Delicate Transition

By Aamer Baig and Jay Norman

Handling the shift from paper-based transactions to electronic payments will require an enterprise-wide payments strategy.

Like a heavily laden fisherman trying to step between two boats, the banking industry is facing a delicate transition as payments shift from paper to electronics. How do institutions forge ahead in the electronic realm while preserving revenues from paper-based transactions? The question is critical, given that payments supply about 40% of revenues at the top 25 banks.

One issue is looming overcapacity in the processing of paper checks. Not only will the traditional market shrink in tandem with the shift to electronics, but many banks also face the possibility of losing share as the market consolidates. Throw in the pressure on paper-based payments exerted by the recent check truncation legislation, and the industry is looking at a 50% increase in excess processing capacity over the next three to four years.

Another issue is the fragmented state of payments-related activities within most banks. To prepare for the electronic future, institutions will need to develop a consolidated view of their payments business and the major customer segments served.

But it's difficult to get product and operations managers from separate silos to collaborate. Even when they do, reinvention and renewal often take a backseat to cost-cutting in this pinched economic environment.

With an estimated $70 billion of industry-wide annual revenue supported directly or indirectly by checks, these issues clearly must be addressed. And the good news is that there still is time for players to address the transitions and even capitalize on them. But only institutions that can think and act strategically on payments can win at this game.

What is needed is an enterprise payments strategy that is based on customer needs, leverages operational and technology capabilities and is in tune with competitive pressures. Institutions that can execute on such a strategy will view the changing payments landscape as a catalyst for improving current business performance and enhancing long-term competitiveness.

One goal is to capture cost savings by collapsing systems, operations and functions. Another is to position the institution for the future by improving customer and product management practices, crafting new demand deposit solutions and significantly improving the operational platform.

None of this will be easy, since the various bank silos in which payments activities are situated are optimized to deliver products, not manage customer relationships. Product managers tend to focus narrowly and will likely resist changes that distract them from achieving near-term revenue goals.

Yet these difficulties can and should be overcome, especially since the alternative is so grim. The revenue stream from paper-based payments is inexorably shrinking, creating excess capacity with traditional activities and intensifying the need to develop new businesses. Electronic payments are here to stay whether bankers like it or not.

Balance-Access Services

It is now clear that the traditional business of processing paper checks is in decline. Per capita on a monthly basis, check usage has plummeted by 25% since 1995, according to the Federal Reserve System. And the passage of the Check Collection for the 21st Century Act likely will accelerate that trend. "Check 21" will facilitate the use of electronic images as check substitutes.

Lest there be any doubt as to the financial consequences of these developments, Boston-based Celent Communications has estimated that banks, as a group, stand to lose $900 million of payments-related revenues cumulatively over the next five years as check volumes continue to sink.

Meanwhile, non-bank organizations with electronic capabilities are jumping in. The pending merger between First Data Corp., Greenwood Village, Colo., and Memphis, Tenn.-based Concord EFS Inc., for example, would create a dominant debit card network.

Elsewhere, players such as Merrill Lynch & Co. and Charles Schwab & Co., are offering quasi-checking products that retain the key advantages of checking accounts while adding information and complementary services. The appeal of these "balance-access" services is compelling. Customers enjoy the flexibility of using their accounts for a variety of functions, such as purchases, investments, bill pay and frequent-use rewards.

Merrill Lynch's balance-access accounts for consumers and small businesses have helped boost the New York-based stock brokerage company's assets to about $65 billion, making it a de facto top 10 bank. It's also a strong payments player, ranking seventh among all debit card issuers last year with point-of-sale volume of approximately nine billion transactions. And San Francisco-based Charles Schwab recently gained regulatory approval to offer bank products and services, such as electronic bill payment and debit cards, along with its standard investment products.

Banks generally are not set up very well to respond. Historically, they have managed payments as a series of splintered revenue streams rather than as a holistic business that takes a unified approach to the customer. Managers of check, debit card and credit card units, for example, often compete among themselves.

The performance of one payment product winds up being optimized at the expense of another. Efforts to encourage online debit usage, for example, naturally result in lower offline debit activity and lower check (or even credit card) volumes, a tradeoff that is likely to decrease payment revenues in the aggregate.

Another drawback of silos is that they tend to limit the possibilities for increased efficiency and more effective use of customer information. Where are the efficiencies in having multiple systems and operating groups that support similar payment transactions? Is innovation possible when lack of integration across payment types constrains banks from capturing information that might otherwise provide real insights into customer behavior and lead to the development of new services?

Fact-Based Approach

Only through the development of an enterprise-wide payments strategy can such problems and questions be definitively addressed. But a wealth of information will be needed. To make tough decisions on where to focus scarce investment dollars and prune operations, executives will need to equip themselves with the facts and build internal consensus.

A fact-based approach to strategy development begins with research into market trends and customer needs. Along with assessing the industry and conversing with experts, strategists must go the extra mile in interacting with customers. There are regulatory trends to be considered, macro-economic factors and general customer behavior patterns. It's vital to learn which customer segments are adopting electronic payments and why, and to identify the quasi-payment services they are purchasing from non-banks.

Along with this, a bank should objectively evaluate its capabilities to identify gaps that need to be closed and strengths that could be further leveraged. There are four dimensions to consider:

Strategic alignment. This entails an assessment of how current payment initiatives mesh with customer needs, competitive positioning and the institution's overall strategy. It's also important to understand the factors that drive revenue and profit.

Management and governance. It is important to review how senior executives oversee payments initiatives that cut across traditional product and functional boundaries in areas such as marketing, partnerships, and technology.

Organization and skills. What strengths can be drawn upon to support the organization's payment businesses, and what are the incentives for managers to cooperate across product silos? Considerations include the organizational structure, product development and management plans, and customer service practices. The goal is to identify where the organization can compete effectively and the capability gaps that must be closed to capture market opportunities.

Technology and operations. This involves a review of the overall technology infrastructure and the business operations supporting the payments business. Considerations include flexibility, support costs and efficiency.

The next step is to develop scenarios and model their potential impact. Inputs include data on revenue streams from payments services, channel and systems costs, salaries and fraud risk. This analysis will also identify the key drivers of profitability and the sensitivity of the payments business to specific customer and market trends.

One problem is that the source data typically is scattered in disparate systems. At the very least, pertinent data will have to be retrieved and consolidated for planning purposes. Actual systems consolidation may have to be considered farther on down the line, both to reduce costs and to improve customer responsiveness.

With the informational groundwork in place, planners can then consider possible developments and courses of action and estimate their consequences. For example, a bank may want to pinpoint the impact of increasing acceptance of debit cards by merchants. Under some scenarios, an increase in debit revenues will result in reduced check deposit fees, less check processing capacity utilization and increased unit processing costs.

By comparing the implications of these trends — at enterprise, product and operational levels — managers can clarify the profit opportunities inherent in the business. It also gives them a glimpse into capacity utilization trends.

Charting the Future

When translating all this into options for action, it is important to be pragmatic in identifying areas where the bank can compete — and to make tough decisions regarding where it cannot. For example, an institution that cannot reasonably sustain its check volumes may not want to invest in imaging to upgrade its check-processing capabilities, despite the apparent benefits of imaging technology.

An enterprise payments strategy should be organized around prime customer segments, and it should contain clear measures and incentives for growing those segments. The impact of pursuits on organizational structure, growth and efficiency should be assessed.

When considering organizational structure, it is important to cluster functions such as sales, product development and servicing around teams serving specific customer segments. These customer-segment teams can do the best job of identifying new growth opportunities, given that the proper measurements and incentive systems are in place.

For example, a bank targeting the retail industry segment could offer incentives to that particular team to develop deeper industry skills. The team may decide to build partnerships with fulfillment, inventory management and software companies to offer a comprehensive retailing management solution. This could include shipments, payments, auto-ordering, matching shipments to payments, cash projections, auto-invest and auto-borrow capabilities.

Efficiency initiatives should be guided by benchmarking specific operational areas against peers. Check processing, for example, may be divided into discrete business functions and compared with industry benchmarks. This comparison should highlight opportunities to reduce costs, since processing costs per check will rise over the next few years as volumes further decline.

This will help to frame options for payments operations. Possibilities include decisions to maintain; improve; in-source; outsource; or exit products/ businesses completely. Non-core operations are prime candidates for outsourcing or pruning. Conversely, operations that outshine the competition and have future potential should be presented to customers as solutions to their own outsourcing needs.

Finally, a summary cost/benefit estimate should be created for each opportunity. Such estimates help guide the level of outlays required to generate the expected value. This is the stage at which competing opportunities are debated and rationalized. The future of the bank's payments business is profiled in a list of actionable opportunities.

The final step is to translate this list into a strategic roadmap. Opportunities that require similar resources and address similar needs can be grouped together into projects, for which detailed plans, budgets and updated business cases are created. People should be recruited to lead and execute the projects, which are then sequenced based on criteria such as immediacy of return, interdependencies with other payment or bank-wide initiatives, and risk. Multiple projects should be grouped into distinct programs.

The result is a consolidated plan of multiple programs that will support payments strategy over a period ranging from one to three years.

Some larger banks and payment processors that have developed such a roadmap often conclude that a major systems and operational overhaul is required. Projections of multi-million dollar investments are not uncommon. To achieve payoffs on these investments, people in the organization must become accountable for ensuring its success.

To that end, it will be helpful to form a "Payments Council" to oversee strategy development and execution, chaired by a senior executive who will lead the process. One of the first steps should be to formally charter a group that will be responsible for pursuing initiatives identified during strategy formulation and realizing financial goals.

Unfortunately, some banks, while generally acknowledging the need for execution planning, often lose focus after plans are laid. While these banks may develop deep insight into the opportunities and threats, they fail to capture real bottom-line benefits. That is why execution planning must go hand-in-hand with strategic planning.

No one should expect a bank to grow its payments business overnight. However, the current paper-to-electronic transition period affords valuable opportunities to optimize current payment operations and improve profitability while gradually implementing a new enterprise payments strategy.

There is a strong case to be made that transition-related planning outlays will be financially justified by risk management improvements and higher margins from electronic payments. Near-term improvement in profits can help shore up the core business and also fund the growth initiatives needed to position the bank for the longer term.

The decline in check volumes may be just the catalyst required for banks to regain control of their payments franchise. Some have already placed their bets. Institutions that do nothing risk falling seriously behind in payments, a condition that could leave them permanently marginalized over the coming years.

Mr. Baig and Mr. Norman are partners with DiamondCluster International Inc., a management-consulting firm based in Chicago.

Copyright © 2003 by Banking Strategies, published by BAI.

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