compensating balances to offset charges
SC ($5,741.01) = Monthly service (analysis) charge
ecr (1.0%) = Annual earnings credit rate
n (30) = # days in month
RCMP = SC / [(ecr/365)(n)]
RCMP = $5, / [(.01/365)(30)]
RCMP = $6,984,896

28. Compensating Balances Example
Frequently, banks will increase the RCMP for deposits it must hold with The Fed and, therefore, cannot lend or invest.
RCMP = SC / [(1 - rr)((ecr/365)(n))]
RCMP = $5, / [( )((.01/365)(30))]
RCMP = $7,760,995
Where:
RCMP = Compensating balances to offset charges
SC ($5,741.01) = Monthly service (analysis) charge
ecr (1.0%) = Annual earnings credit rate
n (30) = # days in month
rr (10%) = Required reserve ratio
RCMP is grossed up for deposits the bank can’t lend or invest ($7,760,995 × 90% = $6,984,896).

29. Compensating Balances
The ecr changes monthly, as does account activity.
In addition, the bank’s prices are subject to change.
Therefore, the compensating balance requirement is re-calculated periodically.
Sometimes, excess balances can be ‘carried- forward’ for quarterly or annual settlement.

30. Fees vs. Compensating Balances
Bank’s Prefer Compensating Balances:
It increases deposits available for investment or loans.
It provides a cushion if the firm is also a loan client and defaults.
Firm’s Generally Prefer Fees:
The ecr is almost always less than the opportunity cost.
Fees are tax-deductible.
Bank prices are generally fixed, but the ecr changes with market rates.