Rational Choices?

By Kenneth Cline

Atlanta Fed payments executive Richard Oliver says bankers — and ultimately consumers — will have to face up to the true cost of technology alternatives.

Are consumers getting a free ride when it comes to payments technologies?

Federal Reserve payments executive Richard Oliver thinks so, pointing to the recent proliferation of alternative technologies. As the payments world increasingly shifts from paper-based to electronic transactions, consumers are making purchases with credit cards, debit cards, e-checks, stored-value cards, person-to-person Internet payments — and even occasionally the old-fashioned paper check. And by and large, financial institutions and not consumers bear the cost of new product introductions.

Oliver, a senior vice president at the Federal Reserve Bank of Atlanta, says that situation can't continue forever. In his view, banks are so concerned about "losing ground to the competition" that they tend to "adopt every technology to protect themselves." And they're doing this even as they face rising per-unit costs in their traditional check processing operations.

"If the unit cost of processing checks continues to grow as banks and other providers invest in all these different electronic alternatives, it would seem that providers can no longer offer everything for free," he says. "The consumer is then going to be confronted by more rational choices."

A starting point for financial institutions to make more rational choices, he adds, is to "think long term." While some institutions have been appointing payment strategists to come up with long-term plans, Oliver says these executives tend to be high-level staff people rather than decision makers. "I don't see companies bringing together management and payments in a way that allows them to truly make serious decisions about what they want to do about payments. Right now, everybody's pretty much protecting their silos," he says.

Oliver is uniquely positioned to make these observations from his pivotal vantage point as retail payments product manager for the Federal Reserve System, where he has responsibility for managing the Fed's check and automated clearing house businesses nationwide. Banking Strategies spoke with him last month in his office in Atlanta.

Banking Strategies: Are we on the cusp of a genuine revolution in payments, or are we just seeing a confluence of incremental changes?

Oliver: I think we finally have reached the cusp of change. Thirty years ago, the concept of a check-less society was first discussed during the Atlanta Payments Project. While the advancement toward that has certainly been glacier-like, a variety of things have come together now to speed up the process, not the least of which is the proliferation of the Internet.

Ultimately, as we've proved over time, it's not what the banking system wants; it's what the end user is willing to do. And I think the Internet has changed what consumers are willing to do. In 2001, when the Fed did its pivotal research on electronic payments and check volumes, 50% of the consumers who exclusively used checks said that within the next year they were planning to try out an electronic payment instrument. Our experience has been that once people try these things, they get more comfortable.

Banking Strategies: So the consumer rather than the technology is driving the process?

Oliver: Well, the technology is driving the consumer preferences. Once people get comfortable with computers and start purchasing things online, they begin to think, for example, that maybe using that debit card at the point of sale is not such a bad idea.

That one instrument alone — the debit card — is probably provoking the biggest change in terms of payment volume. It's displacing checks in great quantities, it's displacing some credit card utilization, and perhaps even some cash.

It's interesting that it's replacing credit card usage, because in the early days of building point-of-sale debit card-based systems, consumers seemed to worry most that they would lose their constitutional right to float, since the transaction hits the demand deposit account immediately. Now they seem to accept that.

Also, the technology has become pervasive. You can go into almost any retail outlet and use a debit card. Consumer research continually points out that the number one criteria for a consumer in selecting a payment option is convenience. At this point in time, the debit card is convenient for both consumers and stores. It's one of those cases where the needs of various parties to a transaction are being met.

Banking Strategies: Would consumers react differently to the float issue with debit cards if interest rates were higher?

Oliver: The nature of payment systems is certainly affected by interest rates. Consumers see the end benefits less than corporate users, but certainly the choices are affected by interest rates.

A classic example on the corporate front would be check conversion. Check conversion at the point of sale hasn't evolved very quickly because most checks written there are drawn on local banks. You can collect them rather quickly and with interest rates at 1%, you don't gain much by doing that a day earlier. Plus, you have to introduce new technology.

That situation would change dramatically with interest rates at 4% or 5%.

Banking Strategies: Looking at the current array of new payments technologies out there, which ones do you think might have the greatest potential?

Oliver: There are two aspects to this. The first is getting the end user to adopt a certain alternative technology. And the other involves changing the form of the payment, as when a check morphs into an Automated Clearing House debit.

In terms of converting payments, there appears to be significant momentum behind check conversion at the lockbox because of the significant opportunities for cost takeout. Even with 1% interest rates, collecting on these items a day earlier is worthwhile, and will get more worthwhile as interest rates rise.

There's also a business case around detecting return items more quickly. Lots of studies show that for every day you're able to detect an item earlier, the percentage of potential collections rises dramatically.

Just as we saw every insurance company go to direct debit when the ACH was founded, I think we're going to see almost every credit card processor, if not major utilities, begin to utilize lockbox conversion.

On the consumer choice front, however, payment alternatives are a bit harder to handicap. For one, end users aren't a homogeneous group. People still feel strongly about not doing certain things. Direct debit is a classic example. Although it's highly reliable and been in place for years, there are still consumer advocates who declare often and loudly that you should never allow anyone to debit your account, even a trusted vendor. Most consumers don't realize they have up to 60 days to refuse the transaction.

So consumer preferences will play a big role here. I've seen situations at checkout counters where buyers had their checks converted and handed back to them stamped "VOID," and they had no idea what had just happened. It makes them irate. And generally, the checkout clerks don't understand either.

The unfortunate result is that various alternatives will coexist for a long period of time. I can't think of a single payments system that's ever disappeared. We just keep adding new ones. And that puts an increasing burden on people in the payments business in terms of investing in and maintaining the various alternatives.

You wonder if the pricing issue isn't going to return. For a long time, the true cost of these various alternatives has been hidden from consumers. But if the unit cost of processing checks continues to grow as banks and other providers invest in all these different electronic alternatives, it would seem that providers can no longer offer everything for free. The consumer is then going to be confronted by more rational choices.

Right now, consumers are free to make any payments choice they want based on how it feels to them. The real issue is whether technologies that lose popularity over time will ever be jettisoned. Will providers have enough courage to force people to do something different?

The risk you have with these technologies today is that by the time you deploy them, things have moved on. Ultimately, you have to ask: Where are you getting the funding to do all these things? And where's the revenue stream? I'm not sure those things are matching up very well any more.

Banking Strategies: What advice would you give to bankers who are trying to decide which investments to make?

Oliver: The main advice I would offer is to think long term. Assess your options long term and begin to build your own vision of what you want to provide to customers and stay true to that. You don't have to be all things to all people.

As an industry, we've gotten fairly sloppy with respect to doing cost-benefit analysis. We've been driven more by fears of losing ground to the competition. This forces a lot of people to think they have to adopt every technology to protect themselves.

While banks have been appointing payment strategists, these tend to be high-level staff people. I don't see companies bringing together management and payments in a way that allows them to truly make serious decisions about what they want to do about payments. Right now, everybody's pretty much protecting their silos. Payments have not always been at the top of the agenda for senior leaders of financial institutions.

Banking Strategies: How is the Fed itself handling the transition from paper-based to electronic payments?

Oliver: Obviously, the decline in check volume is a major change for the Federal Reserve, which is the world's biggest check processor. We have 45 check processing sites across the country that process over half the inter-bank check transactions, one-third of all checks.

So check processing has been the backbone of our employment base. But check processing volume is falling at a rate of at least 3% to 5% a year and we live under the requirement of the Monetary Control Act of 1980 to match costs and revenues for each service we provide. We have no choice but to respond as aggressively as is necessary to continue to fulfill that mandate.

A year ago, we announced we were going to be closing down 13 of our 45 check processing operations. That's underway now. We have moved to consolidate and standardize every aspect of our processing service to reduce costs. We're consolidating and improving some of our large functions within checks, such as adjustments. We've created significant new automation capabilities there. We've introduced Web services to access all our check services so customers can perform many of the tasks they need to do themselves, remotely, at even better levels of service.

We have to continue to change and change rapidly. Every organization involved in check processing is working through the same issue, whether they're local clearing houses or individual financial institutions. As you're probably aware, there's significant excess capacity for check processing in this country. Check reader sorters that were purchased for half a million dollars are now selling for $50,000, and soon will be worth next to nothing.

This is going to cause a short period of considerable disruption in the market as people try to offer services at very low prices to keep the computers running for the remainder of their depreciation cycle. Then, you're going to see a lot of people just choose not to be in the business anymore and outsource it, since it's a commodity business with very low profit margins.

And deep in the midst of all that is the question of how people are going to use check images. A lot of investments have been made in check imaging, but the payback period for those investments is now being extended into the future because the volumes aren't going to be there.

While the impact of a declining check market is difficult for us and others to absorb, the move to electronics is obviously a healthy phenomenon, since it contributes to the efficiency of the system. But the details of how that is going to unfold are a confusing mess and will have to be sorted out piece by piece.

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2004 by Banking Strategies, published by BAI.

back to top