Don't Count Out the Check

By Clint Swift

ECCHO's David Walker, a leader in check electronification, argues that the banking industry should use imaging technology to capitalize on the strengths of the paper check and extend its life as a bank-centric payment system.

Conventional wisdom holds that the paper check is rapidly becoming passé. Yet David Walker, president and CEO of the Electronic Check Clearing House Organization (ECCHO), seeks to turn that kind of thinking on its head.

Consider the possibility, Walker says, that the trend toward electronic transactions may help prolong the life of the check by making it more efficient. "With technology and the elimination of legal barriers, we can separate the physical paper check from the legal instrument that is the check and greatly expand the capabilities of the check as a payment method."

Walker notes that checks can be processed more quickly than Automated Clearing House (ACH) debits with the use of electronic check presentment (ECP) or imaging technology and that no other payments method carries as much data. As opposed to representing the potential to render the check obsolete, Walker says, ECP and imaging can "make the check system more efficient."

Walker is widely credited as having played a leading role in formulating and communicating banking's perspective on Check 21 while the legislation was being formed in conference rooms on Capitol Hill. He was one of only four individuals, outside White House staff and the congressional delegation, invited to be in the Oval Office when the bill was signed.

Walker's views on the check might be expected, given the origins of his organization. ECCHO was formed in 1990 to encourage ECP and now seeks to foster image exchange. The Dallas-based, not-for-profit, national clearinghouse grew out of a check electronification project at nearby Carreker Corp., and Carreker President and CEO J.D. Denny Carreker was ECCHO's first executive director.

Today, ECCHO is involved in three primary activities: rules development, education about ECP and industry advocacy, especially at the federal level. But it is rules that explain ECCHO's day-to-day impact in an industry slowly but surely transforming check processing to rely on exchange of digital images. Ample legislation and case law govern the exchange of paper checks, but no law addresses image exchange. That leaves financial institutions that exchange check images exposed to an unknown and potentially large financial risk. ECCHO's rules provide a multilateral legal framework for check exchange among its members and other organizations that license them.

ECCHO is owned by 19 member banks, ranging from trillion-dollar J.P. Morgan Chase & Co., New York, to $10 billion Frost National Bank, San Antonio. More than 40 organizations, including clearing houses, regional ACH associations, consulting companies, technology companies and banking trade associations, recognize ECCHO as the provider of ECP and image exchange rules in the U.S.

Walker provided his views on the future of the check during a recent interview with Banking Strategies.

Banking Strategies: What major hurdles will you try to help the financial industry overcome as it steps up its participation in check image exchange?

Walker: One of the challenges is educating the industry that banks engaging in image exchanges need new legal protections. The ones used in traditional paper check exchanges will not suffice.

For example, for image exchanges, there is no law to allocate liability among the parties. While this risk is potentially very large, it can be minimized through exchange agreements. Under the Uniform Commercial Code, the best option for agreements is clearing house rules. ECCHO is the only national clearing house with an existing, comprehensive set of image exchange rules.

A second challenge is promoting the check as a long-term, viable payment system as the result of recent changes in law and economics. We're going to spend a lot of time educating everyone as to why the check is important, why it isn't dead, and why banks may not want it to die.

A third is promoting the development of new products and services that are check-based and that use technology for the benefit of the customer. Given that everyone has thought of the check so narrowly for so long and that the evolution of the check has been constrained by law, there is much creative work to be done. That work has already begun, as evidenced by banks beginning to discuss their customers' capture of check images and subsequent electronic deposit of those images.

Banking Strategies: In your list of challenges, you put risk first. Please elaborate on the importance of that challenge.

Walker: Without legal coverage, the risk of exchanging check images is indeterminately large. Compare that with the paper check, which is a payment method that constitutes a legal instrument as defined by law.

In your mind, picture a stack of all the paper documents that comprise paper-check law. Start with the Uniform Commercial Code (UCC) from all 50 states. Then add Reg CC and Reg J, for when checks go through the Fed, and Reg E. On top of that stack, add all documents from the thousands of litigations that have occurred over centuries. In the check world, at least one case from 17th Century England is frequently cited in the assignment of responsibility for check authorization. That stack of legal documents would extend well above your head.

Now, beside that stack, pile all the statutory, regulatory and case law documents that support, validate or authorize the exchange of check images. There is no paper in that stack. Nothing in the law currently tells you how to allocate risk, liabilities and responsibilities when you exchange check images.

In traditional paper check law, banks — usually the paying banks — take on the risk of consequential damages. The assignment of the risk of consequential damages in the paper check world is well established. A common example of the risk of consequential damages is when a relatively small check for an insurance premium is not correctly paid and the insurance coverage lapses. The insured event then occurs and the bank becomes responsible for the value of insured property and other expenses in an amount far greater than that of the check.

Without judicial guidance, it is unknown on what basis courts might resolve disputes regarding check image exchanges. They could decide to assign consequential damages in different scenarios and to different parties than traditionally occur in the paper-check world, thus increasing the risk and the cost of loss-avoidance litigation.

This is where agreements come in. ECCHO rules are agreements between exchanging banks and, as such, provide direction for judges as to how to resolve disputes. ECCHO's rules are intended to support every vendor's image exchange scenarios. The objective is to maximize the number of banks exchanging check images. ECCHO works with Viewpointe, Fiserv, The Clearing House (SVPCO), Metavante and many other vendors so banks are free to select any vendor that best fits their situation under a common set of rules.

Banking Strategies: Last December, Leonard Heckwolf, retiring as chairman of NACHA, the Electronic Payments Association, was quoted as saying that accounts receivables conversion (ARC) is just an interim strategy and that "the endgame is to persuade consumers and corporations to issue electronic payments instead of writing checks." Does that make the paper check just an interim strategy, too?

Walker: The endgame will be dictated by the customers and by economics. If customers want to write checks, then the banking system should implement products and services that support that choice in ways that fit the banks' overall strategies. As we update our way of thinking about checks, checks may very well continue to play a significant part in those strategies.

For too long, we have thought of checks as pieces of paper. With technology and the elimination of legal barriers, we can separate the physical paper check from the legal instrument that is the check and greatly expand the capabilities of the check as a payment method.

The check has served us well; now we have the opportunity to eliminate those aspects that serve us less well. When transitioning the instrument, the economics are changed radically with reduced labor costs and better use of technology and stronger ties to customers. Strategies such as ARC tend to reduce customer ties with the bank and strengthen ties with non-banks. I say let's transition the medium, not the instrument.

Banking Strategies: What's the distinction you're making between the medium and the instrument?

Walker: We've been stuck way too long with the traditional thought that "check" means a piece of paper; that check products and services are limited by what can be done with that paper; that there's so much cost associated with paper that our only choice is to get rid of it; and that getting rid of the paper means getting rid of checks. Of course, that line of thinking has been supported by physical and legal barriers that prevented the check from evolving with changing needs.

Until December 1999, the attorneys tell me, it was illegal to return an unpaid check electronically, even under agreements. Also, there were concerns among banks that they couldn't be the only bank truncating checks or they would lose customers to their competitors across the street who would promise to return paid checks to their customers. But Check 21 eliminates that psychological barrier and allows banks to make a unilateral decision to truncate checks, replacing them where needed with substitute checks. No one wants a large volume of (relatively expensive) substitute checks. So if you have the image technology in place to capture the information to create substitute checks, why not create a better payment system by getting everybody on accelerated implementation schedules to exchange check images?

Banking Strategies: What else has happened to change the potential of the check?

Walker: There have been several changes in the law, each of which eliminates an important barrier to the use of technology to improve the check. Not the least of these are the Uniform Electronic Transactions Act (UETA) and the Federal E-sign Act. These validate that electronic records, including images of checks, are just as good as the original documents.

Other important accelerators are the rising interest rates that increase the financial impact of delayed and accelerated collection and returns, the declining check volume and increasing cost per item, the increasing market demand for image deposits from bank customers, the closure of many Fed processing centers, the Fed's price increases to clear paper checks and the Fed's new products that position the Fed as a key facilitator in the transition to electronics.

The Fed actively supports image exchange. They now offer services to receive checks and replace them with substitute checks and also to receive check images and deliver them as images, when possible, and as substitute checks otherwise.

These accelerators act to significantly raise expectations that checks will be truncated and that checks will be exchanged using image technology. By changing expectations, many more banks will determine that the check is viable long-term and that their best option to control cost and enhance product revenue is to transition the medium not the instrument.

Banking Strategies: So, there's still a strategic role for checks today and at least for the short-term?

Walker: If technology were used to separate the paper from the payment instrument and eliminate or reduce significantly the cost of the hardware, people, facilities and transportation, where's the incentive to get rid of it? Particularly if it's faster than the other available alternatives and offers information richness that none of the other payment types have?

Banking Strategies: Checks are faster than electronic payments?

Walker: Yes. Let's compare check and ACH as an example. The electronic ACH system is designed to be float neutral, not float-less. As a float-neutral system, ACH transactions are future-dated to allow all of the parties an opportunity to post them on the same day. Under the ACH rules, the earliest that most ACH transactions can be posted is the next business day after origination. Checks, on the other hand, suffer no such restrictions and can be collected as fast as they can be presented.

Now consider: Many paper checks are currently cleared on the same day that they are deposited through evening exchanges around 9 p.m. Generally, if all of those same-day checks were converted to ACH transactions, they would not clear for at least one day and many would not make the application cut-off on the deposit day and so would not be originated until the second day, for clearance the third day. In this scenario, paper is much faster than electronics.

By contrast, the application of electronic check processing and image can accelerate the number of items that can be cleared the same day with exchange cut-offs beyond 9 p.m. The technology of check images can be much faster than either traditional paper check collection or other electronic check conversion options available to banks.

Banking Strategies: What is the information richness that checks have but other payment types don't?

Walker: Look at all the information components on the front and back of a check — the drawer's name and perhaps an address; the name and address of the bank on which it is drawn, the drawer's signature, handwriting samples, dollar amount, date, etc. The check may even have a note on the memo line saying why the writer wrote the check. On the back of the check are endorsements, dates and time stamps. There may also be a stamp across the face of the check with additional information about the invoice being paid or about the check writer that the depositor might need to aid its collection process should the check be returned unpaid.

Now imagine taking that same check and converting it to an ACH transaction. Think of the information that would appear on the customer's statement for that same transaction — the date; a short, often meaningless descriptor; and the amount.

There is value in information, and there is a substantial difference in the amount of information in different payment transactions. The check is the most information-intensive payment mechanism we have. To the extent we can use the information intensity of the check, banks may well be able to create valuable new or improved products and services for their customers.

How might the additional information be used? Ever look through your bank statement and notice some electronic debits with unfamiliar descriptors? One very basic need for additional information beyond the basic payment information is simply to recognize the transaction. If you don't, you might question the validity of the payment and spend a significant amount of time researching the transaction and perhaps incurring charges from your bank to research the question. If the transaction was a check image, you will immediately recognize Store ABC, your signature and any notes that you may have written on the memo line as a reminder of why you wrote the check.

Overall, this topic has barely been considered. I know retailers frequently write contact, approval information, store identification, checker ID, etc., on the face of the check. Insurance companies might write customer identification numbers; airlines write flight number information, etc. Generally, information on the check is used to manage risk and/or process. The endorsements on the back of the check facilitate resolution of disputes, charge-backs and adjustments.

Banking Strategies: Then, checks are viable long term?

Walker: Absolutely! Once checks — using check law — become more electronic, the process savings are essentially the same as for other electronic payment types, essentially eliminating the cost differences between checks and other payments. Consider: Check volume is declining and the cost per unit is climbing. What options do banks have to avoid this spiral of diminishing returns on check products and services? Can they convert every check to an ACH transaction? Not without the agreement of their customers.

Assume that banks cannot practically convert all their checks to ACH transactions: What other options are there to offset the impact of rising costs? Could they convert them all to debit card or ATM or credit card transactions? No, because, like the ACH, any truncation of the paper check requires customer agreement. Even in the best of scenarios, they will probably never get 100% customer agreement, and without 100% agreement they would have to maintain the costs of dual payments processing systems for checks and whatever other solution was implemented. An example of this is lockbox processing that transformed a single process — checks — to a multi-payments process involving ARC, checks and demand drafts and, with Check 21, perhaps substitute checks.

Is there a better option? Yes, make the check system more efficient. Use electronics to eliminate processing steps and costs and to accelerate the return of unpaid items. Implement ECP and image exchange of all checks.

Banking Strategies: How long would that take?

Walker: Payment systems tend to evolve slowly. But I believe the transition to image exchange will proceed much more rapidly than most people anticipate. The creation of substitute checks is ramping up, but no one anticipates that a very large percentage of checks will ever become substitute checks and most think that result would be undesirable.

The initial industry focus is almost exclusively on replacing large-dollar, non-consumer checks with substitute checks. As the large-dollar checks are removed from the normal collection process, the remaining number of original checks to be cleared conventionally will remain very large, but the value of those remaining original checks will be relatively small.

The cost of rapid transportation, such as next day, coast-to-coast jet delivery of checks, is covered by the float value of those checks. Reduce the number of high-dollar value checks in paper cash letters and the value will, at some point, not cover the cost of transportation. When that occurs, alternative collection methods will need to be selected. It is likely that those alternatives will involve clearing the original paper checks more slowly than the current methods and would potentially be more costly on a per-item basis.

How will banks address this rising cost per unit? Recently, two organizations made forecasts of the rate of check volume transition. They predicted 20% to 30% of the volume will be imaged by 2006 or 2007. If you assume that 80% of the dollars are from 20% of the checks and that the larger-dollar checks will be converted first, you can anticipate that once 80% of the dollars are converted, the majority of the remaining volume will follow rapidly, and I think more rapidly than either of the forecasts.

Questions or comments about this article? Post them at the Banking Strategies blog.

Mr. Swift is a freelance writer based in San Antonio, Texas.

Copyright © 2004 by Banking Strategies, published by BAI.

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