Although the largest U.S. banks have aggressively outsourced the processing of credit card and electronic bill payment transactions, almost all of these banks process checks in-house. With check volume declining and new technologies introduced to electronify the processing of checks, TowerGroup believes that banks should reexamine their transaction processing strategy and consider outsourcing some or all of their back-office check processing functions.
The increased acceptance of electronic payments such as debit cards, ACH direct deposits, and electronic bill payments resulted in U.S. check origination volume peaking in 1999 to 2000 at approximately 43 billion transactions. The actual banking industry capacity for processing checks is much higher, however, as banks typically must repass many of their transit items to sort the checks by cash letter destination.
TowerGroup estimates reflect the fact that check origination volume is now declining at an annual rate of 3 percent. Furthermore, the actual volume of checks processed by banks is declining at a greater rate due to the electronification of checks. Specifically, NACHA's point-of-purchase check truncation and account receivables check truncation initiatives are electronifying checks before they are deposited at a banking institution. Thus, despite an overall 3 percent drop in check origination, many banks are experiencing year-over-year declines in excess of 5 percent in check processing volume.
The implementation of Check 21 will significantly increase check processing overcapacity. Banks will replace the physical sorting of checks (by transit number) for presentment with digital sorting of the captured images. These images can then be forward presented for conversion to substitute checks or, if the paying bank has agreed to accept electronic presentment, they can be presented as images. TowerGroup estimates that this use of images for presentment will further increase check processing capacity by 20 to 30 percent over the next five years, resulting in an industry processing overcapacity approaching 50 percent. Clearly, banks will be able to scale back personnel as the processing requirements decline, but the facilities and equipment infrastructure costs will prevent them from realizing the full costs savings potential of image technology and Check 21 legislation.
Check 21:The Uncertain Path
The passage of Check 21 does not provide a clear path for banks to implement check truncation. The Act does not mandate the truncation of checks but allows depositing banks the option of truncating the physical check by creating an electronic "substitute check" for presentment to the paying bank. Under the legislation, the depositing bank or its agent can create a file with substitute images of the paper checks, transmit the file to a site near the paying bank, print the substitute documents, and deliver them to the paying bank. The legislation, then, allows depositary banks to truncate the physical check but maintains the ability of the paying bank to process the checks using existing equipment and paper-based processes. Banks, however, may mutually agree to accept electronic check presentments for some or all of their checks without requiring the substitute paper document (using check images for exception handling).
The requirement for presentation of a paper-based substitute document was clearly intended to provide smaller banks with the option of avoiding upgrading their equipment and software for processing electronic check presentments and image files. Many banks, however, are expected to agree to the electronic presentment of checks without requiring the physical production of a substitute check. This total elimination of paper-based processes is clearly the most efficient means of truncating and processing check-originated payments. TowerGroup believes that a gradual shift to full electronic check presentment will occur over a period of several years. In the meantime, banks will be presenting a combination of actual checks, printed substitute documents, and electronic files. These multiple modes of presentment will result in a shifting of equipment and processing requirements during the transition period, adding to the costs of in-house processing during this timeframe.
The Outsourcing Argument
Large U.S. banks typically cite the following reasons for not considering outsourcing of the check processing function.
- The check processing function is critical to the bank.
- Financial loss would result if the outsourcer failed to clear checks in a timely fashion.
- The bank has substantial investment in its check processing equipment and facilities.
- The outsourcing market is fragmented, and the firms lack financial strength.
This is not to say that banks should indiscriminately outsource all check-related functions. Although the majority of check processing functions can be viewed as commodity products that need to be offered on a low-price basis, there are check functions that might best remain in-house. Products such as wholesale lockbox provide value-added services and can remain in-house, while the more commodity-like back-office proof and check clearing functions can be outsourced.
There are several outsourcing models that U.S. banks can use for check processing. Three of these models are direct outsourcing agreements with third-party vendors, forming and operating a check processing consortium with other banks, and forming a consortium with banks and a third-party vendor that manages and operates the consortium.
The direct outsourcing model is used by a number of large U.S., Australian and New Zealand banks. U.S. banks including Citigroup, Washington Mutual, Sovereign Bank and Northern Trust use direct outsourcing agreements for check processing. Citigroup is somewhat unusual in that it processes its New York area check volume in-house but uses outsourcing vendors to process in other regions. Outside the U.S., Unisys has been highly successful in securing direct outsourcing agreements in Australia, and EDS has achieved a dominant market share in the New Zealand market. EDS also has a significant position in the U.K. market, providing outsourcing services to Royal Bank of Scotland/NatWest.
The bank-owned consortium model is used in Canada, where the BMO (Bank of Montreal) Financial Group, Royal Bank Financial Group, and TD (Toronto Dominion) Bank Financial Group formed the Symcor consortium in 1996. The consortium has enabled its member banks to reduce their number of check processing sites from 23 to six.
The bank/vendor-owned consortium model has been successful in the UK. Barclays Bank, Lloyds TSB, and Unisys formed Intelligent Processing Solutions, Ltd. (IPSL) in 1998. Another large bank, HSBC, subsequently joined the consortium. The check volume of the three partner banks and a number of other banks using IPSL on a service bureau basis now represents more than 70 percent of U.K. check volume. A second example of this model can be found in Canada, where INTRIA Items Inc. is owned by CIBC and Fiserv, Inc. Another large Canadian bank, National Bank of Canada, recently announced it would outsource its check processing to INTRIA.
The Logical Outcome
TowerGroup expects a significant increase in check processing outsourcing. It is unlikely, however, that the largest U.S. banks will commit to outsourcing all their check locations in a single agreement. Rather, it makes sense for these banks to outsource their lower-volume regions first while they maintain their high-volume sites in-house. Eventually, they could consider outsourcing the higher-volume sites after evaluating the performance of the direct outsourcer or the success of the consortium.
We believe that large banks' outsourcing will occur primarily in two forms. First, banks will directly employ an outsourcing vendor as in the WAMU-Unisys agreement. Second, we believe that a number of local clearing house organizations will form check outsourcing consortia and then hire an outsourcer to process the checks (with the outsourcer typically becoming a equity owner of the venture). TowerGroup also believes that a number of bank-owned and -operated consortia will be established. However, we think that an outsourcer will eventually be hired to manage and operate these ventures.
Robert Hunt is a senior analyst in the Retail and Wholesale Banking practices at TowerGroup, a leading research and consulting firm focused on the global financial services industry. He is a career banker, with more than 30 years of systems and operations management experience. Mr. Hunt can be reached at [email protected].