Chapter 8 The Payment System and Financial Institution Relationships

1. Chapter 8The Payment System and Financial Institution Relationships

2. The Cash Flow Timeline • Order Order Sale Payment Sent Cash • Placed Received Received • Accounts Collection • < Inventory > < Receivable > < Float > • Time ==> • Accounts Disbursement • < Payable > < Float > • Invoice Received Payment Sent Cash Disbursed

3. Learning Objectives • Explain, understand, and calculate float. • Explain the roles of the two major components of the payment system. • Describe the major paper-based and electronic-based payment systems. • Understand the ACH and how its fits with the EDI. • Use an availability schedule. • Explain the uses of an account analysis statement.

4. Value of Float • The delay in value transfer from the time a check is written until it finally is charged to the payor’s account. • Value of float is based on differences in present value based on time delay.

5. U.S. Payment System • Banking system • ≈ 9,000 Commercial Banks, 1,600 S&Ls, 400 stock or mutual savings banks, and 11,200 Credit unions • Payment mechanisms • 90% of corporate payments and 75% of corporate-to-corporate payments made by paper check • There are also Drafts, Depository Transfer Checks (DTCs), Electronic Depository Transfers (EDTs), and Wire transfers

6. Financial Institutions • Product differences, Ex 8.1 • Most differences have been eliminated in last 20 years • Geographical restrictions • Almost entirely eliminated in 1994 • Safety considerations • FDIC limit of $250,000

7. Federal Reserve System • Organization, Ex 8.2, 8-3 • Fed’s involvement in payment system • Check clearing

8. Organization, Ex 8.2 • Board of Governors (7) Appt. by Pres. • FOMC (7 BOG + 5 FR Bank Pres.) • Federal Advisory Council (12, 1 from each FRB) • District banks, Fig 8.2 (12) • Member banks • Contribute capital • Elect directors of FRBs

9. Fed’s Involvement • Circulate new money • Check processing, 16.5 billion checks/yr • Check settlement • ACH • FedWire • Regulate availability schedules

10. Check Clearing • MICR line, Exhibit 8.5 (slides 11, 12) • Clearing process, Exhibit 8.4 (slide 13)

11. MICR Line, Exhibit 8.5 • 2 digit Fed Bank Code • 2 digit Fed Office Code • 4 digit ABA Code • 1 digit verification code • Account number • Sequence number • Encoded amount

12. MICR CODE  Pay to the xxxxxxxx7.75 Order of $ Dollars ABA Bank# Chk Sequence # Fed Bank Code Check Digit Fed District Code Account Number Encoded Field 

13. The Clearing Process, Exhibit 8.4 2. Supplier (payee) receives 1. Customer sends check check writes check 8. Customer’s bank account is debited 3. Supplier 6. Supplier’s account is credited deposits check 7. Check is presented for payment to customer’s bank Clearing agent: “on-us”, or Fed, or correspondent, or clearinghouse. 4. Check forwarded 5. Supplier’s bank is credited

14. Clearing Mechanisms • House/On-us checks • Local items • Transit items • “Out-of-town” checks Next 3 slides

15. “On-us” Items • Payee deposits check in the bank on which it is drawn • Bank credits depositor’s account • Bank debits payor’s account

16. Local Items • Checks may be sent by courier to be swapped for checks drawn on itself at another bank • Checks may be processed through correspondent bank relationship • Local clearing house may be used

17. Transit Items • Direct send • Correspondent bank • Fed Reserve

18. Concept of Float • Types of float • Collection float • Disbursement float • Components of float • Mail float • Processing float • Clearing float

19. Fed Float • When the Fed grants the depositing bank credit according to a preset availability schedule, but is not always able to present the check to the drawee bank for payment within the same period. • Methods used to reduce float • check truncation (electronic presentment) • high-dollar group sort – Fed service where there is same day credit if presented early in the morning and > $10M of daily presentments • inter-district transportation system – more efficient air service • later presentment and deposit deadlines – fed charges an extra fee

20. Paper-Based Payments • Types • Checks • Drafts: written order to make payment to a third party • DTCs: unsigned checks used to move funds from one account to another • Ledger balance • All credits and debits • Not all spendable • Collected balance • Adjusted ledger • Reg CC, (2-local and 5-nonlocal days)

21. Electronic-Based Payments • Wire transfers • Fast but expensive • Automated clearinghouses • Most common use is direct deposit of payroll checks and SS checks • POS debit cards

22. International Payment Systems • Paper-based systems • Giro systems: primarily retail payments • Value dating – delayed availability of deposited checks • Electronic payments • Clearing House Interbank Payment System, CHIPS • Society for Worldwide Interbank Financial Telecommunications, SWIFT

23. Managing the Bank Relationship • Objectiveto ensure that all the company’s banking services are provided reliably at a reasonable cost (not necessarily minimal cost)

24. Services Provided • Collections • Payments • Information • Credit • Investments Covered in detail in later chapters

25. Collections • Coin & currency • Standard check processing • Lockbox services • Electronic collections • Deposit reporting service

26. Payments • Demand deposit accounts • Zero balance accounts • Controlled disbursements • Payroll

27. Information • Balance reporting services • Account reconciliation • Electronic delivery systems • Advisory or consulting services

28. Credit • Shifting from a direct financing role • Moving toward role of risk-sharing or guarantor

29. Investments • Repurchase agreements • CDs • Commercial paper • Corporate agency services • Trends

30. Bank Selection • Location • Bank/Company Fit • Service Quality and Breadth • Bank Creditworthiness • Bank Specialties • Price

31. Managing the Relationship • Account Analysis Statement, Ex 8-14 • Required Compensating Balance Calculation • Balances vs. Fees (page 303) • Bank’s view: Advantages of Balances • Corp View: Disadvantages of balances

32. Bank’s View: Advantages of Balances • Effect of increasing deposits for the bank • Balances can be lent • Form a cushion in case of loan default

33. Corp View: Disadvantages of Balances • ECR is < investment rate • Fees are tax deductible • Fees offer tangible expense that can be monitored • Fees are generally fixed and thus comparable, ECR floats

34. Daylight Overdrafts and the Availability Schedule • Define: when a bank’s Federal Reserve account book balance is negative during the day. • See page 304 for availability schedule

35. Optimizing the Banking Network • Check list • what is bank’s compensation rate and how will it be paid, fees or balances, etc.? • if balances, over what time period? • multiyear agreement available with capped price increases? • compare a pro-forma account analysis statement • who is the account officer? • who is the customer service rep? • how will float be computed? • what performance guarantees are offered? • penalties for customer overdrafts?

36. NonBank Service Providers • Pepsico’s loan to Marriot ($50M) • Almost half of all consumer and business loans held by nonbank companies • Third-party vendors of information between banks and companies

37. Financial System Trends • Nationwide banking in the US • Economic unification of Europe • Both of these will be catalysts for an ongoing drift toward concentration and globalization in the banking industry. • Imaging • Information services • Banking on the Internet • International aspects of banking relationships • Global bank consolidation

38. Summary • We developed the uniqueness of the US payment system and its major components. • We discussed the role the Federal Reserve plays. • We discussed the payment system using paper-based and electronic-based methods. • We discussed bank selection and relationship management. • We concluded with financial system trends.