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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