| Prevailing
in Payments
By Neal Chambliss and David Taylor
As the migration from paper checks
to electronic media quickens, banks face rising challenges
to their dominance of the $190 billion payments industry.
They can still claim their place in the new digital world
— but not at their leisure.
As electronic payment methods such
as online bill payment, credit cards and prearranged account
transfers proliferate, questions increasingly are being
raised about the continued role of traditional paper checks
-- and of banks themselves. There is a widening recognition
that technologically savvy nonbank players are making
serious inroads, that the emerging electronic system is
up for grabs, and that a delicate and high-stakes transition
is underway.
While it is good that industry leaders
are awakening to these issues, it is imperative that they
move beyond the discussion stage. A joint study by Bank
Administration Institute and PSI Consulting reveals that
consumer and business readiness for electronic commerce
is notably accelerating. Surging use of electronic payment
methods entails a shift of revenues and customer loyalties,
enlarging opportunities for electronic providers while
chipping away at the still-dominant paper check and the
traditional banking system that supports it. Just since
1990, in fact, the proportion of routine household payments
executed via check has fallen by 8 percentage points,
to 79%. We believe the erosion of check market share will
continue, if not accelerate, shifting significant revenues
to electronic payment media.
The stakes are huge. In 1997 alone,
consumers, businesses and governments will generate nearly
650 billion payments having a total value of roughly $22
trillion. The intermediaries that handle these payments
will pull down more than $190 billion of revenues, according
to our estimates. Shifts in usage patterns reallocate
revenues among payments media and intermediaries, and
often put valuable customer relationships up for grabs,
so even small proportionate changes in the nature of market
demand must be taken quite seriously.
For now, banks still derive huge benefits
from their dominant position in the traditional world
of paper-based payments. Having earned customers' trust
in handling money, moreover, banks are uniquely positioned
to carry longstanding relationships into electronic realms,
and to gain new ones.
Instead of a cost center or a means
to collect deposits, progressive managers are embracing
payments as a business -- a business of moving currency
and information. In the increasingly digital world, the
payments business will be about the movement of information
authorizing the transfer of value from one account to
another, as opposed to the transit of checks and currency.
In this world, the information associated with payments
transactions may have greater value than the handling
of transactions themselves.
There are three main strategic avenues
into the new realm of electronic payments, any of which
are open to banks. "Media providers" emphasize payments
products -- such as credit, debit and "smart" cards --
for consumers and businesses. "Acceptance enablers" provide
services to payment recipients, such as merchants, helping
them compile, send and collect bills, and manage information.
"Processors" move information between media providers
and acceptance enablers, completing the linkage between
those who buy and those who sell.
Each approach carries its own sub-options,
opportunities and risks. But intellectual explorations
won't do. Choices must be made and action taken. From
an industry perspective, the price of failing to pursue
focused strategies would likely be a continued decline
in bank dominance over payments. Banks have already lost
significant ground to nonbank players in investments and
lending. The payments business represents the third --
and last -- major bank franchise, and it is a franchise
at risk. New players are aggressively pressing their cause,
and banks simply cannot afford to lose this epic battle.
These views reflect the preliminary
findings of the ongoing BAI/ PSI study, Profiting
From Change in the U.S. Payments System,
which will be published late this year. Co-sponsors of
the project are NationsBank Corp.; SunTrust Banks Inc.;
Comerica Inc. and Diebold Inc. The stated goals of the
project are to detail the structure and size of the payments
industry, project growth rates of various payment methods,
pinpoint risks and opportunities for banks and other stakeholders,
and develop a framework for strategy formulation.
Consumer Receptivity
An important component of our analysis
is an intense look at the behaviors and preferences of
payments customers. From a variety of perspectives, we
found mounting readiness for electronic payments and rising
usage, underscoring the point that there's no time to
be wasted in formulating payments strategy.
Rising numbers of consumers and businesses
are equipping themselves with personal computers and Internet
access, and thus are poised to bypass paper transactions
in favor of electronic information interchange. In the
last four years alone, the proportion of households owning
PCs equipped with modems rose from 12% to 30%, and we
project that figure will leap to 47% by the year 2000.
Even as the number of households equipped
to tap Internet and other online services increases, options
for unwired customers expand as well. For example, growing
numbers of utility companies are offering direct debit
payment options -- and consumers are responding. Though
initial response rates are still low -- typically about
3% -- some utility companies have converted up to 12%
of their customers to direct debit programs, and many
expect the typical penetration rate to reach at least
20% within the next three years.
These episodes of paper check abandonment
represent just the tip of the iceberg. In 1990, consumers
used checks for 86% of household bill payments on items
such as insurance, loans, credit cards, utilities, and
telephone and cable TV service. Just 4% of consumer payments
were handled electronically, predominantly through direct
debits. Today, checks account for 79% of routine consumer
payments -- an 8 percentage-point decline -- while electronic
payments have achieved a 9% market penetration -- a 5
percentage-point increase. Direct debit still accounts
for more than two-thirds of all electronic consumer bill
payments, but PC-based bill payment alternatives are surpassing
phone-based payment options in household usage.
Even cold, hard cash is feeling the
heat from electronic alternatives, particularly from credit
cards. This is evident at supermarkets, where card acceptance
in the checkout lane is a fairly recent phenomenon. The
recent move by McDonalds to expand card acceptance in
its mammoth franchise may have a similar impact on the
fast food industry, one of the last cash strongholds.
Consumer responses to electronic tax
filing and refund payment options also are indicative
of a growing receptivity to electronic payments. The proportion
of households electing to receive tax refunds via direct
deposit will reach 20% this year, according to the Financial
Management Service, an arm of the Treasury Department,
up from only 13% in 1996. While few households opt to
pay taxes through electronic deduction from their checking
or savings accounts, more than 10% plan to file tax returns
electronically in 1997.
Commercial Converts
A growing readiness for electronic
commerce is similarly apparent in the business community,
with the most marked changes occurring among small businesses.
In 1995, 41% of small business treasury personnel were
equipped with a PC and modem, and just 2% were using the
equipment for online banking functions. This year, 60%
are equipped with a computer and modem, and 18% are either
using online banking applications or plan to begin using
them this year.
Small businesses, with their wide diversity
and limited resources, present the greatest obstacles
in converting the exchange of documents and payments from
paper media to electronic media. There has been a breakthrough
over the past two years, however, as inventive intermediary
services have emerged specifically to ease the conversion
for small businesses. Leveraging the universality and
low cost of the Internet, these companies provide seamless
solutions for small businesses, giving them access to
electronic data interchange benefits without the costly
development of proprietary capabilities.
Government initiatives and mandates
also provide a catalyst for business acceptance of electronic
commerce. The purchasing power of the government has such
widespread impact on the U.S. business community that
the ripple effect is far-reaching. Contractors and their
sub-contractors will need to rely on electronic channels
of communication and information exchange if they wish
to compete for government business. On the payments side,
40% of small businesses express strong interest in going
online to make state and federal tax payments.
Government mandates will also have
a ripple effect in other payments environments. At the
point of sale, for example, the introduction of card-based
electronic benefits transfer programs has expanded the
base of merchants accepting credit and debit cards.
The broad-based migration to electronic
payments is matched in importance by the technological
changes occurring behind the scenes. Because many types
of back-end conversions from paper to electronics can
proceed independently of customer behavior, the pace of
change can be revolutionary. Consider the credit card
processing business. Electronic draft capture virtually
eliminated paper processing in less than five years. In
the wake of this conversion, the majority of credit card
transaction processing and merchant acquiring business
shifted from banks to third-party service providers. These
providers now capture the wealth of information associated
with credit card transactions -- information that may
have far greater value than the transactions themselves.
The electronic capture of check information
-- via electronic check presentment and other truncation
initiatives -- promises radical change at the back end
of the check-processing environment. As more information
is captured from check transactions, the balance of value
in this payments arena may also shift from processing
paper to managing and distributing information.
Taking Stock
The U.S. banking industry carries great
strengths into the new electronic realm, but less can
be taken for granted than a cursory examination might
suggest.
In 1996, banking companies garnered
a whopping 53% of domestic payments business revenues,
or nearly $100 billion, according to our estimates, for
the single largest slice of the pie. The banking industry
derives three-fourths of its payments revenues from net
interest income on deposit and credit card accounts. The
remainder largely stems from the industry's dominance
in check processing. The checkless society, prophesied
for two decades, has not arrived . . . and banks have
prospered.
Banking strategists will be sorely
tempted to delay electronic payments ventures, which often
have lower margins, so as to prolong the rich returns
they now enjoy from paper-based operations. To the extent
that banks help hasten the electronic revolution, the
logic goes, they are hastening the obsolescence of their
own prized systems, built up over decades.
While we sympathize with that view,
the raw truth is that new players and payment methods
are already chipping away at the traditional paper-based
payments system, and the trend is only going to grow more
pronounced. By the year 2000, for example, we project
that 65% of U.S. households will use some form of electronic
bill payment, up from 38% in 1995. Measured by volume,
electronic payments could comprise almost 50% of total
non-cash payments, compared with roughly 34% today. Senior
managers can either participate in the transition, facilitating
customer migrations while developing new skills and business
propositions, or they can bury their heads in paper, and
let new electronic payments players make wholesale inroads
with consumers, businesses and government entities.
A further challenge has to do with
customer perceptions about the value of bank involvement
in payments. It is a fine tribute to banks that our surveys
indicate that 90% of consumers believe it is important
that their checking accounts be under bank management,
and that 77% say the same about their savings accounts.
However, the sharp disparity between
actual credit card usage patterns and consumer preferences
for bank sponsorship of their cards could be a harbinger
of things to come in other electronic payment alternatives.
Though nearly 80% of consumers use Visa- and/or MasterCard-branded
credit cards, only 38% say bank sponsorship is an important
aspect of card value.
This imbalance points to a crucial
issue facing banks -- namely marketing. Too often, new
players do a better job of building brand awareness and
customer loyalty than do banks, especially in the newer
types of payment media. And as the new media gain greater
market acceptance, banking's marketing handicaps become
more costly.
Clearly, the industry cannot afford
to have consumers' relative indifference about bank sponsorship
of their credit cards extend to debit cards and bill payment
services. Strong branding of transaction accounts and
related products -- independent of the interfaces customers
use to initiate transactions -- will be essential in helping
banks establish themselves as preferred intermediaries
in electronic payments.
A third major challenge lies in execution.
We believe banks have a truly outstanding
opportunity to consolidate customer relationships, folding
all types of products and delivery channels into packages
that meet modern consumers' demands for a full and easily
accessible array of products and services. After all,
banks enjoy consumer trust. They have a well-developed
payments infrastructure. They possess a treasure trove
of data. And they have well-developed product families.
Thus endowed, and equipped with focused and progressive
strategies, banks conceivably can march bravely into the
new electronic world.
But the catch is, each facet of their
operations must stand up to the withering competition
posed by the category killers. Focused players with special
expertise, for example in credit cards, already command
significant turf in electronic payments, and can be expected
to attack each new market niche. To keep customers from
straying, banks will have to perform at high levels across
a broad delivery and product spectrum. Legacy strengths
and strategy can unlock opportunities, in other words,
but only through superior execution can banks capitalize
on them.
Getting in Gear
The payments aspect of financial services
is looming larger in major alliances and mergers, underscoring
the immediacy of payments- related change, issues and
opportunities.
In acquiring First USA Inc. and subsidiary
First USA Paymentech, Banc One Corp. boosted its credit
card presence to 30 million accounts and $35 billion of
assets, while gaining scale in the payments processing
business. On another front, Banc One is sub-contracting
core banking services, principally checking, to nonbank
players, such as Merrill Lynch, and to technologically
savvy service providers such as Checkfree. This sort of
venture enables new players to market bank products under
their own brand names, and it expands nonbank access to
the traditional payments system.
Elsewhere, First Data Corp. is teaming
up with Microsoft Corp. to enable potentially millions
of households to receive a variety of bills -- such as
for utilities, auto loans and mortgages -- electronically,
instead of through the mail, and to reciprocate with electronic
payments, instead of paper checks. Though principally
involved in areas outside of traditional banking, First
Data already leads in processing credit card transactions.
It manages 153 million bank credit card accounts and last
year processed 5.9 billion charge transactions on behalf
of merchants. Also last year, First Data helped clear
540 million checks through its TeleCheck services subsidiary.
How should senior bankers respond?
Overall, the managerial approach to
payments should be holistic. Instead of allowing various
payments-related units to operate in isolation, institutions
should begin laying the managerial, financial measurement
and operational groundwork needed to support a coordinated
payments strategy. Some institutions, such as BankAmerica
Corp., are going so far as to create senior management
positions that center on payments. At the very least,
institutions must breach the thick managerial walls that
induce business units to respond only to the dynamics
of the particular silos in which they operate, as opposed
to the overall market and overall corporate strategy.
There are three main functions within
the payments system that broadly define strategic options:
media provider, acceptance enabler and processor.
Media provider.
These players offer payments products to consumers and
businesses, ranging from traditional cash and check media
to modern card-based products. The newer end of this business
already is splitting into parts. Some players handle customer
accounts. Others help payment recipients accept and process
payments. For example, banks are far less active in facilitating
credit card transactions than in handling cash and checks.
The separation of account management
from processing has important implications for banks.
Already losing ground in processing electronic transactions,
banks will have to compensate with skills and ventures
that capitalize on client relationships. Specifically,
they will have to promote auxiliary, value-adding services
such as buyer protection plans, global account statements,
and check imaging for corporate clients -- as well as
linkages to other banking and financial services products
-- as a means of retaining customers, differentiating
themselves and augmenting revenues. Not all of these capabilities
can be quickly and economically developed in-house, so
alliances and acquisitions may figure more strongly in
payments strategies than some players now realize.
Acceptance Enabler.
Here, the focus is on serving payment recipients, including
merchants at the point of sale and billers, such as utility
companies.
One approach has more of a manufacturing
emphasis. Players capitalize on large scale and a tight
focus to deliver a narrowly-defined set of services that
are of a high quality and competitively priced. For example,
the QuestPoint subsidiary of CoreStates Financial Corp.
provides a range of paper-based payment processing services
for billers. This capacity can be sold into the market
through a variety of payments services providers and brand
names.
The alternative approach centers on
relationships. Wishing to strengthen ties, for example,
an institution might seek to handle a major client's payment
processing business. Since custom service plays a more
visible role in this strategy, players might often work
with third-party providers, for example in lockbox processing,
to expand the range of capabilities offered to clients.
Processor.
Players in this business move information between
media providers and acceptance enablers. In the credit
card arena, for example, First Data plays an important
functional role in relaying transaction information between
merchants and card issuers.
This is an important payments sector,
boasting 1996 revenues of roughly $40 billion, or 21%
of the payments market. However, margins are slim. This
calls for large-scale, highly efficient operations that
must be supported by substantial capital outlays. It takes
great skill to compete in this arena, including mastery
of information systems and networks, an ability to provide
'round the clock service, and high accuracy and reliability.
Within each of these three strategic
options, players face several key considerations. With
capabilities, the question is whether to build, buy or
enter a partnership. With regards to products and services,
the question is whether to stay in the middle of the pack,
with cost-efficient output that falls more into the commodity
realm, or to seek means of differentiating output and
adding value. In approaching the market, an important
consideration is whether to pursue a manufacturing strategy,
which emphasizes scale, focus, technical expertise and
functional roles, or to pursue a distribution strategy,
which emphasizes relationships and an ability to source
capabilities from a number of providers.
Through it all, questions about branding
and control of relationships will be critical. The upside
of financial services technology is that it breaks physical
constraints, permitting endless combinations of offerings
through a host of convenient delivery channels. One downside
is that precious customer information often can be easily
captured by other players and partners in the payments
chain. A need for high volume complicates the picture,
in that players naturally will want to sell as much of
their capacity into the market as possible, leveraging
large fixed investments in systems. But in so doing, they
run the risk that resellers will impose their own brand
names and lock up primary customer relationships, relegating
underlying producers to commodity status.
The payments challenges are many, but
they are not ones from which banks can shrink.
True, the still-heavy use of cash at
the point of sale and the dominance of checks in bill
payment together keep banks at the center of the payments
universe as essential intermediaries for handling physical
exchange and settlement. Banks enjoy the unique position
of largely owning relationships with payments customers,
moreover, being the trusted, preferred providers of many
of the payments products and related banking services
customers demand. At least for the moment, only banks
can offer a full range of payment media options and services,
ranging from cash and checks, to credit and debit cards,
to electronic funds transfers.
As our study documents, however,
electronic media are gaining increasing market share in
the payments industry, undercutting paper media at an
accelerating rate. Thus, the time for action is now. Banks
no longer can rely on the powers of incumbency to maintain
their commanding role.
Mr.
Chambliss is a senior vice president at PSI, and Mr. Taylor
is an executive vice president at BAI. Also contributing
to this article were John B. Lewis, senior research associate
at BAI; and Mary Donadoni and Leon Majors, respectively
vice president and senior consultant at PSI.
Copyright © 2003 by Banking
Strategies, published by BAI.
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