Imminent Imaging

By Chris Costanzo

With full-scale check imaging less than a year away, the race is on to address sticky operational issues.

The imaging revolution in check processing has arrived, but plans for how to deal with it are still in the making. That's a big challenge, both for individual banks and the industry at large. On the front end are technical issues, on the back end are potentially huge cost-saves, and in the middle are the customers and employees whose cooperation is vital in making the transition work.

The Check Clearing for the 21st Century Act, or "Check 21," as it's popularly known, will allow banks to send checks to each other without a paper trail beginning this October. In other words, neither customers nor other banks need to receive a copy of the cancelled check. In place of that paper, the clearing institution can provide a "substitute check," or electronic image that contains the same information as the original check.

Signed into law by President Bush last October, the legislation doesn't mandate that financial institutions adopt imaging technology. But most experts assume the industry as a whole will gradually phase out paper checks, which could generate an estimated $2 billion to $3 billion in annual cost savings once the process reaches maturity.

Getting to that happy state is the challenge. Even though full implementation of Check 21 is months away, experiments in exchanging images between banks have uncovered major complications, particularly in the "Day Two" processing of exception items. And there are concerns about the cost and quality of substitute checks.

Working as a group, banks must still decide on technical standards so they can ensure the integrity and security of what remains a fundamental bank service. And individually, they need to make strategic decisions about whether to store images internally or in shared archives. Another question: whether to truncate checks in the back office, or invest in technology to remove the paper earlier in the process, such as when checks are collected in the branches.

Further complicating matters, doing nothing is also an option under Check 21. The legislation allows banks to hang on to traditional paper-based processing methods, even as other institutions move to full image capability.

But banks that hang back will likely regret missing out on the cost savings of imaging, especially as check volumes continue to decline, eroding economies of scale in the traditional processing business. Latecomers will also be at a disadvantage vis-à-vis banks that are already using expanded imaging capability to provide innovative new services to consumers and corporate customers.

So for any bank that wants to remain a significant player in financial payments, image technology is a must. The major question, really, is how fast to move in light of a customer demand that remains difficult to gauge.

Day Two Challenge

At its core, Check 21 lets a bank convert an image of a check into a substitute check, or more awkwardly, an "image replacement document." These substitute checks, which are basically paper printouts of electronic items, help bridge the gap between institutions that are fully image-enabled and those that keep processing paper the old way.

Before Check 21, banks could only send check images to other banks that had previously agreed (and were able) to receive them. The new law says substitute checks are the legal equivalent of the original, and it abolishes the paying bank's right to demand presentment of the original paper check as a condition of payment.

Over time, it is expected that most banks will equip themselves to receive images, eventually phasing out substitute checks. Until then, substitutes may help bridge the gap to a fully image-enabled check processing system.

Getting there, however, requires overcoming one considerable technical obstacle: the lack of automation in what is known as "Day Two processing activities." These involve the returns, adjustments and exception items that generally are dealt with on the second day of processing, after the bulk of good items have gone through.

Small Value Payments Co., a New York-based bank consortium, has identified more than a dozen common Day Two back-office functions. Every bank has a different way of handling these applications and for the most part, their workflows are built around routines that incorporate lots of paper and manual handling.

The problems caused by Day Two processing came to light last February, when Charlotte-based Bank of America Corp. and J.P. Morgan Chase & Co., New York, ceased a check-image exchange pilot. Since September 2002, the two banks had been exchanging a few thousand images every night through Viewpointe Archive Services LLC to learn more about the process.

These two original bank owners of Viewpointe, which is an archive that stores images from multiple institutions, had no problem executing the exchanges. The problem occurred when they had to follow up with paper so that each bank could do its Day Two processing. With paper still a crucial part of the process, it wasn't long before the banks reached the point where exchanging images no longer made economic sense.

Mitchell Christensen, an executive vice president of payment strategies at San Francisco-based Wells Fargo & Co., foresees "a lot of heavy lifting" to prepare for Day Two image processing. "It's much easier to capture an image and send it out, versus receiving an image and dealing with it in your Day Two operations. We're not there yet."

Archive Strategy

Efforts are underway to resolve this issue. After taking stock of its pilot results, Viewpointe decided to offer Day Two processing services on an outsourced basis. The services will be integrated into Viewpointe's archive, which will let participating banks avoid hefty capital investments and achieve results more quickly. Viewpointe chairman and CEO John G. Lettko says "a handful" of the company's archive customers have expressed interest in using the service.

Other banks are automating their Day Two processing on their own. Paul Obermeyer, a senior vice president and the manager of operation services at Comerica Inc. in Detroit, identifies exception item processing as probably the biggest task Comerica faces as it prepares for the advent of Check 21. Comerica expects to have that capability built sometime this year. Cleveland-based KeyCorp, meanwhile, is hustling to meet an ambitious timetable of automating its Day Two operations by the first or second quarter.

"It's not a risk-free project by any means," says David J. Harris, a vice president and division manager for item workflow and archive systems at KeyCorp. Harris was referring to the fact that KeyCorp's ability to process Day Two images electronically is in some respects dependent upon the image readiness of other banks.

Another key Check 21 operational issue is whether to store check images internally or in a database with multiple banks. The advantage of a shared archive, such as Viewpointe's, is that images do not need to be moved from bank to bank in order to be exchanged. Rather, they can be stored once and then accessed by any other member of the archive as the need arises, say because of a fraud-related inquiry or a customer request.

According to Lettko, outside consultants have concluded that two banks sharing images through Viewpointe would spend about half as much on image exchange as two banks with internal archives, reflecting lower telecommunication and storage costs.

But opinions on this vary. Comerica, an early pioneer in imaging technology, believes a proprietary archive works best. "Our customers still need large amounts of items delivered to them at discrete points in time," Obermeyer says, citing the example of a customer who receives images in bulk at 8:30 a.m. every morning.

With a shared archive, Obermeyer says, there's too much complexity involved in searching for items across the country to fulfill such customer needs. Plus, there's the risk of receiving a poor quality image. "It's not a practical alternative for banks wanting to provide their own certified quality images."

Atlanta-based SunTrust Banks Inc., which is both an equity partner in and customer of Viewpointe, detects no such problems meeting customer requests using an external archive. "Service level metrics have been excellent," says senior vice president Lou Tiller, adding that archive customers can ensure performance through service agreements with vendors such as Viewpointe.

Substitute Checks

While banks remain divided over key aspects of getting prepared for Check 21, they are almost universally agreed that substitute checks are a bit scary. It is not clear, for example, how much it will cost to create these paper printouts of images, whether they will be of sufficient quality, and what effect they will have on operations. Tiller sums up the attitude of many bankers when he says, "We would prefer to use them no more than what is absolutely necessary."

In fact, Check 21 does not obligate banks to use substitute checks. An image-enabled bank sending a check to an institution not capable of receiving images would probably simply choose to continue sending paper, rather than send an image to a nearby location and print out a substitute check.

KeyCorp, for example, plans to avoid creating substitute checks to pass back to corporate or retail customers, says Allyn Pytel, the senior vice president of media and output management. Instead, customers will be able to select from a range of choices: have their checks truncated, kept by the bank, or presented in imaged format on their statements. Sixty percent of KeyCorp's customers already receive truncated statements.

The only substitute checks that Comerica plans to produce are for return items. In general, substitute checks "are largely going to evolve into a very narrowly defined market," Obermeyer says. That's because the cost of producing them has not proven to be any less expensive than traditional paper, he says.

But there are some instances in which a substitute check makes economic sense, says consultant Steve Ledford, the president of Atlanta-based Global Concepts Inc. Return items, for example, present a good business case. Currently, a bank may spend 50 cents or more to clear a return item through the Federal Reserve. It could avoid that charge by instead printing out, for perhaps 15 cents, a substitute check close to the recipient, Ledford says.

Salt Lake City-based Zions Bancorp. plans to be an aggressive producer of substitute checks, according to executive vice president Danne L. Buchanan. In addition to using substitute checks in the return process, Zions will use them to clear checks from its rural branches. Because these branches are so remote, Zions cannot transport checks accepted after say, 2:30 p.m., and deliver them on time to a central clearing place. So it holds items overnight, to transport them the next day, which slows down the clearing process.

Under Check 21, Zions can send substitute checks, instead of images, to any clearing sites that do not yet have imaging capability. The bank avoids costly transportation hurdles by printing images out at locations that are close to the processing centers. In addition, it can reduce fees it pays to the Federal Reserve by moving non-local items, which incur higher charges, to a local Fed by way of substitute checks.

In Buchanan's view, substitute checks are an inescapable part of the transition to full imaging. "We're not going to flip a switch a year from now and be completely image-enabled on all fronts," he says.

Zions is so convinced of the necessity for substitute checks that in 1998 it created a subsidiary, NetDeposit Inc., to develop products designed to help the industry make the transition from paper- to image-based processing. The company's flagship product is its "decision gateway" system, which automatically selects the most advantageous clearing and settlement channel, whether it is the production of a substitute check, an image transmission, or an automated clearinghouse transaction.

So far, one large New York bank is using the system, and a large bank in the Southeast is piloting it. Other banks are in various degrees of negotiation to purchase the system, according to Buchanan.

Branch Imaging

At the leading edge of imaging activity, some banks are weighing the benefit of capturing check images far earlier in the clearing process. Today, most banks send checks deposited in branches to centralized sites, where they are then imaged for processing. But transforming the checks into images as soon as they come into the branches could provide a number of advantages.

Last fall, for example, Washington Mutual Inc. began installing systems in some of its New Jersey branches that let tellers scan checks into images. It plans to roll out the system to all its branches by the end of this year.

Wamu executives expect major payoffs from providing branch employees access to the images for research and customer service purposes. The imaging system will also enable Wamu to immediately pounce on fraudulent activity. Finally, the Seattle-based thrift will save on transportation costs. Currently it picks up checks from its branches several times a day. With the new system, it will be able to send images throughout the day and have a single check pickup at the end of the day.

Despite Wamu's enthusiasm, other banks question the cost-effectiveness of branch-based imaging. SunTrust's Tiller cites the "huge expense" of buying hardware and software for every branch, and the cost of training all the tellers to use it. Indeed, some banks considering this imaging option are motivated by the need to replace aging teller systems.

Chicago-based Bank One Corp., for example, is planning to add image capture capability in the branch as part of an upgrade of its teller systems, anticipating that imaging will help improve customer service. "We'll be able to provide information on deposits right then and there at the teller line," says Tony Gerevics, first vice president of float, transportation and ECP strategy.

Gerevics is not convinced, however, that a lot of cost savings will come from eliminating the transportation of checks from the branches, noting that banks still need to run internal mail to branches at least once a day.

Beyond individual strategies, institutions need to consider the industry's concerns in the imaging arena. Minimum quality standards, for example, are vital to ensuring the integrity and security of check processing in an image environment. SVPCo, the bank consortium, is working to establish rules and standards that would impose order in this area. For example, banks clearing images through SVPCo would be required to warrant that those images are usable.

Despite the challenges, imaging offers long-term advantages to those institutions that seize the opportunity. Says Buchanan, "It'll be real exciting for the people who get it — and real scary for the people who don't."

Ms. Costanzo is a freelance writer based in Brooklyn, N.Y.

Copyright © 2004 by Banking Strategies, published by BAI.

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