Transition Quandary
By Kenneth Cline
Managing the transition between paper and electronic payments processing will require discipline and vision, according to Wells Fargo's Mitch Christensen.
The widespread electronification of the paper check promises huge payoffs to financial institutions — someday. But for executives such as Mitchell A. Christensen, the more immediate question is how to manage transition expenses.
As executive vice president for payment strategies at Wells Fargo & Co., Christensen is preparing the company to capitalize on opportunities presented by the landmark legislation signed by President Bush last October.
The decisions he and his team make today will help determine whether the San Francisco-based company remains a major force in payments when that industry emerges into its mostly electronic future. Wells Fargo currently processes one out of every 10 paper checks in the United States.
Getting to that future will be a challenge. Christensen believes the process of adapting to the requirements of Check 21 and then transitioning to a more electronic payments system will pose a financial drag on financial institutions over the next three years. "We're caught 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.
Once that trial is past, however, Christensen believes imaging technology will help lower processing costs and foster new products. He predicts this combination will eventually transform payments electronification into a financial gain for the industry.
That hopeful scenario depends on one crucial unknown: will banks of all sizes cooperate sufficiently to move the industry expeditiously and efficiently toward an electronic environment? "A payment, by its very nature, creates an exchange of value between two partners," Christensen says. "If one partner isn't image-capable, you're stuck dealing with the paper."
Christensen, like everyone else, is waiting to see how long the industry must straddle that fence.
Banking Strategies: Everyone agrees Check 21 will bring important changes to the payments business, but will those changes be revolutionary or evolutionary?
Christensen: I see it as more of an evolutionary process. While there will indeed be some sweeping effects, those will take several years to come about. Check 21 provides, for the first time, an environment where we are not required — and in many cases will be unable — to return the original paper check to our customer. While there are transition steps that still involve paper, such as the image replacement document, the ultimate intent is to migrate payment transactions to a more electronic environment.
Banking Strategies: How far away is a mostly electronic environment?
Christensen: About 42 billion checks are written each year in the U.S. According to the best estimates, transaction volume is declining at a rate of between 4% and 5% a year. You could make the case that even under the most optimistic scenario, where the major banks move quickly to electronic imaging, we'll still be dealing with half of those 42 billion checks in 2010.
I don't see a lot of impact this year, although there will be some pilot projects involving image exchange and also the creation of IRDs. While there will be more extensive imaging in 2005, most of the estimates we're looking at indicate there won't be a significant impact on check volume until 2006 or 2007.
Banking Strategies: What's the impact on individual financial institutions? How do you bridge the gap between enduring the decline in profitability of the traditional check processing operation and achieving the cost savings promised by electronification?
Christensen: We're caught 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. Like most large banks, we're reducing the capacity in our check processing environment to accommodate that decline in volume. Across the industry, major check processing banks are making key decisions to form partnerships or joint ventures, or just cut costs.
At Wells Fargo, I think sometime this year we will bottom out in our ability to maintain a flat unit cost, or processing expense per check. After that, we'll start to see per-check processing costs increase, but hopefully at a moderate pace.
So far, we've been able to control expenses largely by eliminating variable costs. But once we've done all that we can in that area, we'll still be saddled with a lot of fixed costs in an environment of declining transaction volume. No matter how hard we work, we're going to end up with rising per-check processing costs in 2005 or 2006.
The benefits of electronification come from two areas. One is from cutting the expense of moving paper. The other is from creating new products and services. Imaging helps us, for example, to accelerate transaction research, thereby providing better information to our customers. On both the corporate and retail sides, we have the ability to create new products, such as allowing business customers to image checks in their own shops. This provides faster clearing and settlement as well as lower costs for the customer.
So there's a revenue opportunity in the business case for electronification, along with the expense reduction opportunity.
Banking Strategies: Balancing transition expenses with potential cost-saves, then, will the move toward electronification be a net negative or net positive for financial institutions in the near term?
Christensen: In the near term, meaning the next three years, I believe it will be a net negative. Most of the investment in imaging technology must occur earlier in the transition, sooner than paper-related processing expenses can be reduced.
Illustrating the challenge, the whole transportation environment is quite fragile. If we aren't careful, we will sustain significant per-unit cost increases as volume declines, or even worse, some shortages of service as couriers adjust. We have to be careful how we ramp that down. Frankly, I think you're going to see higher per-check costs in the next three years in that ramping-down process.
It's like retooling a manufacturing facility. If BMW, say, wants to produce a new model, it has to retool its entire production line. It has to spend a lot of money before that first car gets built. It's not like you can recover all your costs as you go along.
After three years or so, we'll start to see a turn, once a higher percentage of checks are imaged and then processed in an electronic format. At that point, we'll have managed down our traditional capacity, both in transportation and check processing, to where we want it to be for the longer term, meaning three to seven years, and we'll start to see many of the financial benefits.
Also, many of the new products will be online by then, generating significant revenue. So in that three-to-seven year timeline, you'll see electronification become a net positive.
Banking Strategies: Looking at investment in imaging technology per se, how do you decide how far and how fast to go?
Christensen: At Wells Fargo, we're managing this process as carefully and as efficiently as we possibly can, knowing that much of the opportunity in imaging is contingent upon the level of cooperation among all financial institutions and the Federal Reserve. We're continually reviewing how much investment to make and the expected payback. It's really a year-to-year process.
It doesn't do much good for one or two banks to get to that electronic environment too early if the rest of the banks don't come along. 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. Again, that's why I see this as an evolutionary process. Several large check processing players, including the Federal Reserve, must come along this path together to make it work effectively.
At Wells Fargo, we see opportunities to capture images in several places, for example, at our teller lines and automated teller machines, and perhaps down the road, at the offices of corporate customers. This is in addition to the imaging done in our processing centers. And where we can, we plan to acquire images from other organizations that have already imaged the paper check and are looking to draw it on Wells Fargo.
So we're looking at a multi-phase approach. And we want to capture the image as close to the payment transaction as we can, which could be at the point of sale, the teller line or elsewhere.
Consider the fact that the average check today is handled at least seven times before it ends up truncated or in a customer's statement. That means the check passes through at least seven image capture devices. In a full-fledged imaging environment, that check is going to run through just one image capture device. This is one of the efficiencies the industry will be able to reap when institutions can exchange images rather than paper.
While Check 21 is a great first step, it doesn't reduce as many of those passes through the reader/sorter as we would like because of image replacement documents. If you create an IRD from a check, the next bank that pays that check is going to have to run the IRD through its sorter.
Banking Strategies: How does Wells Fargo intend to handle IRDs? Some banks have expressed wariness over their cost and quality.
Christensen: We're in the midst of developing that policy as we speak. Obviously, at the end of October, when Check 21 takes effect, we'll be prepared to accept IRDs, sort them, and provide them to the customers that still want them in their statements. So we'll be prepared to be receivers of IRDs.
The real question is whether or when we will become a creator of IRDs. In other words, do we want to create substitute documents and put them in customer statements as opposed to the original checks? Additionally, do we want to create IRDs to clear and settle our outbound transit checks, i.e., those we clear on other organizations? These are the issues we're considering right now.
There doesn't appear to be a great financial incentive to move to the IRD scenario; the real goal is to move beyond that. That's why Check 21 is kind of a half step. We're still trying to figure out our level of involvement with IRDs.
Banking Strategies: Are there other major technical or operational problems involved in this move toward imaging?
Christensen: Probably the biggest challenge, from a technology standpoint, has to do with the quality of the IRDs and the images themselves. Associated with that are liability issues. We don't yet have minimum standards for the acceptance of images. Those hurdles have yet to be overcome.
For some period of time, the bank that receives an IRD or an image is probably going to have to perform a quality check to see if it's minimally acceptable. We ultimately want that responsibility to be on the collecting bank's shoulders, along with the liability. But we don't yet have the technology to do that on a high-speed capture basis.
Banking Strategies: Isn't there also a problem with second-day exception processing?
Christensen: The issue is not so much a problem with quality, as with the IRD, but with the cumbersome conversion process. Institutions will have to re-tool the second-day operations process, which involves overdrafts, returns and other exceptions, so that people aren't dealing with pieces of paper, like today, but rather work with images on a screen.
Getting there will involve some heavy lifting, and that's where many banks are struggling with their business cases. They won't get the full benefits of imaging so long as paper remains present in the second-day process. Many of the smaller institutions, I think, will outsource this imaging environment. They'll find processors such as Metavante Corp., Electronic Data Systems Corp., Fiserv Inc. and the Fed, who will see an opportunity to pick up more business from the institutions that don't want to make this kind of investment in imaging technology.
Many banks will likely turn to outsourcing on other fronts, such as image exchange and the creation of IRDs, in addition to image capture. While all banks need to be able to receive IRDs, only the large collecting banks are likely to get into the IRD-creating business.
Banking Strategies: Some large banks have decided to handle image exchange on a collective basis, with Viewpointe Archive Services LLC, for example. Why has Wells Fargo decided to conduct image archiving in-house?
Christensen: Mostly control. We wanted to control our own destiny, in terms of how the images are used and how we create products from those images. A group environment can slow you down sometimes. We believe we can move more quickly on our own.
Down the road, you never know. At some point, if the collective exchange becomes tremendously efficient and the product opportunities don't develop, we may re-think the concept of operating our own image archive.
Mr. Cline is senior editor of Banking Strategies.