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Check 21 Is Here Banks Need to Implement Planning Processes

Check 21 Is Here
Banks Need to Implement Planning Processes
By Ken Golliher, Principal, Pegasus Educational Services, LLC

Recent federal legislation dubbed "Check 21" is the biggest change in check clearing since the MICR line. If that's an overstatement, every financial institution in the United States will soon have a chance to develop an alternative conclusion. By the time you read this article, the President will have signed the bill into law. The new law will take effect 12 months later.

Sometime in 2004, a consumer will pay several bills by mail on the 10th , even knowing the pay check dedicated to paying them will not be deposited until the 15th . Like many, he has learned that the combined delay in the United States Postal Service's delivery of the check to the vendor and "float" (the time involved in getting the check from the vendor's bank back to the consumer's bank) assures that the checks will not be presented for payment until after the 15th. He has successfully relied on combined effect of those two delays for years. Yet, this month, he receives a flurry of NSF notices, each with a hefty fee. Apparently, all of the checks hit his bank account on the 14th ; the checks arrived "early". The deposit did not.

When the consumer inquires at the bank he will be told, "Check 21 has taken effect." Float will no longer be a dependable source for short term financing.

Adjusting consumer behavior is not even an ancillary purpose of Check 21. The legislation is intended to:

  • increase the speed of check clearing in the U.S.,
  • lower clearing system costs, and
  • reduce the system's vulnerability to problems with air and ground travel.

The clearing system's vulnerability is not theoretical; the interruption of air travel associated with 9/11 underscored vulnerabilities in the current check clearing system. Millions of checks sat in plastic trays for days - going nowhere until the transportation system returned to normal. In addition to increases in systemic efficiency, Check 21 gives some individual institutions opportunities to reduce their direct costs and, in some cases, staffing.

The Check Stops Moving at the Depositary Bank
"Truncation" is when a check stops moving.

Currently, checks travel from the depositary bank to the paying bank through the clearing system using several modes of transportation, including air travel. Checks are often truncated at the end of that trip, at the paying bank; many paying banks no longer send the original checks to their customer. They keep them for a relatively brief period of time, sending only an image of the check with the customer's periodic statement. (Some provide customers with images of the front and back of the item, others, only the front.)

However, Check 21 enables truncation at the bank of first deposit - long before the check gets to the paying bank. It enables the change by ultimately requiring acceptance of something called a "substitute check" by the paying bank. The original paper check will no longer have to go through the clearing system.

Under the new law, the depositary bank is allowed, but not required, to truncate the original check. Depositary banks keeping the original check will create an electronic image in its place. The electronic image can travel through the clearing system in place of the original as long as the receiving banks agree to accept imaged items; otherwise, a paper "substitute check" must be sent, as described below.. Image quality will be mission critical.

The depositary bank may decide to truncate the check at the branch level or in a centralized location. The first option illustrates one of the points where direct cost savings are possible for individual banks; i.e. deposits can be proven and images created at the point of deposit; i.e. it would not be necessary to transport checks to a main office. This could have a substantial effect on the structure and even the need for "backroom" operations at a particular institution.

Also, the option to truncate the check does not exist solely at the bank of first deposit. Any subsequent bank in the clearing system may make the decision. If the depositary bank continues its current methods of check handling and transports the original items to an upstream correspondent, that correspondent may convert the items to images. It is reasonable to assume the correspondent might impose fees on the bank of first deposit for conversion and storage of the original checks.

The statute does not impose a specific period for which the truncating bank must retain the original checks. However, there are provisions under which the depositary bank may be required to produce the original check or a better copy. Banks converting checks to images will establish their own time frames for which retention of the original is appropriate. Also, some banks may choose to truncate checks selectively; i.e. they may truncate only large or nonlocal checks. They might also only truncate return items or any combination of specific items. Conversely, they may take pains not to truncate checks containing security features that will not appear on images.

Electronic Travel, No "Trains, Planes and Automobiles" or Attendant Problems
Once the image is created, it will travel and be presented electronically. (Remember, it is the image of the check that travels, not just the information on the MICR line.) The images are presented for payment in an image cash letter. The image cash letter follows the established path for the bank's transit items; Check 21 does not supplant the clearing system, it only changes the medium carrying the message. Travel time can be reduced to minutes rather than days; theoretically, a check deposited in Seattle today could be presented at the paying bank in Miami tonight.

If the check is not paid, the electronic image can be returned. The required time for the digitized check to make the round trip, Seattle - Miami - Seattle, is a fraction of the time it would have taken for the paper check. The Seattle customer who deposited the actual check will receive an image replacement document (IRD) or a "substitute check," appropriately marked as a return item under Regulation CC.

At any point in the clearing system, not just when it is returned to the depositor or the payee, the check may be turned back into paper and referred to as a substitute check. The substitute check will be a copy of the front and the back of the original and carry the legend "This is a legal copy of your check. You can use it in the same way you would use the original check." The bank making the transformation is the "reconverting bank." Any reconverting bank makes specific warranties in connection with that action. The reconverting bank must also identify itself as the reconverting bank on the check.

It is the "substitute check" that is the principal contribution of the Check 21 legislation. It enables banks to transmit images through the clearing system by requiring the end recipient to accept the paper reproduction of the original item.

The Paying Bank and Consumer Protection Provisions
The paying bank may receive only an image and use it to post to the customer's account. If it wishes to turn the image back into a paper document to pass on to its customer, it may become a reconverting bank itself. (Obviously, there will be costs involved in that process.) Otherwise, the paying bank will just pass the image on to the customer along with the periodic statement.

It is important to note that paying banks may need to handle a potpourri of items. Not all customer checks will be converted to images. The paying bank will have the originals from "on-us" checks that were actually deposited to it and a combination of originals and substitutes it receives as its in-clearing items.

Some commentators suggest that no bank will be forced into imaging. That is true to the extent that no individual bank will have to create imaged items. However, all banks will have to accept substitute checks as well as deal with new consumer protection and disclosure provisions for paying banks.

The statute contains provisions for "expedited recrediting" that are analogous to those in Regulation E governing electronic funds transfers. (The expedited recrediting provisions apply to consumer, not business accounts.) Substitute checks are still governed by articles 3 and 4 of the Uniform Commercial Code, they are not electronic funds transfers. Yet, the UCC is a commercial law and does not overtly favor consumers; i.e. the model version of the UCC does not contain consumer protection provisions.

Under Check 21, a consumer may make a claim within 40 days from the later of the date the statement is mailed or delivered or the date a substitute check is made available. The consumer must make a warranty claim or claim that the check was not properly charged to the consumer's account. The consumer must also allege that a resulting loss was incurred and production of the original check or a better copy is necessary to determine the claim. The bank may require that the claim be in writing.

In this circumstance, the bank has 10 business days to investigate the claim. It may take up to 45 calendar days to investigate if it recredits the consumer's account up to the amount of the check or $2,500, whichever is less (plus interest if the account is interest bearing). The paying bank's ability to respond to the consumer in any time frame is obviously dependent on the cooperation of the bank that created the substitute check, hence the requirement that reconverting banks provide specific warranties. There are limitations on this process if new accounts, repeated overdrafts or suspected fraud is involved.

This recrediting process will not apply to all checks, only those drawn on consumer accounts that have been converted to substitute checks. Other items will continue to be handled according to service standards set by the bank. If a bank incurs a loss that is attributable to the receipt of a substitute check that bank may seek indemnification from the reconverting bank.

Banks are to provide customers with disclosures which explain the qualifications of a substitute check and the fact that it is a legal equivalent of the original check for all purposes. The disclosure must also explain the consumer rights to recrediting discussed above. The notice is to be provided to existing customers no later than the effective date of the Act and new customers "when the relationship is initiated." The Federal Reserve Board of Governors is charged with developing model language for disclosures.

Task Force Time Again!
Every U.S. bank is directly affected by the legislation. The effects are pervasive and, if addressed at the last minute, will generate chaos and customer relations problems. Some large institutions currently use "electronic presentment" and have been preparing to image foreign items for years. Many banks have worked on the implementing the imaging of foreign items in earnest since 9/11, knowing those events would hasten the legislation.

"We'll wait until the regulations come out," is an appropriate mantra for many compliance management issues, but it will not work for this one. The bulk of the planning effort will revolve around major issues already raised in the statute. Banks need to begin evaluating the decision on whether to adopt imaging for deposited items now. There is no shortage of vendors offering "the answer." As a prelude to evaluating new vendors, it is critical to determine the plans of existing vendors and clearing agents.

The end result will be that imaging will not be for everyone. While some banks will see the efficiencies it generates, they will be unable to justify the costs, legal ramifications and operational duties involved. First, some banks have no current imaging capabilities and they will mistakenly attempt to justify their implementation costs solely based on Check 21. Second, the warranties and indemnifications offered by reconverting banks are not for the faint of heart - the ability to produce a quality image and to assure that the image comports with the MICR line is critical. Third, whether the reconverting bank can find a check drawn on another bank will be the litmus test for how well designed the program is. Fourth, the storage of checks drawn on other banks is a significant issue for banks with substantial numbers of retail customers.

Regardless of their ultimate decision on imaging deposited items, all banks need to develop the mechanisms necessary to provide disclosures and handle consumer requests for recrediting. They also need to develop plans for customer communications when imaged items begin arriving in lieu of originals. Banks cannot afford to adopt the illusion that handing out government authored disclosures that consumers simply do not read will prevent customer questions and complaints.

Start pulling your task force together. Obviously, include those with subject matter expertise, but also include those who will deal with the customer relations issues. You might also ask for help from those with recent experience in implanting significant policy changes in your institution. (Veterans of the recent Customer Identification Program's implementation should have fresh insight, but may be a bit weary from the fight.)

This is a "sleeper" issue. It is hard to realize the impact it has without thoughtful analysis. Your institution's management will realize the enormous importance of the change sometime in the next 12 months. The issue is whether it will be in time to choose between alternatives or simply choose the only path remaining.

Edited Novmber 10, 2003 to clarify references to "images" vs. "substitute" checks.

First published on 10/27/2003

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