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Framing Payments Strategy around the Checking Account

BY GORDON GOETZMANN AND PAUL SUSSMAN

For retail banks, payments strategy must center on the checking account.

|SYNOPSIS | In the wake of the transition from paper-based to electronic transactions, retail banks face a plethora of choices in crafting a payments strategy. To help guide them through the maze, consultants at First Manhattan Consulting Group (FMCG) suggest a practical way to prioritize goals and opportunities and build a plan of action. Banks should consider the materiality of payments to the institution; evaluate potential competitive threats; take stock of their payments competencies and resources; and focus on the drivers of customer satisfaction and dissatisfaction. In doing so, the authors believe banks can capitalize on the primacy of the checking account in the retail payments landscape.

Financial institutions have been losing their foothold in the consumer bill payments arena as check bill payment volumes decline. What can reverse the tide?

For bankers, the word "payments" tends to evoke thoughts of check processing, imaging, Automated Clearing House (ACH), debit and more recently, newer concepts such as remote deposit capture (RDC) and mobile payments. Likely missing from the list will be the "checking account," that most basic and familiar of all retail banking products for both consumer and small business customers.

Related charts Payments Revenues Begin with Checking Fee Income Hinders Organic Deposit Growth

Yet demand deposit and NOW accounts are the most popular vehicles among consumers and small business customers for facilitating payments transactions. Deposits to these accounts still constitute the primary means by which money from these customers enters the payments system and checks or ACH transfers remain the most common ways of settling outstanding obligations.

At FMCG, we believe that leveraging the traditional checking account should be central to the payments strategy of the typical retail— as opposed to wholesale or specialist— financial institution. Such banks, we believe, have many opportunities to develop innovative checking account features as a source of competitive differentiation. And with adequate branching networks and good customer service increasingly viewed as "table stakes" capabilities, most retail banks have few remaining sources of differentiation. Offering a checking account that functions more smoothly and efficiently than the competition's, and that promotes the perception of fair pricing and customer advocacy, will be for many banks the most practical way to increase their competitiveness.

Navigating the Maze
By using the centrality of the checking account as a guiding premise, financial institutions can select the right payments choices from the confusing set of choices that emerged in the wake of the revolution that has occurred in the shift from paper-based to electronic transactions. Imaging, RDC, mobile banking...where should a management team place its bets? How should it begin to sketch out a strategy for the future?

To help retail executives navigate through the payments maze, FMCG has designed an analytical approach that involves making four distinct evaluations to prioritize opportunities and potential initiatives for individual banks. After all, there is no "one size fits all" retail payments strategy because institutions vary in size, resources and business lines—and what is considered "best practice" tends to wax and wane over time. Some retail banks, for example, still issue proprietary credit cards; though most don't but perhaps now wish they still did.

Therefore, such an analytical framework should acknowledge the specific aspects of a particular institution, taking into account factors such as the bank's unique assets and competencies, its customers' wants and needs and the probable actions of its competitors. The analysis should culminate in an appropriate action plan for implementation, or a "Retail Payments Roadmap."

Financial Materiality and Potential Competitive Challenges
Since payments are already a substantial business for retail banks, the ability to strengthen the materiality of payments to bank revenues should be the first test of the worth of any initiative being considered for the payments strategy.

Retail payments today generate almost $200 billion of annual revenues overall and well over half of the typical retail banking unit's total risk-adjusted revenues. Approximately 70% of these revenues are associated with the interest spread and fees generated by the two main "feeder accounts" to the payments system: consumer and small business checking accounts and credit cards. The remaining 30% derives from a combination of transaction revenues, including card interchange, debit interchange and PIN fees and ATM charges. There's also some revenue from the newer forms of payment vehicles such as mobile banking and independent payments networks that we estimate amount to only several billions of the total revenue, at most (see chart, "Payments Revenues Begin with Checking").

Revenues generated by punitive fees, such as for overdrafts, are also under threat. FMCG estimates overdraft fees alone total almost $20 billion per year and have been growing quickly as many banks have allowed customers to overdraft in more complicated ways—such as through debit, online bill payment and ATM withdrawals. But we believe the growth of fee revenues will slow as punitive fees begin to draw the attention of Congress and as legislation is adopted that requires banks to notify customers before imposing an overdraft fee.

Major Assets and Payment Competencies
The next test in developing a payments strategy is to ensure that related activities and initiatives build on the assets and competencies already resident in the bank.

The most important assets of a regional bank are its customers—most of whom have their main checking account with the bank. While it's true that some customers choose their bank because they need a loan, far more base their relationship on checking accounts and, by extension, ATM, debit and online services, as well as accounts such as savings, money market and/or time deposits. The third most frequently held retail product is a credit card and/or some other lending product although not all regional banks have proprietary card portfolios.

The checking account-centric assets of most regional banks also include their branch networks and call centers, which customers use to make deposits (i.e., getting money into the payments system), check on balances, pay bills and resolve the myriad of other questions and problems that arise in facilitating a purchase or settling an obligation.

As for payment competencies, many retail banks possess operational strengths in moving money among institutions in a cost-effective and relatively risk-free manner and pride themselves on their abilities to do so in support of a wide range of products and distribution channels. Most regional banks possess significant assets and competencies regarding product design and marketing around consumer and small business checking accounts, where they compete vigorously for customer loyalties.

With competing on price no longer possible, as almost all banks offer some form of "Free Checking," the breadth of the distribution network and overall ease-of-use are the largest areas of opportunity to build on existing competencies related to the bread-and-butter checking account.

Largest Drivers of Customer Satisfaction and Dissatisfaction
Most banks possess reams of data from industry-level and proprietary surveys on customer satisfaction. Based on research that extends this data with proprietary analysis, FMCG has found retail payments issues are the principal sources of customer dissatisfaction and that banks can attract and retain customers by simplifying checking account policies and fee structures.

Punitive and other "nickel and diming" fees related to checking account and credit card transactions are highly irritating to consumers. Customers who overdraw their accounts get frustrated when they are left with a perception of bad faith on the bank's part caused by lengthy funds availability schedules or by overdrafts on automated transactions such as debit cards, ATM, bill payments, etc. that were approved and "went through" but that end up overdrawing the account, perhaps by only a few cents. FMCG research has found that an estimated 20% to 25% of checking account holders will overdraw their account each year.

Small business customers share many of the same concerns, but also tend to complain about the fairness of credit card policies and fees, foremost the fees charged by processors and associations to merchants and, by extension, to their customers. Small businesses also express dissatisfaction with the need to manage multiple devices, multiple processing relationships and complex fee and settlement schedules to accommodate the variety of transaction types in which they may engage.

Such concerns can be summed up thematically as: "I (the customer) am entrusting you (the bank with the checking account) with my hard-earned money, yet you act as if you are doing me a favor." FMCG has found that these irritants, particularly unfriendly funds availability policies and high punitive fees, trigger as much as 25% or more of the bank's annual customer attrition. Moreover, we have found that the banks with the most aggressive service charges on deposit accounts—primarily Overdraft/Non-Sufficient Funds and other transaction fees—also suffer the most attrition in core deposits (see chart, "Fee Income Hinders Organic Deposit Growth").

Such pain points are important to consider and debate when refining the retail payments strategy for a regional bank. Since switching costs for using competing banks and alternative payment infrastructures have been reduced, banks should recognize that consumers and merchants are increasingly in the driver's seat of the banking relationship. A successful payments strategy will be oriented toward eliminating major friction points in the most common payment-related transactions affecting the most customers, even at the risk of foregoing some current revenues, with the goal of making the current checking and credit card offerings more attractive to new prospects.

The alternative is to focus on more leading-edge products and services with uncertain and probably limited appeal in the foreseeable future. 

Action Planning
While developing a payment strategy is a critical initiative for the retail business, there are a number of challenges in moving from "good idea" to "action." The final test to developing a sound payments strategy is setting the right priorities and translating strategic objectives into concrete plans—or a Retail Payments Roadmap.

The first step is identifying the team of people responsible for developing the strategy and implementation plan and the right decision-making model. The emphasis should be on recruiting people with an understanding of today's major payments-related functions and competitors' potential actions and knowledge of customers' needs and pain points. Also required is an ability to effectively distill and present this information to facilitate executive management review and debate. To empower the team, formally establish how priorities will be determined and decisions made.

Organizing a committee and setting forth a governance approach as a first step might seem quite obvious. But in our experience, because most banks are highly siloed around product lines and channels, the degree of coordination needed to make key decisions can be very challenging—even when the urgency appears quite clear.

The second step in building a plan of action is to mitigate the potential near-term negative revenue impact of large bets by highlighting the promise of a long-term payback for the feeder accounts. For example, suppose the team decides to encourage PIN debit transactions, eliminate charges for certain foreign ATM transactions and back off on the more aggressive punitive fee stances that the bank has adopted over the years. Will the deposit product manager and others who will carry more of the shorter-term negative profit impact to income come onboard?

Third, is there viable information that can be used in evaluating and agreeing upon the most important priorities for the strategy? Conjoint-style and other deep-dive analyses of customer preferences can be useful for quantitatively ranking what customers value and the potential cost/benefit of implementing actions intended to address those customer needs. Such analyses can be invaluable for drawing out what is more important to a larger portion of customers and firming up the foundation for the strategy.

As a final check, the team should verify that they have found the right balance in the consumer/small business focus. Small businesses contribute over 50% of the retail payments stream today. The payments strategy should therefore reflect what payments innovations business customers are looking for. Banks should ask if focusing more efforts on addressing these customers would provide a significant competitive advantage.

Application of the Planning Framework
Working through this framework and answering the above questions can quickly lead to clarifying key objectives and identifying the material growth opportunities. Here are three examples of outcomes that could be obtained from such an analysis:

1. Refinements to current fees and policies.
Perhaps the most opportune starting point for many regional banks in developing a growth-oriented payments strategy is evaluating and simplifying fee schedules and funds availability policies. As previously discussed, the adverse effects of punishing customers in a desire to drive fee-based revenue growth are frequently ignored. The goal for a payments strategy should be to make it more convenient and equitable for existing and prospective customers to use the bank's feeder account products and payment vehicles. Since very few banks have staked this ground out beyond offering "free checking," which is usually only a dressing-up of waived monthly minimum-balance requirements, we believe that doing away with overly complex and punitive fee policies can be quite competitive.

Programs in this area also play to a bank's existing competencies. In fact, some banks (especially internationally) have developed substantial expertise in optimizing fee structures for apparent maximum gain, both from better retention and higher organic growth in new customers. The difficulty for most banks may come in putting together their action plan. Migrating away from a more aggressive fee strategy will likely require changes to product design and incentives—along with patience. It will take some time for stronger organic revenue growth to outpace the fee revenue foregone when a bank takes this plunge.

2. Better integration of new payment technologies.
Regional banks can also position new payment technologies, such as RDC, as integrated complements to other retail banking services, as opposed to one-off products. Our research shows that while most banks now offer RDC, few have exhibited real follow-through, with most doing a subpar job integrating RDC products with other merchant services such as card processing, payroll, expense management and the like. In fact, many banks neglect even the complementary set-up and user support services that could materially improve the implementation and active use of RDC capabilities.

As for materiality, an integrated RDC solution can have a significant impact on competitive standing. For instance, we note that one of the leading merchant card processing providers is now offering "bank-neutral" deposit processing for checks as a complement to their credit card processing service. This product allows merchants to steer check deposits to any institution of their choice using a single device provided by their credit card processor, as opposed to an RDC facility provided by specific banks.

Merchants using this service gain flexibility in accessing core checking accounts, which reduces switching costs and enables them to shop around for the best-priced deposit accounts with the highest service levels. Such a product could represent a substantial threat to banks as it shifts ownership and control of the deposit touch point from the bank to the merchant and their card processor.

Regional banks should, therefore, aggressively investigate their business banking product portfolios alongside their payment offerings and related technology architectures to make sure they are sold as more integrated solutions.

3. Payment innovations strategy.
We believe that only when banks have addressed these fundamental issues of "closing the gap with customers" and integrating the products they already offer will they be positioned to exploit a "payments innovation" strategy that relies on capital investments directed at alternative payments networks or new payment devices.

Clearly some of these new products may indeed threaten banks' core products. Witness the recent emergence of the decoupled debit card, which could, over time, develop into a significant drain on traditional bank deposits. However, even under aggressive growth assumptions, the likely impact of these developments will still remain a relatively small proportion of the revenues associated with the feeder accounts and current transaction revenue streams.

Therefore, while we would recommend close monitoring and assessment of new payment innovations, banks should be careful to pursue only those new developments that are well-aligned with the needs and pain points of consumers and businesses and that offer distinctive levels of convenience, lower cost, more generous rewards schemes or other benefits to a material group of customers. It will also be worth understanding how the new services would be positioned. Will they constitute a separate profit driver or more of a competitive differentiator for the core feeder accounts? And lastly, consider the all-in costs of implementation, including marketing and training.

To be clear, the suggestion is not to be bearish on the new payment technologies, but to instead keep in mind what is most important to customers and shareholders when considering activities in support of the retail bank payments strategy.