Girding for Battle

By Steve Mott

Stored-value, micropayments and just-in-time payments all are fertile ground for innovation.

The payments business is changing at a dizzying speed, with potentially negative implications for banks.

Just in the past year, court verdicts have opened the door for American Express Co. to compete more effectively against the bank-centric card associations; the settlement of a retailers' suit against the same associations has reduced interchange fees banks earn from debit cards; and nonbank technology companies have been making steady inroads into the online payments arena. All this occurs as the credit card, the foundation of banking's payments dominance, is showing signs of flagging momentum.

While the situation has by no means reached crisis proportions, the confluence of negative forces does suggest a need for banks to take a fresh look at their payments strategy. The handful of big card issuers, who drive 80% of the business, cannot assume that the rich revenue streams they enjoy today will continue indefinitely. Meanwhile, thousands of smaller issuers carry a portfolio whose economics they no longer control, and processing banks struggle to balance their interests against that of their merchant customers.

So what can be done?

For starters, banks should demand more innovation from the card associations, Visa and MasterCard, which currently seem stuck in the mode of simply raising interchange fees. Banks themselves need to open their payments networks to the kind of innovation that provides more customer value rather than simply try to preserve an increasingly shaky business model. Far too much bank strategy is driven by a fear of cannibalizing existing revenue streams.

Banks can also provide more customer value by opening up and leveraging access to demand deposit accounts. And they should support rather than contest merchant needs for the extended reach and loyalty rewards integration offered by stored-value cards. Finally, bank Internet capabilities should be leveraged and expanded to offer digital customers the mobility, flexibility and convenience they're seeking.

All this means banks will have to accept the reality that they will be competing under a new set of economics. In essence, they'll be getting paid for the work that they actually do rather than live off the largesse derived from market dominance they've enjoyed until now.

Not all banks will make this transition, but every bank has the potential to do so, and to gain a profitable share of the payments business in the future.

Loss of Influence

From a historical perspective, banks have been retreating from the payments business for some time. Responding to the demands of the public markets, they have tended to focus on areas where they could generate high returns-on-equity and strong earnings-per-share growth.

Payments businesses never produced those kinds of returns. And as this became an increasingly electronic environment, only processors with huge scale earned minimally attractive margins. Few banks could achieve sufficient scale by themselves to qualify.

Thus began a steady move by banks over the last quarter-century to outsource payment processing to third parties. This fostered a slow but inexorable surrendering of bank influence over products, prices, positioning and profitability.

This disturbing shift in banks' control over their payments destiny became clearer in 1999, when BAI and Global Concepts Inc. published research that showed (using 1996 data) U.S. banks had outsourced all but 23.8% of the then-$115 billion in industry payment revenues. Today, with the market about $163 billion in size, based on Boston Consulting Group estimates, the portion of the payments business under direct bank control is undoubtedly even lower.

Considering that the top 25 bank holding companies generate an average 40% of their revenues and income from payments, per a 1999 Federal Reserve study, it can be seen that such a loss of control is no small matter. Now, with Internet technology changing the manner in which payments are made, banks face further challenges in this area.

This loss of control intersects with four other ongoing developments to raise troubling implications for banks of all sizes. First, the credit card business is graying and may no longer hold up as a panacea for retail revenues and earnings. Second, the continuing popularity of debit-account products with both consumers and merchants has some negative implications for bank profitability, since interchange rates are lower. Third, stored-value cards are penetrating long-neglected consumer markets, enabling merchant-controlled payments to siphon off major chunks of future market growth.

Finally, electronic bill payment seems to be gravitating from a bank-centric "consolidator" model to one in which consumers make their payments directly at biller Web sites. Taken together, these developments threaten to crack the entire foundation of the retail payments business, to the potential long-term strategic detriment of many banks.

Consider, for example, the credit card. It has arguably been the most successful financial services product in the past half-century, facilitating more than a quarter of consumer transactions and generating tens of billions in bank revenue. Yet it is also showing clear signs of age as growth in spending drops to mid-single digits and portfolio profitability declines steadily in the face of reduced response rates and higher delinquency rates. A Bernstein Research study in 2003 estimated that the average bank revenue per card has declined to just over five dollars.

Meanwhile, merchant outrage grows over interchange rates, which keep increasing while all other costs of transacting are dropping due to the efficiencies of digital communications. Animosity toward banks has reached such levels that merchants have organized themselves into associations to press payment card companies to fix these problems, or solve them without the involvement of financial institutions. Last year's settlement of the Wal-Mart suit against the card associations over debit card interchange rates gives the merchants continuing leverage in this struggle.

In response, many banks appear to be retreating to the "safe haven" of ever-higher credit card interchange rates, at least for as long as Visa and MasterCard can foist them on an unreceptive market. Sacrificing innovation in this way to preserve unrealistically high fees is hardly the foundation for a durable business model.

Debit Revolution

Even as credit card growth seems to stall, debit card usage is surging in the U.S. And no wonder. Debit products can be used by vastly more consumers, since they simply tap the customer's existing demand deposit account balance. They also provide substantially more flexibility for both consumers and merchants, as well as lower risks to bank providers.

Debit card transactions eclipsed credit cards in 2003. By 2006, there will be more debit card accountholders and cards than credit card equivalents. And by 2007, debit card spending will double from today's levels, according to The Nilson Reports.

Meanwhile, new products are proliferating. Chico, Calif.-based Debitman Card Inc., for example, offers a guaranteed Automated Clearing House card transaction at the point of sale for as low as nine cents. First Data Corp.'s Star network has opened its network to bill payments not made with a personal identification number, including most recently converting ACH bank and account identifying data to electronic funds transfer formats, thereby gaining new electronic transactions with new billers and merchants.

It can be seen, then, that consumers are clearly "voting with their feet" for the expanded usage and enlightened applications of debit products — albeit at the expense of current and future signature-based card volume. While most merchants would prefer expanded use of the real-time funding and proven safety and guarantees of the electronic funds transfer networks, recent Visa-led rate increases in PIN-debit and continued reluctance by banks to deploy PIN-debit systems online have forced them to turn to the low-cost ACH network as their primary alternative. As these new ACH programs grow in popularity, the banks' "take" from these transactions will drop significantly.

The difference between PIN and signature-based transactions is that the former requires customers to enter a PIN for authentication, while signature-based transactions are accepted on the basis of the customer's signature. PIN transactions typically run through the ATM networks, while signature transactions go through Visa and MasterCard.

One offspring of the Debit Revolution has been the stored-value card, which is now used by 97 million Americans, according to a ValueLink/First Data annual survey. Employing a very familiar technology — the mag-stripe — and commanding near ubiquitous usability at card-accepting merchant locations, stored-value cards are penetrating every walk of American life, including telephony, entertainment, events and Starbucks coffee. Starbucks, the poster child for stored value, has issued an estimated 16 million cards in just 30 months, holding more than $400 million in virtually free capital contributed by customers and accounting for more than 15% of transactions.

Banks, however, are being left behind. A recent Unisys Corp./Global Concepts/Talson Associates study indicated that 58% of consumers purchased stored-value cards from merchants, but only three percent bought them from banks. Further, only 20% were likely to buy from banks in the future, largely due to the much more expensive fees for bank cards, despite their ready acceptance at multiple merchant locations.

This problem of banks failing to take advantage of market developments also applies to online bill payment. Three out of five new online bill payers are using the "biller-direct" model — going to as many as 10 separate Web sites a month to pay their bills — rather than using bank payment portals, according to CheckFree Corp. Gartner Group estimates that more than 40% of U.S. households will be paying online by 2006 — mostly via the biller-direct model.

There's no mystery why merchants prefer biller direct. Most of these payments cost the biller only the amortized expenses for the Web site, plus a few pennies for the ACH transaction. To combat this price disadvantage, banks could add more value to their online programs with e-mail alerts, confirmations of payments, automated transfers and other features consumers want. But few do. Many bank online sites, for example, still can't or won't make electronic payments, even to other banks!

The implications for this failure are grim. As consumers migrate to competing payment systems, banks lose the opportunity to build in sufficient value to their aggregated payment portals to capture a decent fee and margin. They also lose out on connecting with a whole new generation of consumers who have discovered that the Internet can get them where they want to go when banks can't or won't.

Bank Response

So what should banks do about all this? For some, the short-term answer has been to levy more and larger fees to make up the revenue shortfalls. For others, the solution is a retreat to the ephemeral "safe haven" of high-rate payment products, such as signature-based credit and debit cards.

But these temporary expedients carry huge risks of both consumer and merchant backlash. And they hardly mask the fundamental problem all banks now face, which is to find and drive new sources of value and revenue in a mission-critical part of their business that has largely been turned over to third parties.

The process for banks "getting it" starts with thinking strategically about payments. Some institutions have done this by appointing payments "czars" and creating enterprise-wide departments to focus on those issues. But initially, at least, many of these efforts seem to be hampered by internal product silos and the continuing injunction from chief financial officers not to sacrifice today's revenue and income for tomorrow's new growth product.

Such obstacles hinder banks from doing what's really required here, which is to evolve new organizational structures that proactively plan and execute on some degree of controlled "cannibalization" of existing non-electronic payment products in favor of faster and cheaper digital replacements.

Take stored-value cards, for example. Researcher Financial Insights predicts this market will grow to $349 billion in purchase volume by 2007, 42% of which will be in payroll cards. Banks are the natural and ideal provider of these new services, which provide employers with float benefits and spare employees the scourge of payday theft, high check-cashing fees, and abusive lending practices.

At least one big bank has defected from the high-fee Visa/MasterCard stored-value camp and begun working with a major consumer electronic retailer to create higher-value, but reasonably priced, stored-value functionality for both offline and online use. Likewise, some bank processors are now beginning to seriously address the micropayments opportunity in the burgeoning digital content business. Most of this business currently involves cash and check replacement, so there's nothing but upside for banks.

In the electronic and telephone bill payment marketplace, a cottage-industry of providers is showing how real value can be provided, such as enabling last-minute payers to transact efficiently and conveniently and at a reasonable fee structure that provides substantial margins without alienating users. In fact, one of the fastest-growing segments of usage comes from people in their twenties who haven't developed disciplined patterns for managing their finances yet and rely on electronic bill payment to avoid punitive treatment by banks. Banks can cultivate the willingness of these "convenience payers" to pay material fees for the value of paying at the last minute.

This kinder and gentler approach can be applied to other areas. Celent Communications has recommended that U.S. banks adopt European-style overdraft features and products, instead of gouging consumers with overdraft and insufficient funds fees. The idea here is to nurture customers into closer relationships rather than punish them for missing payments.

There's no reason this more permissive and enabling approach can't provide banks with a source of new growth and profits. But there's a much larger opportunity at hand that banks must now consider as they confront the mounting opposition to the status quo in payments, and the ever-increasing resourcefulness of non-banks in using the banks' own networks for more creative and innovative purposes than the banks will themselves. And that opportunity involves enabling rather than blocking the use of banks' own networks to support, and therefore exercise more control over, all the new ways to pay.

Examples in this arena include the direct authentication of online purchasers by issuers rather than merchants. Merchants shouldn't have the burden or responsibility of authentication — that's the natural role of banks. NACHA, the Electronic Payments Association, had been considering such a solution for ACH transactions but put the project on the back burner because, in the words of one NACHA board bank, "it starts us down the slippery slope toward lower interchange rates."

Well, what's in the best interest of customers here? Isn't it better to harness the powers of innovation and help vet new services so that all parties to a payment transaction can benefit? Led by a small startup out of Montreal called Othentik Technologies, there are already four different Canadian companies offering this type of authentication functionality. How much longer can this idea be kept out of the U.S.?

PIN-debit/EFT networks constitute another area where banks have been loathe to exploit the full potential and value of their networks. They could become a facilitator of payment innovation and apply their efforts to figuring out how to develop new and potentially more profitable business models. Instead, they've let Visa short-sightedly push interchange rates up for PIN-debit toward signature-debit card levels to prop up an increasingly suspect business model. Further, they've surcharged merchants (and, indirectly, consumers) for the use of PIN-debit cards at the point of sale and forced innovators, by default, to try and re-craft the ACH network to look and act like the PIN-based debit network because that's the functionality consumers and merchants now need.

Whatever path enlightened banks choose to follow, there won't be enough revenue left to support all of them. The Boston Consulting Group projects that revenue per unit of payment will decline steadily, in every part of the world, at 3.4% per year through 2008. If this is the inevitable result of digital technology and other external forces, then banks have no long-term option except to reengineer their networks and payment products and services to alternatives that offer better margins and broader customer relationships.

Banks certainly have the tools and presence to turn the tide back in their favor. But if they blow the opportunity this time, they might never get another chance, and they will have no one to blame but themselves.

Mr. Mott is a principal in BetterBuyDesign, a payments consultancy based in Stamford, Conn.

Copyright © 2004 by Banking Strategies, published by BAI.

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