Sprint or Marathon?

By Chris Costanzo

Check 21 will require some action by all financial institutions, but the options and opportunities vary greatly depending on asset size.

Check 21, while not exactly dictating a transition, has unleashed forces that will almost certainly prompt a widespread migration from paper checks to electronic images over a period of years. But instead of an orderly passage, financial institutions likely face a bumpy ride as they sort through financial, technical and competitive issues.

For large multi-state organizations that intend to remain major payments players, the choice seems inevitable: they must move toward electronic processing, with important implications for how they configure their internal capacity.

The critical questions for them center on the pace and shape of the transition, with high-stakes financial decisions that will be influenced by individual circumstances and larger industry trends.

Small institutions, particularly community banks, face a different decision tree. For them, by and large, re-tooling their entire back-office processing operation has no appeal, since payments is not a line of business. Many will elect to do just the minimum required, while others will turn to outsource providers for help with transitions.

For institutions of all sizes, there are important questions about cooperation and participation. To overcome thorny technical issues, intermediaries of all types and sizes will have to temper their competitive instincts and work together closely. And overall, the pace of the transition from paper to electronics will be strongly influenced by the degree of participation across the industry.

It is important to keep in mind that the Check Clearing for the 21st Century Act, passed by Congress and approved by President Bush last October, doesn't force financial institutions to adopt check imaging technology. It simply removes, as of this Oct. 28, the requirement that an actual paper check be part of the transaction clearing process. Instead, banks can substitute an image replacement document, or IRD, a paper copy of the original check that other institutions in the processing chain can accept if they cannot—or prefer not to—process electronic check images.

So to the crucial issue of how much to invest in imaging technology, the law is silent. Individual institutions must make their own decisions, yet they are clearly affected by the decisions of others. As long as image-capable banks find it necessary to process paper from non image-capable institutions, the estimated $2.1 billion in annual savings the industry expects to reap from full electronification will remain elusive.

To-Do List

For the largest banks, the Check 21 to-do list has been largely winnowed down to a few major items this year: prepare for the day when they will exchange electronic files with other image-capable partners; ready the back office to deal with exceptions, adjustments, and other so-called "Day Two" procedures; and figure out how best to explain changes to both customers and employees.

As stewards of the nation's payment system, the largest institutions have already spent several years preparing for Check 21. They monitored the progress of the legislation through the Congress and installed the cameras necessary for converting paper checks into electronic images. They also figured out how and where they are going to store and access the huge numbers of images they will be collecting. Some have even begun offering new image-based products, such as access to check images via the Internet.

In a recent online survey of financial services executives conducted by BAI, 35% of the respondents from institutions with more than $5 billion of assets said they were currently in the process of implementing a Check 21 strategy, compared with only 19% of respondents from institutions under $5 billion.

Surprisingly, considering the dismal history of past cooperative efforts, large banks have accomplished much of this work by networking among themselves and through industry associations and joint ventures. Consider the Small Value Payments Co. LLC, which is emerging as a major force in the move to imaging. Eight of the 22 owner banks formed a group known as the "vanguard banks," which have set an aggressive time-table for initiating the exchange of images among themselves by mid year. KeyCorp, Cleveland, and San Francisco-based Wells Fargo & Co., for example, agreed to begin exchanging images by June; Chicago-based Bank One Corp. and J.P. Morgan Chase & Co., which recently announced plans to merge, agreed to do so by July.

Viewpointe Archive Services LLC in Charlotte, N.C. is another key player. It was formed at the end of 2000 by three initial investors, Bank of America Corp., Morgan Chase, and International Business Machines Corp. in Armonk, N.Y. Later joined by SunTrust Banks Inc. of Atlanta and U.S. Bancorp, Minneapolis, Viewpointe has created an archive with more than 35 billion check images. In January, the four owner banks agreed to begin sharing check images, even before Check 21's implementation on Oct. 28.

Viewpointe banks were the first to conduct a live pilot of image exchange, which occurred between Bank of America and Morgan Chase in late 2002. While the process of exchanging images proceeded smoothly, the banks ran into trouble when they tried to integrate the images into their Day Two procedures for adjustments and exceptions.

These procedures rely heavily on paper, with little standardization between banks. With their back offices unable to accept images instead of paper, the two banking companies found that the benefits of electronic exchange quickly dwindled.

Now, nearly every big bank is focused on the twin objectives of exchanging images and doing so in a Day Two environment that is fully electronic. Morgan Chase, for example, began reworking its Day Two operations in 2003 and expects to have it completely image enabled by the end of the first quarter of 2004, according to Tom McGuire, a senior vice president and the enterprise operations services executive.

SVPCo and Viewpointe, meanwhile, are working to ensure the compatibility of their image systems. That's important to the industry, because currently, electronic exchanges between SVPCo banks and Viewpointe banks do not work the same way.

SVPCo banks, for example, plan to exchange images much the same way they exchange paper today, by sending full electronic files from one bank to another. In this scenario, each bank must have its own image storage archive.

Viewpointe banks, on the other hand, will not actually exchange images. Rather, they will send them to the same central archive where the images can be accessed as needed, say to respond to a customer request.

To coordinate those two systems, SVPCo plans to provide a network switch that will let Viewpointe customers exchange images with SVPCo banks or others that use archives other than Viewpointe's.

Outsourcing Options

While the imaging of Day Two processing is a concern for large banks, that's not the case with smaller institutions.

Consider Glenview State Bank in Illinois, which has $850 million of assets. Ron Gafron, a senior vice president and the chief technology officer, says the bank handles so few adjustments, rejects, and other exception items that manual processing remains a viable option. "We may eventually invest in Day Two imaging, but there is no current commitment to do so," Gafron says.

In other respects, however, small banks face a much steeper climb than their larger brethren when it comes to the electronification of payments.

In a yearend 2003 survey of almost 500 banks — nearly 75% of them with $4 billion or less in deposits — ESP Consulting Inc. found that 42% had not yet begun preparing their operations for the ramifications of Check 21. Forty-four percent said they had only gotten as far as evaluating information, leaving a scant 4% saying they were operational with new systems or planned to be soon, according to the Salisbury, Md.-based consulting company.

The biggest concern of small banks right now centers on internal operations. Many are grappling with the question of whether to upgrade their existing systems to imaging or hand off the entire back office to an outsourcer. The same options — build or outsource — appear in the debate over whether to build an archive for storing all those images, issues that big banks, for the most part, resolved a year or more ago.

Community First Bankshares in Fargo, N.D. is one institution that opted for outsourcing. Beginning this year, the $6 billion-asset bank began outsourcing its check-image processing to Milwaukee-based Fiserv Inc., which makes all the bank's checks available from one archive. "From the standpoint of cost-efficiency and an ability to move quickly, a single archive was the best solution," says Polly Thorsness, senior vice president of operations at Community First.

Community First had additional motivations to choose the outsourcing option. For example, Fiserv can handle all the research and development tasks for Check 21 that otherwise would have fallen to the bank. Community First is further alleviated of concerns with the intricacies of formats for exchanging images under Check 21, or image-quality issues, or changes in the law that would impact operations. "As soon as Fiserv has image exchange available, we'll be on board," Thorsness says.

Obviously, industry leaders that invested heavily in imaging would like to see its benefits accrue rapidly, and they are hoping that more small banks will work with similar "gateways" that aggregate images on their behalf.

Morgan Chase, for example, envisions establishing direct image-exchange links with a few other large banks, as well as with a handful of organizations that represent many smaller banks, according to McGuire. "Instead of establishing one-to-one links with thousands of other banks, we'll look to aggregators who can assist us," he says. Such aggregators would include the Federal Reserve and Fiserv, both of which supply imaging and archiving services to thousands of small banks.

Even small banks that have been processing images in-house for years appear willing to work with larger entities on image exchange. Glenview State, which has been imaging since 1994, is now working with Oklahoma City-based CheckClear LLC, which offers the Endpoint Exchange network to facilitate image trading with its partner banks. And since the vast majority of Glenview State's volume does not go through Endpoint, Glenview is also talking with the Federal Reserve about image-exchange opportunities.

Gafron points out that Check 21 does not abolish the requirement for a bank to have a formal agreement with every one of its image-trading partners. With an aggregator, by contrast, a bank need only sign one agreement, he says.

Common Goals

There is one Check 21-related issue on which large banks and small banks face a common challenge. That is the need to communicate to customers and employees the changes they should expect when the law takes effect in October. Given that the changes affect nearly every employee as well as every corporate and retail customer, financial institutions will need to tread carefully. "You don't want to get between people and their money," says Steve Hill, the director of business development for Carreker Corp.'s global payments consulting division.

Community First, for example, plans to launch its education campaign in mid-March, according to Thorsness, placing its biggest emphasis on training branch personnel to answer customer questions. Under Check 21, banks are no longer obligated to return original paper checks, so customers may end up with IRDs in their statements, which could cause confusion. "Branch personnel will be pivotal because they have to deal with clients and explain why they're not getting the original check back," Thorsness says.

Glenview State Bank plans to focus much of its education campaign on its 300 to 400 customers (about 3% of its total) who continue to receive their original checks. "We're going to do as much as we can to convince customers that imaging is the way to go," Gafron says. For example, the bank will emphasize that images of past checks can be immediately called up on the bank's Web site, offering significant time savings over traditional research methods.

Morgan Chase faces similar customer issues, albeit obviously on a much larger scale. In addition to training its customer-facing staff, the New York-based bank is contemplating the creation of new types of image statements. According to McGuire, the bank realizes that one way to get more customers to embrace imaging is to offer more types of image statements, for example, ones that show the front and back of checks, or that show fewer than the typical 12 to 18 checks on a statement page, thereby permitting images to be displayed in a larger and more readable size.

If suitable statement options are not available, more customers may choose to continue receiving paper copies of their checks back, he adds. This would likely entail a higher volume of IRDs, which most banks consider an expensive burden. "The economics of doing image statements is much better than for IRDs," McGuire says.

Mutual Benefits

It's conventional wisdom in the industry that the largest institutions, i.e., those with sufficient check processing volume to make the investments in imaging technology worthwhile, will reap most of the benefits of imaging. In the BAI online survey, 84% of the respondents from large banks (assets over $5 billion) expressed confidence that Check 21 would inspire new product development, compared with 68% of the respondents from small institutions.

Detroit-based Comerica, for example, is contemplating offering its check imaging services to smaller banks on an outsourcing basis. "We're very intrigued with that," says Paul Obermeyer, a senior vice president and manager of operation services. He adds that check image outsourcing represents a $600 million to $800 million opportunity in the U.S. "Banks with Comerica's capabilities certainly should be looking at this as a potential revenue stream."

Small banks, however, can also reap some opportunity from imaging. Glenview State Bank, for example, plans to explore the expansion of its lockbox processing business, which it currently conducts on a small scale. "We would like to grow it, but we don't want to handle a ton of paper everyday," Gafron says, noting that Check 21 gives the bank the option of setting up electronic lockboxes rather than traditional paper ones.

Community First, meanwhile, sees cost benefits and a potential small revenue stream from making images available on its Web site. According to Thorsness, the bank envisions offering the basic Web look-up service for free, and perhaps charging extra for more complicated requests.

Elsewhere, as a small bank run almost entirely on the Internet, Atlanta-based NetBank Inc. has an aggressive long-range plan for taking advantage of Check 21. The bank currently receives checks by mail, via automated teller machine deposits and from merchants, and it outsources all of this paper-based check processing.

With the help of Check 21, it plans to generate a larger stream of electronic checks coming into the bank. It will do this, for example, by deploying ATMs that can digitize deposited checks, and by encouraging merchants to digitize checks at the point of sale.

Over time, NetBank will clear these electronic checks internally while winding down its reliance on outsourcing. It expects to save several hundred thousand dollars a year by clearing electronic checks internally versus outsourcing paper processing, says Mickey Ross, the chief strategic initiatives executive. "The closer you put the imaging technology to where the check is presented, the cheaper it is" to process, he says.

From an industry-wide perspective, new product opportunities may offer a way to defend against non-bank invaders into the payments business. Today, for example, merchants rely on companies such as the TeleCheck subsidiary of Denver, Colo.-based First Data Corp. to authorize check payments made at the checkout line. With faster clearing afforded through imaging, banks would be able to provide such guarantees themselves. "Who better to provide that information than the bank where the check was drawn?" asks Comerica's Obermeyer.

With big banks as the leaders, standard setters, and even providers of check imaging, and with small banks as the willing followers, it appears that the vast electronic network that will be necessary to finally get to a "check-less society" is at last falling into place. How speedily that day arrives depends on continued cooperation of banks of all sizes. "No bank is going to get very far down the road by clearing checks with itself," says C. Grant Cole, a senior vice president at Bank of America.

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

Copyright © 2004 by Banking Strategies, published by BAI.

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