Dawn of the Substitute Check
By Clint Swift
Questions abound as banks prepare to send, receive by October 28.
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Having been an industry preoccupation since the enabling legislation was passed last October, substitute checks — or Image Replacement Documents (IRDs) as they are called in industry standards — continue to be the subject of considerable debate. How many financial institutions will create substitute checks? In what volumes? At what cost? How will they be handled in the transaction processing stream?
Requirements and Opportunities
The Check 21 law does not require any bank to truncate originals or create substitute checks. But it covers all U.S. checks and requires:
- Each bank to be able to accept and process a substitute check;
- Each bank to educate customers about the Act and their rights to recredit under it;
- Each bank that creates substitute checks (thereby becoming what's called a "reconverting" bank) to provide warranties and indemnification.
The IRD opportunity in forward collection is to move checks as images, convert them back to negotiable paper substitutes when needed and clear them more quickly, gaining float savings and reducing risk. Bankers and technology suppliers generally agree that the return on investment in returns processing is even greater.
The IRD may function as an "effective transition tool," says Robert Hunt, an analyst with Needham, Mass.-based TowerGroup Inc. According to Hunt, banks that already have invested in electronic presentment technology believe that Check 21 may encourage other banks to slow their migration to all-electronic processing. "If IRD volume represents only a small portion of total check volume," IRDs will help the transition from paper to image, Hunt allows. But he predicts that high volumes will magnify the costs and processing problems associated with IRDs.
Volume estimates published in months leading up to the effective date were widely divergent. At BAI's TransPay 2004 conference in May, Steve Ledford, president of Global Concepts Inc. in Atlanta, estimated that volume would peak at about 3.3 billion in 2007 and begin to decline in 2008. TowerGroup produced a white paper that estimated IRDs would peak in 2006 at about 325 million and start tapering off the next year. Hunt argued that IRD pricing, incentives to move to full electronic check presentment (ECP), low short-term interest rates and declines in check writing would limit volumes.
Most published estimates agree that substitute checks will be around for at least the rest of the decade. If a bank wants savings in transportation and labor that Check 21 makes possible, they will still need an IRD strategy to deal with banks that are not yet image-enabled, says Jeff Johnson, a veteran of nearly two decades in operations and projects with electronic-processing pioneer Zions Bancorp in Salt Lake City, Utah, and now vice president for marketing and business development with Zion's NetDeposit subsidiary. "An IRD option will be necessary until all banks are accepting imaged cash letters," he says.
A host of problems surround truncation. Operations staffs need standards for exchanging electronic images of checks and for creating and using substitute checks. Customers need education about truncation, ECP and electronic imaging as well as resulting check products and account services. The industry needs a broader understanding of the business cases for various types and sizes of depository institutions to take part.
The stakes for reconverting banks are high. The Act requires them to warrant that their IRDs meet the requirements that make them the legal equivalent of an original check and that an account will not be debited twice because of the substitute check. Reconverting banks also are required to indemnify a party that sustains a loss because a substitute check was presented instead of an original.
Business Cases
Although substitute checks gain their new legal equivalence at the end of October, they are not unknown. The Fed created the first production IRDs in its Montana Project in 1999 using software from ImageSoft, a Fiserv Inc. subsidiary. NetDeposit employed them under agreements in some of the earliest bank-to-bank tests and says its software has produced more than 750,000 IRDs that have been accepted and processed by more than 3,700 financial institutions, including the nation's 20 largest banks.
Based on this experience, "We think that if you decide not to produce IRDs, you're going to be passing up opportunities to reduce costs and generate revenue," Johnson told a BAI Webinar in August.
Banks will incur costs in accepting IRDs (testing, customer awareness, new recredit pressures, and training) and sending them (printing and managing, warranties and indemnities). But Johnson said banks should leverage existing check-processing systems wherever they can to reduce IRD production costs.
They also should look for revenue opportunities, Johnson said. NetDeposit customers using remote capture at 25 sites have found savings in transportation, equipment and labor. They also have found they could sell a cash management product, offer better fraud detection to merchants, extend retail-banking hours and improve operations, according to Johnson.
Brookfield, Wisc.-based Fiserv, which has 1,700 outsourced check-processing clients and 2,400 for which it handles processing at the customer's site, is less sanguine about remote capture. Ted Umhoefer, a senior vice president for product management and industry relations, said Fiserv has done nearly 100 studies. Nine times out of 10, the savings don't offset the cost of moving to branch capture, says Umhoefer, whose 26-year Fed career included serving as executive sponsor of the Montana Project.
"The cost to create substitute checks is going to vary, depending on volumes and the operations windows that you have to do it in," Umhoefer said in the Webinar. "But our studies indicate the cost is going to be somewhere between 5 and 10 cents per item. So, it isn't going to be cheap." The Fed prices processing of conventional checks in a range of 3 cents to 9 cents.
When banks have the option to eliminate physical transportation entirely after October 28, the business case is likely to succeed more frequently, about 30% of the time, Umhoefer said. He said bankers need to scrutinize each case individually, asking:
- Can we save on transportation?
- Can we push back the cutoff hour?
- Can we improve services to clients?
- Can we add new services?
At community banks, fewer than 1% of items generate enough savings and availability improvements to justify conversion to substitute checks, Umhoefer said. This is largely a factor of the average dollar value of the items, how many items will be available the next day anyway, and interest rates on collected funds. At larger banks that deal with more commercial items involving larger dollar values, the proportion of items that could justify treatment as substitute checks creeps up a couple of percentage points.
The return items scenario is even clearer. If a bank's paid items are in an image archive, it's going to make sense to use the archive every time the bank needs to generate a return, Umhoefer said. It's less expensive to inquire into the image archive, extract the item and create a substitute check return item than to execute a physical exception-item re-pass, affix a strip to the bottom of the item and place it into a qualified return cash letter. The bank could earn additional benefits by eliminating non-local fees and the wait on non-local availability schedules.
The process also can improve risk management. "If returns are coming back, the entity that those returns are coming to doesn't much care if they're going to hit the account sooner," Umhoefer said. "They want to know that it's a bad item so they can protect themselves. They will be doing whatever they can to make it easy to accommodate an electronic or IRD return."
Substitute checks also offer opportunities in other areas. An institution that processes checks 95% electronically might have some customers that need physical items. It could move items electronically from one branch to another, then print substitute checks for those clients. The bank also could print substitute checks where it still needs the physical item in internal operations, for example, eliminating the need to image-enable Day 2 operations immediately.
"Check 21 really is a stepping stone in the movement toward image exchange and processing," Umhoefer said. The question to ask, he said, is "Where can substitute checks help in the transition?"
Clint Swift is a freelance writer and researcher who has devoted most of the last year to BAI's Check 21 initiative.