The global financial crisis has made all of us revisit the basics of banking. A better understanding of the importance of payments to a bank's overall health can help bankers manage customers' behavior for greater long-term profit.
Since the very beginning of deposit banking three centuries ago, people have kept surplus money in accounts, like checking accounts, that provided immediate access to their funds even when less liquid accounts like CDs, notes and bonds offered far better interest rates. Customers are paying the bank the difference between what they are earning in liquid accounts and what they could earn elsewhere, for the ability to quickly access their funds. This liquidity premium accounted for fully one-third of bank revenues in 2007. And when various service fees, and the premium for credit card loans and overdraft coverage are added in, the business of providing consumers with the banking infrastructure to make payments of various kinds accounted for 65% of revenue.
While these industry-wide numbers remain remarkably consistent over time, there is substantial variation among individual banks in the percentage of their total revenues that are payments related, from a low of 43 percent to a high of 75 percent among the top 12 U.S. banks. This variation is significant, because we have found that in normal market conditions banks with both a high percentage of their revenues related to payments, and a high profit margin on those revenues, tend to be more highly valued by the market over time. Investors tend to value stable, low-risk income streams over other sources of bank revenues
Further, our analysis shows that there is great variation among banks in their payments profit margins, just as in the extent of their payments-related income. Although U.S. banks with assets of more than $1 billion achieved a profit margin of 35 percent, that average includes institutions with margins as high as 48 percent and as low as 6 percent, reflecting different combinations of business mix, economies of scale, and the degree to which the banks have focused on optimizing their payments franchise.
The wide range among banks in the two factors that correlate with good market performance - the percentage of payments-related business and the profitability of that business - means that for most banks there is an enormous opportunity for improvement. In our work with banks over the years we have found that the most successful payments banks do three very important things. First, they manage core banking business - deposit taking, lending and payments - by integrating previously free-standing lines of business like credit and debit cards into an overarching retail organization.
Second, they have sharpened focus on "the business of payments" by implementing payments councils as well as creating payments czars - executives with the authority to drive common measures, metrics, and strategies across organizational barriers.
Third, they seek to understand total customer value to the bank and tailor offerings, pricing, and service levels accordingly, going far beyond simply aggregating customer data across products and accounts. Many banks, anxious to avoid unnecessary risk, have reverted to taking across-the-board actions to re-price and reduce exposure - actions that not only may prove counterproductive, but also may actually increase their legal and regulatory risk.
Most important is for banks to develop a rigorous procedure for measuring, managing, and then optimizing their payments-driven revenues and margins. Without a shared, statistically accurate understanding of how customer payments behavior affects both sides of the bank balance sheet and income statement - a payments P&L in other words - it is hard for banks to make an integrated payments strategy effective.
The next step is to apply this understanding at the retail level to specific customer segments. For example, heavy cash users are less profitable for banks than otherwise identical customers who use debit cards at the point of sale - not just because of lost interchange revenue on the transactions, but because of lower average account balances and ATM-related expenses. This perspective changes the economic case for targeted incentives to encourage this segment of customers to use their debit cards for purchases.
Relatively modest improvements in payments-driven revenues and costs across thousands or millions of accounts can bring big numbers directly to the bottom line, improving overall profit and market value. In today's environment, payments profitability optimization is one of the best uses of scarce bank resources.