Payments and Revenues. Do retail payments really matter to banks?

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1 Payments and Revenues Do retail payments really matter to banks? by Dave Birch Consult Hyperion < Opportunities Banks do lots of things, all of which are affected by the rise of the Net [1]. For example: they manage risk, distribute economic resources and handle payments. So far as the latter is concerned, it s interesting to note that economic theory provides no real rationale as to why banks provide payment services on such a large scale [2], but they clearly do. This has seemed a natural state of affairs, but there is in progress an evolution of new channels for payments the internet, mobile phones, digital TV and so on that may change the dynamics of the sector. The corresponding expectation of new payments products for these media, of which the electronic purse (e purse) is a prime example, means that it is worth questioning whether banks are the right organisations to handle these products. Should banks bother with new mechanisms for retail electronic payment services, or should they forgot all about new digital money technologies and leave them to non bank competitors? The question is far from hypothetical and, certainly in the case of the e purse, worth more detailed consideration. After all, banks may soon be able to drive chip based (EMV) debit card transaction overheads down so that debit cards can be used for transactions under 10 (in many countries 25% of debit card transactions are for less than 10). It s not clear that transactions down at this level can be made economic for merchants, but let s assume that it s possible. This means that banks could concentrate on debit card technology to handle small payments at retail point of sale and leave the e purse to the people who really want it for particular or special reasons: telecommunications and transport operators, for example [3]. This line of argument does not suggest that all other bank payment services be abandoned to competitors. There are different kinds of payment services, for one thing, with very different costs to (and benefits for) their providers. For the purposes of discussion, these payment services can be divided into three different categories: Account based Payments. These are payments from one bank account to another, either by electronic (credit or debit) transfer or by cheque. Also included here are payments from an account to an individual by cash withdrawal at a bank branch or ATM: there were 2.2 billion of these in the UK in 1997, totaling 156 billion. In 1998, 98 billion was withdrawn from ATMs alone. Card based Payments. These are payments made using plastic cards (credit cards, charge cards, debit cards etc) either in person or remotely (eg, mail order, telephone order, internet). There were more than 3 billion such purchases made in the UK last year, accounting for some 123 billion [4]. Hyperion Systems Limited (1999) Page 1 of 5 (This reprint September 29, 1999)

2 Cash Substitutes. The new generation of e purse and micropayment (µpayment) systems intended to substitute for the use of notes and coins. The volume and value of cash substitute transactions are both negligible at present (GeldKarte, for example, has 45 million e purses in circulation in Germany but only around 1% of them are actually used [5]) but they might be expected to grow in the future. It s worth looking at the evolution of these categories to understand the current retail electronic payments landscape. UK Payments In the UK, the last decade has seen a dramatic shift in the payment culture. In 1988, cheques accounted for nearly 56% of cashless transactions and debit cards were just being introduced. Since that time, credit card payments have doubled (although debit cards usage still overtook credit card usage in 1994) and automated payments including credit and debit transfers have increased by 105%. The UK s electronic payment systems are well developed and it has one of the lowest levels of cash in circulation in major economies, both as a percentage of GDP (2.86%), and of Narrow Money M2(4.65%). In addition, it has more credit and debit cards per capita than any other European country. There are an average of 43 card transactions per capita per annum, and only Finland and Denmark (where very different cheque clearing infrastructures are present) have higher levels of payment card usage. Overall, card based payments and account based payments (excluding cheques) account for about 70% of cashless transactions, cheques for about 30%. The UK level of cheque usage is actually quite high. It is well above the EU average (only France has a greater percentage usage) and reflects the maturity of the system in the UK, where the cheque clearing and cheque guarantee card infrastructure is well established and trusted by merchants and consumers alike. Unlike other EU countries such as Spain, where consumers moved straight from cash to cards, there has been little incentive for UK consumers to modify behaviour and cheque payments remain an important part of the payment culture. Cheques are hard work for banks. In the US, nearly three quarters of all cashless payments are cheques yet they account for only 10% of cashless payments by value. In the UK, they account for less than 5%. An interesting contrast is Switzerland, where cheques account for only 1.3% of cashless payments and by value less than 0.1%. Cards, too, are a lot of work for not much money when considered only as payment instruments. In the US again, cards are almost a quarter of cashless payments yet a mere 0.2% by value. Revenue Naturally, discussions of the payment system as a whole are skewed because wholesale credit transfers dominate the value transferred by it. If we consider only retail payments, cards and cheques are obviously a much bigger proportion of the total. Payments relating to goods and services that are produced, sold or consumed within the UK account for 99.97% of the 37+ billion payments (totaling some 39+ trillion) made every year [6]. To put it another way, the whole UK GDP passes through the payment system every six days (by comparison, in the US it is 3.25 days and in Japan 2.5 days). To examine the system in more detail, we must therefore draw a clear distinction between wholesale payments and retail payments. Retail Hyperion Systems Limited (1999) Page 2 of 5 (This reprint September 29, 1999)

3 payments payments initiated by bank customers rather than banks themselves, whether business to consumer or business to business are vastly more numerous and vastly smaller than wholesale transactions. So the payment system is huge but virtually all transactions are small. Who makes a living from this? The top 25 retail banks in the US derive only around 7% of operating revenues from payments. From this one might conclude that it doesn t really matter if, in a world of the pervasive Net access secured by smart cards, the retail payments franchise drifts away from banks to (for example) telecommunications operators or specialist service providers. In fact, this line of thinking goes, if banks were to do away with the distraction of retail payment services then they would be free to concentrate on other potentially more profitable services, such as risk management for electronic transactions. These kinds of services would be not only a reconnection with banks historical origins but are also likely to be in substantial and increased demand in the digital economy. The parallels between merchants trading across continents in the middle ages and merchants trading across the Net today are certainly interesting enough to make this line of argument worth exploring, although not in this article. One of the effects of new technologies will be to extend the reach of the networks currently used for wholesale transfer into the retail domain. Personal computers, the internet, smart cards and public key infrastructure have the potential to provide a transaction platform for the general public hitherto only available to banks. It isn t that far fetched (in purely technological terms) to imagine direct access to national and international payment networks by consumers at home. This isn t necessarily bad news for banks either. Given that around one third of banks costs are related to money transmission (Retail Banking Research, 7/99), the new technologies of digital money are just as important to banks as a means of reducing their own costs as they are to customers as a means of reducing their costs. There s no sign of new channels reducing banks costs so far, so there must be increasing pressure to do this. Is it therefore feasible for banks to handle the higher value and more efficient cashless credit and debit payments through national and international networks and leave the rest (in particular, cross border small payments) to non banks? Despite the figures given previously, the answer must be no. Retail banks have no choice but to invest in the retail payment instruments of the future because of the gap between their payment revenues and their payment driven revenues. Payment revenues might be small, but a detailed analysis of bank income in the US [2] seems to indicate payment driven revenues may be more than one third of operating revenues. What constitutes payments driven revenue, rather than payment revenue, is difficult to quantify. One example is interest foregone by consumers. If consumers keep funds in current accounts to service debit card, cheque and ATM transactions then they are not keeping those funds in deposit accounts. By and large, the less liquid the consumer s funds, the more interest they receive. So current account funds pay less interest than deposit account funds and the interest foregone means increased revenue for the bank. Thus debit cards, for example, contribute far more to bank revenues than merchant service charges. Remember that 40% of European adults have debit cards and that seven out every ten card transactions made by Europeans are debit card transactions: the amount of money kept in current accounts to service these transactions must be vast and the interest foregone correspondingly huge. Hyperion Systems Limited (1999) Page 3 of 5 (This reprint September 29, 1999)

4 Merchant service charges are, in any case, not a highly profitable income stream. There are a large number of card issuers that earn significant interchange fees on card use but a small number of acquirers that earn significant merchant service charges. Acquiring is a volume based business, driven by economies of scale and the margins are thin. Europe is moving towards a single acquiring marketplace, with downward pressure on the fees to be earned through commodity card acquiring [7]. The point here is that interchange income and merchant services charges could be an even smaller fraction of bank income in the future. Challenges Bringing together the discussions from the previous sections, we can define the retail electronic payments sector in the UK reasonably well by excluding CHAPS. CHAPS, while handling a mere 0.4% of clearing volume, accounts for 93% of the value passing through the clearing system. The remaining 7%, plus cards and cash substitutes, is therefore the retail electronic payments sector approximated in Table 1. Subsector Volume Value Account Based Direct credt/debit 3 billion 1,620 billion Cash withdrawl 2 billion 165 billion Cheque 2 billion 1,350 billion Card Based 3 billion 123 billion Cash Substitutes Negligible Negligible Totals About 3 trillion Table 1. The Retail Electronic Payments Sector in the UK. Since banks cannot turn away from this sector, because payments are their portal service and their payment driven revenues are a significant multiple of payment revenues, the challenge is to provide these services cost effectively and efficiently: but provide them they must. If, then, banks are to exploit the new technologies to reduce the cost of providing payment services and they have no choice but to invest in the retail payment services of the future the big question is how best to take the banks approach forward. The use of cash substitutes low at present, but expected to grow is an area where banks are likely to face real competition and therefore finding a suitable bank approach is important. The most obvious examples of the type of competition they will be facing are in the mass transit sector, where substantial card bases can be expected. There are already schemes (eg, Hong Kong) where purse usage is spreading outside the transit system and into convenience stores, vending machines, payphones and so on. The regulatory environment is changing to not only allow but encourage such competition in Europe. The European Commission s proposed Directive on Electronic Money creates a new regulatory construct, the Electronic Money Institution (EMI). The EMI, whose only business is issuing and redeeming electronic value, has much lower capital requirements ( 500k) than credit institutions ( 5m) and must operate within Hyperion Systems Limited (1999) Page 4 of 5 (This reprint September 29, 1999)

5 much stricter investment guidelines than banks do [8]. Rather than abandon the sector and allow the telcos and transit operators to set up their own EMIs, a preferable strategy for banks might be to join with them in creating EMIs. This could deliver benefits across a broad base. It would, for example, allow banks to transfer their digital money, e purse and micropayment strategies away from their confined position within existing bank structures and into a framework where they could develop effectively. If one takes the view that the evolution of the e purse has been hampered by banks natural tendency to handle it as card product (and an unprofitable one at that), then an EMI is an obvious choice as a much better home for e purse operations. Banks retail payment operations would then be released to concentrate on core competencies and businesses, while the EMI would be free to develop new business models and (importantly) new relationships. The EMI could develop acquiring and dispensing relationships with the retailers outside the world of credit and debit acquiring. Banks, after all, don t generally acquire from parking meters or chocolate bar machines and these are just the kinds of point of sale that e purse users want access to. This is why it makes sense for banks to be partners in EMIs, rather than attempt to keep EMIs to themselves. The likely partners BT or Orange or Girovend or London Transport are just the kinds of organisation with both access to the new points of sale and a genuine need for digital money to reduce their costs. In this vision of the future, banks wouldn t give up the retail electronic payments franchise: they would just structure their operations more efficiently in line with the emerging platform for these payments. This way, they stay in the loop. Acknowledgement Many thanks are due to my colleague Oliver Steeley <mailto: for his many helpful comments on the early drafts of this article. References 1. Birch, D. and P. Taylor. Retail Banking in Financial Services & The Internet, A. Hilton, Editor. p.31 52, CSFI (London: 1997). 2. Radecki, L. Banks Payment Driven Revenues in Federal Reserve Bank of New York Economic Policy Review (July 1999). 3. Jones, P. End Games in European Card Review. 6(2): p (April 1999). 4. Plastic Card Review. APACS, report ISBN (London: 1999). 5. Under 1% of GeldKartes in use in Cards International (222) (9th July 1999). 6. Credé, A. Electronic Payment Systems, Electronic Money and the Internet: The United Kingdom Experience to Date. Science Policy Research Unit of the University of Sussex, report (Brighton: June 1998). 7. Howes, K. Cross border acquiring trends and implications in EFMA Newsletter (159): p (May/June 1999). 8. Edgar, L. Payment systems on the net regulating digital cash issuers in Electronic Business Law. 1(3): p.8 10 (April 1999). Hyperion Systems Limited (1999) Page 5 of 5 (This reprint September 29, 1999)

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