Ready or Not

By Kenneth Cline

Large banks are expected to be the readiest for Check 21's implementation date. But even they are bracing for their greatest challenge in managing a multiple-format — original paper, IRD and image — processing environment.

In their rush to implement Check 21, bankers may be leaving themselves exposed to potentially serious problems, such as fraud, technical glitches and irate customers.

Most banks probably will be able to handle the minimum requirements of the Check Clearing for the 21st Century Act, which President Bush signed last year and which is scheduled to be implemented on October 28.

But concern is mounting that some aspects of the process, the production and handling of image replacement documents (IRDs), for example, may prove troublesome.

Lou Riehl, senior vice president of J.P. Morgan & Chase Co. at the time of a recent Banking Strategies interview and chairman of the New York-based Financial Services Technology Consortium (FSTC), goes so far as to warn of "catastrophic losses" should actual data disappear in the shift from paper-based to electronic processing. "I don't think we've had the time to ask, 'What can go wrong?' We're just rushing helter-skelter to get it implemented," Riehl said during a roundtable discussion following a large bank Check 21 presentation at BAI's TransPay 2004 conference in mid-May.

The other Check 21 experts on the panel were less alarmist, but agreed that Congress had set the bar high for the industry by mandating implementation in just one year. Standards on IRDs are still evolving, for example. Noting the heightened danger of fraud, PNC Financial Services Corp. vice president Regis Reinersmann pointed out that "the substitute check, or IRD, will lose the security features of the original check."

Bank employees also need to be trained to deal with Check 21-related issues. Matt Calman, a senior vice president and process engineering executive at Bank of America Corp., commented on the challenges of preparing bank employees for properly re-crediting customer accounts in the event of erroneous image transactions.

Customer reaction was another concern. At this point, nobody knows how customers will respond when IRDs start showing up in their statement envelopes. That has "has added another degree of complexity and uncertainty to this rapidly changing environment," said Steve Anderson, a vice president at BB&T Corp., Winston-Salem, N.C.

Banking Strategies: Is the industry going to be ready for Check 21 on October 28?

Calman: If by that you mean being compliant with regulations and ready for the minimum processing requirements, yes. Institutions will be ready to process IRDs, for example. There's also been a lot of work preparing for expedited re-credit processes and customer education.

Reinersmann: I agree and I would add that banks are anxiously awaiting the Federal Reserve's final ruling on the regulation, which will provide final processing requirements and possibly some revision to the customer disclosure language. Banks need that to finalize all their plans to implement Check 21.

Anderson: I agree that the banks will be ready, since the minimum requirements are very manageable. However, it is going to take some work on the part of the banks to handle some of the challenges.

Calman: The challenges include preparing bank employees for properly handling expedited re-credit claims from consumers for erroneous image transactions. Customer contact employees need to be trained on the details of the Act's expedited re-credit provisions and how to apply their bank's processes to solve the customer's problem.

Riehl: I actually don't think the industry is well prepared for Check 21. When I look back at the amount of work that went into the introduction of Regulation CC, which had to do with expedited funds availability, there was more preparation than I'm seeing here. I think it's because the industry had a longer time to wrestle with Reg CC issues.

A lot of work has been done on Check 21. But given the amount of time we had, I don't think we've had the time to ask, "What can go wrong?" We're just rushing helter- skelter to get it implemented.

I recently gave a presentation to community bankers in New Jersey titled, "Be Careful What You Ask For, You Just Might Get It." The banks asked the government for help in creating a more effective, efficient payments process. They gave us the Check 21 legislation and now we have to respond very, very quickly.

Reinersmann: There are similarities between Check 21 and Regulation CC, which was implemented in two phases over a couple of years. Check 21 can be considered phase one of the transition to an image-exchange environment.

Banking Strategies: What are the major issues that you and your institutions worry about? What could go wrong after October 28?

Reinersmann: Part of the industry's concern involves fraud. The substitute check, or IRD, will lose the security features of the original check. Coupled with the fact that the IRDs will be black and white only, this adds more complexity to banks' exceptions review process.

In today's environment, some institutions have clerks manually handling the original paper check. In the Check 21 world, we'll need to adapt our review process accordingly.

Banks converting paper checks to IRDs also need to determine how long to hold the original paper check. Neither the regulation nor the industry will likely establish mandatory guidelines. As a result, each bank sending images of checks will need to develop its own policy for holding the original checks prior to destruction. In addition, procedures will be required to locate the check, if necessary.

Riehl: I'm concerned about a potential failure of the technology infrastructure. We're doing everything we can to build it tight and build it redundant. But in a physical world, you have a physical thing to rely on. When something fails in an electronic world, it leaves no trace.

In this case, you will have massive electronic records being introduced into the collection process. What happens if those transactions never get to their end destination, the infrastructure fails to recognize that fact, and the people who introduced those electronic transactions destroyed the paper records? There could be catastrophic losses.

Banking Strategies: Bankers seem to be taking a strong dislike to IRDs, in part because they're seen as only a halfway step to full imaging. What's your stance on IRDs?

Riehl: We think IRDs are a double-edged sword: good for the collecting bank, but problematic for the paying bank.

From the collecting bank's perspective, we know that not every bank is going to accept electronics. However, by using IRDs for certain high-dollar items, a collecting bank can transmit an electronic record of the check to a correspondent local of the paying bank that doesn't accept electronics. The correspondent can then print and present an IRD to the paying bank on behalf of the collecting bank. As a collecting bank, we like that.

But no bank is just a collecting bank; it's a paying bank as well. And we just know that these IRDs are going to be produced in environments that lack the tight controls you see with check printers today. You're going to have thousands of banks printing IRDs in little back offices and introducing them into the collection process.

As a big paying bank, we're going to get a lot of those IRDs and a lot of them will have to be rejected.

Banking Strategies: Don't you have standards for printing IRDs?

Calman: Yes, there are ANSI X9 standards, which govern the format, paper and printing specifications of IRDs. But the question is adherence to those standards. We expect to receive some poor quality IRDs initially and, like Lou, we expect to reject some. Sending them back to the re-converting bank is the only way to raise the standards, in practice.

Reinersmann: Although there are standards for printing IRDs, the question that needs to be answered over time is: what is the appropriate quality for the image? To date, the industry hasn't developed a methodology to measure quality.

Banking Strategies: Check 21 is, of course, only a first step on the road to full imaging. What will determine how fast the industry moves down that road?

Calman: There are several levers governing adoption, like short-term cost structures, total clearing costs and customer acceptance. Most important is mutual readiness and the network effect of more and more banks joining the image exchange space. There may be situations, as well, where paper will continue to hold a cost advantage over image clearing for some time.

Banking Strategies: Where would you see that, specifically?

Calman: Local exchanges. If two banks have operations centers that are two miles away from each other, they may find it cheaper to truck those checks between them for some period of time.

Riehl: We're definitely wrestling with that issue in New York, where you have a lot of banks close together. But at the same time, we're wrestling with the total cost of ownership, of weighing a single-thread process against a multi-thread process.

On the surface, it might appear less expensive to continue trucking the checks. But what's the additional cost of having two different workflows in your back office? We're trying to figure that out.

Reinersmann: One angle that needs to be considered, from an incoming perspective, is the source of items. For example, what portion of the work do you receive from local vs. non-local banks? If a bank's local Federal Reserve operations center is negatively affected by the Fed's consolidation, you get later delivery of paper checks for the traditional in-clearing operation.

However, accepting image files of checks will provide the receiving banks the ability to process in-clearing items earlier and more efficiently.

Anderson: Right now, banks have three formats to consider: original paper, IRDs and images. It's during this period that banks will face their greatest challenge in managing the efficiencies of check processing. This multi-thread environment, as Lou put it, is likely to be the most painful for banks as we transition from processing paper checks to processing images.

Calman: Banks are making strategic choices today to accept perhaps a higher clearing cost, or a thin marginal clearing cost, in order to promote a higher adoption of imaging and squeeze paper to a lower proportion of total payments.

Anderson: At the end of the day, banks won't benefit unless the industry is willing to cooperate.

Banking Strategies: The large banks seem to be cooperating, but the smaller institutions have been less involved in planning for Check 21. Is the industry moving toward a bifurcated response, with the large banks adopting imaging and the small ones staying with paper?

Riehl: I don't think so. The community banks have a lot of turnkey image-enabling systems to choose from. Many of them are image-enabled already, so they've made the big upfront investment. For them, getting into image exchange will require only a small incremental investment.

The banks that are image-enabled are going to enjoy a significant cost advantage over the ones that aren't, which will push the others into it. So I think you'll see a rapid adoption at the community bank level. They'll either go to an aggregator, who will do it all for them, or they'll buy one of these turnkey systems, which work very efficiently for a community bank.

Additionally, many community banks already have moved away from sending customers' original checks back with their statements. They're giving them imaged statements instead. That will make it much easier to gain customer acceptance.

Calman: The question is how long that transition period is going to take. We're all trying to guess what the other guy is going to do — how quickly others will adopt imaging. For some period of time, it will be possible to hold out and not make a decision. As long as you're in basic compliance with Check 21, you can take your time with optional capabilities like image exchange.

If you're a community bank positioned as a small, local provider that knows its customers, you might try to assure your customers that there is no impact from Check 21, that they'll get their original checks back.

Riehl: That's a fallacy. I've heard a lot of banks say they'll guarantee customers they'll get their original checks back. But you can't do that. The collecting bank always has the option of sending an IRD rather than the original check. That's completely under the control of the collecting bank.

Calman: And those IRDs are not going to be in color and they're not going to fit into a shoebox like paper checks.

Banking Strategies: So the bottom line is, the consumer will be impacted, one way or another?

Calman: Yes. That's why consumer education was made part of the Check 21 legislation. Whether through their own paid items or through returned deposit items, every customer stands the chance of seeing an IRD.

Reinersmann: Consumers who receive checks in their monthly statements will begin to see IRDs and will undoubtedly ask questions of branch and/or call center personnel. It's extremely important for banks to provide Check 21 education internally to their employees and prepare them for customer questions.

Banking Strategies: Do all of you feel your institutions are on top of that disclosure issue?

Calman: It's fair to say we're all planning for consumer education.

Riehl: We've started the work with our lawyers about the minimum compliant language and we're waiting for the Fed to give us more guidance. We've spent a lot of time working with all the lines of business to tailor the message to different customer segments.

Banking Strategies: Are you also working with your product specialists and marketing people on new products?

Anderson: It's necessary for all the banks to work very closely with the product folks because they dictate our future. If we're not able to influence their thinking and break down silos that may exist, we'll never reach the end game. Getting the buy-in from the client is the only way to be successful in taking advantage of the opportunities provided through Check 21 and image exchange.

It all boils down to providing the products and services that the client wants, and that may not be easy in this environment.

Reinersmann: Whenever regulatory or technology changes are occurring in the industry, it's important for both operations and product/marketing people to work hand in hand to develop the best product set for our customers. Check 21 and image are just the latest examples of that partnership.

Calman: At Bank of America, we try to put customer feedback into the requirements, and then translate the requirements into solutions.

The early work on Check 21 was sponsored by the operations and technology division because of the cost advantage it brings. But very quickly, we brought the operations and products people together to create platforms that satisfy customer needs.

Anderson: You also need to develop products that can be operationally supported. You don't want to design changes that work against the efficiencies you're trying to achieve. Conversely, we can't change the way we process checks if the changes work against the needs of our clients.

The good news is that with all the changes in the payments environment, there seems to be an evolution occurring where you have more business lines crossing boundaries and working together on payments-related issues.

Calman: I think we'll see long lasting benefits as a result of the cooperation that's been occurring. Our engineers are thinking more like customers, and our product leaders are thinking more about the operational and technological implications of their strategies.

Banking Strategies: All of you have been working on Check 21 for a long time. What were the major surprises for you? What did you not expect?

Anderson: For us, the surprise has been the amount of misinformation that exists. It's a challenge enough to educate your clients and your employees about Check 21 without having to deal with the fact that people have been misinformed. It's added another degree of complexity and uncertainty to this rapidly changing environment.

Riehl: The initial consumer resistance to Check 21 surprised me as well.

Anderson: Don't you think it's because they don't really understand it?

Riehl: I think that's part of it. But there are also consumer activists out there encouraging consumers to resist this. Consumers then resist without thinking about how this ultimately makes the banks more efficient, which in turn helps consumers.

Reinersmann: The misinformation only makes it all that much more important for banks to proactively educate their customers on Check 21.

Calman: It has dawned on me that we have an industry of vendors, internal technologists, organizations and process groups that have evolved around continuous improvement. The skill set that's required to drive continuous improvement is quite different from the skill set that's needed to design and build a new infrastructure from scratch.

So adjusting the mindsets of all the people involved in this has been a lot more difficult than I expected. Compared to the evolutionary transition we're accustomed to, this is discontinuous change.

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2004 by Banking Strategies, published by BAI.

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