To Spend or Not To Spend

Relax, directors. Complying with the Check Clearing for the 21st Century Act, which took effect last October, need not be a wrenching affair. No doubt many banks, especially small ones, will opt to implement the bare minimum of requirements, none of which should be severely taxing.

A much bigger problem for bank chief executives and their boards is deciding just how aggressive they should be in replacing paper checks with electronic images. Although Check 21 (as the law is informally known) does not require it, there’s no doubt that it’s unleashing a wave of investment in imaging technologyu00e2u20ac”especially by larger institutions.

Check 21 streamlines the check collection and return process by eliminating the need to physically transport paper from one end of the country to the other. To be compliant, banks must be able to accept a so-called substitute checku00e2u20ac”which is simply a paper copy of the original checku00e2u20ac”a task that may involve technical changes to check-capture systems. They must also have a procedure in place for accepting substitute checks that are being redeposited.Perhaps most important, they must communicate to customers the existence of the substitute checks.

Simply by removing the requirement that a paper check be part of the clearing process, legislators gave processors reason to believe that fully electronic check exchange could be achieved, along with an estimated $2.1 billion in annual savings. But chief executive officers and their directors at community banks are wrestling with the decision of how much and how quickly to invest in imaging technology. With check volumes declining, overinvesting in image is a valid concern. At the same time, they run the risk that competitors could use imaging technology to steal away customers through better pricing or more services.

As a result, banks need to decide whether they want to be aggressive or defensive on imaging, explains Steve Ledford, president of Global Concepts Inc., an Atlanta-based consulting firm. “There’s no one strategy that’s right,” he says. “But you don’t want your strategy decided by default.”

There is no doubt that imaging already has carved out a lasting place for itself in the back offices of banks both large and small. Community banks, in fact, were among the first to deploy such technology to create statements in which images of checks rather than the actual checks are returned. That application led to the creation of storage archives where images of checks could be easily looked up in response to customer inquiries. Now imaging is wending its way further into the back office in support of a more efficient proof-of-deposit and other operations.

Imaging’s success in improving internal processes is not in dispute. But how far should community banks go in taking advantage of imaging when dealing with other institutions? The law offers the possibility of sending and receiving imaged checks between all of an institution’s trading partners. This process, known as image exchange, would eliminate the costly and time-consuming process of transporting paper checks between banks, but it is not considered easy to achieve.
Research from ESP Consulting Inc. of Salisbury, Maryland indicates most banks, particularly small ones, are not inclined at this time to take the promise of Check 21 very far. In a year-end 2003 survey of almost 500 banksu00e2u20ac”nearly 75% of them with $4 billion or less in depositsu00e2u20ac”ESP found that 42% had not yet begun preparing their operations for the ramifications of Check 21. Forty-four percent said they had only gotten as far as evaluating information, while a scant 4% said they were operational with new systems or planned to be soon.

“We’re still on a path for no one to be ready for quite a while,” says Leon Majors, ESP’s president. He offers a reason for the industry’s slow movement to participate in image exchange: “This is a technology that is so broad-reaching within the organization, banks don’t want to take a chance of being wrong.” He notes that even the biggest banks, which have been very aggressive in building image-exchange networks, are still at the beginning stages of electronic exchange. An important milestone came at the end of August when two big banksu00e2u20ac”KeyCorp and J.P. Morgan Chase & Co.’s Bank One subsidiaryu00e2u20ac”exchanged less than 100 images in a fully electronic environment. “Even the biggest banks, spending the most money possible, are not ready,” Majors says. Executives at smaller banks are right to fear getting fired for spending too much money on what is still an unstable technology, he adds.

Majors’ position gets no argument from Russell Johnson, the group manager of operations at $6.2 billion Provident Bank in Baltimore. Provident plans to do the bare minimum to meet the requirements of Check 21 because, as Johnson notes, “there will be a lot of changes, with players coming in and out of the business.”

Another, perhaps bigger, factor is also giving Provident pause. Check 21 creates a new transaction instrument known as an image-replacement document, or substitute check. Since Check 21 does not require banks to create or accept check images, it has introduced substitute checks as a bridge between image-ready and non-image-ready institutions. A bank in California, for example, may choose to zap a check image to a bank in New York to achieve better float. The New York bank, however, may not be able to accept images, in which case a paper copy of the image would be created locally in the form of a substitute check and presented to it.

Though no one knows for sure, conventional wisdom has it that producing substitute checks will be costly, and, in Johnson’s view, small and medium-sized banks will not find it cost-effective. “To get payback, you have to have enough volume to get the advantage of float,” Johnson says. Only big banks executing billions of transactions a day will get enough of a float advantage to make creating substitute checks worthwhile, he adds.

But Mark Craig, the general manager of Oklahoma City-based Checkclear, which is the owner and operator of Endpoint Exchange, says small banks are not doing themselves any favors by taking a wait-and-see attitude on image exchange. Endpoint already has more than 3,000 institutions, mostly community banks, exchanging images through its network, and another 1,000 or so are signed up to do so.

Rather than waiting, Craig advises banks immediately to begin analyzing the business case for moving to imaging. Contrary to the belief that only big banks have the volume necessary to reap benefits from image exchange, Craig says Endpoint Exchange members have been able to achieve payback on their investment as soon as they begin sending and receiving a mere 5% of their volume electronically. While achieving 5% of volume six months ago was a chore, now the exchange has enough participation that 5% can be achieved on the very first day, Craig adds. “For every day you wait, you’re losing money because the business case is so positive.”

Payback comes in a number of ways, he says. The first is through a reduction of float, which is a nonearning asset. The less float a bank has, the less capital it must allocate to that asset, which frees up more money for other revenue-generating uses, such as lending. Demand-deposit account revenues also increase with image exchange because customers either learn not to take advantage of float; pay nonsufficient funds fees, or tap into short-term lines of credit, such as overdraft protection. The final benefits come in the form of greatly improved fraud detection and more efficient procedures for returned items. Craig anticipates adoption of image exchangeu00e2u20ac”at least 90% of all checksu00e2u20ac”by the end of 2006.

But for many banks, it seems that complying with the minimum requirements of Check 21u00e2u20ac”much less getting to image exchangeu00e2u20ac”is more than enough work for now. Provident, for example, has a 30-person project team deployed to cover all the bases. “It’s a lot more than anyone here expected,” Johnson says.

Furthermore, the need to educate bank customers on check imaging should not be underestimated. Polly Thorsness, the vice president of operations at Community First Bankshares in Fargo, North Dakota, reports that some of the $6 billion bank’s customers thought they could avoid getting substitute checks back by switching banks. “I don’t think we really know how customers will react until they get their first substitute check back,” she says.