The payments business has been not only a traditional and long-standing source of income for banks, both retail and wholesale, but in the past two decades, a source of strong revenue growth. But a number of concurrent changes – advances in technology, new regulations, the coming initiation of the single euro payments area (SEPA) – accompanied by the downturned economy, threaten the continued profitability of payments. Banks are reconsidering their strategies and approaches toward keeping payments a viable source of income. Further, this occurs at a time of increased service expectations and demands from clients, without a commensurate willingness to pay increased fees.
It is a situation not without its ironies, in that the same changes that make the future difficult to predict and that potentially threaten profitability are also those driving and abetting growth in the payments business, most notably internationally. Decades of mergers and acquisitions have created a banking industry with far fewer – and many larger – players. It is these larger banks that are best positioned to take advantage of a changing and growing global economy, but increasingly fierce competition among them threatens potential profits. Product differentiation driven by technological investment is critical, but the rapidity of change has banks wary of investing too heavily in short-sighted or incorrect technologies or product choices. Gaining profit in such an environment can be a vexing problem: it’s there, but how best to extract it?
First Steps: Streamline and Economise
It should be noted that even in more stable and predictable times, payments processing has never been inexpensive. Developing and maintaining products and infrastructure, acquiring and keeping a customer base, dealing with regulation, bad debt, fraud – all this costs banks billions of dollars a year. In the US, this is compounded by a highly fragmented and inefficient payments infrastructure. There are more systems for clearing and settling in the US than in any other country, requiring banks to maintain numerous, often redundant technology platforms. So there is much room for banks to benefit their bottom line by doing all these things with greater efficiencies of time and manpower. As well, the aforementioned spate of mergers and acquisitions (M&A), which has heightened competition among a smaller number of banks, has also created greater disparity between larger and smaller banks, providing those larger banks outsourcing opportunities. These in turn offer smaller banks a means staying in the payments business without an investment in research and technology they can ill afford.
As simple as this sounds, it requires of banks a committed change of direction away from creating earnings from M&A growth and product sales and toward a broader, future-oriented strategy. Banks will need to assess which of their current products are likely to remain viable in the next decade and beyond and which are not, and reallocate resources accordingly. This will involve tough choices, as some products that are unlikely to show growth in the future will nevertheless remain profitable in the present and short term.
Corporate Cash Management
Cash management has been a stable and reliable source of profit for banks that rapidly became less so during the current economic downturn. Slow growth, dropping interest rates, and the consequent need of corporations to cut back on spending have taken a swift toll on banks’ earnings. Corporate clients have necessarily become more demanding both out of need and because stiffening competition has made cash management more of a buyers’ market. And, as mentioned, there is no appetite for, or expectation of, paying increased fees for more sophisticated services. This is a situation largely of banks’ own devising, particularly banks with retail businesses, who were able to extend low-fee service to corporate clients by subsidising the cost with profits from checking and credit card accounts, both interest and fees, and from credit card service charges to retailers. But today, many of these fees are being scrutinised by consumers and legislators and retailers are increasingly using PIN formats for debit cards, which is far less expensive than transactions requiring signatures and creates a significant loss of revenue for banks.
The combined effect of electronic payments and a growing global economy has brought with it heightened potential for fraud and other illegalities within the various payments systems. Response to this has been more stringent regulatory efforts both by nations and international agencies, OFAC regulations in the US, being one example. Further, regulations are not uniform from nation to nation or from region to region, so the burden such regulations place on banks requires repeated changes, enhancements, and updates – layers of complexity and cost.
The full SEPA programme is scheduled to go live this year, which will create a zone for the euro in which all payments will be considered domestic. This will allow payments within the area to be made through a single bank with a single set of payment instruments. The initiative should standardise and simplify the payments process in the area; make the process more transparent and less susceptible to crime; increase electronic payments and straight-through processing (STP); and reduce the cost of payment transactions. The effect on banks, however, is a huge investment either in making legacy systems SEPA-compliant, or investing in entirely new technologies. Loss of revenues from diminished fees could be considerable and reliable estimates of future volume flows are difficult to discern, making it more difficult for banks to set appropriate strategies.
As the payments industry becomes increasingly electronic, banks are facing stiffer competition from non-bank payments providers who, for reasons of their smaller size and less stringent regulatory environment, are often quicker to innovate and to exploit new markets. One notable example is the remittance market – low-value, non-commercial, cross-border payments, typically immigrant workers sending money home. This is a growing, multi-billion dollar market that banks are all but out of. Ninety percent of the remittance business is conducted by money transfer companies such as Western Union and MoneyGram. Banks will need not only to find, target, and aggressively pursue such newly opening and growing markets, while taking into account regulatory compliance requirements, but also ensure that markets they currently control aren’t eroded by such smaller, nimbler non-bank entities.
Commoditisation of Payments
One regularly hears the argument that the payments business is becoming commoditised and undifferentiated and that, as a result, mining profits from payments will be more difficult for banks. While differentiating its product offering and underscoring the added value it can provide will be key for any bank in an increasingly competitive environment, one can argue that payments has always been an undifferentiated commodity: payments in this view is simply what banks do. It’s a view that, until recently, seems often to have been held by banks themselves who, until the downturn, were more focused on their investment and asset management services and often lacked a clear and consistent management strategy for payments. This despite the fact that payments is a lucrative source of income and one that has maintained profitability in both good economies and bad. As recently as 2007, payments amounted to 65% of bank revenues, according to US Banker.1 The same publication noted, however, that while these robust numbers are, on average, consistent over time, there is considerable variation among individual banks. Percentage of total revenues due to payments varied from 43% to 75% among the top 12 US banks , indicating that there are clearly ways for any one bank to seize a competitive advantage through correct identification of growth markets, state-of-the-art technology, superior customer relations, and efficient internal management.2
The Payments Landscape
The various points discussed above can be addressed as three basic strategies for banks:
- Streamlining and economising. Largely due to growth by M&A, many banks have numerous redundancies in their systems and platforms. More vigorous analyses of productivity, procedures, location of staff, automation, and reallocation of funds and manpower, can lead to a significantly less expensive and more efficient payments infrastructure.
- Innovation and differentiation. This, as mentioned is difficult and risky – where and how to invest and develop in an environment that is rapidly being changed by technology, globalisation, and regulation. Yet it is an unavoidable step. Clients are increasingly demanding of products that will increase the speed and ease and decrease the cost with which they make payments. Banks with a history of technological innovation have an advantage, but this needs to be married to a strong, flexible, and consistent global strategy.
- Regulation and communications. As mentioned, the payments business is a very expensive one for banks to maintain. Yet the complexity of payments systems is largely unseen by the clients it supports. The fees banks extract to ensure profitability are typically seen as aggressive and exorbitant, not only by consumers but, increasingly, by regulators and legislators who, even as they try to rein fees in, may expect that banks will merely pass the cost back onto the consumer through other avenues. Banks could benefit by more consistently leading this dialog rather than responding to it. The payments system is integral to the health of a national economy, certainly, but banks are not profiteers, living off that system; they created it, maintain it, and drive innovation within it. Banks, in this sense, may be seen as stewards, but this stewardship comes at a cost and banks are for-profit businesses. It is imperative, then, for banks to take a position of leadership in regulatory reform and not one of defensive reaction.
I believe payments will continue to be a viable, growth-oriented business within the banking industry. The challenge for banks is to make the difficult and necessary decisions – whether to process payments themselves or to outsource; whether to commit to investment in new technology and infrastructure – and to make them now. This is a matter not just of wagering a difficult best guess as to where the business is going: it is foremost a matter of a bank’s leadership asking themselves where they want their bank to be in the coming years and what part payments will take in that bank’s overall business strategy. At BNY Mellon, we see the processing of payments as a necessary and integral component of our company, based on our business mix and product areas. Other financial institutions may not, and might prefer to let a processing bank handle the infrastructure necessary to compete in this increasingly challenging business. Either can be a viable and correct choice, but such choices need be made today and will determine the shape of the payments business for banks in the years ahead.
1“[The] liquidity premium accounted for fully one-third of bank revenues in 2007. And when various service fees, and the premium for credit card loans and overdraft coverage are added in, the business of providing consumers with the banking infrastructure to make payments of various kinds accounted for 65% of revenue.” US Banker, December 2009.
2 US Banker, December 2009.
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