Banks as Payment Processors

Before the era of digital payments, all non credit card payments were made by either cash or check. One would get paid by check typically, and then deposit their paycheck in a bank, and draw out a certain amount of cash. The remainder would be left in the account to draw checks on or to be withdrawn at the branch later.

Payments by cash are a pretty simple process, one gives the cash to a merchant or anyone in exchange for something of value, and the person receiving the cash may spend it elsewhere, or may deposit it in a bank.

Checks are still used today as a way to send a payment to someone, and checks represent a promise to pay someone out of funds on deposit at the bank and on the account that the check is drawn upon. Check writing used to be much more widespread in earlier times than it is today though, as it was the only alternative to cash for direct payments.

The problem with checks is that there is no way to verify whether the check will clear or not at the time of acceptance, unless it is certified. In certain cases one would be required to visit their bank and have their bank certify that the check writer has the funds available to clear the check, and the bank would put a hold on these funds to ensure that they were not spent on something else while waiting for the check to clear.

Certified checks are still used in certain circumstances, but in most cases these days, since the check writer has to visit a bank anyway to get a check certified, they will instead have the bank write a check to the person that they are looking to pay with a check, called a money order or bank draft. The funds are instantly debited from the payer’s account at the time of the issuance of the bank check, and the person who is given this bank check can be assured that it is good.

Checks that end up being rejected for payment have been known as rubber checks, which is where the term a check bouncing comes from, although the real term for these are dishonored checks due to non sufficient funds, or NSFs.

Due to the risk of normal checks being dishonored, merchants were often reluctant to accept them as payment, especially at point of sale. A dishonored check results in fees for both the check writer and the intended recipient, where the check bouncer would receive an NSF charge, and the intended recipient would get slapped with a dishonored item fee, or a chargeback.

In the case of point of sale transactions, the merchant would be out the goods or services provided as well, but on the other hand, refusing to accept checks could see their customers take their business elsewhere, so they ended up having to balance lost business with losses, and many did take checks, from select customers at least.

Bill payments were almost always made by check though, which is where the saying the check is in the mail comes from, and the only alternative was to visit the business office of the company that the bill is owed to and pay in cash.

Plastic Takes Over

Using cards as payment started with credit cards, and this occurred well prior to the digital age, where transactions had to be verified with the credit card company over the phone. Many smaller transactions were not verified, but with larger ones, the merchant had to call the credit card company and get an authorization code.

To keep these calls within reason, the credit card had to agree to honor transactions below a certain amount, even though the cardholder may not have available credit for the purchase, because it simply was not efficient to take calls for nominal amounts.

Once the digital age hit, these authorizations became automated, through a computer system. This also brought forth the bank card, similar to a credit card other than the payments aren’t extended by way of credit, but instead by debiting the cardholder’s account, the same way a check would.

Bank cards virtually put an end to using checks as payments for point of sale purchases, once bank cards became ubiquitous. They were optional when they were first introduced, but eventually they became mandatory, and if one could write a check to debit one’s bank account, one could also use their debit card as payment, as long as they had the money in their account to cover it.

The instant verification of plastic cards brought a new level of efficiency to making payments. While the transfer of funds is not instant, the authorization of the payment is, and now merchants can be as assured with non cash transactions as they can be with cash ones, save for counterfeiting with cash and fraud with cards, both of which are uncommon enough to not represent an unacceptable risk to the merchant.

What makes these payments so efficient is that everything is automated now, and neither customers nor merchants have to handle cash with these transactions, which involves both a burden and greater risk to both parties.

Many people still prefer to transact in cash though, and this remains a personal preference, at least so far. Cash is still legal tender, which means people are obligated to take it as payments for goods or services received or for payment of debts, but more and more people are moving away from cash each year and embracing the easier form of making digital payments.

How Banks Transfer Funds Between Payor and Payee

Banks are involved in all forms of payment, whether this be by cash or check or by digital means. People tend to understand how cash works at the banking level, as money is given to someone and they deposit it at their bank and their bank account gets credited with the funds.

The way banks process non cash transactions is much less known. Some wonder what digital cash consists of, or whether or not actual cash changes hands with these transactions, and the answer is that it does not, nor does it need to.

If you make a non cash payment to someone, using a bank account as payment, money does not go directly from your bank account to the bank account of whoever receives the payment. This is possible but it would be way too inefficient, and account charges would be much, much higher than they are if this were the case.

Digital money like Bitcoin does process direct transactions like this, but digital currency is much more efficient by nature and the fact that this is all done on the internet and occurs directly between the parties, peer to peer payments as it is called, makes this possible.

Banks on the other hand process payments in bulk, exchanging money between each other on a net basis. If a payment is between two clients of the same bank, it’s just a matter of debiting one account and crediting the other. Often though these are between institutions, so at the end of the day the banks calculate how much one owes another and either credits or debits the accounts that each have at the other bank or at a third party institution, and most commonly settle these payments through the central bank, where they both have accounts at.

How Bank Deposits Really Work

To understand this properly, we need to realize that money on account at a bank isn’t just money in the bank that we have, but a debt the bank owes to us. Even when we deposit cash, the bank keeps the cash for itself and simply owes us the money, a debt to be paid to us at a future date.

So let’s say you make a purchase at a store for $20, and you bank at Bank A and the merchant banks at Bank B. Bank A does not simply take $20 out of your account and send the cash to Bank B, that would be ridiculously inefficient, and the transaction costs may even exceed the original $20.

Instead, what the banks do is exchange these debts. Let’s say someone else at Bank B made a payment to a store which uses Bank A, your bank, for $20 as well. So for your transaction, your bank no longer owes you the $20, it owes it to Bank B, who in turn owes it to the merchant you spent the $20 at.

Bank B owes Bank A $20 for this other transaction though, so these transactions balance out, and no money ends up being transferred to one or the other bank as a result of these two transactions, as this scenario allows for both transactions to be processed internally. At the end of the day settlement, the banks figure out what the net amount is for all the transactions between all of their parties and transfer the net amount to one another to “settle” their transactions.

This is why, even in this day and age of instant digital processing, bank transactions still do not settle until the next business day, and why people see the processing date and the posted date, when it is settled, as not occuring on the same day. It’s not that banks could not process them instantly, but they wait and do these in bulk, with net amounts, to make the system much more efficient and cheaper to manage.

So digital money isn’t cash, it’s debts between banks and depositors, which is money in a real sense, as it is part of the money supply. The money supply though is much more than all the cash in circulation though, it’s mostly these bank debts to people and businesses. People may wonder whether digital payments use real money, and the answer is that they do but not money as people normally think of it, but it is all legitimate but simply a bank’s promise to pay someone rather than cold hard cash sitting somewhere.

So this is how banks process payments, by shifting around the debts that they owe people to clients within their banks and to other banks as well.