WE ARE USED TO thinking of automation as a beneficial tool that helps us cut costs, do things we couldn't do before, and add value to our products. Certainly this is all true, but automation does more than that. It is also a force that changes industry structure, revamping the basis of competition and helping determine which businesses banks should remain in and which they shouldn't.

Banking offers no clearer example of this than the credit card merchant acquiring business. Acquirers earn about $1 billion in revenue yearly by processing authorizations for merchants, capturing the data from the transactions, and handling the accounting, reporting, and chargeback functions. The market is the approximately 2.3 million merchants who did $250 billion in bank card charge volume in 1992.

Automation in merchant acquiring has become the rule only in the last decade. Originally, the critical piece of paper--the sales draft--contained the transaction data and had to be processed after each sale. Many banks participated in the business up until about 1980 and the industry structure was very fragmented. No competitor had much market share.

But since 1983, a new technology called electronic draft capture has become ubiquitous, and the old-style sales drafts are rapidly vanishing. Transaction data is now captured when the credit card is swiped through the terminal at the time of authorization. Later, editing and posting are performed by the acquirer directly from the electronic data without any manual intervention or paper processing.

This eliminates the costs of data entry and makes the data more accurate. EDC has moved from a 20% share of all credit card transactions in 1983 to about 90% today.

There have been three significant results:

* The process of acquiring transactions is far more efficient, which has led to a long-term decrease in the cost per transaction. Although credit card volume has grown by a factor of 5 since 1983, the industry's aggregate operating expenses have only doubled.

* The economies of scale and minimum efficient size have grown and--with the virtual disappearance of the paper sales draft--the need for a local presence is greatly diminished.

* This technological change has revamped the structure of the industry and changed the successful players. Today, the industry is rapidly consolidating, margins are shrinking, and generally only the largest players can stay in the game profitably.

Three companies--Nabanco, Card Establishment Services, and National Processing Co.--now share more than 40% of the credit card merchant processing market and are gaining in share every year.

These three companies have an operating cost advantage as high as 25 basis points over a lower-volume regional bank acquirer. As a result, they are pulling away from the rest of the industry. For example, Nabanco grew from a charge volume of $8.6 billion in 1987 to $35.8 billion in 1992, a 35% annual growth rate. In the same time period, Card Establishment Services grew from $11.3 billion to $34 billion and National Processing from $16.1 to $33.6 billion. Growth has come through portfolio acquisitions, expanded marketing, new types of merchants, and taking merchants from other players.

To survive, these industry leaders continually reinvest in three things: technology, networks, and volume. The technology is the suite of application programs that perform authorizations, capture and post electronic data, handle chargebacks efficiently, process applications for service from new merchants, generate statements, and handle reporting.

These applications are all proprietary and are very expensive to maintain. For example, the recent PS 2000 requirements by Visa cost each of the major acquirers an estimated $1 million to implement. And many new technological requirements, such as signature capture terminals or Visa's Card Authentication Methodology, are ahead.

The networks are essential to provide reliable service, especially to the big merchants. Both Nabanco and Card Establishment Services maintain their own private networks, an expensive undertaking even without the need to pay for emerging technologies such as data-over-voice or frame relay.

As a result, continual growth in volume is needed to amortize the continued reinvestments. Therefore, consolidation should continue. The three leading players may have 60-70% of the market by 1998.

Smaller players who cannot sustain the reinvestments will have little choice but to sell out. Some banks may resist since they feel that the merchant relationship offers the chance to cross-sell lending or cash management services, especially to small merchants.

Today, with the industry's high levels of profitability, some of the incentive to rationalize has been removed. But, when harsher financial conditions return, we believe that more banks will choose to exit this business.

All the money-center banks have already gotten out of the game. However, banks can compete, even in this consolidating field, if they treat merchant acquiring as a separate business. For example, Cleveland's National City Corp. owns National Processing Co., but runs it quite independently of the banking side.

The entire story illustrates that the required technological scale and focus may not be achievable within the confines of the banking industry's structure. Although banks are consolidating, they are not doing so very rapidly.

Yet an efficient, technology-based processing industry should have only a handful of competitors--like a manufacturing or utility business, in which the leader will have 40% to 70% market share instead of 5% to 10%. So, to achieve that type of structure, the technology must be outside of the industry. That is, the technology leaves the industry, to be provided back to the banks by specialized processing companies.

This transition will generally occur when the transaction becomes completely paperless. With paper, processing work flows are slow, there are fewer economies of scale, and a local presence makes much more sense. Without the paper, workflows change dramatically and business can be carried on nationally to achieve scale and volume. The local presence may well become an expensive albatross.

Given the pace of technological change, other banking businesses are likely to go through similar transitions. A paper-based transaction, be it check, food stamp, or invoice, is going to be increasingly replaced by electronics or images.

Such a transition has already happened in wire transfer and is under way in corporate services such as lockbox and cash management. The checking business is likely to see wholesale changes in the next decade as both electronic check presentment and image processing become widely adopted.

Even home banking has the potential to leave the industry. What is home banking except a way to "acquire" financial transactions without leaving the house? It is very analogous to merchant acquiring and so the long-range result should be the same. Banks will enter the home banking field in the beginning, but after a while, because this channel is so automated, the technological investments will become enormous. National scale will be required and nonbank competitors will appear to buy up the banks' home banking portfolios and gain market share. Fifteen years from now, there should be "home acquiring" firms that provide the technology, maintain the networks, market the service, and settle the transactions with the consumer's bank. And it may be a business with shrinking margins, a high rate of consolidation, and lack of profitability for those players not among the leaders.

The moral of the story is: Recognize that technology will inevitably displace paper in banking (even if slowly) and will create efficiencies. But the requisite minimum efficient scale should go way up, leading to inevitable pressure on the technology to leave the industry. Making acceptable profits in an efficient line of business may only be possible for the leaders. In short, technology can change industry structure dramatically, and those who anticipate these changes will be those with the best chance of future success.

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