Increasing momentum toward the Check Truncation Act of 2003, most commonly known as Check 21, has catalyzed banks to prepare for the inevitable passage of this legislation. Recently passing through both the House and Senate committees, Check 21 will allow financial institutions to use documents created from an electronic image as the legal equivalent to the original paper document. This is widely expected to spur electronic check clearing. The ability to clear checks electronically will ultimately lead to quicker processing of payments for consumers, merchants and financial institutions. Banks must continue to modernize their technology to accommodate the inescapable changes taking place within the financial arena.
As the payments landscape becomes increasingly blended, banks face immense revenue risk. It is imperative for banks to design a profitable transition from paper to electronic payment processing. The question is not should banks adopt image-based technology, but how and when will they adopt these systems. Broadly, banks have taken two parallel initiatives to preparing for a post-Check 21 world. The first approach includes investing in an infrastructure, which will allow image exchange between banks. The second approach includes investing in a moderate infrastructure within the bank to use images, not for exchange with other banks, but rather to improve efficiencies and reduce costs.
Checks remain the preferred method of payment in the United States; an estimated 40 billion checks were written in the United States in 2002 FRS Check Study.
Although check usage may have peaked during the 1990s, roughly 20 percent of all merchant payments are still made by checks and an estimated 70 percent of all bank transactions remain paper-based. As banks continue to embrace technology and strive toward a paperless world, it appears there is still much left to automate. Soon, bank operations will consist of an interchanging mix of paper, data and image eventually leading to the total truncation of paper. To survive, banks must be prepared for the impact this will have on their current check-processing models.
Merchant Electronification of the Check
Checks travel through as many as 26 touch-points, says Chris Nehrbauer, Vice President of Bank One, and with every touch, expenses and margin for error increase, while valuable time and resources are exhausted. Bank officials stated that if they are going to truncate checks, it is better to truncate them sooner in the process than later. The less paper passed around, the fewer touch-points, the lower costs accrued. It makes sense then that checks be truncated at the earliest point of presentment.
As both banks and merchants seek a profitable transition from paper processes of the past to electronic image-based processing of the future, it is helpful to consider efforts already made toward a paperless environment. One of the most notable is the Automated Clearing House (ACH) payment initiative, point-of-sale (POS) check conversion. In its simplest form, this process involves using the check as a source document, reading the MICR line to access the account holder's routing and transit number, and finally converting the check into a debit transaction. POS check conversion provides faster funds availability, a higher degree of collectability and less paper in the back-office, which results in overhead savings for the merchant. According to NACHA, the electronic payments association, more than 166 million POS check conversions occurred in 2002, which represents nearly two percent of the 12 billion consumer checks written at point-of-sale.
In theory, this seems to be the solution to eliminating paper checks at the earliest point of presentment, however, it is not flawless. Adoption barriers include hardware costs, consumer authorization, training, multiple processes and limited item eligibility.
NACHA operating rules do not require merchants to obtain a check image for POS conversions, but many insist on keeping this vital information to assist with the collection of administrative returns. POS conversions significantly reduce the amount of returned items due to insufficient funds, however, merchants continue to struggle with items returned because of an invalid routing number or other administrative flaw. Integrating image-capture devices at every check-out lane is an intrusive and expensive requirement for merchants. Without an image, the merchant is left to collect funds based only on a signature.
Consumer authorization is required for POS check conversion, similar to a credit card authorization www.nacha.org. In many cases, this means trading one piece of paper for another. The education and training required for check out personnel is time-consuming, but without properly trained employees, merchants will be left with returns and costly errors. An additional complicating factor is that not all checks are eligible for POS conversions. For example, business checks do not qualify. At the end of the day, merchants are still left to manually balance their cash drawers in the back-office using assorted processes and then send the deposits to the bank where proofing operations repeat the entire procedure. With multiple pieces of paper passing through multiple hands, room for error is great, and each error costs the bank and merchant time and money.
Merchant Back-Office Automation
An alternative to POS check electronification that leverages Check 21 legislation is a process known as merchant back-office deposit automation. Merchant back-office automation relies on one check image/reader device, which automatically feeds and reads the checks. The software captures the check data and image, reads the courtesy and legal amounts and endorses the check, all with minimal operator intervention. Meanwhile, cash is fed into a cash counting device, and the count is automatically captured using the same deposit automation software. The deposit is balanced and transmitted via an electronic connection to the bank for settlement and clearing as an electronic cash letter, with images of individual checks. The bank's software receives the information electronically and based on account history, may provide funds availability based on the receipt of the electronic information.
In today's paper-based environment, following the transmission, the paper checks are couriered to the bank along with the cash. Following the passage of Check 21, checks would be truncated at the merchant, stored for safekeeping for a few days and then destroyed. With checks electronified, bank's geographical footprints become virtually irrelevant, opening up a new world of opportunities for both banks and merchants.
The advantages in automating back-office deposits for merchants are obvious: less manual work, lower overhead, accelerated postings, timely deposits, improved payment posting accuracy and reduced transaction costs without the expensive intrusion into their POS systems. While a bank will also experience significantly reduced proofing and encoding costs, lower overhead, cleaner deposits and increased accuracy, perhaps the greatest advantage is the widening of the bank's playing field. Truncation of checks within the merchant's back-office allows banks to compete for deposit business outside of their geographical footprint, inviting incremental revenue.
Preparing for Check 21
Checks are not going to disappear completely from transactions. With more than 42.5 billion checks written in 2000, consumers and businesses rely on writing checks as a preferred payment method. Knowing this, banks must begin to strategically streamline their end-to-end deposit processes, including back-office deposits. Crucial to this process is truncating checks at the earliest point of presentment, ideally beginning with the merchant. When Check 21 passes, the stage will be set for banks to begin reaping the benefits of paper truncation and image exchange, if they are ready.
In 1996, the United Kingdom implemented inter-bank data exchange. This enabled banks to exchange electronic clearing data at the end of each day, which required changes in the banks' clearing operations. The largest U.K. banks used an incremental, supplemental strategy to modernize and streamline their central check processing operations. Unlike the U.K. payments strategy model, U.S. banks are addressing the check processing challenges from both ends modernizing the mainframes and legacy systems in their item processing centers, while pursuing a strategy that leads them to the integration of their end-to-end deposit process. In the U.S., converging industry initiatives, regulatory changes, and enabling technologies are speeding the trend toward check truncation and image implementation, closely mirroring what has already happened in the U.K.
Whether it is POS check conversions or automated back-office deposits, the age of paperless transactions is on the horizon. Historically, banks have been slow to change. In a post-Check 21 world, banks must learn to embrace technology if they want to compete. As Check 21 becomes imminently closer to passage, banks and merchants must begin to analyze their present systems and determine where they want to be. The technology to move a bank from paper-based to paperless operations is here.