Check Truncation Strategies

Check Truncation Strategies Implications for Float Management A White Paper by Rick Kuhn www.carreker.com Carreker Corporation 2003 1

CHECK TRUNCATION STRATEGIES IMPLICATIONS FOR FLOAT MANAGEMENT By Rick Kuhn, Senior Principal, Global Payments Consulting This paper is written to ensure that the emerging image clearing network fully accounts for the valuable perspective of float management. It is not unusual to discover the latent presumption that an image environment largely negates float. At the same time, electronification's planners typically tend to under consult with float managers on an area where float managers tend to be among the bank's experts: customers' payments needs, preferences and pricing. As the banking industry readies itself for the Check Truncation Act (or Check 21), the author draws on his work with the country's leading Float Managers to establish a valuable set of criteria for banks' clearing decisions in the emerging image clearing environment. This paper serves as a companion piece to Mr. Kuhn's paper, ARC: The Float and Operational Impacts of a New Blended Payments Product. Executive Summary The float benefits made possible by the Check Truncation Act (CTA), also known as Check 21, rival the benefits stream of any other clearing opportunity since the Monetary Control Act of 1980. Back then, the law created a powerful incentive for banks to accelerate the pace of check collection by adding the Federal Reserve as a competitor for check clearing products. Today, we foresee in the CTA an equally powerful incentive to accelerate the electronification of payments in ways that provide even greater revenue opportunities. To over-simplify a subject that begs for simplification, the Check Truncation Act provides the legal framework to allow banks to clear paper based transactions as either (a) the physical check, (b) an image of the check or (c) a reproduction of the digitized image of the check (called an Image Replacement Document or IRD). As of this writing, the CTA has not been approved. Yet the banking industry, recognizing the law's major implications for traditional products and processes and the long ramp-up for new products and processes, must press forward to establish standards and procedures to accommodate the proposed legislation. In the face of the uncertainty surrounding the law, the new image-based products and the impact on the float revenue that lubricates much of the existing paper payment process, this document was written to serve a specific purpose: to ensure that the emerging image clearing network fully accounts for the valuable perspective of float management personnel. Three basic premises should become apparent through this discussion: 1. The decision process for clearing checks in an image environment is not as difficult as we envisioned several years ago when the Federal Reserve first proposed the basic constructs of the CTA. 2. Image exchanges through multi-lateral agreements are already taking place in a test 2

mode anticipating the enactment of legislation. 3. Float management will continue to play a vital role within the payments system as the CTA heightens the importance of identifying the most cost- and risk-effective method to process a payment and allocate the costs of the collection network. The paper is organized in three parts: Banks that are quick to broadly accept images will potentially subject their own customers with poor quality images. 1. Paying or Receiving Bank Considerations 2. Collecting or Sending Bank Considerations 3. Implementation Strategies, Phases 1 through 5 Paying or Receiving Bank Considerations Under the CTA guidelines, paying banks dictate whether paper or images serve as legal presentment. Collecting banks are therefore compelled to either research the paying bank requirements directly or rely on an intermediary processor who has prior knowledge of all of the requirements within a given region. From a paying bank's perspective, we can equate the image vs. paper decision to the initial Presentment Location decision that paying banks made under Same Day Settlement rules. With SDS, there was considerable risk for the paying bank if they chose the wrong presentment location. Paying banks that chose a presentment location that was too convenient for collecting banks risked losing control over incoming quality. Banks that closed the doors by assigning a remote location risked having to regularly service an out-of-the-way presentment office. Paying banks face similar risks when making the decision to accept images over paper. Those banks that are quick to broadly accept images will potentially subject their own customers with poor quality images captured by institutions beyond the scope of influence. Banks that require paper, on the other hand, may be forced into processing IRDs instead of the actual check. At this point, it is important to note that many paying banks will utilize "image quality sweep" programs to cull out poor quality images. Payment will only occur for images that pass a set of quality criterion. Rejected images will not be paid and will be returned to the collecting institution raising a whole new set of adjustment procedures. Ultimately, the decision on whether to accept images or paper will be determined by market drivers as well as the paying bank's ability to use images in Day-2 functions. Market Drivers Consumers have been fighting truncated or image statements for years. Even institutions with aggressive truncation programs have found it difficult to break the 80 percent truncation barrier despite the fact that savings accounts, credit union accounts and credit card statements are predominantly truncated. We believe this is a short term issue as customers "warm" to the concept of truncated or image statements. 3

Operations Considerations Images are only valuable to banks that have the technology to (a) post from the electronics, (b) print an image statement or provide the images to corporate customers, and (c) use the image for Adjustments, Returns and Exceptions processing. Banks that have not developed an image archive and are not fully image-enabled in the back room will still need to process paper, forcing depositing institutions to present either the original check or an IRD. When evaluating clearing alternatives in a post-cta world,we also have to recognize the implications of image transfer. Collecting or Sending Bank Considerations Prior to the CTA, collecting banks optimized check-clearing patterns by measuring clearing and transportation fees against the value of float. The decision process for clearing imagebased cash letters is not all that different than the techniques used for clearing checks conventionally. When evaluating clearing alternatives in a post-cta world, we not only have to consider clearing costs, float and deadlines, we also have to recognize the implications of image transfer. Image simply adds one more variable to the decision tree. Transmission alternatives Banks that choose to ship images will obviously need a place to ship the images. The actual size of an image file will be determined by standards that have not been established as of the writing of this paper. For the sake of argument, it is safe to assume that each check image will contain anywhere from 25k to 50k bytes of data and we should expect significant time and expense barriers to transmitting large volumes of images especially in the early stages of check truncation. In general, we envision the following potential alternatives to manage image transmissions: Banks may establish direct exchanges, where the paying bank is responsible for populating its image archive. For very large volumes, these exchanges may be made through direct connections. Other alternatives include Frame Relay, the Internet, shared networks or the physical movement of data tapes. Third party vendors such as the Fed, a correspondent bank or a non-bank service provider will develop shared image archives and the sending bank will ship images to a Mail Box that is owned by the receiving bank. Note that the transmission alternative described for direct exchanges also apply to third part archives. Finally, banks may choose to send the images to a correspondent or to the Federal Reserve, who will provide an image clearing service. This alternative will be especially attractive to small respondent banks that do not have the ability to manage complex communications networks. Warranties and Indemnifications Regardless of the transmission methodology, all image based exchanges will require written agreements between sending and receiving institutions. Similar to the agreements required for traditional sending arrangements, both parties must agree on quality, deadlines and settlement issues. In addition to the conventional concerns, image agreements will include indemnifications for the paying 4

bank that the items will not be presented twice. As the "rule maker" for the clearing industry, ECCHO is playing a major role in creating the verbiage that provides these warranties. Creation of an IRD Especially in the early stages of CTA implementations, many paying banks will require a paper document. Alternatively, the sending bank may choose to create the IRD for remotely captured items as opposed to entering the brave new world of settlement and adjustments in an image environment. Although a number of industry pundits are expressing concerns regarding IRDs, the highspeed creation of MICR documents is not new to the industry. Prior to the widespread use of the ACH for Concentration of Funds products, many banks created DTC's (depository transfer checks) on high-speed impact printers. With the advent of MICR laser inks, the process is even more simplified. Regardless, creating an IRD will still be a relatively time consuming, expensive process. For planning purposes, it is not unreasonable to expect that the fully loaded unit cost to create and clear an IRD will be in the $.50 to $.75 range. In other words, banks will create IRDs only for very large dollar items where there are opportunities for significant float improvements. We also envision several alternatives to create an IRD: Privately owned print shops Banks with large volumes of checks drawn on specific regions may establish remote print shops. Third party service providers The Federal Reserve, correspondent banks or data processing service providers may establish a network of IRD print facilities. Receiving banks may charge a fee to print their own IRDs. As in the current process, the ultimate decision on how to clear an item will be based on the potential float/risk benefits as opposed to the cost of acceleration. The following chart depicts the check clearing decision tree in an image-based environment. Image Check Clearing Decision Tree 5

Implementation Strategy Given the cost and complexities of implementing full image sends, most banks will take a phased-in approach to implementing CTA presentments. The initial sends will be between banks that have developed bi-lateral (or multi-lateral) agreements, clearly dictating the rules for presentment and settlement. As experience and technology matures, costs will decrease and additional image sends will become practical. The following chart is representative of the key events relative to outbound CTA sends. Because the actual enactment of the CTA depends on a myriad of political events, the chart assumes that the CTA will be effective within the next 18 months the earliest that most observers would suggest is possible. Note that the sending bank does not have to be fully image-capture enabled to send high dollar cash letters; images for limited volumes can be captured on secondary passes. Phase 1 Image Exchange Agreements ECP, potentially with checks and/or images to follow Banks are not waiting for enactment of the CTA before engaging in the first phases of image exchange. In fact, the early adopters will no doubt be the drivers of the standards and procedures that are currently under development. During this phase, banks will create partnerships through bi-lateral agreements to work through many of the transmission, settlement and posting hurdles. Although image posting is frequently equated to ECP, the back-room implications are significantly different. In an ECP environment, banks typically re-capture the checks and match them to the electronic file. Therefore, all of the images (digital or microfilm) are internal. Under CTA, the images being pulled may not reside on an internal image archive and the back-room systems need to know where to find the image. (On a side note, West Coast banks should be concerned that many of the imagebased standards are being defined primarily around backroom efficiencies. Of the two primary benefits of image exchanges operational savings and float 6

improvements only the operational savings apply to all institutions. Float improvements are significantly greater for banks with payments concentrated on the West Coast. During the "early adopter," it will be difficult, but critical, to maintain a float management perspective to yield the full range of benefits available through the CTA.) Phase 2 Low Volume/Large Dollar Transactions Banks with large concentrations of West Coast depositors will be the first major benefactors of the CTA. Given the impact of multiple time zones, and absent any image exchange opportunities, banks with large concentrations of West Coast depositors will be the first major benefactors of the CTA because of the significant float improvements associated with transmission times over air transportation. Several major assumptions need to be made for CTA planning purposes. In the very early stages, fewer than half of the receiving banks will be prepared to accept images from remote capture centers. Further, many of the banks that are image-enabled in the backroom will take a wait-and-see attitude to verify the quality of image transmissions. Therefore, sending banks should be prepared to create IRDs for a fairly large percentage of transmitted volumes. The cost to transmit a file and create an IRD in the early stages will probably exceed $.50 per item, including clearing fees. At current interest rates, this means that image cash letters will be dollar cut at approximately $10,000. Image cash letters will not only require significant time for IRD printing, delays will also result from staging and transmissions. In our planning engagements, we are recommending that banks cut image cash letters in time for transmissions to be complete by 04:30 local clearing time, providing 3 ½ hours to print the IRDs and transport them for SDS deadlines. In other words, assuming 90 minutes is required for staging and transmissions, West Coast cash letters should be cut by midnight Pacific Time in order to make 08:00 Eastern Time presentments. On a "worst case" scenario, plan on presenting IRD-based HDGS (High Dollar Group Sort) cash letters to the Federal Reserve. On a "best case," anticipate that the Fed or a correspondent will accept an image-based cash letter and will present the items according to the specific instructions of the paying banks. The CTA business case reviews that Carreker has performed under the above assumptions for operations centers in the Pacific Time Zone reveal that significant float improvements are associated with approximately three hours of additional processing time. In several cases, the annual value of the float improvements exceeded $2 million per operations center even in today's low interest rate environment. Phase 3 Initial Large Volume Sends HDGS items to Fully Image-Enabled Banks Banks that are fully image-enabled will prefer to accept images as opposed to paper items to avoid the costs of re-capture. 7

Transmission costs for large volume sends can be reduced by periodically "feeding" the receiving banks' image archive throughout the day. In the early stages, however, the transmission costs may still outweigh the traditional costs of clearing checks. Therefore, our business case for this phase assumes a $1,500 cut similar to what we would use for conventional HDGS cash letters. At some point, digitizing all items at remote branch locations will become more cost effective than physically transporting documents to a centralized capture center. The lower threshold results in a larger number of items, but in lower proportional float benefits. In general, we estimate that the float benefits of Phase 3 are roughly 20 to 25 percent of the float benefits that can be achieved in Phase 2. In this phase, however, banks also begin to accrue significant transportation benefits, as there will no longer be a need for costly premium sending arrangements. Carreker's reviews to date reveal that the potential transportation benefits of Phase 3 are similar to the float benefits available in the previous phases. Phase 4 Remote Branches and ATM's Truncating all activity from remote regions At some point, digitizing all items at remote branch locations will become more cost effective than physically transporting documents to a centralized capture center. It is not uncommon, for example, for a bank to incur inbound transportation expenses of $.05/item to fly work from remote branches to capture. Phase 5 Ramp up Banks in remote locations have a history of being early adopters of truncation related practices, largely resulting from high transportation costs. As an example, recall the broadly implemented inclearing truncation initiatives of the banks in Michigan's Upper Peninsula, where a limited road network is frequently snowcovered. In this example, the UP banks post their on-us items from the Fed's payor services file and exceptions are researched via fax and image. The potential for other remote capture opportunities are also apparent. For example, capturing the images of ATM deposits eliminates the need to service the ATM on a daily basis. Also, large corporate customers will be prime candidates for image capture just as they are today for pre-encoded deposits. The key during this phase will be to balance transportation expenses against the costs of distributed technology. Even in a mature technology, the cost to create an IRD may not drop below the $.05 to $.07 range, which may be still be greater than the cost of processing and presenting the paper. Therefore, the only items that will be forwarded in a mature CTA environment will be to banks accepting all of their items as images or ECP transmissions. 8

Low dollar items, where there are virtually no float benefits, will continue to be processed as paper for the foreseeable future. Ultimately, the industry may move to electronify these low risk payments. Summary To fully exploit the benefits of check truncation, float management personnel need to take an active role in the deployment of image technology. To fully exploit the benefits of check truncation, float management personnel need to take an active role in the deployment of image technology. To date, much of the attention regarding truncation has been focused on the back-room efficiencies of full image archive solutions for Day 2 processes. One possible explanation for this focus is that many institutions are driving CTA development from an East Coast perspective, where the backroom efficiencies may be greater than the anticipated float advantages. Even for West Coast institutions, where the potential float advantages are significant, the impact on non-earning assets has been a secondary concern as evidenced by the fact that many of the image business cases that we have reviewed to date do not include the potential float and transportation benefits provided by the CTA. Specifically, float managers should be charged with: Assuming a substantial role in developing industry standards and procedures relating to the notification, presentment, settlement and adjustments of image-based cash letters. Actively participating in development of their bank's CTA implementation strategy. Providing significant input into the implementation of image technology, including the development of the image business case. Educating product management on the negative float and product opportunities that are associated with the improvements in collection speed. Establishing an open dialog with potential image-based presentment points. For more information, contact Rick Kuhn at 586.774.0448. Information about Carreker's float management consulting services and technology can be obtained at www.carreker.com. 9