Wells Fargo Payments Strategist Mitch Christensen on Electronification, Risk and Competition

BY PAT ALLEN

The following expanded interview includes information that did not appear in the printed May/June 2006 Banking Strategies.

| SYNOPSIS | Wells Fargo & Co. payments strategist Mitch Christensen says the industry's progress toward check electronification has been hindered by slow technology adoption, litigation over intellectual property and heightened concern over data security. He supports the increased use of ARC but believes ACH receivers should be compensated. Wells seeks a level playing field with "under-regulated" third parties and industrial loan companies; and thinks the Fed should reconsider its role as a service provider in the check business.

To talk to Mitchell A. Christensen is to be introduced to how Wells Fargo approaches payments. An undisputed leader in the payments industry with about one-third of its total revenue ($10 billion in 2005) related to payments products and services, the $482 billion-asset Wells has a significant stake in the direction of banks in payments.

Related Sidebar Payments' Importance to Wells

As Wells' Executive Vice President of Enterprise Payment Strategies, Christensen looks across an organization that has many payments silos including check, ACH (Automated Clearing House), wire, debit/credit card and cash. The mission of Enterprise Payment Strategies (EPS) is to resolve business conflicts and pursue opportunities for the enterprise. Wells is deliberate about its industry participation and demands a consistent voice for itself in all things payments.

Such structure and coordination is uncommon in an industry that’s wrestling with so many unresolved questions—and perhaps that’s the point. With EPS’ help, Wells clearly wants to position itself to influence the outcome of the many open issues that will affect bank profitability in payments.

On check electronification, for example, the industry is progressing but not as originally planned. Financial institutions have been slower than expected to prepare for image capture, notes Christensen. Lawsuits over intellectual property rights and tighter controls stemming from data security breaches all have hindered progress. But while the timetable needs to be reset, Wells is a lead advocate for image exchange and more specifically, image on demand.

“The last thing we wanted to have happen was to take down the physical transportation routes and then make us completely reliant on moving all these images around the United States on telephone lines,” Christensen says. “Leave the image wherever it was originally captured and provide indexing capabilities so that if I need to look at that image, I know where to go to see it.”

Christensen is supportive of the recent surge in ARC and other ACH-based products. Wells believes that customers should have the full range in choosing their payment instruments. But he believes that some characteristics of ACH need “repair.”

Payments is the focus of one of Wells Fargo’s 10 corporate strategic initiatives: “Banks traditionally have been the intermediary in the billions of transactions among consumers, businesses and the government. That role, however, is not a birthright.”

As confident as Wells may be of its value proposition—and Christensen says Wells is “not afraid” of other payments providers—he minces no words in calling for a “level playing field.” “You can’t throw a lot of regulatory costs on the table that we have to absorb and then ask us to go out and compete with some of the under-regulated third parties,” says Christensen.

On this, Wells seeks to influence in many ways. One is in lobbying for the Federal Reserve regulation of industrial loan charters. Another is in its less formal and more quiet lobbying for the Federal Reserve to exit the check business. “We believe the Federal Reserve should seriously consider whether they should be both a processor and a regulator in the payments business going forward,” he says.

According to data Christensen cites, payments in the U.S. in 2005 is a $225 billion a year business, growing at 8% a year. Wells believes that it—and by extension, the banking industry—can deliver what customers want: convenience, speed, reliability, safety and transaction information. “Where we (the industry) are not doing a good job,” he says, “is getting our fair share of that new growth.”

If there’s a restlessness in Wells’ otherwise orderly perspective, it is in Christensen’s sense that “we [the industry] are not moving fast enough.”

Q Banking Strategies last interviewed you a little more than two years ago, six months after Check 21 was passed and six months before it was implemented. At that time you spoke about the impact Check 21 would have on driving the electronification of checks. Have the last two years played out as you expected?

Christensen: Hindsight is always 20/20. We’re a lot smarter now than we were back in 2003 and 2004, and for several reasons. One, we underestimated how difficult it was going to be to get image technology installed, not only to be a sender or image creator, but what’s really been a challenge is to get the receivers up and running.

There are many organizations today that can do image capture but they don’t have many receivers to work with. There are not a lot of players that are able to receive images yet. Right now Wells is receiving a very small amount of images from Bank of America but, by and large, most of the large receivers are making good progress. So, what’s happened in the meantime, many of us are imaging on the capture side. Then we’re transmitting the images and creating Image Replacement Documents (IRDs). People knew that IRDs were going to be an interim issue, it’s just that it’s going to be a longer term issue.

Q That was a surprise?

Christensen: I don’t think “surprise” is the right word. It’s been a challenge. Wells is a significant user of IRDs. The rea-
son we are a big user of IRDs is because for the first time, since Check 21, we’re able to take the time zone equation out of the scenario. We are converting about 3% of our checks captured into IRDs and sending them east for collection. It’s not the most economical process to print IRDs, but it’s certainly beneficial if you are working against the time zones.

That was our first issue — that the technology development and implementation for capture, receive and ability to exchange between partners was longer than what we anticipated. Many of us thought it would be two years; it’s probably going to be closer to five.

The next thing that we ran into early on, which is well documented in the press, is the considerable patent and intellectual property issues that we didn’t see coming. Many of us are being sued, and none of these are inexpensive or frivolous lawsuits by any means. Some organizations have now settled. We not only believe that the existing patent claims are slowing the process down, but we also think that there are many other patent holders that have yet to come forward. So document imaging is going to be in litigation for a long period of time and, by the way, it’s going to be very expensive for everyone.

Q So, those concerns are having a chilling effect that’s slowing the entire industry down?

Christensen: That’s right. But it’s not slowing down anyone at this juncture. A year, year-and-a-half ago, it slowed several of us down while we figured out where we stood. Most of us said we can’t hold back, we’ve got to keep moving forward because we’re not sure where this litigation is going to end up. Will the patent holders win? Will we end up buying licenses at very expensive rates? Would we have to go through long, expensive litigation? We still don’t know all of the answers yet, so yes, it has had an effect.

Another challenge, which is also well documented, is that we began to run into the whole issue of data security and breaches. When you convert a check to an electronic image, you fall subject to some state laws that require notification, among other things. Data security legislation is now becoming a very prominent issue in Washington. There are several congressional committees with legislation pending, and it’s not just about financial services, it’s about any kind of sensitive customer information. But we now know that check imaging falls into that arena.

So, we have to be very careful how we proceed, how we’re going to secure information in the future and how this whole scenario will play out. Many in the industry are working very diligently on this issue. But I also think that it had an effect on the conversion process to some degree.

Q What about the surge of ACH? Over the last two years when more check image exchange activity might have been expected, have you been surprised by the dramatic growth in the use of ACH?

Christensen: I did a presentation some time ago, and there was some debate inside my own bank on whether or not we really foresaw the explosive growth in ACH. I tend to think that we didn’t, and we certainly didn’t see all the new applications whether it’s POP (point of purchase) or ARC (Accounts Receivables Conversion) or now back office conversion. It really has been a growth channel for payments.

We believe in eliminating the paper as early in the process as possible, and we support those kinds of conversions. Let’s get them to electronic transactions, whether it’s ACH or debit card or something new, as early in the process as possible.

One of the attractive attributes of ACH is that it’s ubiquitous. You can access every DDA account in the United States whether it’s at a credit union, a savings and loan or a bank. As an originator that makes it a very powerful payment instrument. It’s also relatively inexpensive, particularly considering wire transfer or sometimes even processing IRDs or checks.

Q It’s been attractive to customers. What about the banks — is ACH profitable for banks?

Christensen: There are two trains of thought on that. Clearly, card revenue has been a more attractive alternative for financial institutions, but I think we’re at a point now where you have to make a decision to get all of the payment instruments consistent in both risk and reward for everyone.

What I mean by that is that we have some issues we need to repair in the ACH, for example. One is the value proposition, and the other is risk. We’re actively working on both of those within the industry. In fact, one of our executives (Steve M. Ellis) is the chairman of NACHA and one of his major goals in 2006 is to work on the risk scenario. We do not have all the risk controls in the ACH channel that we need to have.

Also, and this is something I’ve been pushing for several years, the receiver of the ACH transaction as a financial institution gets virtually no value today, other than the value that their client gets by signing up for an electronic transaction as opposed to writing a check. But the receivers have costs, they handle the exceptions and they have settlement risks with no value coming to them from the originating company or through the originating bank. So we believe there needs to be some compensation to ACH receivers in the future.

Q Despite ARC’s popularity, there seems to be a sense among some that once check image exchange is up and running, image exchange will prevail over ARC as a preferred means of electronifying checks. Do you agree?

Christensen: There are five alternatives that wholesale/retail customers have to access their DDA accounts. They can write a check, use cash, ACH, wire transfer or a debit card. We believe that you ought to continue to have access to all of those and maybe more someday. Consumers should be making payment decisions based on the cost, risks and information from the transaction they perform.

Where the industry has not done a good job is in explaining all those advantages or disadvantages to our client base. We should be clearly explaining these cost and benefit issues, so people can make informed decisions about what instruments to use and why.

How to convert checks at the point of sale is a controversial topic, and whether it should be converted to an ACH transaction or converted to an electronic check, and then settled through ECP (electronic check presentment) is one that falls into that vein of risk and reward. The people who really need to make that call are the retail and wholesale customers.

My opinion at this juncture is that organizations that are taking checks and converting them to ACH are probably going to be imaging those checks anyway because of the return items issues. Now the question is: Is it cheaper to push the image or ECP down the pipe, or is it cheaper to convert the check to an ACH transaction and move that down the pipe? That gets us back to the economic value and risk and rewards.

Understand something, too: There’s a natural evolution going on here of first moving paper checks, then imaging checks, then transmitting them and creating IRDs, then exchanging the images directly and then ultimately images on demand. Image on demand is where we need to get to as soon as possible.

The last thing we wanted to have happen was to take down the physical transportation routes and then make us completely reliant on moving all these images around the United States on telephone lines. So, that’s where organizations like Viewpointe [which Wells Fargo is an owner of] are trying to move on the image on demand concept. Leave the image wherever it was originally captured and give me indexing capabilities so that if I need to look at that image, I know where to go to see it.

According to the numbers I’ve seen lately, for every 100 checks imaged, we probably only ever access about 8 of those images. The rest of them never get looked at. So, why move all of them around if 92 out of 100 nobody’s going to access them anyway? Also, not only do you have to image it and archive it, if you exchange it you also have to put it in another archive. So, you’d have it stored twice, in two different archives. That seems like a redundant scenario to me.

Q. When do you now expect image exchange to take off?

Christensen: (laughs) I’ve been talking about this topic for years and I don’t really know for sure.

There’s an awful lot of movement going on right now that would indicate to me that 2007 should be a very big year. Now whether it explodes or just grows steadily, I think is still up for some debate. But I know that Wells and most of the large institutions, as well as five or six major check processing organizations, by the end of 2006 will pretty much have everything in place. In fact, you may see a “hockey stick” growth pattern begin later this year in the fourth quarter. Then I think by 2007, 2008 at the very latest, we should see some significant volume shift.

Q Mitch, you’re one of a relative few executives whose organizations have committed to an enterprise-wide effort to view payments businesses across organizational silos. How is it to Wells Fargo’s benefit that you’re focused this way?

Christensen: Yes, it has been to our benefit. Our Payments Council, which includes our most senior executives, is where we communicate where we have opportunities and where we have conflicts in the payment businesses within Wells Fargo. Since the businesses are resident in silos, they see opportunities that others in the bank don’t. There are some natural conflicts and opportunities. We bring those different views to the table.

We also have recently started what we call the Senior Payments Forum, which is a level down from the Council executives. We try to meet every 60 days as opposed to the Council’s three to four times per year. We talk about all kinds of opportunities, not only investment opportunities.

This year we are starting to create official payments positions for Wells to use in the industry. We are beginning to work on about 10 of these official positions right now. Our goal is to make sure all of us at Wells are working together to influence the industry in the same way.

Something else of significance we did earlier, that some other banks are now doing as well, is we created the Payments Industry Relations Office (PIRO). Two years ago, Dick Kovacevich [Chairman and Chief Executive Officer] asked EPS to get a handle around what Wells is doing in the payments industry. We have all these team members from Wells in all these industry organizations and we don’t really know what they are saying and doing. We are not even sure if we have the right people in the right organizations.

So we built PIRO and asked executives from our lines of business to participate on a Steering Committee to begin the process of centrally managing our industry activities. We initially identified over 50 organizations Wells was active in with over 500 team members. We then began populating our Web site with information on these organizations and who from Wells is involved. We also clear all new participations with the Steering Committee to ensure we have the right representation. It’s working great!!

Another concept we use in industry relations is called Wisdom, Leverage, Relationship and Influence. The first thing we do is understand what are the issues and what organizations are involved. We call that the Wisdom. It’s getting smart around our subject. Then we figure out the leverage and who are the individuals that are the key players. Once we know that we begin the relationship development process. We rate targeted relationships on four levels. Once we have a relationship developed (particularly at the one or two level), we believe we have the ability to begin influencing an agenda.

Right now, I think there are 26 to 28 organizations that we have gone through that entire process with. We also segment the financial services industry and ask specific team members to be experts on their respective segments. Remember, Industry Relations is a constantly changing environment. You may have a great relationship today and none tomorrow.

Q: But how, specifically, is it to Wells’ benefit that you’re organized the way you are?

Christensen: When I think of payments, I think of the movement of value between two parties. Understand that about 30% to 35% of our corporate revenue results from payments. Now we don’t manage payments like we do our lines of business (i.e., wholesale and retail, etc.). But we do know that in 2005 corporately we did about $30 billon in revenue and about $10 billon of that was specifically attributed to payments. Payments represents a lot of value for our shareholders. It’s too large and important not to be focusing on it every day. That’s EPS’ role.

Q What is the value proposition going forward for banks as providers of payments products and services? Why should customers care?

Christensen: Customers care very much about convenience, speed, reliability, safety and information regarding their payments. Clearly we, the banks, have to be competitive to stay in this business. We have had some interesting dialogues about several companies that are big customers of Wells Fargo and they are also big competitors of ours in the payments business. We call them “competitive customers.” At the end of the day, as long as there is a level playing field — and we don’t believe we have a level playing field from a regulatory standpoint now — we ought to be able to compete with anyone that wants to be in the payments business. We don’t have a level playing field when it comes to the under-regulated third parties.

Additionally, we have some issues with industrial loan charter regulation as well. We don’t believe FDIC (Federal Deposit Insurance Corp.) regulation is the same as Federal Reserve or the OCC (Office of the Comptroller of the Currency). As long as you level the playing field, we’re willing to compete with anybody. But you can’t saddle the banks with extra regulatory costs that we have to absorb in our pricing and then ask us to go out and compete with some of these other payments players who don’t have those costs.

Many of the third parties have been able to get into the new electronic environment because they didn’t have to invest in the heavy infrastructure, like we did in check. That’s what kept them out of checks all these years. Clearly, when you look at some of the new channels like stored value or gift cards, they can get in those spaces pretty easily. Kevin Rhein, head of our card business, calls this selection of payment choices the “pay ahead, pay now, pay later” concept. You can pay ahead with a gift card or you can pay now with a debit card or pay later by putting it on a credit card.

The value in payments comes from two areas — fees and balances. Fees are coming under extreme pressure from third parties, legal activities, legislation, etc. We are beginning to see some potential for balance leakage as well due to new channels like stored value cards (i.e., Starbucks cards), PayPal accounts and others that move out balances once kept in DDAs.

We are lobbying for consistent regulations of the industrial loan companies, the same as banks. We believe that an industrial loan company’s parent organization should be regulated under the Bank Holding Company Act the same as banks.

Changing subjects, one issue that confuses many people is when we talk about the volume of payments. People believe check usage is declining and it is. But it’s declining at the processing sites much faster than where they are being written. Overall the number of payments in the U.S. is growing at a healthy 6% to 8% per year.

I have a chart that shows the last 20 years of payments revenue earned by banks and third parties. We, the banks, have not lost any ground on revenue generation during that time. But, what we have lost out on is the overall growth.

So it is a growing, exciting business to be in. The payments business within the U.S. is a $225 billion-a-year business. That is a big market growing at 6% to 8% a year. Where we (the banks) are not doing a good job is getting our fair share of the growth.

Q Why aren’t banks getting what you believe is the fair share?

Christensen: It has nothing to do with how banks are structured organizationally, i.e., whether they have a payments strategies group or not. The reason that I believe that we have lost some or most of that increase in value is related to our ability to move fast enough in the new payment spaces.

Q So, you think that is true for the industry in general.

Christensen: Yes, one of the biggest reasons we are slow is that we as an industry have such a large constituency. It takes a long time to get 8,000 banks to do anything. We have a lot of consolidation at the top level, but you still have to bring along the rest of the industry and that’s a real challenge. One of the other challenges that contributes to the problem has been the fact that the Federal Reserve is both a regulator and a competitor in the payments business.

We believe the Federal Reserve should reconsider their role in the payments business. It’s really difficult to regulate effectively and be an operator/competitor at the same time.

Q Is it a conflict because they sell products and services?

Christensen: That is right. They have product development offices inside the Fed that are there to build products that compete with the private sector for the payments business.

A good example is check. They have closed many of their check sites already. We believe there are effective market alternatives for check. But we also know there are competitive issues, in ACH, for example, where there are only two operators. But you can look at some opportunities for them, particularly around the check business, to say, “There is lots of competition out there and we don’t need to be in that business any longer.”

Q: Let’s close this conversation with your view of the future. Which three payments developments are you most enthusiastic about?

Christensen: We think our industry will have to continue to look for those white light moments that, as Dick [Kovacevich] has said many times, demonstrate that we are not in the banking business, we are in the financial services business. We are there to assist people in being successful in their financial lives.

First, I think mobile could be one of those developments, the ability to use mobile phones or cell phones to access your DDA account. I believe it is one of the most interesting opportunities and it has taken off very quickly around the rest of the world. When my son, who is 17, leaves the house, the one thing he does not leave the house without is his cell phone. He may leave without cash or checks or credit cards or debit cards. He has all of those but he seriously does not want to carry all that other “stuff.” But he is going to carry his cell phone because it has many diverse value propositions for him. It’s a time piece, a calendar, camera, a PDA, etc. and by the way, a phone too!!

There are some very interesting companies beginning to work in this space. There are challenges in this space particularly around the carriers but someone will figure it out soon.

Second on my list is biometrics. It’s going to be huge not only around authentication and authorization but I think it will help speed up the transactions as well. There are issues with this technology, like false positives. But we will overcome these. 9/11 really gave biometric technology a big boost and I think the opportunities and applications are endless.

The third development I would cite will be the dramatic reduction in micropayments over the next five to 10 years. When you consider that 85% of all payments in the U.S. are still done by cash, we sure talked a lot about what is only 15% of the volume.

I believe cash and currency are going to go the same way as the check. The stars are starting to align whether it is debit card activity, mobile technology, stored value or something else. We think the tipping point is coming, and when that happens a lot of coin and currency are going to move out of the environment.

I don’t know when exactly that is going to happen, but we need to be smarter when it does than we were with checks. We need to move much more proactively in adjusting our currency infrastructure than we did with check.

Cards are replacing cash for convenience. There are vending machines that you can use your debit/credit card in today. McDonalds and others accept debit cards when they never used to. Another interesting hurdle about cash to overcome is anonymity. Why do people use cash? In many cases, it’s that they don’t want others to know what kind of transactions they are doing. People do use cash because it is convenient, or easy. Also, they use it because it’s anonymous. The reduction in cash is just the next step in the evolution from paper to electronic payments in the U.S. As soon as the technology changes then you will see the tipping point and then watch out!

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