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Why You Should Care About Merchant-Funded Rewards

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In the last five years, a number of financial institutions, including Bank of America and Regions Bank, have extended their card reward programs with targeted offers generated by merchants. The essential features of the model are as follows:

• Merchants define a target group of consumers, based on such variables as age, income range, address, and total spend in a particular merchant category.

• An intermediary, such as Affinity Solutions, Cartera Commerce or Cardlytics, sends a query to its partner financial institutions, asking for a list of customers that belong to the target group.

• Customers on the list who have opted in to the targeted offer program are sent the offer via e-mail, banner ad on the online banking site, or in-line messages appearing underneath related historical transactions on the online banking site.

What all of these programs have in common is that they enable the financial institution to act as a marketing channel for non-financial businesses. Where the traditional bank loyalty program was focused on increasing usage and sales of bank products, these new programs are focused on non-bank products. The revenue comes in the form of a commission tied to new sales or customer relationships.

This is a substantial paradigm shift, requiring financial institutions to fundamentally rethink their business model. Instead of zealously guarding their customer information, they must be willing to share it, for a price.

However, in a time where the traditional business model is under attack from all sides, incumbents must be willing to move beyond that model and meet their attackers on their own territory.

What is often mistakenly referred to as "disintermediation" is in fact just the opposite, intermediation, the insertion of a third party between the service provider and the customer. In most industries, this occurs to improve efficiency and achieve economies of scale. For example, in consumer packaged goods, distributors reduce the number of interconnections between manufacturers and retailers, keeping a share of the savings for themselves in the form of a markup.

The threat to banks is not so much to their existing business as to their growth prospects; with non-banks seizing most of the new opportunities to add value, banks are trapped in a low-growth, low-margin business, seen primarily as utilities rather than value creators. This has led directly to the increasing willingness on the part of government to establish price controls and restrictions on financial institutions, while non-banks, seen as value creators, are allowed to grow unchecked.

In order to escape from this trap, banks must find ways to exert greater influence over their customers' economic lives.

Reward programs offer a way to do this that builds on the information assets that banks already possess — the transaction history of the consumers that use their payment instruments.

Through their use of services such as Google and Facebook, consumers have strongly signaled that they are willing to sacrifice some personal privacy in exchange for meaningful benefits.

Financial institutions can get their customers' consent to participate in targeted marketing by:

• Explaining the far richer rewards that can be earned through the new system; instead of pennies on the dollar, consumers can get 20% or more. Linking the new rewards to the well-understood coupon can help aid understanding.

• Providing consumers with full control over how many offers they receive, and through which channels.

• Giving consumers an easy way to opt-out of the rewards altogether.

• Partnering with local businesses to encourage participation.

By acting as a channel for targeted rewards, financial institutions can make themselves more relevant to businesses and increase their leverage in negotiations over fees, sales of core financial products, and participation in emerging mobile payment schemes.

If, on the other hand, financial institutions stay in their safe but confining traditional markets, they will face diminishing opportunities.

Aaron McPherson is practice director, Payments and Security, at IDC Financial Insights.

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