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Cash Today, Debit Tomorrow—How Banks Can Benefit
BY DAVID STEWART
The increasing displacement of cash by debit cards should be to banks' advantage. Optimizing the opportunities requires strategic thinking about stimulating and rewarding usage and how the product fits within a payments portfolio.
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SYNOPSIS | Growth in debit cards continues as debit increasingly displaces cash as a payments mechanism. McKinsey & Co. estimates debit cards will generate one-third of bank DDA fees by 2009. But risk factors include pending litigation around interchange fees, customer adoption of less profitable payment alternatives such as ACH and the expense of reward programs. In response, banks need to optimize their rewards programs, increase debit card activation rates, promote direct deposit of payroll and the use of debit cards for bill payment and reconcile their enterprise payments strategy and individual incentives that promote suboptimal customer behavior.
Debit cards represent a $9 billion line of business in a $209 billion payments industry, according to McKinsey & Co. estimates. So, why do strategists focus so much attention on this product?
The answer is that debit card volume and revenues are growing rapidly and will continue to grow as debit cards increasingly displace cash as a payments mechanism. The maturing of the product category warrants senior management attention and the development of an effective debit card strategy. In particular, issues such as debit rewards programs and other incentives to drive usage must be considered carefully vis-à-vis an institution's overall payments strategy.
McKinsey & Co. projects that debit cards will generate almost 30% of U.S. banks' total demand deposit account (DDA) fee income by 2009. That's almost twice the fee income generated by debit cards today (16%). With so much at stake, institutions can ill afford to take their eye off the debit card ball.
Growth Curve
McKinsey & Co. estimates that banks and other organizations earn approximately $209 billion annually from the payment services they provide to U.S. consumers, businesses and government organizations. Industry revenues are growing at a rate of 5% to 8% a year, compared to 4% to 5% for transaction activity.
The expectation that revenues will grow faster than transaction activity reflects a migration from lower-revenue to higher-revenue transaction types. One of the prime examples of this is the growth of debit cards at the expense of paper payments.
McKinsey & Co. estimates that in 2004, debit card issuers earned approximately $9 billion from cardholders' use of debit cards. That's 4% of total fee and net interest income for commercial and retail payment services and approximately 11% of total DDA revenues (including net interest income on deposit balances). By 2009, debit card issuers will earn an estimated $21 billion, or 7% of payment revenues and 18% of total DDA revenues, McKinsey projects.
What will fuel this revenue growth? Volume. Cardholders made 19 billion payments with debit cards in 2004. McKinsey & Co. expects that number to grow 18% per year to 44 billion transactions or more in 2009. This breakneck growth in transaction volume will nearly double the debit card's share of wallet: from 8% of total U.S. payments in 2004 to 15% by 2009.
And what will fuel volume growth? Among other things, cash. As has been the case over the last five years and will be for the foreseeable future, cash displacement has been the dominant force behind electronic payments growth. And, the cash well seems far from dry. McKinsey & Co. estimates that the total number of cash transactions exceeds all other forms of payment combined and may actually be growing, albeit at a slowing rate.
We estimate that there were 133 billion cash payments in 2000 and 151 billion in 2004, about six out of every 10 transactions. Over that period, cash usage increased an estimated 3% to 4% per year. From 2004 to 2009, McKinsey & Co. projects cash usage to slow to a 2% to 3% annual growth.
The net result will be a base of 172 billion transactions for banks to try to migrate to debit and other electronic payment alternatives. Even with 18% average annual growth in debit card usage, the number of debit card transactions will be only one-fourth the total number of cash transactions by 2009. Significant opportunities will remain to displace cash by debit.
The growth in debit from cash displacement primarily reflects changes in point-of-sale behavior. But the point of sale is not the only place where debit card use is increasing. An emerging segment of consumers also uses debit cards to make monthly bill payments.
In 2005, Global Concepts found that one in five U.S. adults (22%) pays at least one bill each month using a debit card and that distinct segments of the population use their debit cards frequently for monthly bill payments. Increasing card acceptance by billers and a new generation of plastic users are shifting the balance of recurring bill payments away from ACH toward debit cards.
PIN vs. Signature? How about Neither?!
Lest we paint too rosy a picture of debit cards, consider that not all types of debit card transactions are equally attractive to card issuers.
The interchange per transaction earned by the issuer may be two to three times higher for offline debit (i.e., "signature-based" debit) than online debit (i.e., "PIN-based" debit). The latter involves much less risk and, therefore, lower reward potential for the issuer (see "Will Fraud Grind Debit's Growth to a Halt?"). Admittedly, the pricing gap is shrinking. The electronic funds transfer (EFT) network business is more competitive now than it was when the networks were regional, bank-owned utilities. Networks compete for traffic on their "rails" by raising the rates issuers earn for each transaction.
Despite the convergence of signature and PIN-based debit fees, the revenue gap per transaction is still dramatic—as is the profitability gap. Debit card issuers have significant financial incentives to steer customers to signature-based debit. Merchants, who bear the cost of debit card interchange in the form of a merchant discount rate, want to steer the cardholder to PIN-based debit.
Risk Factors
Having detailed the good news, we must point out that financial institutions also face challenges when itcomes to debit cards.
One of the key vulnerabilities of the debit card opportunity is that interchange fees for signature-based debit (i.e., offline debit) are under attack. At presstime, there were more than three dozen cases of litigation against issuers and the card associations with regard to interchange in the United States. McKinsey & Co. does not foresee any legislation or regulation that would slash signature-based debit interchange revenue for issuers over the next few years, but it is not unimaginable.
Secondly, issuers face competition from payment alternatives that are less profitable. One form of competition already noted: the use of PIN-debit instead of more profitable alternatives. Other competition comes from electronic payment alternatives other than debit cards. Two challengers of note are closed-loop prepaid cards (i.e., store cards) and ACH-based payment vehicles that debit the consumer checking account. Neither of these alternatives provides much revenue to the banking industry.
Closed loop cards are essentially store credits. They provide no interchange income for issuers, only modest processing fees for a small number of program administrators. Banks might share in the net interest income benefit with a merchant if the merchant deposited prepaid funds into a DDA, but the opportunity pales alongside interchange fee income. ACH-based cards, such as DebitMan, are a dismal alternative from the paying bank’s perspective. A bank earns nothing today to receive ACH debit entries.
Fortunately, the use of these alternatives is extremely low. Even if prepaid card usage doubled from 2004 to 2009, it would account for fewer than 2% of all payments made in the United States. Regardless, the faster the growth in debit card revenues for banks, the greater the incentive for merchants and non-bank entrepreneurs to steer consumers to less profitable alternatives for the bank. Some banks are waiting with bated breath to see what comes of DebitMan, Pay-By-Touch and other front-end applications that allow the merchant to debit a consumer’s checking account through the ACH (with no revenue to the consumer’s bank) rather than over the debit card rails (with interchange to the issuer).
Finally, there’s the conundrum of rewards programs. Following the example of credit card rewards programs, banks are increasingly attaching rewards to debit card usage. The risk is that in vying for customer deposit balances banks will give away more benefit than necessary in response to competitors’ debit rewards programs.
Banks must weigh the costs and benefits of rewards programs carefully and consider all the implications of sharing interchange income with cardholders. This includes retail cardholders but also commercial debit cardholders, with whom banks seem eager to share interchange profits as a way to fuel commercial card usage. It is easy to imagine a day when we lament our use of debit rewards, particularly now as we grumble about the things we have given away to compete for balances: free checking, free ATM transactions, free online banking and bill pay, etc.
Strategic Issues
Given these risk factors, what's the optimal debit card
strategy? The answer will vary with the strategic needs of individual
institutions, but here are some suggestions with general applicability:
• Optimize your
debit rewards program. Banks must develop and implement debit rewards programs
that fit bank-wide strategic objectives. For some banks that may mean no debit
rewards programs at all. Don't do it just because the bank across the street is
doing it. Deposit-hungry banks may reward all debit card transactions, both offline
and online debit, to attract DDA customers. Interchange-hungry banks will limit
their rewards programs to signature-based transactions (and swipe-and-go) in
order to steer customers away from less profitable PIN-based transactions.
Even then, banks may find the lift in debit usage to
beinsufficient. In this case, consider whether rewards bring additional
"stickiness" to the deposit customer relationship. Ultimately, banks must build
detailed and insightful models to determine whether the benefits of customer
acquisition, customer retention or interchange lift justify the risk of
interchange foregone through rewards program payouts.
• Improve
activation and usage rates. To sustain the rates of growth in debit usage to
which they have become accustomed, banks must push harder to gain wallet share
for debit. Issuing cards to new cardholders continues to be the essential first
step, but banks are focusing increasingly on activation, a critical first step
toward usage.
A 2006 survey by Global Concepts found that 73% of
consumers with a DDA reported having a debit card, but only half that many had
used the card in the previous two weeks. To close the gap between ownership and
usage, banks can make outbound calls to check in with new accountholders or
cardholders and encourage activation.
Banks can also provide hard incentives, such as a $5 account deposit, for activation within the
first 30 days after issuance. Some consumers respond well to sweepstakes: Use
your card three times in the first month and you'll have a chance to win cash,
a new gadget, whatever. Other usage incentives, such as rewards programs, may
be ongoing.
• Reconcile enterprise payments strategy and individual incentives. Banks
aspire to have enterprise payments strategies that optimize the value
proposition for customers and shareholders, and they should. But it can be hard
to execute a strategy that holds a line-of-business owner accountable for his
unit's P&L while simultaneously asking him to recognize that the growth of
his unit is not always in the best interest of the enterprise.
After all, what bank would rather have its small business
customer pay by ACH rather than debit card? Now explain that to the ACH product
manager whose take-home pay depends on customer demand for his product.
Ideally, the debit card would be the first tool out of a
cash management salesperson's toolbox. Banks should provide product managers
incentives to build great products. Whether those products are widely used
should be a lesser consideration to the product manager. This is a radical
idea. It means decoupling usage-based incentives for product managers and
implementing truly objective strategies and tools that optimize the mix of
products that are sold to and used by customers.
• Promote direct
deposit of payroll. Direct deposit is hardly news, but its continued growth can
reap significant rewards to banks. Global Concepts finds that a bank customer
who uses direct deposit of payroll is 30% more likely to be a heavy debit card
user than bank customers who do not use direct deposit.
Customers without direct deposit tend to pay by cash more
than debit card. The experience of cashing or depositing a monthly paycheck
puts them in a position to receive relatively large amounts of cash to spend.
In the absence of a check-cashing experience, consumers are more likely to
leave money in the bank (good for net interest income) and use their debit
cards rather than cash (good for fee income).
• Promote debit
card for bill payment. Progressive banks now notify consumer account holders
about which of their billers accept debit cards for monthly payments. To some
banks, this is a risky proposition in that it encourages the accountholder to
go "biller direct." This might result in the consumer's using ACH rather debit
card. But at least the bank wouldn't be getting charged by a third-party
processor to receive those ACH debits, as is the case today for most banks'
online bill payment programs.
Yodlee's online bill payment solution enabling
consumers to pay billers through debit or credit cards (see "Where's the
Innovation?" in the July/August issue of BAI's Banking Strategies) has also
piqued some banks' interest. Now that online banking and bill pay services have
begun to show mainstream appeal, banks will increasingly look for ways to avoid
the expense of ACH-based bill payment solutions in favor of revenue-generating
solutions, such as debit cards.
The payments topics, experts and solutions all focusing on your institution?s profitability in payments will converge at BAI TransPay(SM) Conference & Expo. For registration information, visit BAI TransPay(SM) Conference & Expo, CheckImage Conference, from BAI and ECCHO , and Float Management Conference.
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