In order for innovation to occur in the payments industry, is it necessary for a shift to occur in the industry’s basic assumptions? The current, four-corner, model of the payments business – buyer and a seller, two banks and a clearing house – has not changed in many years: as soon as goods change hands from seller to buyer, money changes hands. New technology allows payments to be made via different channels, but using the same model. The flexibility of where payments can be sent is a key asset of cash and bank payments. The next step is fully exploring the information alongside the payment, with new initiatives such as e-invoicing.
But there are many cross-subsidies that weaken payments business models and make them vulnerable. Cash can seep out, low interest rates put balance and float revenues under pressure. Regulatory and infrastructure changes such as Trans-European Automated Real-time Gross settlement Express Transfer (TARGET), single euro payments area (SEPA) and the Markets in Financial Instruments Directive (MiFID), have had a negative effect. Other trends in the payments business can also squeeze margins: customer demand, competition and standardisation.
There are two ways for companies to solve these problems – innovation and scale. Although regulatory pressure – in particularly for banks to lower transaction fees – is putting sustainable innovation at risk, it also brings positive outcomes.
Pressure on established business models creates pressure to innovate. This was one of the conclusions drawn by consultancy The Glasshouse Partnership, in an innovation roundtable of 12 payments industry experts.1 They estimated that lower interchange fees would significantly increase innovation for 50% of payments companies and somewhat increase it for 40%. Prohibiting interchange fees could be a catalyst for more transparent pricing, especially in retail banking, where customers are rarely charged for services.
Disruption caused by the turmoil has forced banks to go back to basics and returned payments to the agenda. This is because the payments business allows banks to focus on long-term results, generate low-risk income and provides valuable risk management information.
The turmoil is also a catalyst for innovation. This is analogous to the automotive industry, where older products are being superseded by more environmentally-friendly substitutes. In the payments business, it could assist in completing the lifecycle of loss-making legacy products. However, a ‘race to the bottom’ under the aegis of internal market and competitive pressures would be highly undesirable and ultimately stifle innovation. The issue was discussed in the ‘Payments Innovation’ session at Sibos 2009, where panellists’ view was that co-operation among banks and with corporates would be the key to banks lightening their regulatory load and focusing more on innovation. The consensus was that there is still a lot of progress to be made on banks collaborating on infrastructure, where they are not directly competing. However, one panellist highlighted SWIFT as an example of effective bank collaboration – but was less convinced of its value as a source of new ideas with the potential to be quickly executed.
Making the Shift?
Do we need a ‘paradigm shift’ in order to guarantee innovations in the payments business? No, the environment for innovation already exists, to an extent, but a consumer attitudinal shift in pricing and co-operation between banks and the competition authorities would be highly beneficial. Our customers expect payments to be easy, fast and secure. A profitable business is the best guarantee for continuous innovation, and for creating better quality and lowering prices.
It is also worth considering more incentivised business models in order to move customers from legacy domestic products to the new, more efficient products. Banks co-operating with each other and with the competition regulator will hasten the move away from inefficient instruments, which are often offered for free. Moving retail customers away from free services could therefore unleash enormous potential for innovation.
There is a first-mover advantage to be gained for companies establishing themselves and their brand, establishing themselves as the most convenient, the easiest, the safest, etc. The innovation of today is the commodity of tomorrow. However, the first-mover advantage is a short-term one.
Customer acquisition and the need for new income streams are often regarded as the main drivers for innovation. But customers do not choose banks because of new payment products, such as Faster Payments in the UK. Only those customers who are highly dissatisfied are likely to migrate to your bank. Innovations relating to customer retention – such as making payments more convenient, and improving your cost:income ratio, are more important.
Payees, in turn, are impatient to receive their payment. Neutralising the dissatisfaction that is always associated with making or waiting for a payment is key to customer retention. However, the Sibos discussion highlighted the fact that innovative payment solutions for peer-to-peer payments that are provided by banks are viewed by consumers as a welcome alternative to payment instruments provided by other operators. Panellists agreed that this is an area where banks need to hasten innovation, although some believed that Paypal should no longer be seen as the defining model in the peer-to-peer payments sector.
But is the potential for adding value to payments being sufficiently exploited? Payments are not just a commodity in their own right – value can be added at all four ‘corners’ of the payments industry. These services include paper forms, electronic channels, direct debits and cards. This set of tools is now enriched by online payments, mobile and e-invoices. With payments now at the core of banks’ relationship with clients, a long-term view on investment is necessary, even in tough times.
Outsourcing: A Panacea?
Many banks have come to rely on outsourcing their value-added services. In its latest payments industry study,2 Boston Consulting Group stated: “Look carefully at the viability of insourcing and outsourcing strategies; benefits are not easily achieved.” The word ‘easily’ is important – assessing the value of insourcing and outsourcing is a complex process. Choosing the right partners is key.
Some years ago, ING analysed its payments value chain and found that the cost of the transaction processing was less than 10%. Eighty per cent of these costs were fixed, with the local clearing invoice accounting for the remainder. ING’s cost price was competing with the offerings of insourcers. We concluded that there were more easily achievable gains to be found, in further rationalisation of the transaction value chain, and it was also possible to achieve lower clearing costs. SEPA represents a good opportunity for firms to replace a local clearing house, and at a good rate, because of the improved negotiating position that comes with it. Bilateral clearing is also an option.
Like any other industry, payments are becoming more automated. For example, we are focusing on streamlining our systems, channels and order managers. ING believes that outsourcing parts of a bank’s or corporate’s value chain is ultimately unavoidable because of the underlying trends of division of labour, consolidation and increasing economies of scale. The outsourcing decision is just part of the continuous optimisation of our value chain. For transaction banking with, typically, computer systems including large mainframes, legacy systems and a large number of interfaces, the complexity of migration from legacy systems should not be underestimated.
The ultimate goal of outsourcing is to replace a firm’s focus on a certain operation with a greater focus on potential areas of business. The business case for the outsourcing of domestic legacy schemes is, however, hampered by a limited payback period. The current slow pace of SEPA migration is contributing to a longer payback period, which is, in turn, positive for the outsourcing business.
SEPA: Catalyst for Change or Never-ending Story?
The SEPA initiative, which reflects long-term trends such as globalisation and standardisation, is just one example of a process where all types of service providers in the value chain can add their value at a European scale. SEPA is often regarded as being about evolution rather than innovation. However, despite a low level of migration to SEPA, the underlying trend of payments standardisation is arguably sustainable and persistent. It can therefore be regarded as innovation at continental level. Its proponents regard the adoption of SEPA as creating a community by adopting a standard that will create economies of scale. The larger the community, the greater the potential for innovation.
The Glasshouse study revealed: “The overall impact of SEPA on innovation will be negative in the short term, because it will soak up resources [and] occupy minds in place of innovation. But in the long run, innovation will be increased as barriers to cross-national players are removed. [The introduction of] standards never reduces innovation – it supports and facilitates it.”
This high potential level of innovation is another reason to make the costly systems overlap for as short a time as possible. But what is a realistic time frame for implementation? It is difficult to find a comparative Europe-wide financial initiative implementation, even though it started with one standard. The introduction of the euro has been held up as an example of an efficiently implemented Europe-wide infrastructure. But the euro had a physical dimension and there was political commitment at the highest level, driven by specific political aims. The Y2K problem was indeed about IT infrastructure but deadline-driven rather than market-driven.
Many commentators have asserted that, without a definitive implementation date, there can be no definitive start date for SEPA. The European Central Bank (ECB) has called for an ambitious and realistic end-date – a call that banks have welcomed. But there is no programme exactly like SEPA, and some observers have warned that there is a significant risk of banks adopting an excessively optimistic approach. Boston Consulting Group stated in the Weathering the Storm report: “the benefits of further implementation of SEPA are limited…policymakers should stop driving payments providers into unnecessary expenditures. We do not agree that regulators leave SEPA unattended. SEPA is too big to fail.”
Internet and mobile payments have altered the way we work, as well as the way we live. As highlighted in the Sibos discussion, mobile payments could prove crucial into the unbanked and micro-payments market. Mobile payments could be the end of cash, and e-invoicing will change the purchase-to-pay (P2P) and order-to-cash (O2C) processes, but as long as goods go from A to B a payment will go vice versa. Therefore, is innovation about creating value by doing things differently? Have payment innovations really changed our behaviour? Or did we just add technology? A good analogy is replacing the horse on a carriage with an engine and the addition of airbags and navigation – the journey from A to B is still in the same direction. Since the invention of bank payments, a great deal of technology has been introduced to the basic four-corner model to make payments easier, faster and more secure.
The three basic processes of evolution are the creation of variation, selection and transfer of success – if SEPA is about evolution, we can expect a lot of innovations. Again, today’s innovation is tomorrow’s commodity. If you streamlined your own back office to a commodity, the last innovation is to outsource or insource the commodity of others. One thing is certain: innovate – or get out of business. We owe this to our customers.
1 Payments Innovation Jury, Glasshouse Partnership, 2008.
2 Weathering the Storm: Global Payments 2009, Allard Creyghton et al, March 2009.
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