Hoping to drive down costs, banks are trying to transform the way they settle payments by promoting a shift to electronic transaction processing.
However, while banks are expecting to improve their bottom line by making their payment businesses more efficient, the effort will also clearly affect the top line.
Yes, it’s less costly to process payments digitally, and the transactions will settle more quickly, so banks will receive their funds sooner. But some industry watchers point out that the switch could also mean a reduction in fee income associated with traditional paper payments. Another more modest hit is expected as faster settlement reduces float and the benefits associated with banks’ use of customers’ funds.
And even though bankers were probably aware that their efforts would have some revenue effects, some detailed forecasts are beginning to show that the transition could be bumpier than they might have expected.
“You have to look at the big picture, and the big picture shows that banks are going to start losing revenues from payments,” said Adam Dener, a partner in the New York office of Capital Markets Co. NV, a consulting and technology services firm that uses the brand name Capco.
More than 40% of banks’ nontrading income comes from the fees associated with supporting customer accounts, he said — in 2002 such fees generated $25.6 billion. And interest on customer deposits generated $33.6 billion for banks that year. These are two of the most important sources of revenue for banks, and “we’re talking about a big threat to both areas,” Mr. Dener said.
The most significant driver in this trend is the shift away from paper. Consumers who have embraced online bill payment are routing many of their monthly payments through the automated clearing house network instead of writing checks. Billers have further contributed to this transition by converting hundreds of millions of the checks they receive into ACH payments at the lockbox, using the accounts receivable conversion format.
And the Check Clearing for the 21st Century Act will probably exacerbate this shift when it takes effect next week. The law is expected to further reduce check volume as banks begin to convert paper checks into digital images and transmit them across image exchange networks.
Banks note that transmitting images will be far cheaper than using the current system of armored cars and charter planes to move checks around the country every night. By one estimate, imaging technology could carve out $2 billion of annual cost savings for banks.
And while those savings may take years to realize, ACH payments, which cost just pennies to process, are leading to cost savings now.
Leonard J. Heckwolf, the senior vice president and product head for ACH and retail lockbox operations at J.P. Morgan Chase & Co., the largest ACH originating bank, said the long-term cost reductions that come from using the ACH system are far more important to a bank’s bottom line than the potential declines in fees and float.
When a bank shifts to an electronic processing environment, “the payback is significant,” Mr. Heckwolf said. “A more efficient payments network is better for the payments economy.”
He acknowledged that fee income could go down in the short term. “I think it can be properly managed, but there is risk.”
However, Mr. Dener contends that there are hidden costs in the shift from checks to ACH payments. For starters, banks can charge customers more for processing checks than for processing ACH payments. Even if the overall volume of ACH transactions is increasing, and driving up bank revenue from ACH payments, “it’s still just a fraction of the fees they can charge for checks,” he said. “The check is one of a bank’s most profitable services.”
Furthermore, because ACH payments typically settle in just a few days, compared to checks that can require several additional days, the money will be moving out of the paying banks faster. A large proportion of these payments are from consumers to businesses, many of which have savvy and aggressive treasury management programs to transfer funds out of standard bank accounts and into higher-yielding vehicles.
Mr. Dener said a shorter float period will deprive banks of float interest. Over all, he expects the banking industry’s ACH transaction volume to be increasing annually by 15% by 2010, versus the 13.2% compound annual growth he measured between 2000 and 2003.
And though a 15% annual increase would drive up banks’ annual ACH revenues by $6 billion, he also predicts a $11.3 billion decline in check fees, and a $670 million hit to float income, for a net loss of $6 billion.
Mr. Heckwolf, who is also the chairman of Nacha, disputes this conclusion. He said that ACH payments have a higher profit margin than checks at JPMorgan Chase, and that the shift away from paper will generate a net revenue increase on every item. “The bank is very comfortable that this transition can be managed profitably,” he said.
And Mike Herd, a spokesman for the Herndon, Va., electronic payments association, said that a study it completed in 2003 found that a paper check converted into, or replaced by, an ACH payment would lead to a net income increase of 2.2 cents for the originating bank. Per-item revenue may go down, but costs go down even more, he said.
Nonetheless, Mr. Dener said these analyses miss the larger issue of lost income opportunities. “Banks make more money on checks than they do on ACH.”
An item that may the biggest unanswered question is how insufficient funds fees will be adapted in the shift to electronic payments. Banks charge customers $3 billion a year for bounced checks, and “NSF is one of the most profitable” fees in banking, Mr. Dener said.
Some banks have already agreed to temporarily forego this income for at least a little while by agreeing to temporarily waive bounce fees while customers adjust to the new system.
There are some who say it is possible the fee may all but disappear over time, although such voices do not seem to constitute a majority at this point. Under this view, the market will continue to evolve until images are not just immediately captured, but routed across a network to be verified by the bank. If the funds are not present, the merchant could refuse to accept the check, and the consumer would be spared the expense of an NSF penalty.
This is exactly what Visa U.S.A. is doing now with its Visa POS program, according to Dan Yagow, a senior vice president with the San Francisco card association. Merchants that use the service scan checks at the point of sale and create an electronic file containing the magnetic ink character recognition data. This file is routed across the Visa network to authorize the check; banks that have set up the proper links to the network can verify, in real time, that the accounts are valid and the funds are available.
Only 13 banks have set up the connections to support this type of authorization, and only about 15% of the Visa POS check transactions are verified against the customers’ accounts, Mr. Yagow said. (The other checks are verified the traditional way: against negative databases.)
But he also said that the number of returned checks that are verified against a negative database is 10 times higher than “when we can take a check all the way to the bank” for verification.
Vijay Balakrishnan, an executive vice president at the Alpharetta, Ga., imaging technology vendor Alogent Corp., said that banks and merchants could set up a similar system to route check image files to a bank for real-time verification.
“I definitely see a move to straight-through processing” in a way that could include real-time verification, he said.
And Avivah Litan, a vice president at the Stamford, Conn., research and consulting firm Gartner Inc., said that when merchants can instantly verify a check, fewer consumers will write bad checks “If you can get a balance in real time, it will eliminate NSF.”
Some banks generate as much as 30% of their checking account revenues from NSF charges, she said. “It’s a very lucrative field.”
However, she said that some online banking systems let customers set up bill payments even if there are not enough funds in their accounts. Also, customers who set up recurring bill payments could be zinged if they don’t have enough to cover the payment when the biller initiates the transaction.
“The NSF fee is the same whether it comes from a check or an ACH,” she said.
Ms. Litan predicted that if banks lose one source of fee income, they would find ways to recoup the lost revenue.
John Kline, the chief operating officer of Union Savings Bank of Danbury, Conn., agreed with her prediction.
“I think there will be an impact” to bank fees and revenue as banks shift from paper to electronic payments, but even if interest on float and income from fees decline, “banks will find opportunities to make money with new types of fees,” he said.
