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Balancing Electronic Efficiencies and Paper-Processing Costs

BY TIM MILLS AND SEAN SIMS

Electronic transactions help reduce processing costs, but the decline in check usage continues to drive up per-unit paper processing costs.

|SYNOPSIS | In spite of the decline in check usage, banks have enjoyed a decade of remarkable efficiency gains in check processing. But now consultants at Global Concepts say banks may be losing ground in the fight to keep paper processing costs under control. The rapid growth of image exchange is contributing to an increase in paper processing unit costs. In response, the authors say, banks are likely to take more aggressive steps in operational consolidation, functional outsourcing and offshore processing in order to control these costs. Remote capture—whether through corporate capture, lockbox imaging or branch capture—will play a major role in enabling banks to restructure their operations.

One of the payments industry’s most remarkable feats over the past decade had been its ability to maintain and even improve check processing efficiency despite a period of significant check volume decline. Consider that while check volume fell by an estimated 24% between 2000 and 2005, end-to-end item processing costs per deposited check (excluding clearing costs) also declined by over 10% among the large banks that participate in the Global Concepts Check Benchmarking Study.

To accomplish this feat, check operations managers have wrung out efficiencies in nearly every check-processing function. Improved staff management techniques have increased productivity in labor-intensive functions such as proof and encoding, check sorting, balancing and cash letter dispatch. For example, between 1999 and 2005, median productivity in proof and encoding increased by over 10%. This helped keep unit costs stable despite volume decline.

Related Charts The New Order in Check Processing

Technology has also played a significant role in controlling costs. Image technology has helped to streamline and enable more flexible staffing in reject repair, return item processing, photo (image) retrieval and adjustments. Photo retrieval is perhaps the most striking example. In 1999, one top-ten bank reported nearly 300 staff performing image retrieval requests throughout its geography. By 2006, due to image archive technology, that same bank had fewer than 20 employees servicing images in a single location, representing ongoing labor savings well in excess of $5 million per year.

In spite of these past successes, Check Study results for the past two years, 2006 and 2007, show that banks may no longer be keeping up with check volume decline. Paper processing unit costs are now increasing in nearly every function at large banks. Overall, median unit labor costs in the Check Study increased by nearly 16% between 2006 and 2007. Unit operational costs (e.g., equipment, systems, and occupancy) also increased, with real estate costs increasing by 46% during the same period.

The issue now facing the industry is how to regain control over costs in check processing. Since declines in overall check writing and paper-based clearing appear irreversible, we expect banks to take more aggressive steps in operational consolidation, functional outsourcing and offshore processing.

Paper Processing Capacity Issue
The rapid growth in check electronification due primarily to image exchange is a key reason for banking’s current struggle with processing costs. Global Concepts estimates that paper clearing volumes declined by nearly 30% between 2006 and 2007, including image exchange, Image Replacement Documents (IRDs) and check conversion to ACH. By the end of 2008, the industry could be truncating over 70% of checks during clearing, whether via image exchange, IRDs, or ACH conversion (see chart below, “The New Order in Check Processing”).

The overall effect of this electronification for clearing purposes is very positive. The industry has already realized over $1 billion in savings due primarily to float reduction. Electronic clearing also generates clearing fee and operational cost savings in certain functions that should generate roughly another $1 billion in industry savings over the next few years.

However, the rapid decline in volumes is proving difficult for banks to keep up with in terms of adjusting paper processing capacity. Consider a hypothetical example based upon the real-life experiences of at least one large bank. This bank began accepting image inclearings in 2007 and was quickly receiving significant volume via image. The image volume rapidly reduced capacity needs for paper inclearings processing. However, as check managers know, check deposit processing is notoriously peak-intensive and tends to be the primary driver of total capacity requirements in item processing.

Although the bank now processes significantly fewer paper checks, it cannot make significant reductions in its total sorter complement. Its check sorting infrastructure increasingly sits idle on third and first shifts yet must be retained for deposit processing. Although it is saving labor costs in inclearings, overall paper unit costs are rising due to fixed occupancy and, to a lesser extent, equipment expenses.

The growing use of image cash letters is helping banks to achieve some capacity reductions in deposit processing. The ability to use IRDs and image cash letters for clearing lengthens processing windows for banks, which helps to smooth out peaks in the deposit processing and cash lettering workflow. IRDs and image cash letters also eliminate the need for transit fine sorting. These benefits enable banks to retire some sorters and gradually reduce their overall item-processing footprint. In light of the rapid growth in electronic volumes, however, it appears that banks are simply no longer able to keep up by making such small, continuous adjustments to capacity.

A variety of other factors, some related to check electronification and others due to general market trends, are exacerbating paper check processing cost pressures.

Over the past two to three years, many banks have finished depreciating investments made to implement archive technology. The result has been significant declines in capitalized equipment and systems expenses in check operations. However, much of this opportunity to roll depreciated assets “off the books” has dried up in the past one to two years, since most banks made archive investments toward the beginning of the decade.

Labor rates are also on the rise. In response to volume declines, most banks have chosen to reduce check-processing staff through attrition rather than layoffs. Since check operations tend to incur fairly high turnover, banks have had little difficulty keeping up with volume declines without having to terminate staff. However, the remaining staff members tend to be longer tenured and more highly paid. Retaining these experienced employees has been good for productivity. But hourly labor rates have been steadily increasing, up nearly 3% between 2006 and 2007.

Finally, transportation and clearing costs for paper checks are increasing. Unit transportation costs are rising in part due to paper volume decline and in part due to rising fuel costs, with gasoline prices in 2007 up 50% compared to 2005. Clearing fees are also increasing as clearing intermediaries such as the Federal Reserve and regional clearinghouses hike their prices to cope with paper processing volume decline, labor and other input price increases of their own. 

Image-Based Deposits
The combination of rapid paper decline due to check electronification and other factors such as labor cost increases will continue to put tremendous upward pressure on paper check deposit processing costs over the next three to five years. Moreover, this pressure will come at a time when banks are starting to ask whether they have squeezed all of the possible efficiencies out of the predominating check processing model of large, centralized regional item processing centers.

In order to cope with these changes, the industry is likely to undergo a more rapid evolution over the next few years, primarily in the ways that banks gather check deposits from their customers by imaging and truncating them earlier in the deposit cycle and secondarily in the ways earlier truncation allows banks to reshape their operations. Banks are also likely to pass on some cost increases to merchants and billers who opt to continue making paper deposits.

In some respects, the migration toward image-based deposit gathering is already well underway. Just as customer demand forced banks to develop image lockbox and image archive services, when the cost-benefit business case might have been murky or non-existent, customer demand is now pulling banks into offering remote deposit services.

Corporate capture products are becoming a competitive necessity for banks due to customer demand. The product has consistently been the number one growth product in Global Concepts’ research on the product adoption plans of corporate treasurers from a variety of industry segments and company size categories. At a recent conference, the head of a small professional services firm described why remote deposit was so compelling in how it had changed his company’s deposit habits. Prior to remote deposit, his company would deposit the prior week’s check receivables each Monday through a local bank branch. With remote deposit, the company is now able to deposit checks on a daily basis while still reducing the overall time and hassle to do so.

A similar market-driven scenario may also begin to force banks into offering branch capture. While banks still struggle with whether or not to implement branch capture, and if so, which model to adopt— front-counter, back-counter or both—customer demand will likely necessitate that banks implement the service regardless of how murky and risky the business case is on a cost savings basis. Regardless of efficiency gains, the ability to capture images in branches enables banks to keep deposit channels open later in the day and still offer same-day credit to customers, since the images are more rapidly available for downstream processing. As some banks decide to take the plunge, the ability among competitors to provide later deposit deadlines due to branch capture will likely force other banks to follow suit.

We must acknowledge that branch capture will remain a high risk and complex endeavor for most banks. For large banks, a bank-wide, front-counter branch capture initiative can cost well into the $10 million to $20 million range. Back-counter capture is significantly less costly but delivers fewer savings, since it offsets fewer downstream processes. Furthermore, at current image exchange rates, IRD print costs offset much of the transportation savings associated with branch-truncated items. Without these savings, the branch capture business case, front or back-counter, is far more difficult to justify.

There are ways to reduce the business case risk and help banks to overcome the barriers to branch capture. For example, targeting a limited number of high potential branches provides banks with both a test bed for learning the ins and outs of branch capture and a significantly less risky business case in terms of total investment. By targeting branches, banks will often find that a fraction of their branches, perhaps 30% to 40%, generate most of the potential branch capture savings due to their longer distances from operational centers. The benefits of transportation and time savings from branch capture in these branches may justify printing substitute checks even at current levels of image exchange.

Trends in Check Restructuring
The increasing use of remote capture—whether in branches or from corporate depositors and lockboxes—and the growth in image-enabled endpoints will gradually unlock banks from the regionalized item processing infrastructure that now predominates. Given the cost pressures that banks are now feeling in their paper-based operations, we can expect banks to take advantage of this potential to restructure their check processing infrastructure to enable new cost savings. Such restructuring will include operational consolidation and outsourcing/off-shoring:

Operational consolidation 
Large banks, especially, have the advantage of multiple regional operating centers. As remote capture and truncation becomes more feasible or necessary to remain competitive, large banks are likely to exploit the technology to collapse their infrastructure into fewer sites, perhaps down to two or even one centralized processing center where functions such as data keying and balancing may be done remotely via image. The key advantage from shutting down operations will be the ability to relinquish real estate, enabling banks to combat the rising occupancy burden they are now facing.

Consolidation is not without risk. For example, it could be very costly or impossible to reopen centers if banks consolidate prematurely or move to what turns out to be a suboptimal location. Banks that try to turn back may find their prior space leased, sold or internally repurposed within the bank. Since making a U-turn on consolidation strategy can be so difficult, banks must be very careful to develop an effective strategy when choosing if and where to consolidate. The following are a few questions to consider:

• Where can the bank most easily redeploy check processing real estate?

• Which regions will benefit most from branch/remote capture and therefore provide the greatest levels of truncation and transportation savings?

• Which operations might be best suited to winning correspondent business to bulk up operational volumes and offset check decline?

• Which labor markets look best for the bank over the next five to 10 years?
  

Outsourcing/Off-shoring 
Among smaller banks, it is already common to outsource check and other processing operations. Large and mid-sized institutions, however, have typically chosen to maintain most of their operations in-house, while sometimes outsourcing select functions such as document storage and image archive.

The outsourcing market has evolved this way for fairly obvious reasons. For one thing, it is generally easier and less risky, both for banks and outsourcers, to outsource smaller operations. Furthermore, to the extent that there are economies of scale in check operations, smaller banks are more likely to benefit from cost reductions through outsourcing because, by aggregating volumes from multiple institutions, the outsourcer’s scale allows it to generate and pass back cost reductions to the bank.

More or less, the opposite is true for large banks. First, larger banks have incredibly complex check operations that process a wide array of documents. Outsourcing these large operations is risky for both the banks and outsourcers involved. Failures in check operations can ripple through all of a bank’s systems, including the DDA, general ledger, time deposits and loans. Second, most outsourcers do not have the capacity to absorb the operations of a large bank without adding additional capacity, which is a risky proposition given check decline. Finally, for the reasons above—complexity and lack of capacity—there is less opportunity for outsourcers to generate scale efficiencies by combining multiple large operations, making it difficult to generate cost savings to the bank and profits to the outsourcer.

Given the risks to both parties, banks are likely to find large-scale outsourcing deals complex and contentious to negotiate. Outsourcers are likely to require long-term contracts that shift the risk back onto banks by setting pricing and contingencies based upon volume thresholds—i.e., banks will pay more as volumes decline, offsetting the benefits of outsourcing. The bottom line is that full outsourcing deals are still likely to be few and far between, even with check electronification.

One outsourcing option that may work for some larger banks is facilities management, whereby a third party takes over responsibility for the bank’s existing operations. Typically, an outsourcer would do so in the hope of winning additional outsourcing business for the operations in order to bolster volumes that may otherwise be declining at the bank’s operations.

There are, however, also reasons to doubt the viability of the facilities management approach to outsourcing. For example, banks that have large, best-in-class, up-to-date image-enabled operations are much more likely to find outsourcers willing to make such a facilities take-over deal. Yet these banks are probably the ones who least need to outsource since they are in a good position to take advantage of the benefits of image check processing and may be able to bolster their own volumes by selling correspondent processing services to other banks.

Instead of full facilities outsourcing or management deals, the industry is more likely to see increased use of functional outsourcing, possibly with an offshore component. Functional outsourcing allows banks to move components of their operations that may incur high labor and real estate costs to more affordable markets, while maintaining in-house management of their overall operations. These deals allow cost containment while check volume is declining but with significantly less risk than full outsourcing.

Indeed, an increasing trend toward functional outsourcing is already emerging as banks outsource key functions including data keying, balancing and some research tasks. A number of larger banks are also using offshore operations to perform keying for item processing and returns operations; some have done so for a number of years already. Others have outsourced check image research and retrieval functions to U.S. and overseas providers. These types of processing arrangements are likely to become more common as image exchange and remote capture enable banks to consolidate their existing operations. 

Looking Forward
Increasing operational consolidation and functional outsourcing are certainly not the only trends that will emerge to take greater advantage of electronic check clearing and, in so doing, combat rising paper clearing costs. Banks may also look for opportunities to consolidate functions across payment channels, for example, by combining risk management functions for check and ACH. In the long run, the industry may also consider consortium-processing arrangements, such as those seen in the U.K. and Canada.

However, consolidation and limited outsourcing of certain processing functions are likely to be the primary tools large banks use to reduce their check operations infrastructure as electronic check clearing grows and supplants paper clearing. Because large financial institutions maintain correspondingly large and geographically distributed operational footprints, primarily to support check processing, consolidating operations provides the opportunity to significantly reduce operating costs, especially the large fixed cost associated with real estate. The size and complexity of operations, however, mean that wholesale outsourcing will be a highly risky venture for large institutions, for both the banks and the potential outsourcing partners. In light of the risks, banks are more likely to opt to outsource specific functions rather than hand over end-to-end control of their operations.

Image-based deposits, including corporate capture (remote deposit), lockbox imaging and branch capture, will be an essential tool in facilitating operational consolidation and stimulating banks’ search for operating cost reductions through outsourcing and off-shoring of certain functions. Over the next few years, banks are expected to aggressively deploy these technologies, both in response to customer demand and as a necessity in managing the rising costs of paper check clearing.