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Payment Analysts Discuss Bank Tech M&A, Interchange, and Mobile Pay's Future

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Below is an edited transcript of a May 12 roundtable discussion about payments and banking technology. The participants were American Banker editors and reporters; Brett Huff, research analyst with Stephens Inc.; Andrew W. Jeffrey, managing director for equity research with SunTrust Robinson Humphrey; Thomas C. McCrohan, managing director for business services with Janney Montgomery Scott; Darren Peller, vice president and senior analyst for IT consulting and computer services with Barclays Capital; and Greg Smith, managing director for financial technology equity research at Duncan-Williams Inc.

American Banker: What do you think is the most interesting payments technology that we're hearing about these days?
THOMAS C. McCROHAN: I think the coolest technology right now is delivering financial services to the poor. It could be mobile payments, it could be smart cards. I think it just is an area of tremendous growth.

ANDREW JEFFREY: In my mind, the coolest new technology is probably mobile. Having the ability to reach around 5 million merchants who have never been able to accept credit cards with some type of PDA-based swipe device is probably the mobile technology that's got the most legs. The question becomes who wins, because it's a relatively low-barrier-to-entry technology, so whoever's got the best distribution will probably do well.

BRETT HUFF: I agree with the mobile comment, primarily driven by the increasing number of services that we'll be using. I think that online payments, and accessing services via mobile will be a key driver, but it's so nascent it's hard to really put numbers around it. I think distribution will be the name of the game.

GREG SMITH: I guess just to be different, I'll say prepaid. Prepaid's kind of the fastest-growing area of payments today and has many, many applications, whether it's on the payroll card side for rebates, for teens, for being able to pay for things in online gaming, virtual goods, things like that. It has so many applications, and I think prepaid will be one of the things that really continues to eat away at cash, and for somebody who maybe can't get a traditional credit or debit card, it brings them into the world of electronic payments.

There's a lot happening with mobile phones. Is acceptance the most important initiative now?
JEFFREY: I think so. But I want to clarify my comments. I'm not a believer in mobile payments. I believe that there's a tremendous amount of smoke and absolutely no fire with regard to mobile payments. I think that you will see companies like Visa and MasterCard create mobile payment technology around card-based infrastructure in their networks, and I think that's a logical extension of the network infrastructure.

But when I start to read about global mobile money transfers and mobile commerce that's software-based, I'm a huge skeptic. Look at M-PESA in Kenya, for example, or Obopay. In certain limited quarters it has a place and has growth potential. But I think when you get into the regulatory and the technology nitty-gritty of thousands of global corridors, it's a nonstarter. That's why I'm such a big bull on Western Union, because I think that all the talk of disintermediation is somewhat overblown.

I think mobile probably goes the way of Internet banking: it's a good way to facilitate online access to accounts, and for banks serving card-to-cash or card-to-card payments, probably will get some traction. But as far as truly expanding the ability of the unbanked to access money transfer or access funds, I'm a skeptic.

SMITH: You still need cash at the end of the day. Just because you can receive a money transfer somehow on a mobile phone, it doesn't come full circle until you can feed the cash in there easily and use it to make purchases. But I do think it'll happen. So I guess I'm not quite as skeptical as Andrew, but I do think it'll take a long time.

When you say it will happen, what is "it"?
SMITH: That you will be able to completely facilitate commerce on a mobile phone, whether it's money transfer or purchasing something at the point of sale without a card or cash, having the mobile phone completely displace cash, checks and cards.

People want choice. There are times you want to use cash at the point of sale. Or you may want to use a credit card or debit card, and it may not be easy with one device to select all those different types of purchases. That's an important issue.

But I do think mobile payments are going to pick up steam. We're already seeing it internationally. For example, the ability to purchase something online via mobile phone with a text-based payment system and have that show up on your cell phone bill as opposed to your credit card bill. There are lots of companies targeting that area, and I think that's going to be a big area of growth.

JEFFREY: That's really is an outgrowth of current technology.

SMITH: But putting it directly on your cell phone bill is kind of a new. It disintermediates Visa and MasterCard. If you can buy something with your cell phone and have it appear on your cell phone bill, Visa and MasterCard aren't getting any of that, and there are a lot of companies out there doing that.

JEFFREY: I agree that mobile payments at the point of sale probably happens, but I also think it's more of a hardware story, with NFC or some other type of device-based solution.

SMITH: You can get your boarding pass on your iPhone, as a bar code. You could have that at the point of sale, too.

They do that. Target and Starbucks, that's exactly what they're doing.

SMITH: Yeah. I don't know the cost differential relative to NFC, but it's definitely an interesting technology.

HUFF: As more people manage their lives using a smart phone, I think the next step is a payment of some sort. It's probably not going to be super whiz-bang technology. I think it'll an extension of what we have now. Mobile isn't just Internet banking 2.0, but I think the way people use it, it probably will be.

PELLER: I think you're already seeing it on the other end, for accepting payments. There's VeriFone and Square and other products; it's a pretty popular product. It's clearly something the press has picked up upon, and I think some consumers are pretty excited about it. And it's in the stores now. I think it's something that shows the use, the potential use, of mobile for payments products.

Why that can't go the other way, I can't understand why it wouldn't occur. Some of the products that have been shown are pretty impressive. You know, where they have a phone that you put up to a billboard on the wall. You get a coupon on your phone. You take that coupon to a store, wave it in front of the contactless terminal and sure enough, you get 10% off at Foot Locker on your sneakers, which is pretty neat.

That said, you hear from [Global Payments CEO] Paul Garcia and others in the market, "Is it really necessary for somebody to use a phone when they're perfectly happy using their cards?" And I think that's sort of a reality. Is it really going to catch on?

SMITH: People are going to want choice, and want to use different payment devices at different times, and no payment type has ever really died. We're still using cash, checks. They just die very, very slowly. I don't think everything's going to be mobile in 10 years. No way.

JEFFREY: When I think about the history of new consumer financial technology, whether it's credit cards or ATMs or online banking or online bill pay, the hype tends to be way out in front of the reality.

SMITH: I think especially for Square these days.

JEFFREY: I think for any new consumer financial technology, it always takes longer than the common opinion as far as consumer adoption goes. I think we forget that sometimes on Wall Street. I've been paying my bills online for 10 or 12 years, but we're talking about people who are not as financially sophisticated or comfortable, and it takes them a long time to get comfortable with the technology.

SMITH: On Wall Street I literally get the question, Why would anyone use debit? Hello, get away from the coasts. Not everybody pays their credit card bill off every month. I get that question from sophisticated Wall Street investors. Why would anyone ever use debit?

To get the points.
SMITH: Yes, but debit points aren't as lucrative as credit.

JEFFREY: Right, and you don't get the float. I'll take the float every day.

McCROHAN: Hasn't history shown that any type of new payment technology that focuses on the merchant never takes off? Square has really become a merchant acceptance type of device. Unless you focus on the consumer these technologies never take off.

SMITH: It's chicken and egg. You go to the merchant and say, "Accept this." Well, I'll accept it when there's enough consumers. And then you go to the consumer and say, "Well, I'll take it when there's enough merchants."

JEFFREY: My wife is an antique dealer, and I bought her a wireless terminal for an antique show. I spent $350 on this thing, and it's still 3% of each transaction and it's still costing me $32 a month, and she does a show every other year. So I can go and pay a nominal amount for Square or VeriFone's mobile payment hardware, and yeah, I'm paying a $20 monthly fee, but I'm not paying much for the hardware up front, and then I'm only paying a swipe fee, which is no different, and all of a sudden it's integrated in a device she has and she uses and is comfortable with. This is easier for her to use, and it's all integrated.

I'm still not convinced it takes off like a hockey stick, but it's got a better shot than some of the other technologies we're looking at.

SMITH: I think Square opens up a world of small-value payments, and for somebody that's taking payments infrequently, it makes perfect sense. But is that going to be a humongous market? Probably not, at the end of the day.

Let's talk about near-field communication, contactless in a phone. It seems like an idea we've been hearing about for years. Is it really coming?
JEFFREY: Transit, I think, is the application that would help that take off and gain adoption. There's 10 billion trips here in the U.S. that people take on buses, trains. That's a lot of transactions.

Micropayments are not exactly attractive to a lot of people, but if they can come up with an open standard in transit so I can use the same NFC card in D.C., in New York, in San Francisco that's going to create some incentives. I had to buy a MetroCard to get here today. I used to live in New York, so every time I clean a drawer in my house, I find another one and wonder, Oh, is this still loaded? It's so convoluted and it doesn't make any sense, so I think NFC and transit makes the most sense.

SMITH: On mobile, the fundamental problem right now is who controls the wallet, and where does the payment actually go? Does it show up on your cell phone bill?

Apple wants to make payments run through iTunes, which is interesting. iTunes ultimately runs through your credit card, so that's not really a game changer.

But does a payment show up on your cell phone bill? Does it run against the traditional credit card? Everyone's sort of battling this out, and we don't have any set form, and that's why you're not seeing the adoption.

HUFF: You're talking about proprietary systems. Well, there are already systems out there already that everybody uses, called Visa and MasterCard. It's a question of whether you need smart cards to make it all work, and I'm not sure you do.

JEFFREY: I don't see why Visa and MasterCard have any meaningful motivation to give up economics to either the carriers or the handset manufacturers, because all these transactions ultimately come back to a credit card.

SMITH: Until they're not. If you have the ability to put it directly on a cell phone bill.

JEFFREY: I'd still rather have it on my credit card.

SMITH: You would. But if you're a 15-year-old kid buying a sword in an online game, you may not have a credit card, but you probably have a cell phone.

JEFFREY: Most of those phones are also tied to credit cards.

SMITH: Yeah, and now you can get a prepaid card for online gaming that may or may not run through Visa. But I agree with you. There's no incentive.

JEFFREY: Everything that Visa talks about in terms of new technology is being positioned as an offering that they can sell to the banks, or push down into the banks' customer base, as a justification for raising price. I don't think Visa has any interest in changing paradigms.

I think CyberSource is an interesting departure for Visa, but I think the company has said fairly clearly that the economics of that transaction don't pencil without a big international expansion of the business. So I think that everything Visa does is about enhancing its offering to the banks and making it increasingly relevant, because that's how it's going to ultimately justify its fees. I think it makes a ton of sense, and I think they do have the technology and obviously the network to leverage those initiatives. But I don't think they're out there trying to supplant anybody else's technology.

SMITH: I agree. The only area where I think they will be a first mover is in some of the emerging markets, where they have the ability to maybe step on some of the banks' toes. I think everything they do is from a defensive standpoint. The economics are very good. Why upset the apple cart unless there is a real threat? And it brings up the innovator's dilemma. Maybe they should be a little more forward-thinking, but they've got a darned good business today.

Would you say the same thing about MasterCard?
JEFFREY: I think MasterCard — this is heresy — is a better company. From the management DNA perspective, Visa's the better brand. It's hard to dispute they ran way out in front of MasterCard in debit.

But as far as a forward-looking company that really has the management DNA to innovate and potentially make some game-changing acquisitions, MasterCard in a lot of ways is a lot more dynamic than Visa.

I think that results from having been the underdog forever. They always had to scrap and fight and battle for share and battle for brand recognition, and I think MasterCard's going to surprise some people in terms of some of the innovation.

SMITH: I agree. The proof point of them being more of an innovator was decoupled debit. Even though that hasn't really panned out, the fact is they went into decoupled debit and clearly upset some banks, and gave Visa the selling point of, "Hey, we're never going to try to steal your debit business like MasterCard's doing."

They have a little bit less to lose, and they are always fighting for market share, so they're willing to take a few more chances.

HUFF: We're talking a lot about the rails, and how the payments get done, but a lot of that flows from where the money is held. Is it held in a prepaid card? If it's held in the DDA, then bill pay becomes more relevant, if it's held on a phone in a smart chip, that becomes more relevant.

To me, where the money lies will drive mobile, or not.

JEFFREY: I agree. The DDA is still the lifeblood of the banks, and that's why debit is such a huge portion.

Do you think we're going to see decoupled debit come back?
SMITH: It does fundamentally make sense. It's lost a lot of steam, but it still fundamentally makes sense. I think part of the problem is that the ACH network just isn't as robust. I think people underestimate the value of dispute resolution and the whole chargeback system. It's very easy for a consumer to know that, "Hey, if I don't make a purchase I don't have to pay for it."

When you get into decoupled debit, you have the issue of do you call your bank or do you call the issuer, or whoever issued that card.

JEFFREY: That's why I think it's interesting that Square is basically taking merchant risk. I'm not quite sure what the logic is behind that.

SMITH: Well, they still haven't explained how they're doing it.

PELLER: Square is acting as the merchant, on behalf of the user.

SMITH: Are they the actual acquirer?

JEFFREY: No, they're just a gateway. They're underwriting the merchants.

SMITH: And if there's massive merchant fraud, who eats it?

JEFFREY: Square.

PELLER: Here's the way it works. We just had a meeting about this. Square operates as the merchant. They price the transaction fee to the user to cover the cost of paying a merchant acquirer and still make money on top of that.

SMITH: But they are taking the risk? Square is taking the risk?

PELLER: Yeah, they're taking the risk, but then the merchant acquirer's taking the risk on Square.

JEFFREY: If you're a Square customer, your point of contact and your support and service and everything else resides with Square. These guys think it's easy. Merchant acquiring and processing is not that easy a business when it comes to service and support and chargebacks, dispute resolution and underwriting.

SMITH: What's the failure rate of the type of merchant they're targeting? It's probably pretty high.

JEFFREY: I think Square is taking on a huge risk with merchant underwriting.

If payments systems aimed at merchants are unlikely to take off, how do you think consumers want pay? Are they open to new ways to pay, or do they even care? How can you teach them to like something they don't know exists?
McCROHAN: Well, that's the argument on why mobile phones are not taking off for payments in the U.S. There's no compelling reason why a consumer really needs it. Most places where mobile payments have taken off, there's no bank infrastructure. I don't need to pay with my mobile phone. I really don't.

Yeah, but wouldn't it be cool?
McCROHAN: Well, it would be cool. So it could be a demographic thing. But I don't think the mobile phone will ever replace my wallet. I think it'll be more for prepaid things, small-ticket stuff.

I don't think it's going to happen. People will not adopt that. It's a solution looking for problem right now here in the U.S. But in emerging economies I think it makes more sense, where there are other reasons why it's taking off. But it's a little bit like catching lightning in a bottle.

PELLER: One big question is whether or not the U.S. is going to roll chip-and-PIN in full force, like Canada and other markets. You have to get through that hurdle before you get to mobile.

SMITH: I do think smart cards are coming, chip and PIN. And the merchants are going to have to bear a huge cost. That's one of the reasons we don't have it.

I think fraud is going to pick up in the U.S., because our payment system is relatively antiquated relative to what they have in the U.K. and other places now. It's just a matter of time before we move to true smart cards.

JEFFREY: The banks would rather eat that fraud cost than the cost of rolling out EMV.

PELLER: Speaking about mobile is almost a moot point until you get past smart card and whether or not chip technology is implemented in the U.S. at the same level as it is in other areas. It has to be pretty universally accepted and rolled out first. It doesn't have to be on a card itself, but that means the terminals have to be adjusted for it. The cards have to be reissued. There's a massive cost among the issuers. The networks less so. It's a huge, huge overhaul that most issuers would fight furiously against. And they've been pretty public about that.

SMITH: I think it ultimately will come, and I think two things will drive it. I think fraud will increase in the U.S., and I think we're seeing signs of that already happening as the fraudsters focus on the weakest link. And the other is that our cards are no longer going to work abroad. That's already an issue.

But I agree. It's a huge expense. Nobody wants to do it now.

PELLER: It's not just going to be that near-term. The banks have too much else to worry about.

JEFFREY: I think the whole effort to eliminate signatures for credit card purchases of less than $25 is brilliant, because it really does eliminate the need to carry around a separate payment device. When I can walk into Starbucks and get a latte and have my card swiped and walk away, that makes a huge difference from a convenience standpoint.

SMITH: I love it. If I know I don't have to sign I'm more apt to use a card over cash.

JEFFREY: And I'll put a $2 purchase on my Amex card, because I'm getting the points.

SMITH: But I feel guilty for the merchants, if it's a small little business. I won't use my Amex at my dry cleaner just to be nice.

We know the cost of implementing EMV would be enormous, and the industry is weighing that against the cost of fraud. But how does that compare to making customers angry, as more and more people travel abroad can't use their cards?
JEFFREY: EMV is something that's always been out there, but increasingly you read about difficulties using magnetic stripe cards in Europe. I think that that could be a real driver.

Let's spend some time talking about the tech vendors. Are we going to see more M&A this year? We sure didn't see much last year.
SMITH: Well, if you look at all the point vendors, 99% of them have already been acquired. When CheckFree got acquired, to me that was the last big one out there. You still have ORCC. IPay, which Jack Henry's acquiring, is one of the larger point providers. I think we've already seen the vast majority of that M&A occur.

And then the FIS-Metavante deal was the next leg, where the big acquirers say, "Well, wait a minute, there's only so many point solution providers we can acquire. If we get together, we can get a lot of synergy." So we saw that.

There's still Jack Henry out there and a few other providers that I think will eventually get acquired. But to me, the next big wave is going to be an IBM or an HP making a run at one of these guys. I think that definitely will happen at some point, to get somebody like a Fiserv or an FIS, with banking expertise.

The HPs of the world aren't growing dramatically anyway, so they don't need huge organic growth. If they could consolidate data centers and leverage that bank domain expertise, I think that could be a valid reason.

JEFFREY: You've been talking to Bill Foley too much.

HUFF: The real secular trend is going to be international, and I think there's only a handful of bank tech vendors that really have that exposure.

JEFFREY: I'm less sanguine on the odds of an HP or IBM coming into this space. I think culturally it's a terrible fit. I can't imagine Larry Ellison running Fiserv. It just doesn't make sense.

I think that if the markets continue going the way we're going and the valuations that we're seeing in the public markets and the private markets begin to converge a little bit you're going to see a lot of these prior LBOs come back public.

SunGard Data is certainly a company that would love a public market entree. I know KKR would love to IPO FirstData.

And PayPal's another one. I know eBay swears up and down that they don't want to monetize PayPal, and that there are lots of synergies, but all of a sudden, you have a pure-play payments company.

There just aren't a lot of big players left to be bought.

PELLER: I think the key question is about the leveraged markets. Most of our companies in our sector are underlevered. It's a question of whether or not the banks will fund a deal.

If the Fidelity National buyout actually goes through, I think that's a very good sign for the LBO market. The indications we have are that a lot of the leveraged loans are coming back. There's a lot more interest among banks. As soon as capital feels a little more comfortable that you're going to see banks continue lending, and I think you absolutely will see more deals.

JEFFREY: You're going to see some activity involving providers who would like to remain independent — Global Payments comes to mind. Paul [Garcia, Global Payments' CEO] has to do something. He knows he has to do something. He's got the laziest balance sheet in the group. The stock's been a pig. Somebody's going to come along and force his hand, or he's got to make a deal.

SMITH: Look how many people are looking at the RBS WorldPay deal. A few of the companies that don't get it might just look at Global.

JEFFREY: He's got a six-month window to do something.

PELLER: The amount of cash that private equity firms have built up over the past two to three years, that was given to them before the '07 and '08 time frame, is extraordinarily high.

SMITH: That's money they haven't been able to spend.

PELLER: So they're just waiting on the banks to provide the funding.

What's the benefit to banks, from a technology perspective, from these large buyouts of tech vendors? What's the potential downside?
SMITH: I don't think there's any upside for the end bank customer. If anything, there would only be a negative just from the internal disruption that comes when their vendor has a new parent and people are wondering about their jobs.

But in some cases, a buyout can make customers more confident. If you're a CyberSource customer, you're happy Visa's acquiring it.

But from an LBO perspective, if I'm a bank, you know they're going to want to cut costs further, and it just creates uncertainty among the employees.

JEFFREY: I think it's clear that the big banks have no interest on spending on core systems upgrades anytime soon. I don't think there's any impetus whatsoever. They'll hold those systems together with bubble gum and Band-Aids.

SMITH: I disagree. I think they have to. I think they'll continue to spend. I don't think we'll see some big, massive wave. But I think there is a fair level of spending going on.

JEFFREY: There's one company we haven't talked about that I think is benefiting consumers, and that's Cardtronics. I think that what Cardtronics is doing, more than any of the core processors, is creating an environment in which small banks can compete much more effectively with bigger banks.

The Allpoint surcharge-free network is a great example of how a small bank or credit union can allow its customers to access ATMs just about anywhere. It's also created a situation where through branding deals with some larger banks, SunTrust, Chase, that they can really expand ATM networks in some of these convenience stores and other areas that historically have cost consumers a lot of money. As far as access to cash and reduction of fees, it's potentially the most consumer-friendly company in my universe today.

How will legislation affect banks, and their ability to collect fees?
PELLER: The question about who's hurt more, the consumer or the bank or some other party, has come up repeatedly over the past few years, as we've been on this fast-forward move of legislation. I think the consumer's been hit in numerous ways from the CARD Act.

Well, that wasn't the intent.
PELLER: That's my point. I think the CARD Act intention was to defend and help consumers watch out for hidden fees or even just higher fees than necessary.

SMITH: You're not smart enough to do it yourself, so the government's going to do it for you.

PELLER: Right, and instead you have different types of fees and potentially higher APRs.

SMITH: Everyone raised the rates just before it went into effect.

PELLER: It's hard to really see the benefits sometimes. There are numerous times that legislation was passed by people in government who don't have the same expertise as the industry.

McCROHAN: Unintended consequences.

HUFF: With overdraft fees soon going away, that's a big deal, and it's interesting to me that there hasn't been more talk among vendors about how they're going to help banks solve that problem. As consumers start paying more to use a checking account, a DDA, they're going to go to alternative methods.

So insofar as the banks can figure out how to use technology to lower their costs, which is probably the only way they can do it, consumers will benefit from that. Banks are trying to keep those customers and keep those deposits on hand, and I think that's one way that they can try and fight that battle.

What do you think about interchange regulation? Merchants have been pushing this idea for a long time, that they're hurt by interchange, and they want the rest of the world to understand their plight.
SMITH: But what happens if interchange comes down. Do they really pass that on to the consumer? No. They make more money. It just comes out of one hand into the other, and the consumers lose because their rewards programs go down. So when you really educate consumers on this and say, "Do you really want this to happen? Here's what's going to happen to you. You're going to lose all your rewards," they'll say no instead of signing the 7-Eleven petition that went around.

JEFFREY: Merchant acquirers are going to keep some of that, the interchange reduction. They're not going to pass that on at all.

SMITH: And I think Visa will raise its prices. If you look what's happening with Visa and MasterCard, their fees to the financial institutions are starting to go down, fees to the merchants are going up. If Interchange goes down, it just gets even more exaggerated.

JEFFREY: What's really interesting is that the Durbin amendment is debit-centric, which I find very curious.

PELLER: It is different. The Interchange regulation debate has always been more focused on credit being extraordinarily high.

SMITH: Visa's and MasterCard's best argument is that the merchant doesn't bear the cost if the consumer doesn't pay. Surety of payment — what is that worth? They get paid no matter what, even if the consumer ultimately never pays that bill. That's worth a lot of money.

If every merchant had to manage that risk themselves — I sound like a Visa/MasterCard lobbyist, but I do buy that argument. If every merchant had to bear that risk themselves, the cost would be significantly higher.

JEFFREY: I think there is something to the argument that when you walk into a merchant with a card, you're more likely to spend more.

SMITH: I am. Absolutely.

JEFFREY: You're more likely to make an impulse purchase, you're more likely to walk out of the store with something that you wouldn't be walking out of the store with if you'd gone in with cash or even with a check.

But the fact of the matter is, if I'm indifferent to using my Amex card because I'm not getting any rewards, I may buy less or use cash or eventually go to debit.

The way interchange is set up now, does anyone think the fees for merchants are unfairly high?
PELLER: Here's the question. When people ask, is interchange generally too high, what is the right number? It might not be. It might not. I don't think anyone in the room would argue there should be zero interchange, nor would most merchants, because there are some costs. It's more a question of whether or not there's a real justification for there to be roughly 100% higher interchange for signature debit than PIN debit.

Why have interchange rates not come down on the credit card side for a number of years when technology and innovation has really added to that. I don't think merchants have an idea as to what the right number is.

SMITH: I think they're probably too high. Probably all of us in this room get at least 1% back on every transaction. Does it have to be 1% back in rewards? If we cut it by 50 basis points, I don't think that would have a dramatic impact.

JEFFREY: I don't know that's the right question. We should ask are the interchange rules too complex? Let's start there. I think interchange would be less of an issue for merchants if they know that when Greg walks in with a particular card they're going to pay X. And then you do give them the ability to steer, which most merchants do anyway, with the clear knowledge that they're going to pay less interchange on a different card in Greg's wallet, that's unambiguous. That alleviates a lot of merchant concerns, too. But a hundred pages of interchange rules are daunting for anyone.

PELLER: The complexity of those is the reason that many of the acquirers, are able to get away with charging somewhat egregious spreads on top of interchange rates.

JEFFREY: Let's talk about PCI fees. Forget about interchange for a second. Why aren't merchants screaming and yelling about PCI compliance? Some acquirers are charging merchants egregious PCI compliance fees. It's disgusting.

HUFF: Especially very small, unsophisticated merchants.

JEFFREY: I think interchange is a red herring, personally.

McCROHAN: There are some confusing parts of interchange. The complexity is definitely a problem. For some small payment transactions, Visa charges a fixed fee, a percentage plus a fixed. MasterCard is percentage plus zero. So the MasterCard interchange fee works and makes the economics work for buying a can of Coke out of a vending machine. The Visa interchange doesn't. So there's not even parity between these schedules. I mean, it's bizarre.

And another thing I'm confused about is e-commerce card-not-present transactions. The fee is higher, but the merchant assumes the risk if they don't do certain checks. So why are you charging them, double-whammying the merchant? They are being charged a higher interchange fee, but they're also absorbing all the risk of the transaction if there's fraud. That makes no sense to me.

SMITH: I think if Visa and MasterCard were to do anything, it would reduce the complexity and then slowly standardize interchange. They should be slowly reducing the rates. That would be in their best interest. I think the writing's on the wall where we're headed.

I would be willing to bet that interchange rates are lower five years from now than they are now. How do we get there? I'd like to see Visa and MasterCard be a little more proactive in getting there themselves without regulation, because I think there will be so many unintended consequences, but it may take some kind of regulation.

PELLER: I don't think regulation is going to be the way. I think it's going to end up through the litigation. I think it could be similar to what you've seen in the past with the Wal-Mart settlement. I think you're going to see some settlement, and with that I think you're going to see some concession on the interchange rate on the credit card side. I think that's going to be more likely than regulation.

SMITH: The GAO report was pretty clear in saying there's no easy answer.

PELLER: Yeah, it was. It was pretty clear in not giving a conclusion.

SMITH: That study presented both sides, and it said there may be some benefits to regulating interchange, but it's not definitive.

JEFFREY: I think we're in a populist environment right now. And interchange is a tough populist issue. It's so complicated.

SMITH: But it's not really a consumer issue. You can make it a consumer issue by focusing on rewards.

JEFFREY: And that's why the odds of passage of these amendments are still relatively low. When the rubber hits the road, it's really hard to make the argument.

But, if interchange is coming down, what do you think the implications are for Visa and MasterCard?

SMITH: I don't think it's negative for Visa and MasterCard. I think they're shifting fees anyway. I think they're in a unique position where they can balance their fees to the issuers and to the merchants, and they'll be able to preserve their revenue yields. When the stocks are down on interchange, I buy them.

McCROHAN: But doesn't it depend on what American Express does, too? If Visa and MasterCard lower interchange fees and American Express' fees are still up there, it makes Visa and MasterCard much more attractive.

SMITH: That's happened in Australia. But we didn't see a huge flight to Amex. We saw an initial small flight to Amex, but it didn't last.

McCROHAN: American Express eventually lowered their fees voluntarily.

JEFFREY: You saw a shift to cash in Australia.

SMITH: Every time a bank has tried to force you off Visa or MasterCard to an Amex card it hasn't worked. Consumers say, "Why did you send me this card?"

JEFFREY: It's more a question of, do consumers revert to cash?

SMITH: Surcharging scares me, which is gaining steam in Australia. If the surcharge is more than the rewards I'm getting back, I don't have the same incentive. It's nice to use a card. You still get the float. But if it ever tilts the equation to where using a card costs me even a penny, I'll probably use cash. To me that's bad for the entire system. That's bad for everyone.

McCROHAN: Including retailers, right?

SMITH: Consumers, retailers. That's why I think the unintended consequences have to be considered. Anything that incentivizes — or disincentivizes — the use of cards is bad for everyone.

One thing we saw in Australia was that prices didn't come down significantly.
SMITH: Hey, big surprise. But the rewards came down, dramatically.

That's something people notice. How do you make a consumer understand or even care about interchange fees?
SMITH: They shouldn't care. They're not paying anything right now to use cards. But if they should realize that if interchange comes down they're going to lose their rewards and they may have additional fees. If we cut rewards, and if interchange came down 50 basis points, I don't think that upsets the systems. I think banks survive, merchants get a little benefit.

The thing you've got to remember is that the credit card business is an enormously profitable, great business over the cycles. It's hurting right now, but it's still a very, very profitable, good business. If you take a little bit out of it, I wouldn't change my description of the business. You can implement an annual $50 fee and offset at least a 50-basis-point drop in interchange.

McCROHAN: There's other ways, pockets you can kind of —

SMITH: I think Visa and MasterCard should just proactively start lowering interchange at the top end and raise it at the other end, like they're doing with PIN debit. There's an opportunity for them to tweak it, and relieve some of the pressure.

JEFFREY: That's the other interesting thing about the interchange discussions, speaking of broad and unintended consequences. Some of the retailers which initially made the most noise about interchange actually have something to lose if interchange becomes less complex. It's going to benefit smaller retailers, but Visa and MasterCard aren't stupid. They've already tiered interchange in such a way that the big-box retailers and some of the higher-volume retailers are paying much less interchange than they used to.

The big guys have something to lose in a flat interchange kind of environment.

SMITH: Yeah. The still probably would benefit, depending on how much interchange came down.

JEFFREY: They would benefit if they could officially drive consumers to PIN.

SMITH: If, through regulation, interchange came down 100 basis points, Wal-Mart would benefit. There's no two ways about it.

McCROHAN: And something like 30, 35 merchants have their own interchange negotiations.

PELLER: Yeah, I don't think Visa and MasterCard should proactively lower rates at all. I think you'd be upsetting the apple cart. I think the system works extremely well right now. I think you always are going to have merchants complaining about something, whether or not it's interchange or another topic.

JEFFREY: It's a game of chicken, right?

SMITH: I'm saying it's coming down. I'm not sure how, but it will come down. Yeah, it's a game of chicken. But I think the writing is on the wall.

Do you think it's even possible to draft an interchange regulation bill that makes sense?
JEFFREY: I think any time you set prices you upset free markets.

SMITH: There should be more transparency on the receipt.

You mean, if the receipt told the consumer how much of their charge went to the card networks?
SMITH: Yeah. I think that would be interesting.

I do agree with the merchant argument, that they're almost forced into accepting cards, and that's why they needed litigation to get together as a single entity to fight the issuers. I do agree that merchants are disadvantaged in the interchange equation. I think it's moved a little bit in their favor with the ownership structure of Visa and MasterCard changing.

If Visa and MasterCard proactively began to bring interchange down, it would just release some of the pressure, and the issue might fade away.

JEFFREY: I think the issue fades away in Washington if the Republicans pick up as many seats in both houses of Congress as most people think they're going to. I mean, I think it's a broadly populist issue that got momentum in a Democrat-controlled government. If you get a more divided government, which the American people have said over and over again is what they want, this issue basically goes away. Anybody who's not more skeptical of the government after the last three or four years is not paying attention.

Let's go back to core systems upgrades. People have been saying for years that big banks have to upgrade their cores. Do you think that's going to happen?
JEFFREY: I don't think it's going to happen.

Ever?
JEFFREY: Not in this cycle. I think eventually they have to, but I think it's way down the road.

The big banks continue to say, "We're not going to spend on these systems until we absolutely have to." I don't know. Three years from now, GDP's growing 3 or 4%, and the credit card business is a profitable business again. Then maybe there's an incentive. I'm just not sure that in a world where 10 banks control a big chunk of the DDAs and 90% of the card issuance that there's a real impetus to spend money. I think the ROI case is pretty low.

It's just the cost-benefit analysis? Banks don't need to spend the money now, so they don't want to?
JEFFREY: Smaller banks need to. Smaller banks need to be competitive and smaller banks still have something to gain by outsourcing.

PELLER: I think it's going to come within a couple of years. I think the banks want to do it. Some of the larger banks are certainly going to take longer or don't have the same immediate need, but from all the chats we've had, I think the biggest reasons they've held off is just capital. Regulatory issues have also slowed them down.

I think if you're sitting in a bank executive's shoes right now and you have a certain amount of money to spend, you're going to spend it to make sure you're meeting regulatory requirements, and that everything is in tip-top shape for the regulators, because they're looking at you literally every single month, if not every week, whereas historically they look at you every quarter or two.

Once you have credit quality improving, profitability improves, the return on tangible equity among banks actually starts to improve. Then I think you'll see them spend. And that probably is another year out.

Spend on core or spend on other things?
PELLER: Both, I think.

SMITH: We hear Citi's switching, to FIS' platform.

HUFF: I think, again that lowering some of the overdraft fees and some of those other things will force the hands of some of the players, both on the ancillary technology and on core. But I think it will be gradual.

How will it force their hands?
HUFF: They're going to have to figure out how to lower their costs.

SMITH: And get even more efficient.

HUFF: The big banks have figured out the technology. They realized early on that technology is their friend. It can be a differentiator. With the 10 top banks that are competing with each other, I do think there is a motivation to spend some money. I don't know when it's going to be core, but I do think at some point that's the system of record.

JEFFREY: Core upgrades are potentially disruptive, and banks know that.

SMITH: Yeah, it's pretty much the biggest technology product bank can do.

McCROHAN: One of the catalysts I'd cite is cost savings. As the core processing vendors keep getting bigger, they can offer lower prices. But given the disruption, I wonder how much Citi saved on its FIS switch.

SMITH: I'd love to know.

McCROHAN: Is a 50% price reduction enough to make you pull the trigger? Ten percent's not going to do it. It's such a high-stake conversion.

JEFFREY: And Citi was already a FIS customer. I'm they were getting more of a holistic pricing for that.

PELLER: I think within the core banking solutions, there are certain products that are going to be taken advantage of.

You have loyalty products that obviously banks are focused on. You have credit management products. I mean, we were at CoreLogic's investor day, and spent quite a lot of time on what they called their new dynamic data analytics. It could allow banks or even broker-dealers or others to analyze changing credit profiles of borrowers.

In this environment I think that's probably the most pressing need for the banks, to make sure their credit is solid. So there are products offered by some of these solutions providers that can be used today. I suspect a true overall core processing overhaul is going to be a little ways out.

If not core, what do you think banks are looking at most intently now, or should be?
HUFF: Risk.

SMITH: Regulatory risk, security fraud management. Those are all the buzzwords.

PELLER: Credit-quality risk, capital management.

That's all mandatory. Is there anything that's optional?
SMITH: Mobile. Better the customer access, better online banking, things like that.

JEFFREY: Imaging.

Have most banks already moved to that?
JEFFREY: Yes, but I think that's still an area where there's a lot of potential for growth.

HUFF: I think analytics is important, although it's kind of risk. Banks will figure out that they have to think a little bit more like retailers in some cases. There's probably too many branches out there. They're going to have to figure out how to deal with customers, how they want to be dealt with, credit quality, etc.

SMITH: I think banks should be looking at prepaid as a way to gain customers they might not think could be profitable customers. I'm just shocked that more banks are letting that business go to the Green Dots of the world.

PELLER: It takes a solid customer base for that product to be successful. I just had a long call with about three or four experts in this industry. Western Union is a prime example of a company that has the perfect customer base for prepaid. They have 9 million-plus Gold Cards with loyalty embedded in them, they have addresses, names, phone numbers. Many of these customers are not banked or underbanked. These are the customers you want to pinpoint, and I think that small prepaid companies can compete in niche, small areas. But to see a lot of the banks do it — it's not as easy as it sounds.

SMITH: I agree. But I'm surprised there aren't more banks that see the opportunity.

JEFFREY: I'm surprised there aren't more banks that aren't willing to capitulate on money transfer and sign up with a white-label solution, or a branded solution from Western Union or from MoneyGram. I think the U.S. Banks of the world that recognize the opportunity in cash-to-card are going to do very well with that.

SMITH: B of A tried to do something like that a few years ago, but to get it for free you had to have a certain amount in your checking account, which automatically disqualified all the potential customers.

I'm just surprised banks aren't more broadly looking at the immigrant populations that tend to gravitate to the Western Unions as a bigger opportunity. I know it's difficult, but I'm still surprised.

HUFF: You've got to think about deposits beyond the DDA.

SMITH: Well, the prepaid card is the DDA for young people and others.

JEFFREY: Well, we'll see if Western Union can capitalize on this. They have the ideal customer base. If they can't figure out how to tap those Gold Card users in the U.S. Right now, they are missing a huge growth opportunity.

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