In a speech to a large group of bankers late last year, industry veteran Rick Hartnack, now a vice chairman of U.S. Bancorp, was clearly trying to stir the pot.
With a smile on his face and his hands in his pockets, Mr. Hartnack predicted that successful credit unions would increasingly look to sell out and convert to bank charters. Then he asserted that mortgage lenders were putting overly risky products in the hands of customers who lack the skills to manage them.
And then he did something bankers seldom do anymore: He offered what sounded suspiciously like a general definition of a "bank," and with that a general recipe for their success or failure.
In the most basic terms, Mr. Hartnack said, commercial banking companies traditionally do two things - "store" customer assets and provide transaction capabilities. To the degree banks can maintain "tight linkage" between these two functions, he declared, they will succeed - but there is a "risk that storage and payments are going to get disconnected."
His remarks, surely not coincidentally, echoed his employer's own strategy. In recent years U.S. Bancorp has been the industry's most dedicated acquirer of payments-related businesses.
What's more, his structural critique, if you can call it that, was not exactly what an audience accustomed to lectures about product innovation and superior service expected to hear.
But there are a lot of people in and around the banking industry these days who would probably agree with Mr. Hartnack and then some - especially about the risk that banks will lose their grip on the payments business.
When you get past all the talk of banking companies' inherent strengths (which are many) … when you accept that banks have indeed put in place a powerful array of offensive and defensive strategies and tactics (everything from anointing payments czars to participating in image exchanges to giving customers RFID devices) … when you concede that regulators will likely do all they can to slow the pace of change (maybe) … it's clear that banks are still facing a whole mess of trouble.
Recently, American Banker asked a wide range of industry authorities whether banks are still necessary when it comes to payments. Not surprisingly, many we talked to had interesting things to say about how the threat has been exaggerated and offered much advice on what banks must do to stay relevant.
But in this article, we let the naysayers speak. Entrepreneurs looking for a piece of the action. Consultants now on the outside looking in. Lawyers. Analysts. Demographers.
Loudly and clearly, they explain that depositories' dominance of the payments system is threatened on several fronts. They point to a steady march of events that are undermining banks' position.
Retailers, fed up with the rising costs of accepting payment cards, are looking for end runs. Some are doing so in ways that could undercut banks' relationships with their customers - such as encouraging customers to make payments through automated clearing house debits rather than cards.
Meanwhile, a generation of consumers coming of age prefers to transact business in ways that banks have failed to fully exploit (the Internet) or embrace (cell phones) - and for that matter, don't have particularly strong roots in.
And though card associations' rules restrict membership to banks right now, that could conceivably change too.
MasterCard International plans an initial public offering next quarter, and many have predicted that once subject to the capital markets' growth targets MasterCard will have to open up membership to nonbanks. For some observers, the forthcoming IPO also portends the unraveling of the bank-owned card-association model and the emergence of payment networks that would compete with MasterCard and Visa U.S.A.
Make no mistake: Few, if any, forecast that banks will become irrelevant to payments. Rather, the risk is that they will no longer be integral; their role in facilitating the transaction is far from secure.
ACH-TUNG
Ironically, one payment alternative that some in the industry say could disintermediate banks from the transactional side of the payment chain is not all that new.
The automated clearing house transaction has long been used for inter-institution transfers, payroll deposits, and a subsegment of bill payments but has seen little action when it comes to everyday consumer payments.
That seems to be changing. Merchants are starting to steer some consumers toward using ACH payment rather than traditional payment cards, because the cost of processing ACH transactions is much lower - only about 10 cents to 15 cents per transaction, according to Celent LLC, a Boston market research firm. Credit card interchange fees range from 1.5% to 2.4% of the total transaction, depending on the size of the merchant.
A number of companies are ready and willing to support such a conversion, not least of which is the processing giant First Data Corp., which revealed last month that it was pilot testing a program through which customers of Stop and Shop Supermarket Co. could use the chain's loyalty cards to initiate ACH payments from their bank accounts. The program began late last year.
Safeway Inc., a subsidiary of Albertson's Inc., has been allowing customers to use their loyalty cards to make ACH payments for several years.
Consumer and merchant demand for ACH payments is a "reality" that "at the end of the day banks are going to have to face," said Paul Garcia, the chief executive of the merchant processor Global Payments Inc.
"My guess is that the enlightened ones will say, 'OK, the world is spinning that way - this may be a more convenient way for consumers to pay.' The world continues to spin, so you either adopt or you perish. It's better to be an adopter."
Another company trying to help merchants make the switch to ACH is the Chico, Calif., payment network Debitman Card Inc. It lets retailers issue their own debit cards and routes the payments across the ACH network.
Wal-Mart Stores Inc. agreed in November to begin accepting Debitman cards, and Debitman plans to announce a number of additional merchant partners over the next few months, according to R. Scott Hatfield, its president and chief operating officer.
"Now that we have our rails into the retailer, now we can really change the payments space," Mr. Hatfield said. "True competition to interchange fees will lower the fees, and then we'll see what the space really looks like. … Banks will have to compete in the real world."
Soon to become another ACH facilitator is Fastlane, a subsidiary of Combined Payments LLC, which plans to introduce a payment system in April that connects driver's licenses to bank accounts.
Consumers who provide their bank account numbers to Fastlane will be able to use their licenses to initiate ACH debits at participating merchants.
Carl Towner, the chief executive of Combined Payments, said his long-term goal is to provide an alternate payment network to Visa, MasterCard, and American Express Co.
"I think that Visa/MasterCard could lose market share in the years to come," Mr. Towner said. "The timing is right and the market is right." He said that he expects to sign up 20,000 to 40,000 merchants during the second quarter, and that "down the road" the company will also issue credit.
THE YOUNGER GENERATIONS
Even bankers acknowledge that as the next generation of potential banking customers emerges, banks risk not being able to give them what they want.
Forrester Research Inc. of Cambridge, Mass., says that Gen Y - typically defined as those born from 1976 to the early 1990s - will make up 24% of all U.S. households by 2010 and will increasingly demand new ways to manage finances.
The number of Gen Y-ers paying bills online for example, will grow 219% from 2005 to 2010, to 18.2 million households, according to Forrester. No other age group is expected to add online bill payers as fast.
"Customers' preferences are changing; they're looking for different ways to do business," said Ray Mulhern, a senior vice president at Wachovia Corp. "For banks to remain relevant, we need to understand that shift and be ahead of it. The challenge to the bank is if you're not there, a third party will fill that gap for you."
Some demographers are starting to call those born in the late 1980s and the early 1990s the iGeneration, after the iPod. Those born since 2001 are tentatively being called the New Silent Generation.
Banks are not even close to capturing all the opportunity associated with electronic payments, said Tim Sloane, the director of the debit advisory service at Mercator Advisory Group Inc. of Waltham, Mass.
That's largely because they don't understand the consumers who are using such products, most of whom are younger and "wedded" to the Internet, he said.
"Banks should start thinking about how they're going to not just enable the payment but wrap themselves around the [online] environment to add value," he said. "Banks haven't yet said the users of that service are likely to be different than the other account holders."
Another difference with younger consumers is that "their development of credit transactions is significantly lower," said Barry McCarthy, the senior vice president of product and business development at First Data.
"We believe that those consumers are going to demand choice in how they pay for goods and services," he said.
Banks will also have to commit themselves to mobile phones to acquire as well as retain younger customers, experts say. But an impasse over how to divvy up mobile payments' costs and revenues among banks, phone carriers, and card associations has impeded development.
Research firms have found that teens are heavy cell-phone users.
WPP Group's MindShare Online Research reported that cell-phone ownership by those 13 to 17 increased 43% last year. Among 16- and 17-year-olds, seven out of 10 own cell phones. So do half of all 14- and 15-year-olds and a fourth of all 13-year-olds.
Eighty-three percent of teens who carry cell phones use them every day, and 64% use them at least several times a day, according to the WPP study.
Were they to obtain bank charters, phone carriers could eventually become providers of financial services, relegating depository institutions to providing settlement services.
"Cell-phone companies are very anxious to get as many applications on their phones as they can," said Global Payments' Mr. Garcia. They're going to help drive changes in the payments industry "in a big way," he said.
In Asia, cell phones can be used to buy anything from movie tickets to milk. Motorola Inc. is working on a similar system, which would enable U.S. consumers to make purchases by waving a cell phone with an embedded chip over cash-register scanners.
AFTER THE ASSOCIATIONS
The foundation of banks' modern-day payments power - the card associations - also faces revolutionary change.
According to Carl Pascarella, who gave up the CEO job at Visa last year and now works at a private equity firm: "What was an association model owned by the banks and governed by the banks" is becoming "a value-based model."
As the banks lose control of the associations, Mr. Pascarella predicted, banks will have to become more specialized, sell even more payment services into their footprints, and use "payment devices as a key to retention and cross-selling."
Steve Mott, the CEO of BetterBuyDesign, a Stamford, Conn., consulting firm, said banks' biggest "sin of commission" has been granting the associations the authority to speak for them.
"The sin of omission is the banks suffer from a mass inferiority complex. They are actually the world's best risk managers, and they really do add value in things like issuing cards. But they have to be able to unshackle themselves from their tradition and go out and deliver the natural value they can provide," Mr. Mott said.
"The associations created the most successful retail products," he said, "but banks held onto the business model for too long."
That the eight or 10 top banking companies are the predominant voices in the payments industry has added to other banks' inferiority complex, he said. "The other banks have rolled over and played dead and let the big banks call the shots."
MasterCard's plan to go public spurred speculation that the Purchase, N.Y., company would let nonbanks issue cards through its network. Industry observers have said retailers and telecommunications and insurance companies might be MasterCard issuers.
Bruce Cundiff, a research analyst at Javelin Strategy and Research of Pleasanton, Calif., said MasterCard's IPO will be "a greenfield opportunity for nonbank issuers."
"If you have a Verizon as an issuer, it would allow for a large number of cards to be issued and could reduce inefficiencies," Mr. Cundiff said.
Among retailers, Wal-Mart, which filed its application for an industrial loan charter in July, is one of the clearest contenders to go head to head with banks, most agree. Wal-Mart has said that it plans to use the charter only to eliminate the fees it pays merchant acquirers for access to the payment networks.
But Duncan McDonald, the former general counsel for Citigroup Inc.'s North American cards business, said: "My guess is that if they get the ILC, they set up the structure to start lowering the transactional costs, then after a year or so they say, 'We want our own bank license - and yeah, we're going to get into the card business.' "
Mr. McDonald said the effect of such a move on interchange "would have to be staggering." Wal-Mart's incursion creates "an enormous revenue risk" for banks, he said.
Wal-Mart's ILC bid has met strong headwinds this year, with everyone from former Federal Reserve Board Chairman Alan Greenspan to Sen. Hilary Rodham Clinton to Rep. Barney Frank to the National Association of Realtors voicing concerns. The issue is so controversial that the Federal Deposit Insurance Corp. is taking the unprecedented step of holding public hearings on the application next month. But it is unclear whether the FDIC can say no, having approved retailer Target Corp.'s ILC application several years ago.
A MERCHANT-RUN NETWORK?
Some say the end of the association model could also create more space for retailers and other nonbanks to form a network that would compete directly with Visa and MasterCard, forcing banks to slash the fees they charge merchants to accept their cards.
Merchants are still trying to figure out how to create a retail-centric network, said Mallory Duncan, a senior vice president and the general counsel of the National Retail Federation trade group.
"I've heard discussions," said Mr. Duncan, who declined to elaborate.
Analysts disagree on the idea's feasibility, but many acknowledge that it is a possibility.
Another threat to banks is the skyrocketing use of debit cards, especially PIN debit. Some say debit networks like NYCE (which is operated by Metavante Corp., the technology subsidiary of the Milwaukee banking company Marshall & Ilsley Corp.) and First Data's Star network could be further leveraged to provide a direct-debit option to merchants.
Dan Schatt, a senior analyst at Celent, said that such networks "would cause banks to lose on interchange."
(Signature debit fees range from 0.6% to 1.4% of the transaction plus an additional set fee of around 25 cents, according to Celent. PIN debit fees are usually capped at 30 cents to 60 cents per transaction.)
And no forward-looking discussion of a threatened business model would be complete these days without a mention of Chinese competition.
Several experts brought up China Union Pay, China's largest card network, as a threat to U.S. card networks. CUP was established in 2002, and its cards are already accepted in 10 countries outside China. The company has formed strategic relationships with Total System Services Inc., Citigroup, and Morgan Stanley's Discover Financial Services Inc.
"They are basically establishing a new payment mechanism for one of the fastest-growing economies," Mr. Pascarella said, "but they are no longer only in China. It's certainly something you've got to admire, their aggressiveness and foresight."
MasterCard singled out China Union Pay in a filing with the Securities and Exchange Committee related to its proposed initial public offering. "New competitors may also enter our marketplace from time to time," MasterCard said. "For example, China Union Pay has been established as the predominant domestic card acceptance brand in the People's Republic of China and may seek to expand its acceptance and cash access network internationally."
PROCESSING AND ACQUIRING
Banks' role in merchant processing and acquiring is also under pressure, some say, especially if more retailers start to bring such activities in-house and perhaps opt to provide the services to other merchants.
Celent's Mr. Schatt said PayPal Inc., the San Jose, Calif., Internet payments division of eBay Inc., could, for example, eventually provide credit-card processing to merchants.
"I think there is a possibility of more disintermediation, particularly in the online world, because you have organizations like PayPal that are looking to embed themselves with merchants and offer more than just a payment instrument," he said.
Wal-Mart's attempt to reduce its costs (by bringing acquiring in-house) could lead companies such as PayPal to "develop relationships with whole segments of industries that banks could never reach well," Mr. Schatt said.
When asked if it would consider providing credit card processing to merchans, PayPal said in an e-mailed statement, "There are no plans to do so at this time."
Wal-Mart's action could inspire other retailers, albeit only the largest ones, to take similar steps to save on acquiring fees, some analysts say.
Aaron McPherson, the manager of payments research at Financial Insights Inc. of Framingham, Mass. said, "If Wal-Mart starts doing it, it will put pressure on its competitors to do it."
Mr. McPherson said he could see the 10 largest retailers moving into acquiring and pointed to Target and BestBuy Co. Inc. as potential candidates for such a move.
Mr. Garcia of Global Payments said roughly "half a dozen" merchants could emulate Wal-Mart - though he considered such disintermediation unlikely because of what he considers the high costs of doing the work in-house.
But even if other merchants copied Wal-Mart, the loss to banks would be less in the fees than in the opportunity to collect data on consumers' spending habits - data that can be mined to the benefit of the issuing side of the house.
"Most of the money banks make is on the issuing side," Mr. McPherson said. "While the big banks have been getting back into … [acquiring], my impression is that it's not so much about the fee income, but more about vertical integration. You could see how it could enhance reward programs, which now seem to be the principal means of competition."
Indeed, when it comes to acquiring, Mr. Pascarella said, though a number of banks have recently quit the business, they are starting to realize that doing so was a huge mistake.
"I was very vocal and to some degree critical of banks getting out of the acquiring business," he said. "I believe that they were selling the customer experience at the point of transaction to third parties who didn't have an interest in the relationship."
JPMorgan Chase., Bank of America., U.S. Bancorp, and Wells Fargo & Co. are the banking companies that have most clearly recommitted themselves to the payment process, he said.
"I don't believe they're going to abdicate that again," Mr. Pascarella said.
