The Check Stops Here

The media hype leading up to the US Check 21 Act paled in comparison to the coverage of Y2K in 1999. But while 2000 came and went without much notice, let alone the predicted doom, the long-term effects sparked by the Check 21 Act and a parallel Canadian initiative appear to be significant in terms of long-term cost-savings and enhanced customer service options.

Check 21 legislation, as it reads, does not truly reflect emerging practices in the US and in itself does not create the revolutionary changes financial institutions and consumers are likely to experience. But it sets in motion a change that will likely transform the banking industry over the next two years.

The Check Clearing for the 21st Century Act (Check 21) was signed into law on 28 October 2003, and became effective exactly one year later. The purpose of the Act was to enhance efficiency by reducing some of the legal impediments to check truncation. To achieve this, the law facilitates check truncation in the US by creating a new negotiable instrument called a substitute check, which permits financial institutions to process check information electronically and to deliver substitute checks to banks that want to continue receiving paper checks. The substitute check is the legal equivalent of the original check and includes all the information included on the original check.

What initially made this interesting to the US media was the implication for US consumers, who had become accustomed to writing checks “on the float” knowing that additional money would be deposited into their accounts by the time the check cleared. At the same time, US account holders often have to wait for a short period before all the funds deposited at their branch via a check are verified and made available by the bank. In Canada, float hasn’t been an issue for more than 30 years thanks to the national clearing system in which MICR-line information moves the checks and related data across the country overnight. checks that are deposited at branches during the day are generally exchanged between FIs through the clearing system overnight and can then be posted to the proper account right away.

Customers of Canadian financial institutions are technically affected by changes under the Check 21 Act only in two possible ways. The most significant implication is that those currently receiving cancelled checks that were cashed in the US may receive some image-based substitute in lieu of an original document. This could occur if the FI that accepted the check on deposit or another FI involved in the clearing process elected to truncate the check, create an image of it to transmit to a location closer to the drawee FI, and then print out a substitute check for delivery to the drawee FI and potentially to the customer.

“Customers will be impacted currently when they receive a substitute check or as it is more commonly called, an image replacement document (IRD) with their statement rather than the original document,” says Michael Wenzel, consulting manager, Bank of Montreal. “While a small percentage may initially resist the idea of this change, Canada’s truncation initiative holds so many benefits that customers and financial institutions will both benefit significantly in terms of convenience, accessibility and availability by 2007.”

In the US, only checks that include an ABA routing number may be subject to the changes effected under the Check 21 Act. These include US-dollar checks drawn on a Canadian account and deposited in the US and US-dollar checks drawn on a US financial institution and deposited in Canada. “Our customers who need to write a check to the US can write it through our US subsidiary,” says Mo Jansons, director of industry affairs and interbank operations, RBC Financial Group, “so at this point Canadian account holders would almost never be affected by Check 21.” In fact, nearly three billion checks were cleared across Canada in 2004; of the US-encashed items presented to RBC on 28 October 2004, the first day of Check 21, only seven items were received as IRDs. This number has only now grown to 20 items per day.

“American banks have been slow to adopt the use of substitute checks and that affects our customers as well,” says Jansons, “but all of our clients have been notified of the potential of receiving substitute checks. At some point, we hope to turn off the exchange of all paper checks and provide our customers solely with images. We want to be ahead of the curve in receiving US items in image format. It no longer makes sense to put checks on a plane in New York and send them overnight to Canada.”

So what makes this US legislation, which affects almost no one at this stage, such a monumental catalyst in revolutionizing the banking industry?

In a parallel development to Check 21, the Canadian Payments Association (CPA) is leading a national initiative to modernize the Canadian check-clearing system. “Our project takes an industry-wide approach that will see Canadian financial institutions adopt image-based clearing for all checks, rather than exchanging millions of paper documents each business day as they do currently,” says Roger Dowdall, vice-president, communications and education, Canadian Payments Association. Check 21, at this point, does not mandate truncation in the US, so FIs and their customers are likely to see a mix of original checks and IRDs, Dowdall says. While US law clarifies that recipients can no longer demand the original check, it does not specify that everyone has to use images or substitute checks. By comparison, Canada’s Truncation and Electronic Check Presentment initiative will require universal participation across the country.

Canada’s current clearing system reflects provisions of the Bills of Exchange Act, which has been in place for more than 100 years. Paper-based payments in Canada, such as checks, are exchanged between financial institutions daily at six regional settlement points across the nation. checks go through no fewer than 10 steps from the time the customer deposits a check at his or her bank until the document is returned to the issuing party.

The use of consumer-initiated physical checks has declined in both Canada and the US as electronic payment options become more convenient. “We’ve seen a huge trend in the last ten years where we’re now 70 per cent electronic and 30 per cent paper-based in terms of payments,” says Jansons. “But what we’ve also noticed is that, while the consumer has slipped toward electronic, the business sector has remained the same. So business growth has gone to electronic payments, but paper-based payments have not been cut altogether.”

According to Jansons, retail sales in Canada by Royal Bank of Canada customers are annually broken down by 40 per cent debit, 40 per cent credit, 7 per cent checks and 13 per cent other. As for RBC, it issues 80 per cent of payments to its suppliers electronically, almost matching the federal Canadian government’s percentage.

In December 2004, surveys conducted by the US Federal Reserve confirmed that electronic payment transactions in the US exceeded check payments for the first time. The number of checks declined from 41.9 billion transactions to 36.7 billion, reflecting an annual average rate of decline of 4.3 per cent from 2000 to 2003, while electronic forms of payment increased from 30.6 billion to 44.5 billion, an average annual rate of increase of 13.2 per cent. Canada has seen a 4-5 per cent reduction in checks every year. In 2004, electronic payments made up three-quarters of the total clearing volume.

“I believe this is the most fundamental change we’ve introduced in banking in this century,” says Jansons. “The second was the MICR line. I liken it to the days when we moved from wax and seals on documents to signatures. Adapting to the US Check 21 Act gives banks an opportunity to re-engineer our processes. We have to educate clients on the possibility that they may not receive their original checks back and have options and tools available to them to replace the physical document.”

Most major Canadian financial institutions already have some image-based services available for at least one client sector. “We expect the roll-out of new services to accelerate over the next two years,” explains Dowdall. “Two provincial governments and a number of corporate clients that we consulted are already receiving images of checks they issue and have integrated images into their own accounting operations. Judging by their corporate feedback, we have found that the corporate sector gets significant advantages.”

One benefit is the ability to view a check online to respond to vendor inquiries regarding payment status. A second benefit is the speed of access to check data using an imaging archive over a traditional storage method. The reduction in physical space for the long-term storage of important documentation saves money, as well. As the process evolves, the efficiency gains will benefit FIs, the corporate sector and consumers. “As we move forward with our own initiative, at some point we’ll be able to accept and process electronic images received from the US or from other countries directly,” adds BMO’s Wenzel.

But perhaps the most important benefits of an image-based system will include a reduction in fraud and weather-related interference and dramatically increased ATM service to clients in rural areas. “If we could figure out how to end fraud, we would all be ahead,” says Jansons. “But fraud is a part of business, and the best way to control fraud is to speed up the process of exchanging checks.”

As for weather-related interference, all clearing operations in eastern Canada were forced to close two Mondays in a row this past January. “Staff could not get into branches, and business came to a grinding halt,” says Cathy Williams, senior manager of industry affairs and interbank operations at RBC Financial Group. “Although the bulk of checks you take in a region stays in a region, there are always exceptions, and a closure of this magnitude affects everyone.”

Unlike the US, Canada will not be introducing IRDs. As items are transferred electronically across Canada, transportation logistics and potential weather disruptions will become a less significant factor. Additionally, ATMs in remote locations may not have to be fully serviced every day, given the potential for all check information deposited through the channel to be transmitted electronically. “Change will be universally mandated in Canada and is likely to happen in the US as market forces drive these initiatives,” says Jansons.

“Certainly, with regard to cross-border banking, we’re following the developments in the US and looking at international ANSI standards with a view to having compatible approaches as we go forward,” says Dowdall. “We’re also keeping our eyes on other countries that have moved to implement electronic processes for clearing checks, sometimes involving images and sometimes not.”

“Some people need a reason to change, and this could be that reason,” says Williams, referring to Check 21.

“For some, the changes brought on by Check 21 or the Canadian initiative will be simply a change in expectations,” Jansons adds. “For businesses, it could change some processes, particularly the way they store and use paid checks; however, it is also an opportunity to re-evaluate and improve these processes, many of which have not been assessed in decades.”

Change is inevitable. Most consumers, businesses and financial institutions may not yet be seeing the results of the work to modernize check-clearing systems, both in Canada and the US. But the changes, re-education and re-engineered business processes resulting from the groundwork now in progress will eventually offer all parties more benefits than the current systems in either the US or Canada.