Banks that have made money from issuing credit and debit cards no longer have a choice: They must innovate or kiss this significant source of profit goodbye. Ironically, it's the new regulations that are the catalysts for innovation.

The Federal Reserve Board will slash the amount of fees that banks can earn from signature debit cards by May 2011 as a result of the financial reform legislation. The Credit Card Accountability, Responsibility, and Disclosure Act, commonly called the CARD Act, has sharply reduced the ability of banks to earn fees from credit cards. Looming farther in the distance are the possibility of reductions in credit card interchange fees and a highly intrusive consumer financial protection bureau.

The legislation that led to these regulations points to a more profound problem for the card industry. Card issuers and networks have irritated the two groups of customers that provide all the revenue and profits-cardholders and merchants. Cardholders became annoyed with seemingly sneaky fees while merchants came to see interchange fees as an increasingly hefty tax on their profits. The industry has counters to these complaints. But the old adage applies: The customer is always right.

This has happened at a time when another dagger is aimed at the heart of the traditional card industry-the Internet. You might think that the Internet is old news. After all, it has been 15 years since the commercial Web got off the ground and a decade since the dot-com bust. But during that time, PayPal has built a huge franchise by making it really easy to pay and be paid with cards and other tender types on the Web.

It has done this largely on the backs of the card networks and is cleverly making money by luring cardholders in and then flipping them to automated clearing house transactions. Meanwhile, card networks have floundered online. While it takes mere seconds for a card transaction at the physical point of sale, online card forms take minutes to fill out, frustrating consumers.

This failure online is a big problem for the traditional card industry because the walls between the online and physical worlds are blurring and it isn't because more people are going to be doing more transactions while sitting at their computers surfing the Web. It will blur because more and more devices are being connected to the Internet, like mobile phones. It is likely that physical point-of-sale devices will be connected to the Internet with software applications running in the cloud.

Square, which came out of nowhere eight months ago, may or may not succeed in building up a new payment system but it has shown how Web-connected mobile devices and cloud computing can revolutionize the point of sale and do it almost overnight.

PayPal now is a real threat to the card networks and all the issuers that depend on them. Its recent efforts to build an app store, by encouraging developers to use the PayPal X platform to create payment-enabled applications has rattled the card networks. MasterCard has already made significant moves to get into this game and American Express seems close behind.

Bank issuers and card networks aren't at any risk of going the way of the typewriter in the next decade. But they are at risk of becoming what the mobile telcos are to Apple and Google-plumbing to be used by the folks who drive real innovation.

Card issuers and networks need to focus on things that will provide real value to cardholders and merchants. Looking for easy ways to make up revenue will help in the short run but won't prevent bank issuers being marginalized by clever innovators. They should be looking for a killer app for cards that will provide massive value to consumers and merchants.

The traditional card industry also really needs to start treating merchants as significant customers who choose to work with the industry because they are getting significant value-not because they feel like they have no choice but to take cards. New Internet-based technology provides lots of ways for card businesses to provide value-added services to merchants at the point of sale. Merchant acquirers will probably take the lead in thinking about these, but issuers and networks need to be as focused on the merchant side as on the cardholder side.

The card industry has gotten a bad rap. The credit, debit, and prepaid cards have been extremely innovative products that have benefited consumers and merchants enormously while generating well-deserved profits for the payments industry. Banks need to get over the hurt feelings, though, and use the powerful new tools available to them-smart mobile phones, cloud computing, data analytics, and payments software platforms-to drive innovation and profits forward.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.