Paper to Pixels

Check 21 poses challenges for large and small banks alike, yet the entire industry will benefit from a swift transition from paper to electronic processing.

"Fasten your seat belts" might be an apt phrase when it comes to assessing Check 21's likely impact on the banking industry. The legislation signed by President Bush in October 2003 may not by itself constitute a full-scale payments revolution, but it will certainly help provoke major changes in the way banks process payments.

Technically speaking, the Check Clearing for the 21st Century Act is rather limited in scope, only requiring that financial institutions be prepared to process image replacement documents, or IRDs, by Oct. 28, 2004. But the expected repercussions of the legislation make it a big deal indeed.

By hastening the proliferation of electronic imaging, Check 21 places institutions in the position of losing efficiency in their traditional paper-based payment operations even as they incur new expenses for imaging technology. Mitchell A. Christensen, executive vice president for payment strategies at Wells Fargo & Co., is bullish long-term, but believes that the paper-to-electronic transition will pose a financial drag on institutions over the next three years.

To overcome thorny technical issues, intermediaries of all types and sizes will have to temper their competitive instincts and work together closely, especially on so-called "Day Two" processing issues involving exceptions, corrections and overdrafts. Overall, the pace of the transition from paper to electronics will be strongly influenced by the degree of participation across the industry.

The good news is that substantial cost savings are on the horizon, perhaps more than $2 billion annually industry-wide, reflecting the efficiency of processing electronic files versus paper checks. But attaining that happy state will be expensive and challenging, as Banking Strategies demonstrates in the following special report.

Meeting the specific requirements of the federal law has more to do with customer service than technology. But how will institutions handle the larger imaging revolution? That question has institutions convening task forces and designating Check 21 "czars" to plot payments strategies. Each intermediary will need to figure out its role in a payments system likely to be increasingly dominated by electronic transactions.

The more specific challenge is figuring out the approach to imaging technology and its ancillary issues, such as image exchange and archiving. In a recent BAI online survey, large numbers of the 225 respondents from financial institutions anticipated that Check 21 would drive their strategies in image exchange and archive, check truncation, electronic check processing, remote image capture at branches and remote image capture at automated teller machines.

Cost Bubble

Although Check 21 is inevitably linked with imaging in public discussion, the law itself is silent on the issue of whether financial institutions should adopt imaging technology. It only requires that they accept IRDs, which are paper documents that include a copy of the electronic image of a check.

Banks can decide for themselves whether to accept the electronic image of the original check or the IRD (which looks a lot like the original check). The problem, however, is that IRDs represent 1) an intermediate step to full imaging, and 2) an unsatisfactory intermediate step, since they are not electronic.

One bank-owned technology consortium estimates that mixing IRDs into the current paper check processing system will boost per-unit costs to a range of between seven and 11 cents. That exceeds the range of between six cents and eight cents that it currently costs to process paper alone. Full-image processing, by contrast, would drive those per-unit costs to below four cents.

Clearly, there is a powerful incentive to move beyond IRDs toward full-fledged image processing. And that's where things get complicated, and expensive. While many major banks have already installed the technology necessary to transform paper checks into electronic images, some technical hurdles still must be overcome before they can easily exchange those files between institutions.

One issue involves image quality. The industry has yet to agree on standards, which raises liability issues. What if one bank in the processing chain deems the image quality of an electronic payment to be unacceptable? How is the dispute resolved?

Another issue is Day Two processing, which refers to the exception items, such as illegible checks and overdrafts, that must be handled after the "clean" checks have run through sorter-readers, typically a day later. Since these items still have to be handled manually, in a paper format, the cost benefits of imaging on Day One are diminished.

Then there's the larger issue of declining check volume, which inevitably drives up per-unit processing costs. As Christensen explains in one of our articles, this places banks "in a difficult situation, in that the volume of checks is declining at the same time we're being asked to invest capital and resources in re-tooling the infrastructure."

Christensen says the paper-to-electronic transition will turn into a net positive only when a critical mass of banks has adopted imaging and new imaging-based products are helping make up some of the revenue lost from the decline in check processing. One respondent to the BAI survey summed up the situation succinctly when he predicted that Check 21 would lead to reduced costs and improved efficiency "in the long run, but a cost bubble in the short term."

Differing Perspectives

Another key finding of our reporting concerns the differing perspectives of large banks and small banks regarding the opportunities and challenges of Check 21. Large institutions, by and large, are better prepared for the transition to electronic processing and express a higher degree of optimism about its benefits.

This partly reflects the fact that the largest banks have already made substantial investments in imaging technology. Likewise, most have by now settled on their image exchange and archiving strategies. So where 35% of respondents from banks with more than $5 billion of assets in the BAI survey say they're "in the process of implementing a strategy" for Check 21, only 19% of respondents from smaller banks make that claim.

It's also significant that respondents from large banks were more likely to anticipate benefits from electronification, such as new product development (84%), lower collection costs (69%) and improved customer service (61%). The corresponding percentages for respondents from banks with less than $5 billion of assets were 68%, 50% and 50%, respectively.

That's not to say that small banks have nothing to gain from electronic processing. Like their larger brethren, some expect to earn incremental revenue by providing their customers with real-time access to imaged statements. Atlanta's NetBank Inc. believes that digitizing the deposits it receives at ATMs and the checks sent from merchants will save several hundred thousand dollars a year in processing costs, allowing it to shift more of that work from outsourcers to its own employees. Other small banks expect to participate in the digital revolution by going in the opposite direction and outsourcing their imaging activities.

Despite the differing approaches, banks of all size share some common concerns. One is the need to help their customers through the transition away from paper checks. In the short term, Check 21 is as much about customer handling as it is about technology. The millions of people who are accustomed to receiving their cancelled checks every month, as opposed to imaged statements, are likely to be particularly put off by the appearance of IRDs, even in a paper format.

So banks face an educational challenge, and potentially a marketing opportunity as well Ñ if they want to migrate their customers to electronic transactions. The key to allaying customer fears and selling them on the benefits of imaging is providing appropriate training for bank employees. More than two-thirds of all financial institution executives responding to the BAI survey anticipated that Check 21 would affect customer communications. "Customer and employee education will be one of the biggest challenges to the industry," one respondent predicted.

A final concern that cuts across all asset size categories is the need for the industry to harmonize its adoption of imaging technology. It does no institution any good to get too far ahead of the crowd because the benefits will be wasted. As Christensen says, "A payment, by its very nature, creates an exchange of value between two partners. If one partner isn't image-capable, you're stuck dealing with the paper."

In that light, it's encouraging that large banks have been working effectively through industry organizations such as the Small Value Payments Co., Viewpointe Archive Services LLC, the Financial Services Technology Consortium, and the Electronic Check Clearing House Organization. Smaller banks, meanwhile, are participating through their technology vendors and the Federal Reserve. Everyone involved with these various efforts seems to understand that electronic processing is something that must be pursued on a cooperative basis if individual institutions are ever to enjoy its promised benefits.