The Bankers Dilemma

The Boston Consulting Group posed this question as the central theme of a report that was conducted for the Payment Systems International Conference held recently in Switzerland.

Nick Viner, vice-president at BCG and co-author of the report says: "Payments are a particularly tricky area for banks to get their arms around. Accounting for the revenues in payments is hard, accounting for the true cost of payments is much harder, and banks admit that they find this extremely difficult. But until they have a clear picture of the payments costs and revenues it will be possible to assess effectively the impact of the changes on their business and systems."

 

The report observed that although the volumes of payments and the value of these payments will grow, the revenues associated with payments will not grow at such an explosive rate and, in some cases, will fall.

The consultancy finds that the wholesale franchise, which had a global size of 40 billion transactions (valued at $1,600 trillion) in 1994, could grow to a potential size of 72 billion transaction($4,000 trillion) by 2004. Revenues, however, will not grow at the same rate.

Domestic wholesale payment revenues will actually decline (from $26 billion to $25 billion), while cross-border revenues will grow at a mere 5 per cent per annum (from $16 billion to $24 billion). That will represent an overall loss of potential revenues to banks of $174 million a day.

Retail payment transactions are also set to experience significant growth. Retail payments, which stood at a level of more than 120 billion transactions (with revenues of $166 billion) in 1994, are set to more than double to 267 billion transactions (with revenues of $240 billion) by 2004. Revenues from domestic retail payments will increase by 9 per cent a year, but revenues per payment will actually decline by 35 per cent overall (from $1.37 per payment to $0.90 per payment).

The report explains that this is due to a shift to new, cheaper electronic payment instruments. "The decline will be exacerbated by non-bank competitors entering the market in order to capture attractive parts of the payments value chain," the report adds.

The new, cheaper instruments referred to by the report are the smart cards, plastic cards with an embedded chip, which are growing rapidly in Europe, and the potential rise of electronic money (such as Digicash and CyberCash) which is taking off in the US with the growth in electronic commerce.

According to the UK's Association for Payment Clearing Services (APACS) the use of plastic and smart cards is set to rise rapidly in the UK as a means of reducing the massive costs to banks and merchants associated with handling physical cash - out of a total cost of Pound 4.5 billion (7.5 billion) of money transmission incurred by banks the cost of handling money stood at Pound 2 billion last year in the UK alone. The UK's Mondex has been piloting its smart card in Swindon since 1995 and is expected to go live nationally next year.

That trend is consistent in other European countries such as Denmark, where the banking industry developed common standards for the Dammont smart card, which boasted 308,000 customers in June 1995. Belgium's Banksys has been running the Proton stored-value card since 1995 and has licensed the technology to companies in other countries. The US and Canada have advanced less rapidly in the plastic card arena and are happy using cheques.

The BCG report is sceptical about the potential of some electronic purse initiatives.

European trials have shown that customers are unwilling to pay for the card, and merchants are not keen to pay for card reading devices or service charges. Indeed one US retailer, when asked about the success of the recent Atlanta Olympics trial, was quoted as saying: "If there is any fee I'd throw the machine out of the window." However, the initiatives still seem lucrative enough for the banks to continue the trials and for Mastercard's acquisition of 51 per cent in Mondex International. Mondex was started by the UK's National Westminster Bank, Midland Bank and British Telecom, and was sold in July to a consortium of 17 organisations in four countries.

Observers believe that Mondex International may have resigned itself to the fact that it needs a global player to help it take off. Others do not see the synergy in Mastercard's acquisition of such a scheme, claiming that Mondex's core philosophy of not providing an audit trail may go against the grain of a credit-card company's strategy. That might make it difficult to extend the Mondex card to include credit card functionality.

Retailer loyalty cards with enhanced payment functions also pose a threat to the payments franchise. A UK supermarket, Tesco, launched with National Westminster Bank a loyalty card which allows grocery purchases and cash withdrawal at the supermarket's stores and cash withdrawals from the ATMs of its partner. Tesco performs all the value-added functions of the payment cycle, while NatWest is "limited to providing a utility service through its ATM network, and settling balances".

Similarly for the newly formed Sainsburys Bank, which received regulatory approval in the UK two months ago and which has partnered with the Royal Bank of Scotland.

The danger to the payments franchise lies in the emergence of these non-bank players providing banking services. According to the report: "Banks will face relegation to the role of settlement providers - the last, largely commoditised and least profitable part of the value chain. And this does not represent the ultimate danger. If payments are lost further damage can occur. Banks can lose information about their customers, their brand value can erode, and ultimately they can lose the overall customer account and relationship."

According to Kit Needam, director services and payment systems at the American Bankers Association, the Internet is the most threatening to the banks. "With smart cards we understand the risks and then it is just a question of evolving in different ways. With PC Banking and the Internet, I do not think we know the risks."

Over the next decade there is going to be a shift from traditional branches and ATMs to new electronic channels such as kiosks, telephone banking, electronic funds transfer point of sale and PC banking.

The last is the most important area for the banks to address because the customer segments most attracted by the technology are the banks most profitable customers.

According to the BCG report, the US banks have lost the PC banking race to personal finance software providers Intuit (publisher of Quicken) and Microsoft (publisher of Microsoft Money). Together they have more than 85 per cent in the personal finance software market, according to PC Data, a Virginia-based market researcher.

Banks are not capturing any of the value-added information about the customers purchasing practices. As David marsh, vice-president Boston Consulting Group and co-author of the report says: "You get great information when a customer takes out a loan but how often does a customer do that and how soon does the information go stale? Payment information is very accurate, it is repeatable, you can go back and see how trends are developing in terms of understanding customer behavior - it is extremely valuable data."

Until recently, Intuit's payments over the Internet could only be processed by Intuit's on-line banking and bill payment processing unit, Intuit Services Corp (ISC). That left the banks which had allied with Intuit to perform the settlement of transactions. In September Intuit sold ISC to another electronic payments processor, Checkfree, for $227.6 million, and announced "open connectivity standards" which will let any bank provide home banking through Quicken, regardless of the payments processor used.

When the deal, which also includes Intuit's acquisition of a 23 per cent stake in checkfree is completed, Checkfree claims that it will be providing home banking and bill payment services to 180 financial institutions and more than 1 million US customers. Observers hope the economies of scale will lead to lower transaction fees and set the pace for competition with Visa Interactive.

Alarmingly, BCG points out that PC banking may not seem economically attractive because it will add costs and little revenue in the short term.

But the message from the report is that banks that do nothing risk the danger of faring significantly worse. By not offering the service they will lose customers and market share. Marsh explains: "Despite the fact that it looks uneconomic it is strategic and therefore banks have to react quite swiftly."

So why do banks open their doors to these non-bank players, such as Microsoft or Intuit, and then complain that they are taking away the payments franchise? "It is a prisoner's dilemma," explains marsh. "You can either believe that all banks will recognise self-interest and not let these new players in, or you can say, the first bank that does it will make a lot of money so we might as well be first." He continues: "In the US, because there are so many players, you can guarantee that someone is going to break rank."

Where does that leave banks? Over the past few months alliances have been set up by the banking industry ostensibly to keep it in control of its technology and its payments systems. Integrion, a consortium of 15 US banks and IBM, was set up to develop a secure platform for interactive banking and electronic commerce over the Internet.The main focus will be to develop an industry server and pipeline for the secure transmission of transactions.

Other initiatives include The Open Banking Consortium, started up by David Zimmerman of Unisys and supported by a range of banks, telecoms companies and banking systems providers from around the world.

The Bankers Roundatable, whose members come from the top 125 banks in the US, has set up the Banking Industry Technology Secretariat (Bits).

Johyn S.Rippey, acting chief executive of Bits, says that whereas in the past large banks tended to go their separate ways on all issues even in the technology area, now attitudes have changed, so that even the largest banks are recognising that they do not have the requisite capital and technology capability to thrive in the new electronic environment.

"Microsoft, Intuit, Checkfree, Visa and others have set the pace and development of their electronic payment systems. We (Bits) are trying to reverse the information flow and explain to these third party providers how to behave."

The Secretariat is hoping to impose common standards for the inter-operability and interfaces of these third-party systems with the banks' internal banking systems. "The idea is to have a set of common standards that work for the plumbing so that the products that are built on top of the basic structure can be differentiated according to whatever competitive plan the company wants to follow."

Bits hopes to ensure that the bank brand is the only one that appears on the PC when a personal finance software package is activated and, more significantly, it will only issue certifications to the middle processors that agree not to use and manipulate the customer information for marketing information which, Bits maintains, should remain the property of the bank.

In the wholesale side of payment systems the picture looks different. According to BCB, banks' franchise of the payment chain is unlikely to be threatened by outside players, as in the retail case. However, there are other issues that come to the fore.

BCG maintains that there will be three to five players (believed to be Citibank, Chase, Bank of America, HSBC and possibly Deutsche Bank or ABN Amro) which will dominate the cross-border payments market. What distinguishes them is the scope of their international presence, their expertise and superior service quality and an aggressive global strategy.

In terms of technology, the report adds: "The concerted efforts they have made over time, backed by huge investments in building proprietary networks and in creating grand marketing sophisticated treasury and cash management tools." BCG maintains this group will capture upto two thirds of the available cross-border franchise revenue.

Citicorp, for example, has invested heavily in uniform software around the world so it can offer a single point of sale to a corporate for all its international payments, and all the netting and sophisticated cash management techniques in an end-to-end service.

Chase's Lori hricik, senior vice president responsible for technology and operation for global payment and treasury services businesses, is not convinced of the merits of investing in proprietary networks. She claims that in going forward Chase is looking into using the Internet as a means of transmitting payment transaction information. Chase has partnered with other companies such as premenos to build the firewalls for a secure infrastructure.

Marsh comments that there are no other contestants that are close to being included in this league. "What we are seeing now is the playing out of decisions that were made several years ago And, because of the scale economies of the business, once a handful of players starts getting increased volume it is even harder for other players to catch up." He adds: "They will have to spend a fortune on it and they will lose a fortune for a long time."

To those that do not meet the criteria of the three to five global cross-border players' league, BCGH has a clear message: "Now is probably the time to move away from global ambitions." Viner suggests these banks can channel their payments needs through the global players and focus on the domestic market.

In the domestic wholesale market the report distinguishes between two camps; those from countries that are predominantly per based (US, Canada) and those that are predominantly electronic (Sweden). Most Orgnisation for Economic Co-operation & Development countries (excluding Italy) are moving towards electronic forms of payment and a decline in the volume of cheques with cost savings coming from reduced processing costs, elimination of corporate accounts departments and reductions in fraud.

Those that are reluctant to switch to electronic payment mechanisms are either those countries where the banking industry has already invested heavily in the cheque processing and clearing business, where automation will mean a write-off the existing infrastructure. Or those countries where the wholesale customer, usually the small to medium-sized companies, is till heavily wedded to paper.

The report claims that: "While banks in `still to convert' markets face a dilemma, those in `paperless' markets have more to play for."

One opportunity that banks are yet to take advantage of, according to BCG, is Financial Electronic Data Interchange (FEDI), the exchange of standard, formatted messages between the computer systems of trading partners and their banks.

In Europe the appetite for FEDI is growing, with 14 per cent of EDI users using FEDI and a further 30 per cent claiming they plan to do so with two years. Banks have been mistaken in the development of EDI-based services that compete head-on with two years.

Banks have been mistaken in the development of EDI-based services that compete head-on with the value-added network providers, such as Advantis, EDS and Geisco (in the US). Where an opening is available for automation is in financial management such as involvement in the payments information received electronically from the corporate customer, the payment information which is relayed between corporates and the settlement capability.

Some more pioneering banks, like Bank of America, Chase and Kellon Bank, are working on FEDI for the Internet.

As Hubert Huske, adviser to the executive board of the Union Bank of Switzerland said at the conference: "Banks have to position themselves regarding the role they want to play in payment systems and services.

"They have to clarify, whom they want to serve and how they can establish a profitable business."

He points out: "They also should be aware that giving away the payments business for cost saving reasons could have a major impact on other traditional banking activities and products."

Reprinted with permission from The Banker , FT publication.

Banks can lose information about their customers, their brand value can erode, and ultimately lose the customer account and relationship.