Check Clearing

Definition

Check clearing is the process by which a bank collects funds from the bank on which a check is drawn and makes those funds available to the bank's customer who deposited the check. It is a critical component of how banks create money through the fractional reserve banking system.

5 Must Know Facts For Your Next Test

1. Check clearing allows banks to make funds available to customers before the check has fully cleared, enabling the bank to earn interest on those funds in the meantime.
2. The check clearing process involves the depositing bank presenting the check to the bank on which it is drawn, who then transfers the funds to the depositing bank.
3. Banks can create new money through the check clearing process by making loans that become new deposits, which can then be used to make additional loans.
4. The speed of the check clearing process is an important factor in the bank's ability to create money, as faster clearing allows banks to lend out more of their deposits.
5. Regulations such as the Expedited Funds Availability Act have impacted the check clearing process by requiring banks to make funds available to customers more quickly.

Review Questions

• Explain how the check clearing process allows banks to create new money through the fractional reserve banking system.
  • The check clearing process is a key mechanism by which banks create new money in the fractional reserve banking system. When a customer deposits a check, the bank does not need to wait for the full clearing process to complete before making those funds available. This allows the bank to lend out a portion of those deposits, which then become new deposits in the banking system. The bank can then use these new deposits to make additional loans, further expanding the money supply. The speed of the check clearing process is an important factor, as faster clearing enables banks to lend out more of their deposits and create more new money.
• Describe the role of regulations, such as the Expedited Funds Availability Act, in the check clearing process and their impact on a bank's ability to create money.
  • Regulations like the Expedited Funds Availability Act have influenced the check clearing process by requiring banks to make funds available to customers more quickly. This has had a direct impact on a bank's ability to create new money through the fractional reserve banking system. By shortening the time it takes for checks to clear, these regulations limit the period during which banks can lend out a portion of the deposited funds. This reduces the multiplier effect and the overall amount of new money that can be created. Consequently, faster check clearing, driven by regulations, constrains the money creation capacity of banks, as they have less time to leverage customer deposits through the lending process.
• Analyze the potential risks and consequences associated with the check clearing process in the context of the fractional reserve banking system.
  • The check clearing process, while enabling banks to create new money, also introduces potential risks and consequences. One notable risk is the possibility of check kiting, a form of fraud where individuals write checks between accounts to artificially inflate their apparent account balances. This can disrupt the check clearing process and undermine the stability of the fractional reserve banking system. Additionally, the speed of the check clearing process can amplify the money creation capacity of banks, potentially leading to excessive credit expansion and asset bubbles. Regulators must carefully balance the need to facilitate efficient check clearing with the imperative to maintain financial stability and prevent the abuse of the money creation process. Striking this balance is crucial in mitigating the risks associated with the check clearing process within the fractional reserve banking framework.

Related terms

Fractional Reserve Banking:

A banking system where banks only hold a fraction of their deposits as reserves, allowing them to lend out the rest and create new money.

Deposit Creation: The process by which banks create new money by making loans, which then become new deposits in the banking system.

Check Kiting: A form of fraud where someone writes checks between two or more accounts to make it appear that they have more money than they actually do.