For Efficiency's Sake

By Kenneth Cline

While paper check processing remains lucrative for banks, roundtable participants say the payments system overall would profit from more electronics.

The goal of a checkless society certainly has proved elusive. Even as electronic payments proliferate, check usage increases as well. Over the last two years alone, the annual estimated volume of paper check transactions rose from 66 billion to 68 billion, and experts are continually confounded in their predictions of a plateau.

The issues are complex for all payments stakeholders. Electronic payments indisputably are faster and more efficient. That's why the Banking Industry Technology Secretariat, or BITS, a major trade group, has been promoting electronic check presentment, or ECP, a kind of halfway house between a paper-based and fully electronic system. Under this system, collecting banks scan checks with ECP equipment and then electronically process them through to the paying bank, accelerating the posting process by about a day.

Despite the operational advantages, the financial benefits often are difficult to discern and can vary depending on an individual bank's role in the transaction stream. For example, it appears that some of the early payoffs will go to the entities involved in check processing, including individual banks and the Federal Reserve System. On the other hand, participating institutions face up-front costs and stand to lose some of the float advantages they get from paper checks. Customers, both retail and commercial, also lose float and would seem to gain little from the improved efficiency.

So how do managers weigh the pros and cons of transitioning to an electronics-based payments system? For answers, we consulted a panel of payments experts: Anthony "Tony" Gerevics, vice president and ECP strategy manager, Bank One Corp.; Fred Herr, senior vice president, Federal Reserve Bank of Atlanta; and Phyllis Meyerson, associate director, Electronic Check Clearing House Organization.

All three support ECP on the grounds that it improves efficiency and reduces fraud in the payment system, thereby overcoming other short-term disadvantages. They see pricing incentives ahead, moreover, as more banks adopt ECP. Finally, they view ECP as the inevitable precursor to a fully electronic system that would likely include imaging technology. "ECP was never envisioned as the final step," Meyerson says, "but rather as an excellent transition step to full electronification."

Indeed, experiments are already underway with more advanced systems. Under electronic check "truncation," for example, the information from a check is transformed into an electronic document, and the paper check itself is then either discarded or handed back to the customer. This contrasts with most current ECP systems, in which the original paper check is eventually shipped to the paying bank. But since truncation and imaging systems still face major legal and regulatory issues, ECP remains the technology of choice for banks that wish to transition to an electronic system.

We held our discussion in April during BAI's transaction processing conference in Orlando.

Banking Strategies: Where is the industry today with ECP, in terms of the adoption rate by banks?

Meyerson: In 1998, BITS established a goal of achieving 50% of large-bank check volume through ECP by 2001. Although progress has been substantial, it's unlikely this goal will be met.

Gerevics: Y2K provided another catalyst by hastening system upgrades, and the modernized technology platforms will allow institutions to deploy ECP more rapidly.

ECP volume through the Small Value Payments Co. is approaching 40 million items a month. SVPCo is a for-profit offshoot of the New York Clearing House, an association supported by 21 of the top 25 bank holding companies. At Bank One, which is part of SVPCo, we've gone from zero ECP items about two years ago to nearly eight million a month.

While SVPCo's ECP growth has been dramatic, its current volume of roughly a quarter of a billion items per year still represents only a tiny portion of the 68 billion or so checks presented annually in the United States. So we still have quite a bit of work to do.

Herr: Institutions receive over four billion items annually from the Federal Reserve in some form of electronic medium. This represents a little more than 28% of the volume we present for payment.

During the last couple of years, additional emphasis has been placed on utilizing electronics for paper-based payments, an effort the BITS initiative has highlighted. Current Fed ECP volume is nearly one billion items a quarter.

To adopt ECP, institutions have to change internal data flows in order to match other accounting needs, which has hindered progress. Many are waiting to see if the industry can reach critical mass, which will help minimize the overall conversion cost within institutions.

Banking Strategies: Are these technical obstacles substantial?

Gerevics: If you're talking about ECP with "paper-to-follow," I'd say not. There are technical issues involving check truncation, however, where the magnetic ink character recognition (or MICR) numbers are scanned at the point-of-sale and the actual paper isn't sent to the collecting bank. There are also technical issues with imaging, where the digital image of the check replaces the actual paper document.

Meyerson: There are some ECP operational issues surrounding the arrival of the paper check at the paying bank, but that's not primarily a technological problem. With ECP, banks still need the paper to perform certain tasks, such as return-item processing. Transportation schedules and shipping distances sometimes make it difficult to ensure that the paper arrives when needed.

Gerevics: The technical standards were the big issue, and that was overcome with BITS' assistance. In addition, SVPCo, as the operating utility, created a set of operating procedures, while ECCHO established rules for the legal framework of ECP exchanges. SVPCo and the Fed are currently engaged in interoperability discussions involving how individual banks handle ECP traffic.

Banking Strategies: What's the business case for ECP? Who actually benefits from this technology?

Gerevics: The paying bank gets some benefit from accelerated posting — by bringing the transaction into its posting system a day sooner. To the extent that the items are drawn on an interest-bearing account, interest expense is reduced: The check is debited from the account one day sooner than under the conventional paper process, and therefore the bank does not pay the corresponding day's interest to the customer.

Because the ECP exchange takes place in the late evening, the paying bank does not settle with the collecting bank until the next day. So it's the paying bank that gets the financial benefit, not the collecting bank.

On the other hand, the collecting bank does receive more timely information from the ECP process, which helps reduce the risk of fraud. By processing checks a day sooner, the paying bank can either return or send notice of return to the depository bank one day sooner as well. Accelerated information on a return item allows the bank to either place or extend holds on the depositor's account.

The depository bank can also provide this information to the depositor. A business, for example, can act on such information by declining to ship goods or accept additional pur-chase orders.

Herr: At present, significant infrastructure is required to process paper checks. ECP eliminates much of the redundancy. Paper handling is reduced, thus reducing the chances for errors. Electronic media allow institutions to reengineer and adapt internal processes to gain efficiencies, both in labor and time.

Banking Strategies: What's restraining ECP from reaching critical mass?

Herr: You're dealing with 10,000-plus banks. It's extremely difficult to change processes, operating rules and legislation to accommodate something as significant as moving from a paper-based infrastructure to an electronic-driven process. The Board of Governors is working with the industry to draft proposed legislation that would enable financial institutions to better utilize electronic media for presentment of paper items.

Meyerson: We don't know whether that proposed legislation will pass in its present form. Changes are still being made to what is known as the Check Truncation Act. The Federal Reserve Board has produced a number of drafts and has requested industry input throughout the process. The intent was to build consensus before the legislation went to the Hill. We hope the bill will be introduced in this Congress.

Gerevics: Another reason ECP hasn't yet reached critical mass is that it's difficult for institutions to grasp its value. While larger banks can indeed use the technology to reduce interest expense, the reduction is not very significant at a time when the typical interest-bearing account is paying only 1% or 2%. Again, the paying bank primarily benefits by avoiding having to pay interest on funds that were debited a day earlier.

Smaller banks, meanwhile, may not have sufficient interest-bearing accounts and/or dollar volume to justify investing in ECP infrastructure. And in many cases, these smaller banks use third-party processors.

Meyerson: Installation is a problem. Large banks have to deal with lots of different interface issues. For example, when a bank receives an ECP file and posts it to the customer's account, it must then integrate that file with other internal systems, such as stop payment, return and exception processing, as well as account balance reporting.

And smaller banks have to worry about "double posting" when they receive a single transaction in both paper and electronic forms. If systems are not properly designed and installed, it's possible for the ECP and the paper check to double-post to a customer's account.

Basically, ECP is an operational issue for banks. While an institution derives benefits in terms of float and reductions in interest expense, those benefits are not clearly reflected in the operations area. So the project may lack an institutional advocate. And then when managers consider all the other projects their institution is involved with, ECP falls down on the priority list.

Herr: The present system also works pretty well. People understand it. That's a high bar to overcome.

Gerevics: That's right. It costs us a little more than a penny to clear a paper check, on average. And we already collect most of our 15 million transit items within a day. So the paper check is relatively efficient. It also provides significant revenue in terms of overdraft and bounced-check fees.

If we eliminate the paper check, we had better find a replacement for that lost revenue. Banks are struggling with the question of how to ensure that electronics do not cannibalize the significant revenue, both in float and fees, generated by the paper check.

Banking Strategies: Isn't it also true that bank customers, both retail and commercial, don't really have a dog in this hunt?

Gerevics: For consumers, probably not. They don't gain much from ECP. They lose disbursement float, in fact, because transactions are posted a day sooner. Merchant and corporate customers, however, might benefit from any fraud reduction stemming from accelerated posting.

Banking Strategies: Given this background, how should decision-makers at large banks approach the ECP issue?

Gerevics: I think the larger banks already get it. Most of the top 25 institutions are involved with ECP. Even some of the mid-tier banks, such as Cullen/Frost Bankers Inc., San Antonio, are doing a phenomenal job, not only with ECP but also with imaging technology.

But additional volume also needs to come from the next tier of banks under the top 25. The community banks probably lack a good business case to do it, although they do have an opportunity to eliminate some of their back-office infrastructure.

Meyerson: Organizations such as ECCHO and SVPCo can provide a lot of information about ECP for managers who want to get educated on the topic.

Herr: As the use of ECP technology expands, efficiencies will come into play, lowering costs. Right now, transitioning to electronics is challenging because the paper process is very efficient.

At some point, it's going to flip-flop, and the electronic process will become more efficient. Bank strategists will have to watch that evolution and stand ready to take advantage of the opportunity when it presents itself.

Banking Strategies: When will that transition occur? Is it still several years away?

Gerevics: It's already begun, in my opinion, with some of the pricing that the Fed has put in place. They now offer a discount for an electronic presentment file of the items in advance of the paper showing up, because they get some efficiencies by having the electronic file to compare the paper against. That allows them to improve quality and reduce rejects.

Another factor is that paper-processing costs are continuing to move higher.

Banking Strategies: What is the risk of not doing anything with ECP? Why is this an important issue for senior managers?

Herr: That's like asking about the risk of personal computer illiteracy. In the short-run, there's probably not a whole lot of downside. But tomorrow, it could be extreme. ECP allows institutions to provide payment information quicker and more reliably, with fewer errors.

One reason ECP hasn't taken hold more quickly is that the support for imaging has been lacking. But imaging has big advantages. The basic ECP file only transmits the MICR line, which does not, in many cases, provide all the information that is needed for reconcilement by the user. If a problem occurs, a copy of the check is needed. Image technology allows for the storage of the image and accessibility as required. It is highly reliable and lends itself to electronic transmission, which speeds problem resolution.

Gerevics: On average, a check item that gets sent back to a customer will run through a sorter machine no fewer than seven or eight times. When that happens, the MICR starts falling apart, which leads to operational problems.

This is where imaging technology would help. If we could reduce all
the physical touch points and truncate the check at its earliest practical source, perhaps even at the point of entry, meaning at the branch or automated teller machines, we could eliminate a lot of redundant handling. We wouldn't need to constantly re-balance and validate.

At Bank One, for example, we found that we have up to 26 touch points from the time the paper check enters a branch to the time we send it to a customer, as we hand it off from one operating area to another, re-balancing every time.

Myerson: We all agree that ECP is a kind of a predecessor to imaging. Since an image of a check is approximately 50,000 characters, depending on the check (retail or corporate) and an ECP record is 80 characters, it is logical that ECP records would precede the image files. The ECP records can be used to post transactions, a process that needs to be done quickly, and the image files can be subsequently used for other back-office processes.

Time and expense dictate that ECP should precede imaging. ECP was never envisioned as the final step, but rather as an excellent transition step to full electronification.

Banking Strategies: So what is your advice to institutions still standing on the sidelines?

Meyerson: Such institutions need to get involved and start understanding the process. You can't decide that you're not going to do ECP.

Herr: The more you understand, the better prepared you'll be to take advantage of the changes.

Gerevics: For many banks, ECP is not only a tactical initiative, but also has strategic significance. The ECP infrastructure we're building today could become the backbone of an image-exchange environment tomorrow, which has profound implications for operating efficiency and customer service.

Mr. Cline is senior editor with Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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