Financial Update (October-December 1996)
Improving the Check System
While Planning Its Demise
Jack Guynn, president and chief executive officer of the Federal Reserve Bank of Atlanta, offered comments on improving the payments system to the Bank Administration Institute's Image Technology in Banking Conference in Orlando, Florida. Following are excerpts from his speech.
ne practical dilemma facing us concerns the overall efficiency of the payments system. By one account, the existing payments system consumes 1 to 2 percent of GDP (gross domestic product), a number four times that of other industrial nations. This is a substantial infrastructure to support—with no short-term promise of improvement. And virtually every study continues to project growth in the check business while electronic alternatives evolve.
This situation does not imply a more efficient system in the short term; instead, it promises a long period of redundant costs. These costs can be even higher if alternative payment systems evolve in such a way that standards are not clearly defined and movement from system to system becomes a costly hurdle. In the past, the Federal Reserve has been involved in dealing with standards issues, whether it was the MICR (magnetic ink character recognition) line or ACH (Automated Clearinghouse) formats. Perhaps the Fed could again play a useful role by bringing diverse parties together to deal with issues of interoperability in an attempt to make this transitional period as efficient as possible.
President and CEO of the Atlanta Fed
This is but one of the ramifications of the "brave new world" of our increasingly complex payments system, a world that remains dominated by paper-based systems, including what is regularly described as the "inefficient check system." Everything I know about the check system tells me that it is inefficient, and everything I know about electronic alternatives promises long-run improvements in efficiency.
But if paper is so inefficient, why do people keep using it? From an economic standpoint, the answer is that someone must be providing a subsidy. Where then is the subsidy? Certainly, float is part of it, in that the industry does not pass along the true cost to the users of the check system. The Fed also partners with corporate America to reap the benefits of float. For that matter, I'm not at all sure that the true cost of any aspect of the check system is passed along to the end user. But we must be careful to ask when we argue that the check system is inefficient, inefficient from whose viewpoint?
For the Fed, the cost of handling a check is certainly higher than handling an ACH entry. And, from an end-to-end societal perspective, there are numerous studies proclaiming the relative inefficiency of paper. But I'll bet there isn't a financial institution that can say that an ACH entry is less expensive than a check in the back room. The systems, the cost discipline, and the economies of scale just aren't there yet.
So we must realize that the check system is still going to be a vital part of the future. Should we then do the unthinkable and try to make the check system better, while we simultaneously plan its demise? I don't think it would surprise anyone if I told you that there is considerable disagreement within the Fed on this point, as I am sure there is in many institutions.
I believe, though, that, as an industry, the goal should be to make the payments system more efficient over the long term. The goal should not be to make the system more electronic, per se, unless electronic alternatives are actually more efficient. And with 60 billion checks a year in play, the definition of the long term may be very long.
In the meantime, if an analysis of the environment shows that rapid change is not likely, should we forgo the opportunity to lower the costs of paper-based systems? I think the answer is, No! The industry should do everything possible to improve the system, subject to certain guidelines. First, improvement should not be at the expense of promising electronic alternatives. Second, reasonable capital budgeting decisions must be made that will allow for the investment in paper-based infrastructure to be recovered over time. Third, we should see some synergies with where the electronic world is heading, as a means of further leveraging any investments. Finally, each improvement should truly improve the efficiency of the end-to-end process.
One of the clear benefits of electronic check presentment—reduced float—will make electronic alternatives for large-dollar checks even more attractive.
The promise of electronic check presentment
As a case in point, let's take a look at the concept of check truncation at or near the point of first deposit. I will refer to this as electronic check presentment, or ECP, from this point on. Fundamentally, it involves the capture of a check at the bank, or Fed, of first deposit (we'll call this the "keeper" bank), and the conversion of that item into an electronic transaction for further clearing and posting to the customer's account. An image or copy of the check is maintained at the keeper organization and the paper is eventually destroyed. Returns and disputes are handled through electronic retrieval of the images from a keeper's data bases.
ECP appears to pass all of our tests. First, it is a system that does not benefit at the expense of electronic alternatives. I could argue that, with ACH as the format and delivery system for the truncated item, it could actually help to make the ACH more efficient by introducing new volumes, improving economies of scale, and reducing the marginal cost of the electronic alternative. Moreover, one of the clear benefits of ECP—reduced float—will make electronic alternatives for large-dollar checks even more attractive.
Second, although it is difficult to know whether it is possible to recoup the investment in ECP technology, because many of the costs of a full-blown ECP environment are not yet well known, the costs of added infrastructure—given the huge volume of checks in play—seem reasonable. The primary investments in storage and retrieval equipment, clearing systems, and data communications resources can be partially offset in the short run by savings stemming from float reduction and ultimately from overall reduction in processing capacity. In summary, ECP seems synergistic, and it supports the critical success notion of electronic payments: that is, that the customer doesn't need a physical item returned with the statement.
It's because of this promise for improvement that we at the Fed are approaching ECP as one of our most important strategic goals in the next few years. You may be aware that we have organized an industry advisory group for ECP, consisting of representatives from some of the largest check processors in the country as well as community bankers and trade groups. We are very excited about this effort and the interest that exists in the industry. As we head into 1997, I hope that we'll be able to bring you some empirical data and, hopefully, some positive results that will lay the groundwork for more widespread efforts.
The role of image technology
This raises another point, and it relates to the role that image technology may play in the future payments system. Early on in the development of image concepts, many believed that the future lay in image capture and full transmission of images as the replacement for the truncated paper item. Given the early success that some institutions had with image statements, this belief was not surprising.
While one might argue that image, as a primary payment flow, might pass some of the improvement tests, it appears hard to justify it from a payments system efficiency standpoint. The cost of transmitting full images and warehousing them in multiple locations is not justified, given the current economics of these technologies. It also seems odd that this approach falls into the common trap of technology evolution: trying to use technology to mimic a previous system, in this case, paper-based flows. In fact, the financial industry should be trying to figure out how to use technology to create a new method of doing things.
While the verdict is still out on the future economics of wholesale imaging, it's clear that use of images can really make some back-room operations more efficient. This seems particularly true in proof of deposit, bulk storage of truncated items, adjustments, statement rendering, and customer historical research. In essence, imaging appears to be a powerful support technology for many aspects of the paper-based system and, used in these capacities, makes sense.
With that in mind, the Reserve Banks are deeply involved in working with IBM, Unisys, the U.S. Treasury, and others to develop proposals for image interchange standards in the banking environment. The Fed is also looking at all aspects of central site archiving and retrieval.
A very complex period
I would like to offer a final thought. We live in a period in the evolution of the payments system that is very, very complex. There are so many alternatives being explored that both consumers and banks are bewildered about where to make investments. According to Fed Chairman Alan Greenspan, the reason for this is that as a society we have a terrible track record of predicting the technologies that will succeed.However, there is one thing that I'm pretty sure about: with 60 billion checks a year in play, one of the most important questions is how to use new technology to get further improvements in the check system—while at the same time championing new electronic payments services.