ARC:
Billers Like It;
Bankers Have Their Doubts
BY JARRETT HELMS
ARC is low-cost and available. But its popularity notwithstanding, financial institutions prefer to wait for widespread image exchange. Banks —particularly those with modest ACH volumes —have their reasons for rooting for image exchange. But are they jeopardizing their biller deposit business and their competitiveness in being able to offer a "clearing mix" that includes ARC, image and IRDs?
CONTENTS
Customers and Their Checks
Check Images: To Share or To Exchange
ARC: Billers Like It; Bankers Have Their Doubts
|
SYNOPSIS | In recent years, Accounts Receivable Conversion (ARC) has become an increasingly popular technology for converting paper payments into an electronic funds transfer. Yet many banks are still undecided about whether to offer ARC, believing that image exchange is a better long-term choice. In taking this stance, financial institutions are failing to consider the preferences of their customers. Global Concepts, Inc. research reports that billers find ARC an efficient and cost-effective clearing method compared to existing alternatives. "Dynamic clearing" allows processors to make real-time decisions on how to process individual items, taking full advantage of ARC, image exchange and Image Replacement Documents (IRDs). Institutions without the ability to offer all clearing options may be considered less competitive.
It's no secret that Accounts Receivables Con-version (ARC) has seen explosive growth over the past three years. What might catch financial institutions off-guard, however, is the growing opinion that ARC might be a very important long-term strategy for clearing paper remittances.
ARC is clearly no longer the overlooked younger sibling to paper-based remittance processing. More than 1.25 billion remittance items are converted annually to Automated Clearing House (ACH) transactions via ARC, and, in the eyes of many billers, ARC is the cost-effective alternative to the seemingly necessary evil of paper processing. Yet many financial institutions do not share the same enthusiasm for ARC. In fact, it's ARC they often view as a necessary evil.
How can that be? ARC is presently more cost-effective than image exchange, which is the major non-paper alternative to ARC. The problem is that ARC is dominated by large volume players who can bring economies of scale to bear. Institutions with lower ACH volumes may see more opportunity for themselves in image exchange.
Yet this belief is probably misplaced, given the uncertainties surrounding the deployment of image exchange. Financial institutions would be better off focusing on the needs of their customers, who often favor ARC. The optimal approach is "dynamic clearing," which combines ARC, image exchange and even paper, in the form of substitute checks, or Image Replacement Documents (IRDs). By mixing and matching clearing methods, banks can meet the needs of their customers by utilizing the advantages of each technology in the manner appropriate to the situation.
'How Cheap Did You Say?'
At the heart of the ARC discussion is a choice that is more complex than simply evaluating whether or not to offer ARC. The issue actually incorporates present and future decisions and assumptions on Check 21 and image exchange, as well as client perception and the current saturation of ARC offerings in the market.
We'll consider perception first. In an effort to understand where each group stands on the issue of ARC, Global Concepts Inc. conducted a study of 56 billers, 34 banks and two third-party remittance processors in the summer of 2004. The results underscore that banks and billers do not agree on the value proposition of ARC.
There is, however, at least one main point of agreement between billers and banks: both groups project ARC to hold the lion's share of remittance volume by the end of 2006. In total, respondents project that they will clear half (49%) of their total remittance volume by ARC by year-end 2006, 35% by paper, and 16% by image exchange. These figures clearly indicate that the market feels image exchange will lose in the remittance world, at least in the short-term. Will this actually be the case?
To answer that question, we have to understand what motivates each group to choose a clearing method. The simple answer is cost. Both banks and billers want to use the cheapest clearing method; they just can't agree on what that is.
Yet one thing is clear: no one believes paper is the cheapest clearing method. It would also be nearly impossible to argue that using IRDs is cheaper than processing paper (although IRDs remain a valuable option in certain instances). That leaves ARC and image exchange to contend for the designation of lowest-cost form of remittance processing. And therein lies the rub: Global Concepts' study found that billers perceive ARC to provide lower bank fees and reduced processing costs. Banks, however, perceive image exchange to be the lower-cost alternative.
The obvious weakness behind these perceptions is that image exchange is not yet a full-blown reality. Many billers at the time of the study had not even formulated an opinion on image exchange. In fact, 89% of the biller respondents indicated that they were either currently evaluating image exchange or had not evaluated it at all. In effect, banks are leveraging their knowledge and expectations for image exchange into perceptions of lower-cost processing, while billers are scrambling to figure out if image exchange even applies to them. Of course, while it is fair to assume that some billers are uninformed about image exchange, others simply find ARC to offer a better overall clearing solution.
This held true for the largest billers in the study who are familiar with image exchange but still chose ARC as their preferred clearing method. In fact, larger billers, in terms of processing volume, seem to prefer ARC more than smaller billers do. This finding probably indicates less about the size of a biller interested in ARC and more about the nature of the businesses in which the largest billers engage.
Large billers, such as credit card companies, for example, like that ARC has a fast return cycle, which allows for quicker action on questionable accounts and a reduction in credit risk exposure. Billers with national customer bases may view ARC as an opportunity to accelerate collections on what might have been a high percentage of checks that require two days to clear. It appears that billers, in general, are acting rationally. They want to use a product that provides a lower cost and offers other additional benefits.
Based on the study's findings, however, banks seem irrationally attached to image exchange. In an interesting departure from the "lowest-cost clearing option wins" concept, 50% of banks in the study still prefer image exchange even if it would cost up to 10% more than ARC. Carrying this further, 10% of banks reported they would use image exchange over ARC even if it was 25% more expensive.
Make no mistake; these institutions have clear reasons for wanting image exchange to prevail. To understand why, we have to look at the ACH market.
Big Pond, Bigger Fish
ACH transactions can reach every financial institution in the nation, meaning that every institution could be a potential originator. Despite this fact, a few large players dominate the world of ACH origination.
This is very apparent in the ARC market. According to research conducted by Global Concepts, the top four ARC originators are responsible for 50% of total ARC volumes. This gives these few originators incredible economies of scale. The more volume you have, the lower your ARC pricing can be.
Because cost is the largest motivating factor for billers, the top ACH processors hold a massive advantage over the rest of the market. And the cycle perpetuates itself: large volumes yield lower costs, low costs allow lower pricing, lower pricing brings more clients, which add to the volume, and so it goes.
This reality makes it difficult for any originator not among the top four to compete for high-volume, national clients. Not only are there fewer high-volume clients left to fight over, but the market rate for ARC pricing is significantly lower than a financial institution with moderate volume can match.
On top of that, for many institutions, the business case for ARC is difficult to justify regardless of market share. ARC is costly to implement and the return on investment
is tricky when declining check volumes lead to rising unit costs.
There are certainly many institutions that are already funding image exchange initiatives through item processing that are not among the top ACH originators. These institutions hope that image exchange will eventually offer an even lower cost processing option to ARC and that this will once again level the playing field. Because image exchange pricing also benefits from economies of scale, these institutions are willing to pay a premium for image exchange in the short-term, roughly 10% to 25%, for the opportunity to hold more image exchange volume down the road.
In one way, that's not a bad strategy, but, ironically, it may be too shortsighted.
Waiting For The Future
A problem with waiting for image exchange is that
critical mass seems to be taking longer and longer to arrive - or even to come within sight. So there is an indefinite period of time before image exchange will actually be available as a cheaper alternative to ARC. More important, the banks that originate the majority of ARC volume are also developing image exchange initiatives of their own, and, surprise, surprise, they may be among the first to clear significant volumes of image-exchanged items.
Even though image exchange is a low-cost, efficient way to process checks, it still will not be used to clear 100% of items. Large volumes of items will be image exchanged among the larger banks, but many small institutions may not be image-enabled for a long time, which necessitates the use of an alternate payment instrument to reach those endpoints. For the foreseeable future, banks will rely heavily on IRDs to reach those small endpoints.
IRDs are expensive to print, however. And if it is
necessary to print a lot of them, the cost benefit of image exchange is lost. The question is: how many IRDs can an institution print and still provide a cheaper alternative to ARC?
This question points directly to the complexity of the ARC decision. Unlike image exchange, ARC can reach all endpoints, but not with all items. Banks cannot ARC corporate checks, for example. While many originators would like that to change, there are significant barriers to allowing all corporate checks to be converted, such as disruption to treasury management products like controlled disbursement or positive pay.
Where one channel is weak, another is likely strong. The Holy Grail of check clearing is obtained when it is possible to capitalize on the advantages that each channel offers. Using the best available channel for each item is a concept called dynamic clearing. At its best, dynamic clearing will allow processors to make real-time decisions on how to process individual items. ARC could be used for low cost retail processing, image exchange could be used for business checks, and IRDs can fill in the gaps for a few high-dollar items to remote endpoints. Dynamic clearing is the best possible clearing option because it allows for choices between the channels. Institutions without the ability to choose lose the ability to offer a
comprehensive clearing mix.
All of this essentially means that financial institutions waiting for image exchange to allow them to undercut competitors on remittance pricing may be waiting in vain. It also means that without ARC, those processors may be missing a valuable channel for dynamic clearing and losing the deposit business of billers who want to minimize their cost of clearing remittance payments.
Ultimately, the choice over ARC lies with the client - not the bank - and that is the single most important thing for financial institutions to remember. In many cases, clients may not find lower ARC pricing enough of a reason to move to another institution; in some cases they will.
For billers there may be more to ARC than just cost. ARC seems dangerously close to becoming the corporate fad de jour. It just seems like the right thing to do. And once hooked by the concept, billers find that
ARC does offer enough advantages to keep their attention.
So it's best to examine the ARC vs. no-ARC decision in terms of client desire, not simply based on implementation costs or prevailing market pricing. How valuable are certain clients to the institution, and how badly do they want ARC? Does the client simply want ARC-like pricing, or do they truly need ARC for other advantages? If the client wants only a lower price, then it may be worth taking a hit on the nose in order to retain that client's total value to the institution. Remember that once a client leaves one institution for another based on lower pricing, it will be very difficult to gain that client back if future offerings cannot promise to be lower cost.
All too often, banks base the ARC decision on an operational budget that is tight at best while trying to prepare for image exchange. Don't let the very real, but future, advantages of image exchange supercede client desires. This is not a decision just for operations or even receivables products, but for treasury services as a whole. What makes a client valuable? Certainly it is not just the retail lockbox relationship. Does the client bring in revenue through deposits that is worth far more money than the loss sustained by implementing ARC?
If so, the answer on whether to ARC is clear.
CONTENTS
Customers and Their Checks
Check Images: To Share or To Exchange
ARC: Billers Like It; Bankers Have Their Doubts
Questions or comments about this article? Post them at the Banking Strategies blog.
|
