Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Sun, 06 Nov 2011

Pricing of cheques and electronic payments

India seems to be now moving to a system where it costs the originator more to make an electronic payment than to issue a cheque. This is dysfunctional because the cheque imposes costs both on the receiver and on the payment system (the paying bank, the collecting bank and the clearing house). Of course, in a free market, banks are free to levy charges as they deem fit and charges do vary significantly across banks in India. What is interesting is (a) that the resulting market equilibrium is so perverse, and (b) that this perversity is a recent phenomenon.

In the past, many banks were not charging for electronic payments through the National Electronic Fund Transfer (NEFT) system operated by the Reserve Bank of India. Recently, more and more banks seem to be introducing charges at the maximum permitted rate of Rs 5 per outbound electronic transfer for small transactions. By contrast, most banks charge only about Rs 2 per cheque leaf, and the first 20-30 cheques per year are typically free.

This means that it may now be advantageous for many retail consumers to issue cheques instead of using NEFT for inter-bank transfers within the same city. This privately optimal decision does however have a huge negative externality. The cost to the paying and collecting bank of processing this cheque might be about Rs 50 each, and there are costs elsewhere in the system (for the payee who has to deposit the cheque and for the clearing house which has to process it).

What I would like to know is whether this pricing decision is optimal for the individual banks. Perverse as the end result is, the pricing can be rational for individual banks if customers sophisticated enough to use NEFT are assumed to be relatively price insensitive. In that case, the customers continue to use NEFT and the bank simply pockets another source of revenue. The alternative hypothesis is that the costing and transfer pricing system in many banks is badly broken. In that case, the costs of processing paper cheques is not fully reflected in the pricing decision, while the cost of the electronic transfer is a transparent out of pocket cost (the fee charged by NEFT). A naive cost-plus-pricing system does the rest of the mischief. It would be interesting to figure out which hypothesis is closer to the truth.

In either case, the problem can be solved by a Pigovian tax on cheques.

Posted at 20:29 on Sun, 06 Nov 2011     6 comments     permanent link


Kapil Singh Dhaka wrote on Sun, 06 Nov 2011 21:02

Re: Pricing of cheques and electronic payments

I think the rationale is quite simple. Customer segments for cheque and NEFT are completely different. Rs5 per transaction is so small that nobody would go for a cheque to save it. Even if there is a bank which provides same service free of cost, nobody would change their bank to save Rs5/transaction. Secondly, since it does not involve any physical labor/effot to transfer via NEFT, people use it irrationally (as in they would make too many transactions which were not necessary in the first place).

Jasjit Singh wrote on Tue, 08 Nov 2011 11:44

Re: Pricing of cheques and electronic payments

Even I did not think of Rs 5 + service tax as a very high price to pay for online money transfer transactions through NEFT. However, Prof. Verma's blog has set me thinking. Overhead for electronic transactions would definitely be lower than the overheads of processing physical cheques. I am sure banks are using the upper limit set on NEFT transactions to make additional money.

Rajeev wrote on Mon, 14 Nov 2011 16:48

Re: Pricing of cheques and electronic payments

I guess in relation to NEFT pricing - it is perverse if you are viewing it from the cost plus pricing angle. But if you viewing from the marginal utility angle, i am sure the neft users are still enjoying surplus utility even at Rs.5/- per NEFT transfer.

Commercial Vehicle Finance wrote on Wed, 15 Feb 2012 14:53

Re: Pricing of cheques and electronic payments

Hi.. I think the big transition of money will neglect the little amount deduction and no doubt one will never change his/her bank to save the small amount.

Neeraj Varshney wrote on Wed, 14 Mar 2012 05:59

Re: Pricing of cheques and electronic payments

The idea propounded by the Prof is meaningful. I as a customer changed my bank from SBI to ICICI because of this very reason. On every net transfer of amount they were charging me a "miniscule amount". I found cheque payment cheaper. And then I said WTF, change banks.

Amateur wrote on Fri, 13 Apr 2012 22:59

Re: Pricing of cheques and electronic payments

why isn't any one talking about the cost of time involved in the clearing process? Interbank check clearing takes at least 2-3 days