Automated Clearing House Payment System Essay Example

style="text-align: justify;">Although there were differing opinions on the advancement of ACH, experts remained positive that local and regional ACHs would transform into a nationwide electronic payments clearing system that is efficient, accessible, and widely accepted. Nevertheless, it was not until banks started shouldering additional expenses for check and currency processing services and transferring them to their customers that ACH gained customer acceptance.

The analysis focuses on the advantages.

Research shows that the social cost of processing an automated clearing house (ACH) transaction is less than that of processing a paper check transaction. According to Humphrey and Berger (1990) as well as Wells (1996), the estimated social cost for a check transaction is $0.79, whereas an ACH transaction has a social cost estimate of $0.29.

Wells (1996) states that in 1993, the social cost of a check transaction was estimated to be between $2.78 and $3.09, while an ACH transaction ranged from $1.15 to $1.47. Both Humphrey and Berger's study (1990) and Wells' study (1996) consistently concluded that an ACH transaction is approximately one-third to one-half as expensive as a paper check transaction. However, there were variations in the results, indicating that specific assumptions impact the estimation of social costs for each payment method.

The pros and cons of ACH.

The ACH relationship is highly valued in modern banking as a strong indicator of loyalty. ACH data offers abundant transaction information, making it an invaluable resource. Financial institutions can combine ACH data with MCIF data and demographic data to gain a comprehensive understanding of their banking customers, ultimately enhancing their ability to cross-sell services effectively.

ACH transactions are a cost-effective

way for financial institutions to enhance their offerings to ACH customers without the worry of losing them. If a customer only has a Direct Deposit Account (DDA) and no other ACH connections, there is a high chance they will switch banks due to fee hikes.

On the other hand, a DDA customer with an ACH relationship may be more willing to accept slight price changes because they believe it can be difficult to switch ACH transactions to another bank.

The statement is supported by a case study on the customer profitability profile of a popular bank. The analysis uncovered that retail customers with a DDA relationship usually produce an average yearly profit of $22.61. These specific retail customers can be categorized into two groups: (1) customers without an ACH relationship and (2) customers with an ACH relationship.

The initial retail customer group experienced a loss of $45.07 per person annually, whereas the second group had an average profit of $104.01 per person. Additionally, the mean deposit balances for both groups were $3,663 and $4,695 respectively. Moreover, ACH customers in retail had a 27 percent longer average tenure with the bank compared to non-ACH customers (Coffey 2002).

Impressive results were also achieved in the commercial sector. The average annual profit for all businesses with a DDA relationship was $403.13. These commercial customers can be divided into two groups: (1) businesses without an ACH relationship and (2) businesses with an ACH relationship.

Coffey (2002) reported that non-ACH customers experienced an average loss of $9.89, whereas ACH customers achieved a profit of $1,230. The average deposit balances for the two groups were $21,730

and $29,494 correspondingly.

The disadvantages of something are the negatives or drawbacks associated with it.

When comparing the ACH payment system to check processing, its drawbacks become apparent. While checks can be returned due to insufficient funds, electronic payments made through the ACH or wire transfers do not offer this option since the settlement is considered final. Therefore, if a customer cannot cover the resulting overdraft, it becomes the bank's responsibility.

Furthermore, the apprehension regarding transaction risk on ACH is heightened due to concerns about fraud. An illustration provided by a vice president of risk management highlights the potential manifestation of this fear: "To illustrate, suppose a specific customer transfers all the funds from its account."

In the meantime, corporate cash managers fund an ACH payroll using the same funds because ACH and wire do not communicate with each other. Beverly Kennedy explains that if a company experiences financial issues, the bank's exposure could result in a loss (as cited in McClure 1994, p. 23+).

It is important to note that ACH is the least regulated bank application and therefore carries growing risks. It is even possible for customers to authorize a transaction of $10 million as easily as $10,000 without any review before it is executed. The bank's predefined ACH limits do not account for the current balance or other transactions made during the day.

The risk of bank exposure is real when it comes to the payroll files of ACH. These files, consisting of credits, are sent from the bank around two days before the settlement date.

The bank is unable to recover the ACH transaction

if it realizes that funds are not available on the settlement date because the consumer's accounts have already been deposited with the funds. The increase in volume of ACH cash concentration has also increased the occurrence of kiting, which involves fraudulent increase of amount.

Typically, the fluctuation in balances of small, retail accounts doesn't heavily impact the bank's exposure level. However, when a corporate customer has multiple accounts across different banks and states, their actions can greatly affect the bank's cash position.

At the relationship level, corporate accounts are typically overseen by officers who can assess the overall status of these accounts. By examining all the accounts collectively, officers can differentiate between isolated overdraft issues and those occurring across all the accounts, thus providing insight into the decline of the company's financial position.

Obtaining an accurate balance is difficult for both individual and corporate customers when their accounts have been highly active. Releasing funds without confirmation can be risky, especially for corporate customers who often transfer money between accounts to cover large transactions. In some cases, the same funds may have already been used by another application without the officer's knowledge.

Banks commonly provide loans known as daylight overdraft or intraday funds to trustworthy customers, hoping that these customers will repay their overdrafts by the end of the processing day.

If a customer who is considered 'good' by the bank faces financial issues without informing the bank, it puts the bank at risk. This happens when the bank has released more funds than it received and doesn't have enough money to cover the overdraft, which creates a financial burden for

the bank.

The cost analysis of the ACH payment system is being conducted.

Analyzing the cost of transactions on the ACH payment system proves challenging due to the difficulty in obtaining accurate statistics on transaction risk. Banks choose to keep their losses and vulnerabilities undisclosed to uphold a strong and stable public image.

Financial institutions are facing increasing difficulties in identifying and addressing the controls they have implemented to combat the issue. This task becomes more challenging when crucial incidents come to light long after their occurrence. As a result, numerous banks are recruiting risk managers and establishing risk committees to detect potential vulnerabilities and promptly offer remedies.

Progressive banks typically have risk committees that take transaction risk seriously. They understand that policing their customers' accounts and potentially creating negative experiences could drive these customers to seek services elsewhere. Hence, these banks establish risk committees to effectively tackle these concerns.

In order to mitigate the risks associated with transactions, banks are now seeking methods to charge customers who cause daylight overdrafts. Currently, no system can accurately attribute the charge to a specific customer. Developing such a technology is expensive and complex, making financial risks even more daunting if a major transaction goes awry.

Banks face a significant challenge in developing a technology for daylight overdraft charging due to their extensive investment in diverse software applications from multiple vendors.

Regrettably, banks have never been able to successfully implement a comprehensive transaction processing system from a single vendor. As a result, integration has become quite challenging. The dilemma faced by banks is how to safeguard their technological investments while also

grappling with the obstacles presented when vendors refuse to integrate their products with those of rival companies.

Banks often develop their own interfaces between applications, which leads to additional challenges. According to McClure (1994), when the ACH application builds interfaces with other applications in the bank to obtain balance information, it results in complex webs that are expensive to maintain and difficult to monitor (p. 23+).

Combatting the expense of transaction risk costs.

On a contractual basis, banks are supposed to loan money to borrowers only after setting terms and verifying their creditworthiness. However, in reality, financial institutions often unintentionally provide credit to customers without any terms or assurance of repayment. This risky practice occurs because the bank is unable to monitor intraday transaction balances. Solving this issue requires finding an immediate solution – transaction risk control.

Both vendors and banks are prioritizing risk management to address perceived transaction risk costs. Some vendors are developing the Risk Management and Control System (RMAC) to monitor intraday, bank-wide transactions.

This is an intraday transaction monitoring system based on DB2 that is built around a central repository to accurately provide intraday balances to all interfacing applications.

Addressing the transaction risk problem goes beyond individual application areas, especially on ACH payment system, for executives at the top who have enough perspective to understand its magnitude.

A customer's top concerns are account security and having competent bank executives who can effectively address transaction risk. It is crucial to recognize that transaction risk is a significant problem affecting the entire bank and is not adequately supported in any specific department.

Currently, transaction risk management

is mainly viewed as an insurance policy. However, if there is a significant loss, banks will struggle to justify the cost of a solution. Nonetheless, the banking industry is evolving as banks diligently seek methods to minimize fraud possibilities and adopt technologies that aid in managing both their own funds and their customers' funds.

References

The article titled "Lessons in ACH Data: Using ACH Data to Profile Your Customers and Increased Profitability" by Coffey, J. J. (2002) can be found in the ABA Banking Journal, volume 34(3), page 52.

FHFB Office of Supervision (2007 April), in their Examination Manual, discusses the Payment Systems: Wire Transfers and Automated Clearing House (ACH).

Gup, B. E. (Ed.). (2003). The Future of Banking. Westport, CT: Quorum Books.

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In the book called "The U. S. Payment System: Efficiency, Risk and the Role of the Federal Reserve" edited by D. B. Humphrey, Humphrey, D. B. and A. N. Berger authored a chapter titled "Market Failure and Resource Use: Economic Incentives to Use Different Payment Instruments." The chapter can be found on pages 45-86 in the book published by Kluwer Academic Publishers in Boston, MA in 1990.

According to McClure (1994 March), in the article "Taking the Risk out of Transactions" published in Security Management, it is important to minimize the risks associated with transactions.

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Wells, K. E. 1996. "Are Checks Overused?" Federal Reserve Bank of Minneapolis Quarterly Review (Fall), pp. 2-12.