Checking Out E-Payments

By John R. Engen

Banks derive hefty earnings from paper checks, but they must embrace electronic payments to retain valuable customers.

It would be easy for Andy Reeher to feel as though he's at the helm of a sinking ship. For most of his career, the vice president of marketing for paper payment systems at Deluxe Corp. has heard talk of the check's imminent demise at the hands of new, easier-to-use electronic payment systems. "Being a marketer for a check printer,"he quips," is the definition of an optimist."

But his ship is proving surprisingly buoyant, which is why Reeher hasn't had to change careers. Indeed, since pundits first predicted the death of the check in the 1970s, annual check volumes have more than tripled. Some 65 billion checks were written last year, and that figure is expected to grow by as much as 2% annually through 2005 – hardly the profile of a dying industry.

And yet, change is coming. Electronic payments are projected to grow sharply, rising from today's 25% share of non-cash transaction volume to between 45% and 58% by 2010. St. Paul, Minn.-based Deluxe, the nation's largest check printer, is itself investing heavily in electronic payment processing and electronic check conversion. "Marketing is about giving consumers what they want, and what most people want today is a mix of payment transactions," Reeher says.

This gradual but irresistible shift to electronic payments presents banks with a thorny strategic dilemma. The industry's fortunes are sharply affected by consumer usage of the paper check. The checking account serves as the very foundation of the banking relationship by providing the mechanism for customers to deposit and then disburse their funds. The control that banks exert over this checking infrastructure translates into a dominant role for them in the payments system. On top of all that, checks provide the industry with billions of dollars annually in float and fee income.

Banks walk away from such a lucrative business at their peril. But do they have any choice? The emerging electronic payments infrastructure is dominated by nonbank technology companies. While those firms are working with banks today, they could conceivably establish their own financial services relationships with consumers and businesses in the future, in essence stealing bank customers.

To protect those valuable relationships, banks need to begin carving out a dominant role for themselves in electronic payments – even if it means nudging their customers away from reliance on the paper check. "Your choice is to cannibalize yourself now, and position yourself for the future, or be left hanging onto a shell of the past," says Lou Anne Alexander, e-channels product director for First Union Corp. and an architect of the Charlotte N.C.-based company's long-term payments strategy.

While most bankers may agree with Alexander in theory, they also understand that the transition to electronic payments might span decades.In an era when institutions are under great pressure to meet short-term earnings targets, the task of trying to wean customers away from a profitable product does not engender a lot of enthusiasm. Electronic payment technologies, in the short term at least, represent just another costly layer of service, similar to the startup phases of automated teller machines and Internet banking.

That leaves strategists facing a series of troubling questions. Should they continue to bank on the check's staying power and the income it generates, while risking the gradual loss of customers to alternative electronic payments providers? Or should they give up lucrative near-term check profits and willingly facilitate customers' shift to debit cards, electronic bill payment and other mechanisms? If they choose the second course, should they try to develop their own technical solutions or turn to outside vendors? And how will they replace the checking-related revenues that comprise the bulk of fee income for some institutions?

Each institution will have to look to its own strategies, resources and business mix to find answers to these questions. Large institutions, obviously, possess more options. Some consultants suggest that banks can hasten the transition by incentivizing their customers to move to electronics and imposing some penalties (which could generate more fee income) for continued check usage. While this may help to a point, it leaves banks with the risk of antitrust problems and customer flight to competitors who continue to offer low-cost checking accounts.

The hard truth is that no approach is likely to be painless. Ultimately, strategists must weigh competing risks: the risk of moving their customers to electronics too soon versus the risk of moving too late. One way or another, those customers will begin moving, and the banks had better be ready to serve them electronically when they do.

Waiting on Electronics

Compared with most other countries in the world, the paper check has established a bedrock position in American economic life. From modest roots more than two centuries ago, this payment mechanism has evolved to the point where most Americans now consider a checking account, with its security, record-keeping and personalization features, essential to their lives.

In 1998, the average American wrote 25 checks a month – 52% for recurring bills, and about 35% for point-of-sale purchases, making it the most-popular of all payment mechanisms, according to Paul Green, editor-in-chief of Green Sheet, a checking industry newsletter. A Green Sheet study last year estimated that 88% of American adults possess checking accounts, while 37% still consider it the preferred payment method, winning out over credit-, debit- and ATM-cards combined. "From a consumer's perspective, the paper check provides one of the most important reasons – if not the only reason – to use a bank," says Green, who is based in Rohnert Park, Calif.

Banks benefit from this customer loyalty big time. Green Sheet estimates that banks generate $60 billion in revenues annually from the float, fees and low-cost funds generated by checking accounts, including about $5.6 billion from bounced-check fees and an average of 16 cents per-check in overnight interest. Deluxe estimates that banks earn $1.5 billion simply by reselling checks to customers. And these numbers don't include many intangibles, such as the loan volume and other indirect revenues rooted in checking relationships.

It's no wonder, then, that many bankers are content to continue their reliance on the check, while waiting for the electronic payments market to take shape. "Our strategy is to watch, study and learn," says Bill Cooper, chairman and CEO of $10.3 billion-asset TCF Financial Corp. in Minneapolis, Minn. Cooper estimates the average account contributes $165 a year in fees to TCF's income statement and that checking customers have generated about $3 billion of the loans on his balance sheet. "At some point in the future, people will use fewer checks," Cooper says. "But even then, the check will be the primary payments vehicle."

Even the most ardent electronic payments advocates would agree with that statement. But those advocates also argue that the importance of the check is diminishing rapidly as cheaper and more convenient payment mechanisms come online. Already, says Florida State University finance professor David Humphrey, the check's dominance is being eroded in areas such as payroll disbursement, where employers are now making direct deposit their default payment option, and in business-to-business transactions.

Consumer usage of electronic payments is expected to follow close behind. PSI Global projects that more than 20% of all bill payments will be executed electronically by 2005, up from just 7% last year. While most of the current volume is transacted through the automated clearinghouse system, PSI Global expects PC-based billing to account for some five billion payments in five years, compared with about 20 million today. "Once it takes off, there will be a snowball effect," says Beth Robertson, vice president for bill payment at the Tampa-based consulting company. Similarly, the Nilson Report, Oxnard, Calif. predicts that debit cards will be used for 29.7 billion point-of-sale transactions in 2010 – up from 4.9 billion in 1998.

Bankers generally view electronic payments with apprehension because of the paper-based revenues at risk. But it's also possible that electronics might present some revenue opportunities that are not immediately apparent. TCF's Cooper notes that ATMs were viewed mainly as an incremental expense when they were introduced, but slowly began generating revenues from access and interchange fees. Similarly, financial institutions could benefit from offering consumers online financial management services and payment verification or fraud protection services to merchants. "If you can assure the merchant that it's a safe transaction, you've created something of value for them that also could generate revenues to offset the fewer bounced-check fees," says Kathy DeWit, executive vice president for payment strategies at Wells Fargo & Co., San Francisco.

Price Incentives

Beyond the expense of building the necessary infrastructure, there's the challenge of encouraging customers to adopt the new payments methods. It's definitely proving easier with debit cards than with electronic bill payment. Since banks receive interchange fees from stores for debit card use, usually about 1.5% of the purchase amount, they are motivated to encourage customers to use the cards. TCF, for example, offers customers restaurant coupons for first-time debit card use, while Bank of America Corp. is considering offering frequent-flier miles to spur interest.

On the bill-payment side, however, banks receive scant revenue – just from small monthly charges that only antagonize customers. In theory, Humphrey says, banks should be able to use pricing to drive customers to alternative payment methods. In Canada and Europe, which feature much higher electronic payment usage than the U.S., banks have jointly introduced new checking fees to encourage the transition. "To move rapidly into the sphere of electronic payments, you need relative pricing of payment instruments, and everyone has to follow suit," Humphrey says.

But those banking markets are more consolidated than in the U.S. Any concerted industry move to introduce pricing incentives here would raise antitrust concerns. And individual banks that might move unilaterally to spur migration would invite competitors, including community banks and credit unions, to pursue their customers with lower-cost accounts.

Ladd Willis, executive vice president at First Manhattan Consulting Group, sees one way out of this dilemma. He suggests that banks use the information in their customer databases to "precision price" products in a way that pushes only unprofitable checking customers to paperless payment mechanisms. By analyzing data to understand individual customers' usage of products, delivery channels and transaction types, Willis explains, bankers should be able to figure out how to solidify relationships with profitable customers by giving them a better deal, while forcing the unprofitable ones to either carry their own weight or leave.

"If you implement pricing that impacts all customers the same way, regardless of their profitability or their transaction preference or usage, then clearly you'll shoot yourself in the foot," Willis says. On the other hand, "if a bank does its pricing right, the movement to electronic payments will cause it to lose customers – but only the ones it wants to lose."

Many banks already use some selective pricing techniques. But most executives, fearing a customer backlash, are more interested in finding other ways to create critical mass in electronic payments. "We'd rather pull people than push them," says David Watterworth, executive vice president for integrated sales and service at Bank of America Corp., Charlotte, N.C.

Many in the industry, for example, look to electronic bill presentment – the process of viewing bills online – as the "killer app" that will jumpstart electronic bill payment. Spectrum LLP, a recently-formed joint venture of Chase Manhattan Corp, First Union and Wells Fargo, aims to promote electronic billing with a system that allows consumers to aggregate most of their bills at one, bank-owned Web site. "If a critical mass of billers agree to do things a certain way, the rate of adoption will become much greater," says Wells Fargo's DeWit.

At the same time, bankers rightly fret over the revenue losses such automation could bring. Online customers who opt to have their credit-card bills paid electronically on the due date, for example, will never pay a late fee. Unsurprisingly, the innovators in this field so far have been technology companies such as Atlanta-based CheckFree Holdings Corp., which controls nearly 80% of the market for electronic bill presentment and payment.

Belatedly, banks are beginning to respond to the challenge. Several, including Citigroup, Wells Fargo and First Union, are laying multi-million-dollar bets on numerous electronic fronts. They're partnering with technology providers and each other – a la Spectrum – while simultaneously developing their own proprietary systems for the future. Smaller institutions, meanwhile, are beginning to offer outsourced solutions. First Busey Corp. of Urbana, Ill., for example, recently began offering EBP&P services provided by Atlanta-based S1 Corp., a vendor of online banking products.

Bridging the Gap

Even as electronic payments advance, efforts are underway to prolong the life of the paper check, which is both good news and bad news for banks. The National Automated Clearing House Association and Visa USA, for example, are both involved in pilot programs to provide merchants with electronic check conversion. This technology, also known as "electronic check truncation," enables retailers to scan a check into the ACH system at the point-of-sale. The purchase amount is then debited from the customer's checking account on a delayed rather than real-time basis.

On the positive side, banks should gain from reduced check processing costs and a continued customer adherence to the paper check. The problem is that check truncation simply bridges the gap between paper-based and electronics-based payments, ultimately threatening banks' paper-based revenues. For example, instantaneous verification of truncated checks via the ATM network – the subject of another promising pilot – would dramatically slash the fees earned from bounced checks. It's no surprise, then, that banks have signed on to such pilots somewhat grudgingly.

They really have no choice, however. Merchants like the ease and potential fraud savings offered by electronic check conversion. If banks don't help implement such solutions, those customers will simply turn to someone else. "A lot of merchants are only going to have one or two relationships to facilitate electronic payments, and those relationships are being established now," DeWit says. "You have to be positioned as a credible provider of these services, or you could get lost in the dust when momentum picks up."

The past 30 years have shown that forecasting the future of payments is a dicey business. Though doubters remain, a consensus has formed that the strategic importance of electronic payments justifies the money and effort that banks are now expending to position themselves in this market. "These changes are going to happen, and trying to avoid that reality is fruitless,"DeWit says. The key for banks, she adds, is "to understand what electronic payments mean to them, and then try to influence the transition to their benefit."

Mr. Engen is a freelance writer based in Minneapolis, Minn.

Copyright © 2003 by Banking Strategies, published by BAI.

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