Many believe that as banks start using electronic images to clear checks they will switch from the Federal Reserve banks' check processing service to private systems.
Nobody expects an instant transformation Thursday, when the Check Clearing for the 21st Century Act will take effect. The law will merely make banks accept printouts of check images as substitute checks.
But Thursday will be a symbolic kickoff to full-scale image clearing, and a number of companies are poised to offer image-based clearing and settlement, which would divert business from the Fed.
Furthermore, community bankers are among those at the forefront of a clamor for change. That would surprise the Fed committee that in 1998 said a Fed pullout from check processing would hurt smaller banks.
Scott Copeland, the executive vice president and chief information officer at the $3 billion-asset BancFirst Corp. of Oklahoma, said he plans to move more of his item processing volume to private processors.
BancFirst was one of two banking companies to start settling transactions with check images two years ago in a pilot test of the Endpoint Exchange network. The network was then operated by CheckClear LLC, which was acquired in July by Metavante Corp.
BancFirst, of Oklahoma City, now clears about 8% to 9% of its checks through Endpoint; the rest go through the Fed or correspondent banks. Mr. Copeland said he is eager to shift as much traffic as he can to the electronic network, to reduce his reliance on the Fed.
"The Fed has done a good job for us historically," he said, but it is planning to close its Oklahoma City check processing center next year, while private image networks are ramping up.
"It looks like the private sector players are ahead of the game," Mr. Copeland said.
A number of contenders are positioning themselves to capture image traffic. Endpoint has signed up more than 3,200 community banks and credit unions and was the first to go into commercial operation, in 2002. Its members agreed to rules that permit image exchange.
Other systems have conducted tests but are waiting until Check 21 takes effect before starting high-volume settlement.
Steve Whitney, a senior vice president in the retail payments office at the Federal Reserve Bank of Boston, said he is eager to facilitate the transition to imaging, no matter what that may do to the Fed's item processing volume."We think it's important for us to be there and start the move toward this electronic environment. It moves the industry in that direction, and that's the key thing," he said.
Fed executives have acknowledged that the Fed is losing its position in the check processing world.
Anthony M. Santomero, the president of the Philadelphia Fed, said Oct. 16 at a conference in Spain: "It is expected that the Fed's role in paper processing will diminish over time as checks recede in both absolute volume and relative importance in our retail payments system."
Until recent years the Fed cleared about half of the nation's checks, with the rest going through private clearing houses, correspondent banks, direct exchanges between pairs of banks, or internal "on-us" settlement. And though precise figures are hard to come by, the consensus today is that the Fed's market share has dropped to about one-third.
Jeanne Capachin, the research director of corporate banking at the research firm Financial Insights Inc. of Framingham, Mass., said the privatization of check processing may be more than just a consequence of market action.
"I think the Fed is going to make that happen, actually," she said in an interview. "The private market is trying to capture volume. The Fed is less concerned about that and more concerned about overall trends in the payment system."
The Fed's role is already shrinking. Last October it said it expected to clear 4.7% fewer checks that year, and 9% fewer this year. This summer it revised its 2004 projection to an 11% plunge, and recently it predicted an even steeper 13% to 15% for next year.
Fed officials cite a variety of factors, including increased use of payment cards, the surging popularity of check conversion to automated clearing house transactions, and big-bank mergers, which increase the number of on-us transactions.
And the downward slide will probably accelerate even more when Check 21 begins to affect check volume, as the Fed expects it to do by the end of next year.
As its volume falls, the Fed is consolidating its processing operations. It announced plans in August to shut down nine check clearing centers in 2005 and 2006; last year it announced it would close 13 others. These closings could well help motivate banks to shift to private image networks.
There is some precedent suggesting that the Fed could abandon its role as an intermediary for check processing. The Federal Home Loan banks also once offered check processing services. But in a series of transactions dating back to 1991, they sold all of these operations to private outsourcers.
The Federal Home Loan Bank of Indianapolis, the last to sell, in November 2003, cited geographic limitations restricting its growth and the expense of installing imaging equipment.
Still, even the private network operators are cautious about predicting the end of the Fed's role in check processing.
Ted Umhoefer, the senior vice president of product management and industry relations in the item processing group of Fiserv, of Brookfield, Wis., said the transition to image clearing will be a long time coming. "The challenges of moving away from paper are easy to underestimate, and the benefits are elusive," he said. "Bankers are good at not moving until the benefits are clear."
A key issue in the transition from the Fed will probably be pricing.
Jim Eckenrode, the vice president of consumer banking research at MasterCard International's TowerGroup in Needham, Mass., said banks have developed complex pricing structures for processing paper checks and now must add image clearing.
Though electronic settlement is more efficient, in the near term it could cost more than paper, because banks must add processes and equipment, he said.
"They're going to be looking at this very closely," Mr. Eckenrode said.
Thomas E. Rea, the executive vice president of transaction processing services at U.S. Bancorp of Minneapolis, agreed. "In the short term, our operating costs are going to be higher. There's no question about it," he said.
Huey Townsend, the president and chief executive of the $251.3 million Guaranty Bank and Trust Co. of Belzoni, Miss., said that though he is ready to convert to image clearing, pricing issues could delay his plans to shift from the Fed.
"We are 100% imaged and have been for a number of years," Mr. Townsend said. "We're not going to be able to send image cash letters out because we don't think the pricing is where we can afford to do it."
Pricing is the only issue, Mr. Townsend said. "As soon as we get to where we think it's beneficial, we'll go 100% to image."
