Shift to Electronic Payments Quietly Eroding Banks' Margins

CHICAGO – To protect their lucrative payments business amidst the acceleration from paper to electronic consumer payments, large U.S. banks must move quickly. A new report by the global management consulting firm DiamondCluster International (Nasdaq: DTPI) predicts that the increase in electronic payments will have major ramifications on the U.S. payments industry, including: A shift in the payments battleground to the retail store and point-of-sale; the realization that the information about the electronic payment transaction may become as valuable to banks and others as the payment transaction itself; and, an understanding that old networks may be used in ways that aren’t to banks’ advantage.

The report illustrates how information technology has profoundly changed the basis of competition in the U.S. payments industry over the last 30 years and outlines significant new opportunities (and threats) for U.S. banks. Further fueling this trend, the Federal Reserve recently announced that 2003 was the first year in which the number of electronic payment transactions in the U.S. (from credit cards, debit cards, and automated clearinghouse transactions) exceeded the number of check payments (44.5 billion vs. 36.7 billion).

Predictions for the Payments Industry
In the report, the authors predict that the increase in electronic payments will have major ramifications on the U.S. payments industry. The most significant ones are:

• The retail store and point-of-sale is the new payments battleground. The DiamondCluster report shows how the impact of technology on the bank payments business since the 1980s has shifted from the “back end” of the payments value chain (creating economies of scale on the acquiring side of payments transactions), to the front end in the 1990s (applying advanced technology to improve issuing of payment instruments such as credit cards), to the middle link: the use of the payment instrument itself in the consumer’s purchasing process (including the store).

  
  “The focus today for banks is influencing how the customer pays at the point of sale. The good news is that there is still plenty of opportunity for banks to offer new value to consumers and merchants that will warrant attractive payment fees and new revenue streams,” said Carl Hugener, a partner in DiamondCluster’s financial services practice and co-author of the new report. “Bank One [now part of JP Morgan Chase], for example, has successfully partnered with Starbucks Coffee to offer a combined credit card and stored-value card (the Starbucks Duetto). In addition, banks must help merchants make the sale and assure payments.”

• Information about the electronic payment transaction may become as valuable to banks and others as the payment transaction itself. Banks collect enormous information on consumer habits through their payments businesses. Such information could become a goldmine of data for banks to improve their own cross-sell efforts, and to work with retailers and product manufacturers to improve their marketing programs. For instance, bank payment records show which retailers are frequented by certain consumers. Banks could identify those consumers that go to overlapping retailers and provide joint marketing programs — all without threatening consumer privacy.

  
  “The merchants we interviewed for the report, such as consumer electronics giant Best Buy Co. Inc., say bank payment data and joint marketing programs are very attractive,” said Larry Lerner, a principal in DiamondCluster’s financial services practice and co- author of the report. “But they also said those programs are very rare. That sounds like an opportunity.”

• Old networks are being used in ways that aren’t to banks’ advantage. The role of payment networks today is vastly different than it was when they were conceived more than 30 years ago. Today’s networks, such as the ACH network and the EFT networks, are now being used to undercut banks’ more lucrative payment networks. As new payment products such as the PIN debit card gain momentum, networks are being repurposed to garner more efficiency out of the system.

  
  “The lesson here is that technology is constantly changing the payments landscape and players in the value chain that today may seem your friend may end up being your foe tomorrow,” Hugener explains.

Prioritizing Information Technology Investments
The report details how the banking industry’s stranglehold on the payments business has been loosening since the 1980s, when third-party payments processors such as First Data Corp. made huge inroads into banks’ back-office processing of payments. The trend continued in the 1990s when new monoline banks such as Capital One, MBNA and First U.S.A. used technology to win major shares of the credit card business from large banks.

In the latest round of payments innovation, information technology again is the driving force of change. The rapid replacement of checks and cash with credit and debit cards, gift cards, electronic check conversion, and wireless payments is likely to further open up the payments business to non-banks and non-traditional banks in the U.S., the report concluded. The financial ramifications are enormous; for the 40 biggest U.S. banks, payments-related revenue accounts for up to 40% of total revenue.

According Hugener, “The difference this time is that technology is changing both the payment product as well as the retail purchasing process. Payment mechanisms such as wireless phones, stored-value cards, and debit cards are giving banks and non-banks major opportunities to improve the way consumers shop and manage their finances, as well as dramatically improve the way merchants market and get consumers to and through their stores.”

Because of the sea change in the payments business, banks must now carefully weigh many big decisions, Lerner contends. “Banks always face major investments in payments technology. However, with the Check 21 Act behind us now, the scale of these investments will grow. More than ever, banks need to create rigorous long- and short-term payments strategies that reflect the lessons of the past on how technology has restructured the payments industry — and that reflect the strategic opportunities and threats that technology poses for the future.”

The Call to Action for Bank Management
Facing such a high stakes challenge, what steps should banking management take to secure their electronic payments franchise? The authors of the DiamondCluster study propose several critical next steps.

One of the first steps a bank must take to compete in the payments future is to develop a decision-making process that crosses payments businesses. Key decisions must be made across the payment portfolio of businesses: investment or divestment of payment businesses, technology investments, which payment methods to market or not market, how to get consumers to switch payment products, and which customers to keep. The authors advocate a payments council, such as the one Bank of America formed in 2003, to bring heads of the company’s payment businesses together with top management. Participants should come from the retail, wholesale and operational parts of the bank. Technology must have equal representation at the table. And decisions must be made in the context of a cross-company financial model.

The silos in banks’ payment businesses must also be reconfigured. Information about the customer can no longer be maintained in separate information systems for each banking product. Even banks with centralized customer information files usually have only superficial information on these customers. To help consumers balance their debt across payment instruments and give bankers a full picture of their purchasing behavior, most banks will have to link their siloed systems.

There are several approaches to address this. Most successful banks start by focusing on the technical architecture. This enables the integration of data and processes and provides flexibility for the bank to expand into new functions. In addition, the majority of banks that lack scale in processing payment transactions must consider shifting their operations to third-party processors to achieve cost competitiveness for commodity transactions.

Above all, banks need payments strategies that cross their payments businesses. Perhaps the biggest challenge will be abandoning their siloed approaches to payments and focusing on customer needs. When banks controlled the payments system, the customer’s interests did not have to come first; neither the merchant nor the consumer had much choice. But given that merchants can now push payments to lower-cost channels to avoid interchange fees and consumers have more choices of their own, banks must begin their payment strategies with what customers want. That will require a more sophisticated approach to customer analytics.

Obtaining a Copy of the Report
The report, “Banking on Payments: Protecting and Extending Banks’ Electronic Payments Franchise,” concludes seven months of research and an in- depth analysis of three decades of payments trends. The researchers gathered a range of perspectives by interviewing executives in major banks, payment processors, retailers, and other industry executives.

Complimentary copies of the 28-page report are available on request by sending an email to PaymentsReport@diamondcluster.com .