Check 21 and the Migration to Electronic Payments
The implementation of Check 21 legislation in the fourth quarter of 2004 further accelerated the migration from paper to electronic payments. At the time, it was estimated that banking institutions would need to invest in the front-, middle-, and back-office infrastructures with total industry costs exceeding $10bn over the course of the decade. The increasing migration also raised risks to banks as businesses became better able to gain benefit from changes and in turn better able to collect funds. The acceleration of collection has had potential negative consequences on bank revenues from deposits and payment products.
The objective of the Check 21 legislation (implemented in October 2004) was to reduce systemic risk associated with physical check movement and to provide a mechanism to reduce the costs associated with check payment processing. Check 21 creates a newly acceptable payment instrument and provides a foundation for the imaging of checks as the basis for creating new payment instruments and their acceptance by other banks. While the legislation does not specifically require that images be presented bank to bank, the legal and operational foundation exists for this evolution.
Closer scrutiny of the legislation, however points to significant business risks from both a cost and revenue perspective. These include:
‘An Act to facilitate check truncation by authorizing substitute checks, to foster innovation in the check collection system without mandating receipt of checks in electronic form, and to improve the overall efficiency of the Nation’s payments system, and for other purposes.’ Public Law 108-100, 108th Congress.
President Bush signed the Check Truncation Act into law on 28 October 2003. The law, commonly referred to as Check 21, provides a legal framework for banks to accept substitute forms of checks effective October 2004. The goals of the legislation are the reduction of systemic risk of lost checks due to business continuity failure, such as 9/11, and cost reduction by allowing banks to agree to electronic presentation, thereby eliminating the need for physical presentation and transportation of checks for settlement.
It is the broader implications of the law, however, that create even more significant benefits as well as risks for banks. The legislation serves as an enabler that will form the basis of check digitization leading to digital presentation bank-to-bank.
The detailed provisions of the Check 21 Act incorporate a framework that includes the definition of substitute checks, the establishment of a new negotiable instrument, and an agreement that a substitute check is a paper reproduction of the original check and can be processed as such. The paper reproduction must, however, meet industry standards for substitute checks, include an image of the front and back of the original check, and be MICR encoded and machine-readable.
A substitute check is the legal equivalent of the original provided that it accurately represents all the information on the front and back of the original check, bears a legend stating it is a legal copy of your check and that you can use it the same way you would use the original, and that no agreement is needed to transfer a legally equivalent substitute. Check 21 does not, however, specifically provide for electronic exchange bank-to-bank although implicit in the legislation is the ability for this type of service provision.
Before Check 21, the check-processing environment involved a complex network of processes involving significant labour, expensive equipment and systems, transportation, and inter-party affiliations. A key element of determining the necessary check processes was the predicated location of presentation of the check by or to a bank, which as discussed previously, is a legal negotiable document. Check 21 has complicated this situation by expanding the scope of current and potential processes while increasing the need for technology support for the equipment and systems that support them.
The short-term impact of Check 21 compliance will be increased expenses to support redefined processes, incorporation of imaging and digital conversion into the processes, and incorporation of imaging technologies. These legacy costs will increase cost-per-check processing in the short term. Initial transportation cost reductions will not adequately offset the increased costs, while redundancy costs inherent in processing environments will significantly increase.
We estimate that the industry’s near term investment costs will be approximately $10bn over the next three to five years. This figure includes new imaging input hardware, storage, retrieval, and software supporting input, storage, and retrieval. In addition, it includes network connectivity supporting input, storage, retrieval, and presentation as well as the redundancy costs of current check processing environments, including labour. The banking industry has the ability to control elements of this impact through staging, predicated on a redefinition of processing. However, other banks could also drive these impacts and key customers who could hasten and even define implementation staging by pursuing legislatively supported operational benefits.
In commercial payments, the transition to ACH has accelerated with conversion increasing significantly over 2003 and 2004. During this period, the Federal Reserve noted ACH growth at more than 15 per cent. While ACH has traditionally offered lower direct processing costs, commercial payers have been slow to transfer due to the potentially negative impact on working capital, in the form of lost float and control over payment dates. Large, sophisticated companies have historically utilized internal and external resources to analyze the benefits of using checks versus ACH payments, and changed those payment flows they felt beneficial.
Disbursing corporations have the potential to lose float benefits as collection cycles can be reduced through utilization of Check 21-aided digitization and electronic presentation. As a result, companies utilizing check float have mostly modified their processes to neutralize the lost float benefit and control. ACH mechanisms can enable incorporation of disbursing lags to attempt cash flow neutrality.
Alternatively, these companies may accept the lost float as an accomplished reality and migrate towards less expensive ACH payments. The impact of this conversion is significant for banks. While ACH services offer lower processing costs – this transition stranding significant investments in check processing infrastructures and shared benefits of collection and disbursing float – they also lower transaction revenues and margins.
Corporations have been willing to accept the positive benefits of converting check-based receipts to ACH transactions, generically referred to as check conversion. This is also borne out by the rapid growth of check conversion transactions over 2003-2004. Until the end of 2004, check conversion had had little impact on corporate payments, since it had, by regulation, been limited to consumer initiated transactions. This situation began to change when the US treasury issued proposed regulations that allowed it to convert commercial payments to ACH transactions as well if it wished to do so. The implementation of Check 21 truncation, which has no similar limitation, has also accelerated the movement towards electronic payments.
The result of these customer and regulatory transitions is decreasing margin exacerbation in check processing, as check volume declines. Bank attempts to maintain margins by raising check prices could drive more transactions to electronic media or competitors, compounding the problem. Such events could further strain the significant investments in check infrastructures and economics.
Another change related to Check 21 is lower revenues predicated by the retail needs of customers at point of presentation and with bank-to-bank presentment. Most bank imaging efforts have been focused on internal processing. While certain industry efforts have been created that are focused on inter-bank capabilities, such as archiving, the advent of bank-to-bank presentment capabilities and image capture at point of presentation has had an impact on check-processing economics.
The bulk of retail check presentation occurs at bank branches, retail merchants, and check-processing merchants. Such presentation is physical across multiple channels (e.g. ATM, teller, POS) and represents a significant opportunity to transfer processing costs to the presenter by incorporating imaging into presentation processing. This capability will be of benefit to bank branches and retailers with significant collection requirements. Some retailers, including banks, have driven bank providers to enable capabilities for their benefit – to expedite their collection and float concentration capabilities – to the detriment of less sophisticated disbursers and disbursing banks. The incorporation of imaging technology at point of presentation has both enabled significant savings and opportunity as well as change behaviours of end-user customers.
In addition, bank-to-bank presentation for collection has driven further cost efficiencies. By incorporating imaging POPIC with electronic presentation processing, settlement can be enabled by the presenter automatically without direct staffing (or transportation) other than support for the custodial function of imaged checks.
In addition to business continuity related risk reduction, Check 21 implementation offers significant long-term financial incentives for the industry, including reduced transportation costs, process staffing, and labour requirements.
Check 21 regulations entered the business cycle at a precarious time for the banking industry. Already under economic pressure exacerbated by recession and credit cycle, the traditional commercial business was experiencing client conversion-based adoption of ACH while consumer business was under margin pressure due to increased competition for account ownership amid rising costs for new branches. Compounding these challenges, POPIC implementation and bank-to-bank presentation capabilities have the potential to significantly reduce bank revenues via reductions in float related to check collection and potentially altering processes related to insufficient funds (NSF) and transaction fees.
Disbursers and banks benefit from check float in three distinct cycles: mail float, the cycle where the check is in transit to collector (in transactions where presentation is not at POS); processing float, the cycle where the check is being processed by the collector and by the collector’s bank; and clearing float, the cycle where the check is being moved from depository to paying bank for final settlement and funds release.
Dependent upon the method of presentation, a significant number of checks that are presented via POPIC incorporating B2BP would potentially reduce the processing and clearing cycles. This cycle reduction would have significant impact in speeding up available collections, thereby reducing funds balances among disbursers and their banking providers.
Federal Reserve statistics offered significant insight into the potential impact of Check 21 before implementation. Monthly transaction deposit data (i.e. non-savings-accounts for commercial and retail customers) seem to be relatively flat over the prceding 13 years. Estimated float revenues generated from those deposits (i.e. Fed Funds rates) showed the net impact of the reducing interest rate environment. These impacts are significant but will be increased through further ACH and imaging based conversion. Check float has been decreasing as a result and further product transition and behaviour change is likely to significantly reduce revenue potential.
Comprehensive imaging enablement also suggests further potential benefits for the industry, including the ability to better ensure ‘good funds’ availability. With end-to-end image enablement, there will be greater ability for the industry to test availability of funds via image presentment directly to the paying bank.
While offering significant exception processing cost reduction, this benefit may also indirectly pressure a substantial source of fee income – NSF fees related to insufficient funds. We estimate that NSF and related fees exceed $3bn annually, generated primarily with little additional non-standard process cost.
Check 21 has significantly altered the flows, processes, and economics of check processing. However, its larger implication is the possible reduction in revenue related to use of funds and check processing related transaction fees.
Check 21 is a significant regulatory event with broad business, operational, and technical implications. The implementation of the Act came at a challenging time for an industry grappling with escalating costs and decreasing revenues. There is significant potential for Check 21 to exacerbate these challenges. Experience suggests that the banking industry has responded to the legislation largely as a compliance initiative. Given the breadth and scope of the issues involved with managing change related to this regulation, activist business lead programming has focused on understanding flows of funds and the value created by those flows for the bank and coming to grips with the costs and risks associated with compliance as well as the possible broader revenue and cost ramifications.
Check 21 has impacted the economics of US banking. Given the various industry approaches, customers, and execution plans, there are winners and losers among providers. In my view, the winners are those institutions that have developed and executed robust operational plans focused on the legislation’s direct impacts on their business and competitive positioning.
This article is reprinted with permission from the Capco Institute, publishers of the “Journal of Financial Transformation”.