The New War in Electronic Payments

  The payments business is under attack. For banks and their credit card businesses, the availability of more types of electronic payments to consumers is irreversible. It also should be worrisome.
  Our research shows that as technology plays a larger role in the payments business, the organizations that are savviest about technology often are not the established full-service banks.
  Looking at the innovations and the market leaders in the U.S. payments industry over the past 25 years, we found three distinct trends in the evolution of payments and in the use of payment technologies, trends that can be seen as taking place in different parts of the payment-value chain.
  In the 1980s, nonbanks such as First Data Corp. began buying banks' payment-processing businesses and used technology to bring scale (and, thus, price advantages) to this business.
  In the 1990s, the payments innovations centered in banks' front offices-functions such as sales, marketing and services responsible for finding, acquiring and serving customers. A new monoline bank, Capital One, was created inside Signet Bank in 1991 by an outsider to the institution, Richard Fairbank. Fairbank pioneered the use of technology to crunch data for tailoring credit card offers to individuals instead of larger consumer segments.
  Cap One later pioneered the balance-transfer account, which funneled consumer debt from other credit cards to a Cap One card with a better interest rate. The company has exploited technology and generated enormous wealth, last year generating a $1.5 billion profit on $4.8 billion in revenue.
  Another monoline bank, MBNA, pioneered the affinity credit card. MBNA in 2004 had $2.7 billion in net income. (Bank of America in June announced plans to acquire MBNA. The deal was expected to be finalized in the fourth quarter.)
  Over the last decade, the focus of payments innovation has been at the cash register and in the payment product itself. Merchants such as Wal-Mart Stores Inc., Target Corp. and Walgreen Co. have been irate about rising interchange and for good reason: it is eroding their slim margins.
  In response, retailers have been encouraging customers to use PIN debit instead of signature debit, converting checks to automated clearinghouse transactions and even participating in independent debit card networks such as Debitman, which processes PIN-based debit card purchases through the ACH system.
  Is the $24 billion in annual interchange fees in the U.S. really at risk? Should banks be concerned about it or any of the threats that technology poses to their lucrative payments businesses, which for some is responsible for up to 40% of total income?
  The answer is yes. One only needs to look at the market standing of key players in the business over the last 10 years to understand the perils.
  In 1994, the bankcard industry was highly fragmented. After Citicorp, with a 15% share, the market leaders had small shares: MBNA, 7%; AT&T and First Chicago, each with 5%; and First USA, Household Bank and Chase, each with a 4% share.
  Fast forward 10 years and the picture is different. Four institutions-J.P. Morgan Chase, Citigroup, MBNA, Bank of America and Cap One-control three-quarters of the bankcard market. Two of them, MBNA and Cap One, together command nearly a quarter (23%) of the market, the same size share as that of Chase.
  Given the impact that non-traditional players such as monolines have had on the industry, what is to prevent other innovative newcomers from stealing shares of the credit card business in the years to come?
  Over the rest of this decade and beyond, not every bank can expect to stay a leader across the payments value chain. We believe banks must choose at least one of the following three strategies to remain competitive in an era of electronic payments: Become a scale provider of payment services, integrate consumer banking products across product lines or innovate at the point of sale.
  Strategy Options
  The first strategy calls for becoming a scale player. But how much scale?
  Competing on scale will not be a strategy for every bank. Even some of the largest will choose not to do so because of the huge and ongoing technology investments this business will require.
  The second strategy-integrating banking products on behalf of consumers-over time will be critical for full-service banks to survive the withering attacks on their credit card businesses.
  Besides overcoming the technical hurdles to doing this (each financial product typically is supported by its own information system), the bigger question is how to link banking products in ways that delight consumers and keep them using the bank's checks and credit and debit cards. Imagine, for example, the ability at the point of sale to help a consumer spread his purchase across his demand-deposit, credit card, home equity and other accounts.
  In this way a bank could, in effect, become a financial adviser, a service for which it might be able to charge a fee. Doing so would mean bringing the sophisticated debt-financing practices of large companies to the individual consumer.
  The third strategy that banks can pursue to protect and increase their payments business is a radical departure for many. It is based on the premise that the information about a payment is more valuable than the transaction revenue itself. Banks could use their payments information to improve how they sell their own products and how retailers promote their products to consumers.
  The airline industry discovered this in the 1980s with their computerized reservation systems. Airlines such as American and United made huge profits from providing information about flights, in some years generating greater profits from their systems than from flying airplanes. American Express has been known for years to segment its cardholder database, looking for opportunities to sell travel-related products and services.
  Cross-Selling
  Banks could follow the lead of companies such as Wells Fargo in using payment data to cross-sell payment and other financial products. Wells Fargo sells twice as many financial products to its consumer customers as does the average bank (4.5 versus 2). Its goal is to sell an average of eight products to each customer, a target it achieved with 12% of its banking households in 2003.
  Cross-selling financial products can be highly profitable. Wells Fargo generated $672 million in after-tax profits by selling additional financial products to its mortgage customers in 2003, profits above and beyond its hefty earnings on the mortgages themselves.
  The retailers we spoke with during our research said the place banks hold in the purchasing value chain is one that gives them valuable information and exposure to consumers before they visit a store. Just before entering a store, a consumer often will take cash from an ATM, cash a paycheck at a branch, check on a deposit online or phone a bank call center to check on a deposit. Thus, the bank is often the last place the consumer goes before entering a store.
  Retailers such as Best Buy believe that banks, by leveraging their consumers' purchasing data, could help them drive traffic to their stores. Of course, consumer privacy must not be sacrificed. But banks have a unique opportunity to sell important aggregated data to retailers, to create joint marketing campaigns with non-competing retailers (which would reduce each merchant's marketing costs), and to make other money off their payment data.
  The electronification of payments once again will reorder the industry. Banks that can recognize the opportunities and pursue them quickly and smartly will maintain and increase their lucrative payments businesses. And by leveraging payment data in ways that add great value to consumers and retailers, they may make even bigger fortunes from whole new payments businesses.
  Carl Hugener is a partner and Larry Lerner is a principal in DiamondCluster International's financial services practice. This article is based on the authors' study "Banking on Payments: Protecting and Extending Banks' Electronic Payments Franchise." The free report can be downloaded from http://www.diamondcluster.com.
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