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 paperbased and electronic-based payment
systems, and explain the purpose of an
account analysis statement.
Cash Flow Timeline
3
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.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.
Historical Check Clearing Process
4

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
3
5
6
7
- The Fed District/Office to which the ‘drawee bank’ belongs.
- The drawee bank identification number.
- Account number of ‘payor.’
- Check number of payor.
- Amount encoded on check by ‘collecting bank.’
Historical Check Clearing Process
5

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 nonOn 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.
Life of a Check – Customer View
6
Life of a Check – Bank View
7
Paper Checks
8


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.
Check 21 – The Checkless Age?
9




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.
Checks/Other Noncash Payments
10

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.
Automated Clearinghouse (ACH)
11

ACH items are electronic, repetitive, preauthorized 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)
Distribution of Noncash Payments
12
Based on number of items
Checks/Other Noncash Payments
13


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.
Checks Cleared Electronically
14


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 2010. Effective
12/31/12, paper items are processed in Atlanta.
These changes are increasing the efficiency of the check
clearing system and reducing float.
Automated Clearinghouse (ACH)
15


The number of ACH
payments increased
9.3% from 2006 to
2009.
Some consumer
checks are converted
to ACH items, so the
number of checks
paid differs from the
number of checks
written.
Other Noncash Payment Systems
16
 Phone
Apps
 ATMs
 Electronic
 Wire
Bill Pay
Transfer
17
Banking Relationships
Treasury Management Services
18

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.
Bank Balances
19

Firms have several ‘balances’ at the bank:

Book (Ledger)


Collected


Reflects all posted account activity.
Actual funds collected / disbursed.
Available (Investable)

Balance available for withdrawal (includes holds) and earnings
credit (could include reserves, etc.)
Corporate Cash Management
20

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.
Financial Reform (Dodd-Frank Bill)
21

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.
Net Analysis Position Example
22
Account Analysis


This firm incurred
$5,741.01 in
analysis charges for
this 30-day month.
What is the net
analysis position
based on the
balances
maintained in the
same month?
Service Description
Price
Units
Charges
Account Maintenance
$18.000
5
$90.00
Cash Deposited ($2.30/$1,000)
$2.300
250
$575.00
Cash Supplied (per strap)
$0.500
43
$21.50
Deposits Credited
$0.800
210
$168.00
Items Deposited
$0.110
1,512
$166.32
Returned Items
$10.000
50
$500.00
Items Paid
$0.200
1,014
$202.80
Stop Payments
$36.000
5
$180.00
Electronic Debits
$0.170
48
$8.16
Electronic Credits
$0.200
320
$64.00
Deposit Correction
$6.000
2
$12.00
Wire Transfer - Incoming
$15.000
59
$885.00
Wire Transfer - Outgoing
$50.000
43
$2,150.00
Deposit Insurance (per $1,000)
$0.109
6,589
$718.23
Total Charges for Services (Analysis Charges)
$5,741.01
Net Analysis Position Example
23
Account Analysis


This firm incurred
$5,741.01 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)]
Average Positive Ledger Balance
$6,589,254
Less: Average Float
$1,317,851
Average Collected Balance
$5,271,403
Less: 10% Reserve Requirement
Average Available Balance
$527,140
$4,744,263
Value of Average Available Balance (1.0%)
$3,899.39
Total Charges
$5,741.01
Net Analysis Position
-$1,841.61
$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.
Federal Reserve Requirements
24
Reserves
Requirements
are the
amount of
funds that a
bank must
hold in reserve
at The Fed
against specific
deposit types.
Compensating Balances
25

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.
Compensating Balances
26

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
Compensating Balances Example
27

Where:





RCMP
SC ($5,741.01)
ecr (1.0%)
n (30)
= Compensating balances to offset charges
= Monthly service (analysis) charge
= Annual earnings credit rate
= # days in month
RCMP = SC / [(ecr/365)(n)]


RCMP = $5,741.01 / [(.01/365)(30)]
RCMP = $6,984,896
Compensating Balances Example
28

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 = $5,741.01 / [(1 - 0.10)((.01/365)(30))]

RCMP = $7,760,995

RCMP is grossed up for deposits the bank can’t
lend or invest ($7,760,995 × 90% = $6,984,896).
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
Compensating Balances
29

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 ‘carriedforward’ for quarterly or annual settlement.
Fees vs. Compensating Balances
30


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.