Payment's Mass Conversion

By Karen Epper Hoffman

Accounts receivable conversion has become the fastest growing payment type in automated clearing house history. But as Check 21 ushers in the age of image exchange, how long will ARC serve a purpose? And how can banks best manage the move ahead?

One wouldn't ordinarily associate the phrase "accounts receivable conversion" with "hot" or "trendy." But since its introduction three years ago, the check digitization technique better known by its acronym "ARC" has taken the payments business by storm, in the process becoming the most commonly used electronic check format.

ARC is a process by which paper checks are converted into automated clearing house (ACH) debits at lockboxes that banks operate for their corporate clients. Some of the country's biggest banks, which are major players in the lockbox business, have embraced ARC, driving the number of ARC-formatted payments to an estimated 1.25 billion in 2004, according to NACHA, the Herndon, Va.-based organization that develops operating rules and business practices for the ACH Network and for electronic payments. That represents a 468% increase over 2003's volume of 220 million ARC payments, which itself represented an eight-fold increase over 2002's numbers.

The big question facing ARC now is whether that turbo-charged growth can continue. On the positive side, demand is likely to remain high as banks such as J.P. Morgan Chase & Co., Mellon Financial Corp., and Wells Fargo & Co. continue to push their check conversion offerings to corporate clients that want to enjoy some of the benefits of cheaper, more rapid electronic transactions, without having to wait for the long-trumpeted advent of check image exchange.

Yet even ARC's most ardent supporters admit that it's more or less an interim technology, which will eventually be overtaken by check image exchange. The real question for most banks is how soon that change will take place, and how drastically the payments business will be re-shaped in the meantime.

In the short term, bank cash management departments must offset the revenues they had been enjoying from traditional check processing and float. Check clearing revenues fell 9% in 2003, according to Ernst & Young's 21st Annual Cash Management Survey published last year. ACH debits are growing at the same time, but the associated fees don't necessarily match what banks are losing on the check processing side. This revenue squeeze has sent financial institutions searching for cost efficiencies and innovative new income streams, including white-labeling ARC services for other banks (see sidebar).

ARC Advantages

When compared with traditional paper check processing, ARC does offer some clear cost advantages to banks, since it eliminates the need to transport paper and provides opportunities for back office staff reduction. "The concept of converting a check to ACH is an attractive one since it is relatively easy to implement and relatively cheap," says Richard Oliver, senior vice president of the Federal Reserve Bank of Atlanta and retail payments product manager for the Federal Reserve System, which handles about two-thirds of the country's 10 billion annual ACH payments.

ARC is also no more error-prone than traditional check processing. According to Daniel Miner, senior director of electronic check for NACHA, the rate of returned ARC payments dropped from 2.34% in the third quarter of 2002 to just over half of one percent (0.54%) in the third quarter of 2004. That's on par with paper checks, which are returned at a rate of about 0.5% according to the Federal Reserve's most recent payments study.

Because NACHA rules demand that ACH debits must come back within two days of the original transaction - as opposed to the 10 to 14 days it may take to return a paper check - banks can also more quickly limit their exposure to fraud and better control their credit risk.

Stephen Winston, treasury operations manager for McLean, Va.-based Capital One Financial Corp., whose ARC volume doubled in 2003, says that his bank has saved "millions of dollars" in processing costs with ARC. In addition, faster settlement has provided the bank a more predictable sense of its cash flow, he says.

Proponents argue that ARC offers clear regulatory benefits as well. Traditional checks are governed under the Uniform Commercial Code, and the Federal Reserve's Regulation CC, while checks converted to ACH payments are covered by NACHA's operating rules and the Fed's Regulation E. Reg E provides stronger protection for both consumers and receiving banks against unauthorized or erroneous payments. For example, Reg E provides a 10-day right of re-credit - a set period during which consumers can demand disputed funds be returned. The UCC, by contrast, offers no clear time frame for such disputes, forcing banks to tackle the subjective issues of promptness and consumers to sue for the return of funds.

In spite of the fact that consumers can choose not to have their checks converted, NACHA's Miner and John Lucas, product line manager for Mellon Global Cash Management's electronic services, both say that less than one half of one percent of consumers have opted out. Jose Becquer, executive vice president for treasury management sales and marketing at Wells Fargo, credits the highly publicized Check Clearing for the 21st Century Act with educating consumers and making them "much more aggressive" in their acceptance of payments digitization.

"The biggest concern about ARC was negative consumer reaction; no one wanted to make customers angry because they didn't get their checks back," Lucas says. "But now that we've seen early adopters be successful, volumes are just continuing to grow."

Adjusting to ARC

With all these benefits of ARC, one big disadvantage is that it will not be able to immediately replace the revenue banks have received from check processing, whose volume is expected to drop by as much as 13% to 15% this year, after falling by about 10% to 11% in 2004, according to the Federal Reserve.

There are several reasons for the check volume decline, including conversion, replacement, or because consumers are switching to other forms of payment, like debit. But the effect is the same: lost revenue. Check processing, float, exception items and related fees have historically accounted for as much as 40% of banks' revenue. According to Ernst & Young LLP, the banking industry's cash management revenue fell 0.5% between 2002 and 2003, the first decline in the 21-year history of the study.

Even though ARC's new cost efficiencies and revenue streams will ease the sting, Oliver of the Fed says that "the next couple of years are going to be pretty painful" for banks.

Additionally, "There may be some concern that check conversion will cannibalize cash management revenues," says Aaron McPherson, research manager for payments with Framingham, Mass.-based Financial Insights, a unit of IDC. "If you're doing ARC, your float income will go down, and you might initially see more of a reduction in revenue than in cost."

(For methods banks are using to ease the pain and offset the revenue losses, see sidebar.)

ARC has also brought along some new challenges of its own, such as the accidental processing of non-consumer checks. Currently, NACHA rules prohibit banks from converting business checks, largely because many processors lack the connections between their corporate accounts and their ACH systems that would allow them to offer positive pay or other corporate services on converted items, and might make fraud a bigger issue and accounting more difficult for corporate clients. Since business checks make up such a large percentage of the overall check pool, and many businesses nowadays use smaller-size checks that resemble consumer checks, many banks have reported that these non-convertible items are often slipping in under the radar.

As ARC grows in popularity, some bankers are advocating changing the rule that limits ARC to consumer checks. Both Alan Koenigsberg, vice president and global ACH senior product manager at J.P. Morgan Chase Treasury Services, and Lucas of Mellon fit into this category. Lucas was recently elected vice chairman of NACHA's electronic check council, which sets the rules for the category code.

"We're very big proponents of changing the rules to accept business checks," says Koenigsberg. Since conversion has been around for three years, most progressive banks have had the time to link corporate accounting systems with ACH, he adds.

Adding corporate checks to the ARC mix would likely help fuel check conversion's continuing rapid rise, since businesses tend to be more tied to their checkbooks than consumers. In 2003, only 28% of the 25.4 billion payments made by businesses and government were electronic, according to a recent study by the Federal Reserve.

ARC vs. Image Exchange

Offsetting this optimistic outlook is the view of many experts that ARC has already had its moment in the sun and that banks - at least those not yet committed to conversion - would be better served to leapfrog ahead and focus their energies (and their budgets) on check imaging, a process by which paper checks and transaction data are transferred into digital images at the point of capture.

Even ARC's most ardent admirers agree that check image exchange will eventually outpace, and perhaps even supplant, conversion. Since so many banks are not yet equipped to handle images, many check imaging banks are forced to use image replacement documents (IRDs), also known as substitute checks. The irony is that IRDs can make a check imaging transaction more costly than processing a paper check. Given that, ARC has been seen as the less costly and more easily implemented interim move to getting paper out of the check process.

"People don't realize the problem with Check 21 in the short term, which is that it's not as economically effective," says Oliver, referring to the fact that many banks that are image-ready today have to do business with banks that are not, hence the need for IRDs. "The trade-offs between Check 21 and ARC lean heavily toward favoring ARC. It's something that's available now."

Linked to that argument is the assertion that the large early movers - like Morgan Chase and Mellon - have already barreled into the ARC market so aggressively that it's not worth competing for. Morgan Chase alone commands about half the market for converted items, handling "something north of 400 million ARC payments in 2004," according to Koenigsberg.

"It's all about volume," says Wells Fargo's Becquer. The country's top 10 banks are already expanding their position, commanding 57% of ACH originations in 2003, up from just over 52% in 2000, according to McPherson. "The big originators have such a head start, and most of the growth has been seen," he says. "If you haven't decided to do it in 2005, it's almost too late."

By getting an early jump in conversion, banks like Wells Fargo and Morgan Chase will likely dominate an even bigger piece of the payments pie than they previously have, McPherson adds. "The concentration of payments volume among the top 10 banks will continue to grow as they try to offset revenue losses by expanding their market share."

And where does this leave banks that aren't at the top of the heap? McPherson says "tier two banks" will more actively begin outsourcing or white-labeling their payments business - further increasing the economies of scale for big banks and processors, and further altering the shape of the payments landscape.

Parallel Paths

While ARC is still experiencing phenomenal growth, the pace of conversion's climb may be slowing: The year-over-year growth was 509% in last year's third quarter, down from 791% in the second quarter of 2004, according to NACHA. Yet Miner says, "I don't think this suggests ARC has hit a plateau." He predicts the number of converted items will almost double to 2 billion in 2005, as many banks that are still in the process of implementing ARC get up and running early this year.

In any case, imaging technology is also gaining ground, having received a huge boost from the Check 21 law, which legitimizes substitute checks. As more banks begin to settle transactions by exchanging images across networks, obviating the need to convert items into expensive substitute checks, imaging could become an increasingly attractive alternative to ARC, McPherson and others believe. Banks such as Wachovia Corp. and BB&T Corp. have announced plans to start remotely capturing check images, while Bank of America Corp. has been testing the technology for a year.

Celent Communications expects that by 2006 check clearing fees will even out enough for banks to "justify switching gears from ARC to check image exchange." The Boston, Mass.-based market researcher expects that ARC volumes will peak at 3.5 billion items in 2007, then begin to decline to 2.6 billion by 2008, ultimately becoming "a marginal item in the ACH network" by 2010.

These are only projections, however, and the choice faced by banks is not clear-cut. "There's a lot of indecision out there," says McPherson of Financial Insights. "While many banks feel they have to do image exchange, they don't necessarily feel they have to do ARC. The big ones will do both."

Indeed, Wells Fargo is a major player in ARC at the same time that it pilots imaging. Becquer expects this imaging platform to be in production soon. "Ideally, we'd like to offer both ARC and imaging. I think they're going to run in parallel for a while as the industry adopts image exchange over the long term."

J.P. Morgan Chase is also pursuing both ARC and imaging, according to Koenigsberg, who sees ARC as a vehicle to help banks transition out of the "diminishing market" of paper check processing. He believes image exchange is at least two to three years away from "critical mass." In the meantime, check imaging is "still costing the same as processing a paper check and not getting us any cost savings yet." The key, Koenigsberg adds, is "not to over-invest" in either imaging or conversion.

Mellon's Lucas likewise sees check imaging and conversion "complementing each other," as banks develop processes that will route checks to either be imaged or converted based on their eligibility and the cost of the transaction.

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

Ms. Hoffman is a freelance writer based in Poulsbo, Wash.

Copyright © 2005 by Banking Strategies, published by BAI.

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