Unexpected Disruption in Payments Technology
BY LEON MAJORS
When users embrace payments alternatives, disruptive change can follow. Should banks lead, follow or get out of the way?
Remote Deposit Capture (RDC) and related technologies are on the verge of significant customer adoption. While banks would like to guide the transition from paper-based to electronic payments in their own best interests, the users of those technologies are likely to dictate how events play out.
When new technologies, or new applications for old technologies, are introduced into markets, they are pre-packaged with developer-designed applications and carry expectations for user adoption. Market success or failure is subject to user response to the technology. When a user base truly embraces a new technology, change can be rapid and even disruptive, but it does not necessarily follow the path intended by its developers.
Remote deposit capture (RDC) and related technologies, which convert paper checks to electronic media or transactions when they enter the payments system, are new applications of existing technologies that are on the brink of significant user adoption. Banks tend to view these applications as processing tools, but users are already claiming them and re-naming them to suit their own applications and objectives.
When users — in this case businesses — take ownership of a technology or application, the result is likely to be disruptive. In the case of RDC and related technologies, the impact of sweeping adoption is likely to have far-reaching and unintended effects on consumer payment behavior, check processing infrastructures and bank fee income.
Payment Alternatives
Over the past two decades, the financial services industry provided a variety of payment alternatives to consumers and businesses, several of which (debit cards and electronic bill payment) specifically targeted checks for displacement. Most of these alternatives have been adopted and are being used, but not necessarily with the intended result of eliminating checks.
Debit cards, introduced in the 1980s with the expectation of displacing check use at the point-of-sale (POS), experienced significant growth in use over the past five years. But a measurable decline in the check volume received by merchants is only just being realized. Likewise, electronic bill payment (EBP) of all types finds new users every day. But while the volume of electronic bill payments is growing sharply, relative growth in the use of EBP had not kept pace with an absolute increase in the number of bills paid, so check volumes associated with bill payments are only beginning to drop.
More than one-quarter of small businesses and small offices/home offices (SOHOs) we surveyed in 2006 experienced an increase in incoming check payment volume over the past two years. More than one-third expect check payment volume to increase over the next two years. With strong expectations that checks will continue to dominate the payment mix, and with check volumes increasing as the business grows, the business case for RDC and E-Check grows stronger (see chart, "Checks Still Dominate the Mix").
Despite the intentions or objectives of the industry, at the end of the day, it is the user who defines how payment media will be used and what, if any, payment methods will be displaced. And consumers and businesses continue to cling to check-writing as a core payment tool for purchases and bill payments.
Paper vs. Electronic Check Processing
Faced with user inertia, the industry turned its attention from check use on the front end to check processing on the back end, intent on making the back end more efficient and less costly. Traditional check processing systems were refined and streamlined, image processing was added and per item processing costs dropped lower and lower. The combined impact of the many new methodologies now available to convert paper checks to images or to electronic transactions at the point they enter the payments system will drive processing costs lower still.
Paper check processing is extremely efficient and per-item processing costs continue to be shaved by the use of image technologies. Check 21 legalized the use of Image Replacement Documents (IRDs), which further reduced processing costs by eliminating the need to physically move checks from point-to-point or to store them. But the combined impact of imaging and Check 21 and the simultaneous development of the ability to convert paper checks to electronic Automated Clearing House (ACH) transactions resulted in a proliferation of methodologies for processing checks, including:
- RDC at the POS or in the back office;
- Accounts Receivables Conversion (ARC);
- e-Check (ACH conversion at the POS);
- back-office ACH conversion (BOC), which is approved
to start in March 2007; - hybrid combinations of all of the above.
Individually, any of these methodologies could follow its own adoption curve, adding to, rather than displacing, prior methodologies. Together, however, they have the potential to be disruptive. And it is the nature of a disruptive technology that you can't always predict it and you can rarely create it, but you'd better recognize it when it arrives or you risk being caught on the wrong side of it.
Recognizing a Disruptive Technology
One way to recognize a disruptive technology is to look at its name derivation. Not very long ago, the financial industry talked about check imaging and the productivity gains it provided. "Check imaging" then became "remote image capture" and bankers and analysts debated the most desirable capture points. Both of these labels were imposed by the supply side but neither term had any resonance with the demand side, i.e., the business looking at its bottom line.
RDC is the same technology, with a user-defined label, that sends a completely different message. We are no longer talking about capturing "images" but about capturing "deposits." For the business, the message is no longer about more efficient check processing, but about more efficient deposits, which means fewer trips to the bank and faster funds availability. And once a technology is named by the user and as soon as someone makes access convenient and affordable, the conversion is typically rapid, irreversible and disruptive.
Banks tend to wait to promote disruptive technologies until long after they are available. RDC technology has been available for decades (Phoenix ESP principals first conducted image exchange research in 1984). But the change in legislation via Check 21 had a dramatic impact on the application of the technology. Even so, banks (most of them anyway) still are not pushing for conversion. Instead, they focus on revenues lost from paper check processing fees. And, to be fair, Wall Street does tend to punish soft revenues even when profit margins rise dramatically. Inaction, however, threatens to cut many banks out of the revenue stream for RDC fees.
Keep in mind what happened when Electronic Data Capture (EDC) swept the merchant arena in the 1980s. Paper draft processing of credit cards almost vanished within a year, leaving manufacturers of paper draft processing equipment sitting on literally tons of inventory. More significantly, how many banks were positioned to pick up fees from processing electronic credit card transactions? For businesses and merchants, RDC (and e-check and ARC) has the same compelling business case as EDC — faster funds availability.
Application of these technologies will result in cost savings, but not necessarily in the way that banks expect. It will certainly cost less to process paper checks if they don't have to be physically moved or stored. But it will also cost less for the merchant to accept checks at the POS if the checks can be converted on acceptance to an electronic transaction — either through e-check conversion at the register or back-office RDC. Which methodology is chosen will depend on overall check volume and POS structure at the merchant.
But then what? The bank loses paper check processing fees from that merchant. Theoretically, that revenue is replaced by electronic processing service fees. But what if the bank is not getting those fees because a third party takes over electronic processing for checks, as in the EDC environment?
Re-positioning for Disruption
Banks are behaving as if they expect a gradual migration from check processing to RDC to trickle down to their smaller business customers after it has been adopted at the large corporate and middle market levels. They think they have time to re-position gradually. They need to think again.
Our data indicates that close to 10% of small businesses and SOHOs in the manufacturing, wholesale and retail sectors are already using RDC or have concrete plans to begin using RDC by the end of 2007 (see chart "Small Business Raring to Go with RDC and E-Check" on this page). And with awareness of the technology already at 50% among these small companies, the actual adoption rate for these segments in 2007 is likely to be substantially higher. When a transition is disruptive, measurements of adoption will always lag behind the actual experience of the marketplace.
And it's not just RDC that small businesses are adopting. Phoenix ESP research measured substantial growth over the past year in the numbers of small firms planning to use ACH and image capture by 2007. More than half of SOHOs and small businesses in the industry segments we surveyed are familiar with e-check services (conversion of paper checks to ACH transactions) and just under 10% of these firms are already using e-check services or planning to begin using them before the end of 2007.
Though the percentages of small businesses using or planning to use these services right now may seem small, it is important to keep in mind that with millions of small businesses and SOHOs in the U.S., each percentage point represents hundreds of thousands of companies. Already, demand is overwhelming supply, so banks that are unprepared to meet demand stand to lose more than check processing fees. They risk losing business relationships.
There is always a shift in fee-income sources when disruptive technologies sweep a market. Free business checking offered to small businesses may have won new customers, but the key is to keep them. That will mean re-examining fee structures and promoting technologies and services that provide strong relationship glue. RDC has the potential to provide such glue. It also has the potential to drive small business customers to a competitor if RDC and E-Check services are not made available. At present, only a small number of banks are actively marketing these services and manufacturers have shipped and installed only about 30,000 terminals.
The merchants and businesses that adopt electronic check conversion technologies will choose from available methodologies to build a solution that works best for their specific circumstances. Front-end conversion, in the form of e-check at the POS, makes the most sense for businesses with a high volume of low-dollar checks and fairly sophisticated POS systems. The relative drawbacks of front-end conversion are potentially higher initial installation costs and negative feedback from customers who object to having their checks handed back to them with their receipt. To some extent, this latter "drawback" may move some number of diehard check-writers to using a debit card.
BOC, which is expected to begin rolling out in March, 2007, puts the capture point in the "back room" and is more appropriate for firms receiving a fewer number of checks either at the POS or through the mail. BOC is, at least theoretically, less expensive to install because it requires only a scanner and a connection, although scanner quality will have an impact on equipment cost. In addition, there is less opportunity for negative customer impact, as customers won't actually see their checks being converted and discarded.
In either case, vendors are poised to put the equipment in the hands of the businesses. For those in a position to sell associated transaction processing services, there is a strong case for making the equipment readily affordable to the business and locking in an ongoing relationship.
Implications for Banks
Over the past year, Phoenix ESP Payments Research Group has interviewed thousands of small, mid-sized and large businesses, as well as 600-plus banking organizations with the goal of sorting out actual and planned capabilities versus expectations. Our conclusion: banks and merchants now have the opportunity to spend up to $20 billion deploying these new technologies with no clear picture of the real impact.
The banking industry has yet to establish standard pricing, product features, service levels or availability for the mass marketing of these services. Yet the small business community already expects this new array of electronic receivables services to be available in the normal course of business. This is exactly why banks need to respond proactively to what is happening — they are at real risk of losing this fee income stream altogether.
Neither banks nor merchants will deploy all of these technologies. Some vendors are offering combinations of services, but price points and acceptance levels are still unclear. The banking industry needs to work with the end-user customers to develop comprehensive solutions that meet everyone's needs — and "everyone" includes banks, merchants and end-user check-writing (or card-using) customers. All of these constituent needs must be met or we really are just building a road to nowhere.
Ideally, banks would like to carve a straight path that leads directly to them. But the users will ultimately determine their own path based on what makes the most economic sense for them. Banks will have to follow... or find a different way to lead.
Mr. Majors is president of Salisbury, Md.-based Phoenix ESP Payments Research Group, a subsidiary of Rhinebeck, N.Y.-based Phoenix Marketing International.