Carpe Diem: the Business Case for SEPA and the PSD During an Economic Slowdown

This article is a summary of a research paper that analyses the economic situation in the European financial industry, its impact on the cost and time of migration to SEPA and timely, effective implementation of PSD. It also provides recommendations on the practical measures and steps towards the successful implementation of these systemically important projects.

Will the effort and investment into the single euro payments area (SEPA) and the Payment Services Directive (PSD) to date go down in flames and the European payment services users and providers (PSUs and PSPs) get stuck in 'lose-lose' situation for years? Or will Europe find a champion (regulatory body, banking association, government) to unite the stakeholders and lead the implementation of SEPA and PSD?

To date there's been no attempt to summarise various estimates (Capgemini, Tower Group, European Commission) on the benefits and costs of SEPA implementation and migration. In 2007 Capgemini, commissioned by the European Commission (EC), delivered a report setting benefit 'targets' for SEPA - of €123bn over 6 years.¹

In summary, based on analysis in the research project, the effects of the economic crisis and the regulated market on SEPA implementation are:

• There is a direct negative effect of macro- and micro-economic conditions on the cost and time-to-market of the SEPA and PSD implementation/migration. It is not enough to set the end-2010 SEPA migration target for public entities - enforceable milestones and centralised structured programme management approach are required for this stakeholder group to succeed.
• Partial nationalisation of major banks leads to change in budgeting, spending and investment priorities of the major European financial institutions (FIs). Depending on the scenario the nationalisation of banks can work both ways for the implementation of SEPA: (a) a positive effect - regulators assume more responsibility and engage hands-on in the implementation process; or (b) a negative or neutral effect - regulators stand back relying on the self-regulatory potential of the financial industry, which so far has not fully attended to the interests of other SEPA stakeholder groups.

Below are the major conclusions based on the analysis of market data/information.

The business case for SEPA and PSD must be reviewed

European regulators, PSUs - (incorporating consumers, corporates and public sector) and PSPs must re-evaluate the investment strategies and operational approach to achieve tangible on 1 November 2009, which of course is only 10 months from now.

A central management structure is needed

There is a necessity for strong central structure for managing and governing the SEPA and PSD migration. For example, an independently funded and managed SEPA programme management office (SPMO) that must be resilient towards any fluctuations of funding and independent from any stake holder group.

In September 2008, SEPA Credit Transfer (SCT) achieved the market share of only 1.6% of the overall community's credit transfer volume. If this sluggish trend continues and SEPA Direct Debit (SDD) migration follows the same pattern, the perceived SEPA benefits won't be achieved over 6-10 years.

The SEPA and PSD business cases have evolved under the changing economic conditions

The constituent parts of possible outcomes are the following factors:

• Adherence to the provisions of PSD, meeting estimated benefits.
• Implementation within the EC's timeframe.
• Staying on the level of original planned investment.
• Reaching the required levels of penetration within all stakeholder groups.

Review investment and cost aspects

There is a necessity for the review of the investment and cost aspects of SEPA and PSD migration due to changed economic conditions. These factors, and especially the decline in IT spend, negatively affect the following aspects of SEPA solutions and systems:

• Number of SEPA dedicated products offered on a given IT platform.
• Number of SEPA dedicated/ready channels offered to customers.
• Complexity of SEPA system/solutions - strategic vs. tactical. There is a risk of emerging 'sticky-tape solutions', the ones implemented as temporary solutions and notorious to stay within the payments infrastructure permanently.
• Use of the most efficient technology may create impediments towards standardisation.
• Ability and willingness to pass SEPA benefits on to the end-customer in the form of lower fee and/or lower-priced service.
• Increase in operational risk due to quick-fit solutions and cutting corners during implementation and testing.

Changes in capital markets

The role, origin and cost of capital have significantly changed the allocation of investment and distribution of benefits for SEPA and PSD business cases. According to Morgan Stanley, the cost of equity for banks has risen to about 12.5%, while future returns at the end of the crises may be no higher than 13%.² In the EC and Capgemini's analyses the cost of capital was assumed to stay unchanged; currency fluctuations have not been taken into account either. These factors will significantly change the estimated cost of SEPA - €8bn (Tower Group) or €10bn (Capgemini) - for the banking community.

So how can a business case for SEPA and the PSD be made in the current economic climate? The rest of the article offers possible courses of action, and the conclusions that these may bring.

Enter the Regulated Market for Financial Services to Ensure Economic Stability and Protect Community Stakeholders

Losses and re-capitalisation of banks

The Institute of International Finance (IIF) calculated the damaging consequences of the credit crunch: up to June 2008, banks internationally made US$476bn (€373bn or £294bn) in credit writedowns and also raised US$354bn (€278bn³ or £234bn⁴ ) in capital.⁵ By the end of September 2008, the re-capitalisation figures further increased to US$554.5bn (€435.2bn or £342bn) with US$338bn for the US, £55bn for the UK and €96.1bn for European banks.⁶ Morgan Stanley predicts that Europe's banks might need an additional €83bn (US$105bn) capital injection.

Impact from failing national economies

Although participation of individual payment service providers is very important for the successful implementation of SEPA (31 national payment systems), the co-operation and coherent actions of 29⁷ national communities, which are subjects to PSD, is also important. Therefore the current systemic crises in general, and failure of the whole national economies such as Iceland (not subject to PSD) and Hungary in particular, are major negative factors and impediments to the successful implementation of these initiatives and legislation.

Conclusions

The following macro-economic factors will adversely impact the prices for the financial services, on-going regulatory expenditure and markets' investment into large projects such as PSD, SEPA and core payment systems, if left unattended:

• Overall decline in real global GDP. The GDP dynamics in 2009, as a normal pattern during economic slowdowns, would to a great extent depend on public sector spending and development of fiscal and social policies.
• Surge in inflation for advanced and developing economies.

In addition, the public establishment virtually has control over decision-making process on both sides: the financial sector and public entities.

Finally, as a result of re-capitalisation, funding must be available for systemically important programmes and change, such as SEPA and PSD.

The Deterioration in the European and World Economy and Decline in Financial Services Markets can Jeopardise the Timeline and Level of Investment in SEPA and PSD

In the worst-case scenario, this could lead to a complete failure of coherent implementation with the following consequences:

• Diminished ROI on previous and on-going investment in SEPA and payment transformation initiatives.
• Leaving the retail payments infrastructure in the current fragmented state for an unspecified period, affecting standardisation, interoperability, price convergence and defects handling.
• Inability to achieve the expected level of benefits for the financial industry and consumers.
• Limited choice of payment products/services, high cost of transaction processing and adverse effect on the cost and choice for consumers.
• Undermining the authority of regulators and trust in the financial system's ability to change.
  

Analysis of the operational cost savings

For PSPs, the operational cost savings range on the scale from a minimum of €10bn to a maximum of €49bn. The PSUs' operational cost savings range from minimum of €75bn and maximum of €101bn. Conclusions to be drawn here include:

• Shift of the target timeframe. In the current economic climate and with the predicted cut in IT spending, the existing change programmes will slow down and downscale - the effect of decommissioned old legacy payment processing technology is unlikely to be achieved by 2012. A 10-year timeframe - up to 2016 - is more realistic for the realisation of SEPA benefits.
• Threat to achieving minimum cost saving targets. If tactical SEPA solutions dominate the market over strategic in-house and/or outsourced processing, the most likely outcome for the community would be the pessimistic scenario of operational cost savings of €10bn for PSPs and lower scale of €75bn for PSUs.
• Use of ACH/PE-ACH services and outsourced processing. The current 1.6% uptake of the SCT is the result of each financial institution attempting to develop its own solution and low take-up of the services by dedicated payment processing organisations. Recent hit to the credibility of the Indian IT outsourcing industry may lead towards tighter checks and revelation of more problems. Solution: resort to near-shore outsourcing providers to have tight control and governance over operations.

Analysis of the transactional fees' dynamics

• Reduction in transaction fees (PSUs)/loss of transaction fees' revenue (PSPs). Analyses of the payments related fees' revenue loss/reduction lead to the projected range between €37.7bn and €91bn. Cards' fees loss/reduction still remains to be determined⁸ - how does this figure effect the range? Even higher loss of transaction fees' revenue for PSPs, in an ideal scenario, should be offset by the rising volume of transactions and reduced operational costs. The average volume growth for payment transactions is 9.5% per year. This amounts to a 68% increase on average in the EU-16 over the six-year period.⁹ Most probably the rise in the number of transactions may not happen in the next two years due to general contraction of the financial sector and decline in overall spending across all industries.
• Multi-factorial effect of national derogations and inefficiencies in applying of the regulation. This may significantly erode the effect of price transparency and comparativeness of services for PSUs therefore complicating the PSUs' choice and switching of services. In other words, there may be limited increase in competitiveness and further retention of captive markets by PSPs.

Analysis of the PSPs' costs and investments

• PSPs' operational costs. The case of the SEPA effect on the operational costs of banks (reduction) is based on the assumption that it will be influenced by the technology optimisation, standardisation and phasing out of legacy systems. As previously discussed, the market and industry economic factors (assumptions) leading towards the operational cost reduction of 20% over six years to 2012 may not hold and in the best case scenario the banks' operational costs will remain on the annual level of €71bn or show insignificant improvement.
• PSPs investment into SEPA and PSD. Attitude towards the investment in SEPA and PSD in the financial industry can be summarised into three broad categories: (a) strategic case; (b) follow the leader; and (c) a necessary evil. The investment in SEPA for banks is estimated in the range of €8bn to €10bn. However, there are a number of unknown factors to the PSPs' investment case: (a) double investment into in-house and ACH/PEACH solutions, and (b) the extent of 'subsidy' from PSPs to PSUs in the form of free technical solutions and other capabilities in exchange for custom. We may find sooner rather than later (in 2011) that the PSPs' investment in SEPA has been underestimated, with the addition of another €5-8bn (50-80%) to the original estimate due to the above underestimated investment factors.

Analysis of the PSUs' costs and investments

There is no clear figure on the operational costs of running payments infrastructure for the demand side of SEPA, i.e. PSUs. It is highly unlikely that legacy infrastructure will be phased out quickly, however, due to predicted lower transaction volumes and possibilities of 'subsidy' from PSPs, operational cost savings are possible at 10-20% level.

• PSUs' investment - any outcome is possible. The investment €10-17bn by the demand side may either lead to a gain of €131bn or a loss of €31bn. Logically both outcomes should create the incentive for the demand side to assume a more proactive role in the implementation of SEPA.
• Cost of establishing the regulatory regime. Last, but not least, the effort (10 months for PSD) to establish and maintain the regulatory regime and its estimated one-off sunk cost of €200m across the community should not be underestimated. The annual regulatory activities are estimated to cost the community (and picked up by the PSPs) around €300m in the first year (end of 2009 - and through 2010) and around on going €200m after that.
• Containment of loss and unlocking of benefits. The loss is not imminent (mainly loss of opportunity); the perceived gain needs to be unlocked (not guaranteed).

The Proliferation of the Regulated Market in Financial Services Would Benefit the Seamless Adoption of PSD (November 2009) and timely migration to SEPA (end-2010)

As evident from data in Figure 1, the peak of activity for the adoption of PSD and SDD will happen in Q2 of 2009. The migration of 51% of the overall number of Member States (69% on-going migration) would make management and governance easier to plan. Also these 69% process almost 100% of all the community's transaction volume and value, the fact that would significantly reduce the risk of delays and leave a cushion for re-testing and management of extraordinary situations.

Figure1: PSD Migration Timeline and Progress

Source: Adopted from European Commission, http://ec.europa.eu/internal_market/payments/framework/transposition_en.htm

Based on the analysis of market data/information and particularly the conclusions of the ECB's 6th SEPA Report,¹⁰ it can be concluded that the implementation of SEPA and PSD is not sufficiently governed and monitored as a 'mega project' for the adherence to the implementation targets, in particular:

• The overall pan-European 'business case' misses systemically important data on costs and investments. The estimated cost of PSD regulation could be a one-off €300m over two years and annual on going €200m for the European PSPs. The overall cost of establishing the regulation is estimated at a one-off €200m for the central banks and regulatory entities. Therefore, the overall cost of regulation from 2007 to 2012 (over six years) is estimated at €1.7bn.
• Impediment to co-operative implementation effort due to up until recently insufficient regulatory activity on the part of national central banks and the ECB on imposing finite and irreversible legislation, deadlines and obligations for all parties in SEPA. The EC's proposed regulation on cross-border payments¹¹ (regulating the direct debits) and provisions of the ECB's 6th SEPA Report are not yet legislated.
• Monitoring and centralised reporting on the time-to-market and adequacy of solutions from banks (products and services) and vendors (compliant payment systems). The only existing pan-European catalysts of the compliance are testing programmes from SWIFT's STAG and EBA Clearing. However, granularity of statistical data and trends from both programmes is not sufficient for proving the sustainability of the 'business case' and measuring the success of the project.

Time for regulatory intervention as ways of reinforcement of the 'self-regulation' model for the migration to SEPA and PSD

In 2005, based on the analysis of the PSD's Impact Assessment, the EC has chosen formula 'EU-regulation +self-regulation' as the working model for policy intervention.

It is time for the EC and ECB to reinforce the efforts of the national regulators with establishing a strong centre for co-ordination of the pan-European migration. The question we all face now is: would regulators be able to pick up the reigns of power and maintain the pace and benefits of migration for SEPA and PSD?