mericans wrote 42.5 billion checks in 2001, according to a research paper¹ published by the Federal Reserve. Each of these checks typically passes through 15 or more handling steps as it clears through the banking system and is returned to the check writer in a monthly bank statement. Legislation now pending in Congress, the Check 21 Act², promises to remove billions of paper checks from the banking system. The legislation, if enacted, would effectively render electronic check images the legal equivalent of the original paper checks.

If you're an executive at a big bank, such as Bank One, with billions of dollars invested in regional data centers and staffers dedicated to processing paper checks, managing the transition from paper- to image-based clearing can be a huge challenge. Banks that fail to meet this challenge will find that traditional check processing centers can be a drag on profitability.

This research report describes radical changes banks need to make to profitably manage the transition from paper to electronic clearing. The authors convey a strong sense of confidence in their recommendations, based upon recent experiences in Great Britain. If the authors are correct, there will be major implications for Merchant Level Salespersons and transaction acquirers.

Executive Summary

The premise of this white paper is that three fundamental changes are necessary to profitably migrate from paper checks to electronic payments. These are:

1. Reduce the number of check processing touch-points. In other words, the authors advise banks to consolidate check-processing sites, to drive economies of scale during the transition from paper to electronics. This will require secure Internet pipelines, capable of transporting check images between banks and image archive centers.

   Once banks start to build these pipelines, there will be tremendous pressure by retailers and major corporations to build interfaces that allow them to electronically deposit their check images.

2. Move the check payment stream from a serial process to concurrent process flow. The message here is that banks need to move from daily batch processing of checks to a process that continuously accepts and processes check images. This will be welcomed by the largest retailers who want "real-time processing" of POS transactions.

   Wal-Mart is driving this technology objective by providing its suppliers with continuous POS transaction data feeds that come with the obligation to automatically replenish merchandise at the store level. But real-time processing doesn't stop at inventory management; it extends to every aspect of retailing, including transaction posting. Cash-flow reporting is going to be in great demand.

3. Integrate the front-end retail network with the back-end processing center. Check images should be captured as soon as possible once entered into the collection stream. For banks, this means at branch sites or image-enabled ATMs. Once the "pipes" have been laid for feeding images to high speed image processing centers, the cash flow improvements and costs savings available to merchants will drive retailers to install and upgrade check scanners. Integration isn't going to stop at the branch but will extend out to the local retailer, government agency or commercial client that collects payments.

There are many alternatives to writing checks (including the ACH) that are significantly cheaper. Federal Reserve charges for processing an ACH transaction to a depositor bank amount to about 0.9 cents. If a transaction-acquiring bank charges a retailer 6 cents to convert a check to an ACH transaction, the margins seem impressive, but, remember, the transaction replaces a traditional check deposit, for which the bank can charge processing fees of 10 to 15 cents. And there is no revenue source available to the check writer's bank when checks used at the point-of-sale or for consumer bill payments are converted to ACH transactions. Compare this payment model with the Visa POS Check model. Under this Visa method of check truncation, transaction-acquiring banks can charge retailers whatever the market will bear and the check writers' banks earn fees for authorizing and guaranteeing transactions. It's just like the interchange structure that governs credit card transactions. Visa's POS Check program also offers verification options, but in all cases Visa drives revenues back to the check writer's bank. This is not the case with ACH check conversion.

The authors expand on their three-part strategy for profitable migration from paper checks to electronic payments by focusing attention on what they refer to as "three tactical mantras" - Truncation, Automation and Integration.

1. Truncation: Remove paper from the processing stream whenever possible - not just checks, but deposit slips, ATM and batch header cards used in traditional check processing environments. From an ISO or acquirer standpoint, I would suggest expanding the universe of checks that can be truncated to include third-party transactions such as payroll checks, welfare payments and money orders. There is no question in my mind that passage of the Check 21 Act will make it feasible for these types of checks to be truncated by retailers for in-lane purchases with the "cash back" being automatically applied to the retailer's loyalty card for that customer.

   The cardholder then will be able to obtain cash from any ATM or effect transfers to pay bills or move money to other bank accounts. While the retailer is responsible for disposing of the original item, images of the original checks (scanned at the checkout) will be available when collecting funds from the issuer of the check or money order.

2. Automation: Here the authors are broadly describing an opportunity to rethink the traditional check-processing stream and eliminate duplicate balancing, sort passes and continuous processing without consideration of deadlines.

3. Integration: The authors counsel bankers to consider truncating checks as soon as possible and to move digital images across the branch network to the data center and on into the settlement networks. They predict extensive productivity gains for seamless integration. Staff savings, for example, can be redirected to better serving customers or selling services.

The authors believe their vision of the evolution of payment processing because it's the way things have worked out in the United Kingdom. What they don't mention is that there are only five large commercial banks in the U.K.; the U.S. has about 10,000 commercial banks and at least that many credit unions and savings banks.

Changing the direction of an industry of this size and diversity is going to be like turning around an aircraft carrier. It will take awhile before you start to recognize any change of course. If you check the Web sites listed below, you will find that the major banks and Federal Reserve aren't waiting for the passage of the Check 21 Act. They already have placed their bets that imaging will foster the migration from paper to electronic payments.

Excerpts from this White Paper

"These are exciting times for banking, and in payment processing in particular. It is said that there has been more change in the past three years than in the previous 30 combined."

"The conventional (paper check) cost model is clearly in competition with alternative payment channels, i.e., ACH conversion."

"Rapid advances in Internet and telecommunications technology ... are removing excuses for implementing improvements in the payment process infrastructure."

"Check MICR data, images and amounts are easily and quickly captured using small footprint capture devices. Transactions are then automatically proofed, balanced and cleared for posting with minimal effort by the teller or by offsite, 'online' processing staff."

"An integrated enterprise workflow will eliminate the cycle-time barriers between transaction points of entry and downstream central processing operations by leveraging the merger of paper payments with electronic data."

"In the United Kingdom, the trend from paper check processing to electronic payments and channels began earlier and accelerated faster than in the U.S. Solutions such as those described here, in fact, are currently used to process the majority of checks in the U.K."

Eric Thomson is Executive Vice President of Profit Source Advisors. He can be reached at etprosc@attbi.com.

Web Sites for More Information

www.kc.frb.org/FRFS/NonBankPaper.pdf "Nonbanks in the Payment System," by Terri Bradford, Matt Davies and Stuart E. Weiner, Federal Reserve Bank of Kansas City, March 2003.

www.ny.frb.org/rmaghome/staff_rp/sr62.pdf "Bank Payments - Driven Revenues," by Lawrence J. Radecki, Research and Markets Analysis Group, Federal Reserve Bank of New York, February 1999.

www.bitsinfo.org/checksafekeepingjan2003.pdf "Safekeeping and Electrification in the Financial Services Industry," by Charles E. Siegmann, Executive Vice President and CTO, Merchantile Bankshares Corp. and Grant Cole, Senior Vice President, Bank of America Corp., January 2003.

www.federalreserve.gov/paymentsystems/truncation//gs_archive.php?emagazineIssueNumber=030502 "Proposed Check Truncation Act," Federal Reserve Board Chairman Alan Greenspan's testimony to Congress, section-by-section analysis, March 14, 2002.

www.eccho.com/PDFs/Comparison_Chart%20_10-01-02.pdf "Comparison of the current House, Senate and FRB versions of the CTA" (which has come to be called the Check 21 Act).

www.endpointe.com/ One of the major check image exchange consortiums formed by large banks.

www.viewpointearchive.com/flash/index.asp The nation's largest private sector check image archive, with more than 24 billion checks (and counting) in storage. The nation's largest banks are behind this technology powerhouse.

www.frbservices.org/retail/fedimage.cfm By far the largest check image archive built, at a massive expenditure by the Federal Reserve Bank - primarily for community banks, thrifts and credit unions.

Authors: Christopher Nehrbauer, Vice President, Bank One, and Brian Geisel, CEO, Alogent Corp.

Date: March 2003

Size: 10 pages

Relevance Rating: Medium-High

Web Address: techlibrary.banktech.com/data/detail?id=1042646737_446&type=RES&x=522086140

¹ "U.S. Checks Are Only 50 Billion Annually ... Or Are They?", The Green Sheet, February 2, 2002, issue 02:02:01, www.greensheet.com/PriorIssues-/020302-//gs_archive.php?emagazineIssueNumber=030502

² See relevant site links at the end of this column for current status of this act's passage.