R E V E N U E ENHANCEMENT: REFRAMING THE VALUE OF DEPOSITORY ACCOUNTS

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1 R E V E N U E ENHANCEMENT: REFRAMING THE VALUE OF DEPOSITORY ACCOUNTS A Mercator Advisory Group Executive Brief Sponsored by PULSE October

2 About PULSE PULSE, a Discover Financial Services (NYSE: DFS) company, is a leading debit/atm network, serving more than 4,400 banks, credit unions and savings institutions across the United States. The network links cardholders with ATMs and POS terminals at retail locations nationwide. Through its global ATM network, PULSE provides worldwide cash access for Diners Club and Discover cardholders through hundreds of thousands of ATM locations. The company is also a source of electronic payments research and is committed to providing its participants with education on emerging products, services and trends in the payments industry. PULSE offers a full range of payment solutions, including ATM network services, PIN and signature debit products, credit products, stored value card programs and PINless bill payment. And all PULSE network participants benefit from the DebitProtect fraud detection system, the most extensive system of its kind to be implemented at the debit network level. For more information, visit 2

3 Table of Contents Executive Summary...4 Consumer Outlook and Trends...4 A Regulatory Environment Like No Other...5 Communicating the Value of Financial Services...6 Issuer Best Practices...6 Portfolio Optimization...8 Deeply Understanding Demographics...9 Some Things are Clear, Others Not So Much

4 Executive Summary Debit card issuers today are faced with managing their portfolios under the combined weight of economic and regulatory pressures unheard of in the modern payments market forcing financial institutions to do nothing less than reshape their legacy business models. At the same time, consumers are embracing pay now product forms, sparking both product innovation and new market entrants. The push-pull effect of these dynamics is serving to provide both opportunity and risk in a debit card market where only thing one can be certain, which is that no one issuer of any kind or any size can be confident in what s coming next. On the positive side of the market, the forecast for debit card transactions and payment volume continues to be good, with most analysts agreeing that a range of 8%-10% YOY annual growth for the next few years at least is entirely realistic. Since most debit card transactions represent everyday spend, the near term challenge for issuers will be to migrate more cash payments to debit card payments. At the same time, strategies to boost debit card payment volume will also need to focus on migrating check payments to debit card payments. While credit card usage has declined dramatically, there are some indicators that the market may have bottomed out, which means the window of opportunity for debit card issuers to stake a claim in the market is beginning to close. Millions of consumers have been affected by the downturn in the economy either through unemployment, underemployment, and the drop in household wealth or any combination of these situations. Circumstances have converged to create a new consumer who is more frugal, more aware of where and how they spend their money, and who require access to financial information in ways they haven t needed in the past. The emergence of the new normal consumer has also served to drive non-traditional financial services providers into the market as they attempt to leverage consumer dissatisfaction with financial institutions and introduce their own brand into payment markets. The key issues that debit card portfolio managers face in today s highly charged and still volatile market require a strong focus on the issuing institution s core market competency, a clear understanding of their competitive market, the consideration of value-based fee models, along with consistent communications across the myriad communication channels they have to manage every day. Modern consumer places a high value on immediacy and relevancy, regardless of the product or service they are purchasing, and this includes financial services. Debit card issuers who will be most successful in this market environment will be ones that connect to their customers and members on an emotional level with products and services that offer real value and demonstrate their ability to support consumers to reach their financial goals. Consumer Outlook and Trends For the past decade, the outlook for debit card payment products has been strong and debit card usage trends going forward indicate that while 20%+ compounded annual growth rates may not be sustained, consumers will continue to expand their use of debit cards, as one can see in Exhibit 1 below. This underscores the value of the 4

5 convenience and availability of debit card payment forms as well as consumer s preference for electronic payment methods in general. Exhibit 1: Debit card trends indicate sustained growth opportunities $2,000 $1,500 $1,000 $500 Signature Debit PIN Debit Total Debit $- In bils est. Source: Nilson Reports, ATM & Debit News, Mercator Advisory Group, 2010 At the same time, the debit market has evolved in such a way as to support two new major product strategies in the form of prepaid cards and alternative debit options. Prepaid cards in particular, are beginning to have a larger impact on the market as their share grows, since the majority of these types of cards are of limited purpose, onetime use, or infrequently used. However, open-loop general purpose reloadable (GPR) and payroll cards do tend to support their use as pseudo-depository accounts and the exclusion of these cards from interchange regulation in the Durbin Amendment is likely to boost their profile even higher. A Regulatory Environment Like No Other The first decade of the 21 st Century will go down in history as the period when a new era in financial institution regulations and practices has been put into place. The economic recession of 2007 has served to upend the American consumer and create a new financial market where consumers freely shop for professional services, use payment forms on an ad-hoc basis, and have access to more information than ever before about the financial institutions they do business with. Beginning in earnest with the Consumer Overdraft Protection Fair Practices Act of November 2009 and culminating in the Dodd-Frank Bill which contained the Durbin Amendment, financial institutions, and debit card issuers in particular, have been asked to do nothing less than transition their business model from one based on interchange and exception fees, to one based on the value of the depository relationship in its entirety. Consumers who have long benefited from access to no or low cost financial services are also being asked to shift their behavior and participate in paying more of the cost of the services they consume. 5

6 Communicating the Value of Financial Services This new change in the manner in which financial institutions have to model their services requires that issuers develop a focus on their core competency, as outlined in Exhibit 2. Exhibit 2: Financial institutions create market value through their core competency differentiator The Retailer Broad Product Portfolio Superior Service Niche Banks Branches are stores Encourage consumers to shop for services Innovative products Product performance Relationship oriented Customer knowledge Personalized solutions Serve a specific constituency Create channel primacy Source: Mercator Advisory Group, 2010 Understanding this primary competency is a key component of creating value-based pricing models which serve to encourage consumers to choose services based more on their personal value rather than price. As the U.S. financial institution market grapples with migrating free checking account business models to a for-fee model, these strategies will become even more important since non-traditional financial service providers regularly charge for their services and therefore, the market runs the risk of creating a price-competition which ultimately may have the effect of undermining the industry as whole. Issuer Best Practices In an age in which communication happens so fast itself can serve to randomize experiences and perceptions, a strong online banking identity is a key component of most highly successful financial institution brands. This can take the form of a completely unique online identity, such as Redneckbank.com or a unique online account identity such as Momentum by Frost Bank. In addition, the prevalence of social media and the rise of the social networks require that financial institutions are especially careful to establish loyalty at the institution, rather than the product level. Engaging consumers and connecting them emotionally to the brand is a hallmark of modern best practices. 6

7 Exhibit 3: Relationship Loyalty means the financial institution itself becomes the product Source: Mercator Advisory Group, 2010 The difference in overall relationship value between a casual user and a power use can mean the difference between an average number of debit card transaction per month and at least one debit card transaction every day of the month. Therefore, establishing relevancy to the consumer can translate into a high-value relationship. Another example of where this relevancy becomes apparent is in the area of Personal Financial Management or PFM. PFM is being quickly embraced by the market as one of the next big things in mainstream financial services. We agree that PFM can be a highly valuable service for a bank or credit union to offer. It serves to encourage consumers to see their financial institution as their partner in money and reinforces brand value on an everyday basis. It also offers the service provider an almost unparalleled view into consumer payment behavior preferences and habits, which is a treasure trove for product development and marketing strategies. At the same time however, it requires no small amount of care and feeding by consumers and also may not represent the broad population of consumers who see their personal financial management on a smaller scale. Therefore, we also consider the following to be components of the PFM market: PFM through Social Networking where financial institutions establish and maintain blogs that provide help and advice on financial management matters. PFM through the Online Banking Experience where simply providing account summary, bill payment, and basic transaction reporting offer consumers an easier entry point for their financial services management. PFM for the New Savers where savings goals and tracking can be established, which can be especially effective if combined with bonuses or rewards for saving milestones. 7

8 While Personal Financial Management may be attractive to consumers, for many it is also aspirational, therefore, providing an entry point that requires less effort, such as promoting online banking and bill payment, may be an effective PFM strategy as well. Portfolio Optimization Debit card portfolio optimization is best managed by focusing on three main activities: 1. Penetration within the depository account base. 2. Activation by consumers who are issued cards. 3. Utilization by consumers who activate their cards. We characterize these activities using the concept of a Value Wheel, where each of these strategies is looked at both individually and collectively. Interviews with leading issuers and product experts around the country have yielded common practices that can serve as a roadmap to portfolio optimization. Penetration Best Practices 1. Evaluate screening process and recalibrate at least annually. 2. Shop your closet to define new cardholders. 3. Establish a goal and track/incent to it. 4. Convert ATM card users. 5. Offer personalized cards. 6. Establish a decline offer feedback loop. 7. Create a check-free product that is not a down-sell. 8. Consider small business debit. Activation Best Practices 1. Educate consumers consider instant card issuance or in-branch card pick up. 2. Create a new card sweepstakes (quarterly). 3. Make activation easy and accessible. 4. Allow self-select PIN. 5. Establish regular touch points until card is activated. 6. Offer bonus or reward that is larger the sooner the card is used at a POS. 7. Build a personalized outreach program. 8

9 Utilization Practices 1. Focus on the first 90 days of account lifecycle. 2. Reinforce zero liability to promote online utilization. 3. Emphasize cash back features. 4. Optimize authorization strategies. 5. Offer transaction tracking and reporting online. 6. Develop sweepstakes tied to ticket size. 7. Consider merchant funded discounts and local shopping. 8. Benchmark loyalty programs. 9. Encourage or incent employee engagement to reinforce card value. Understanding Demographics - Deeply The granularity of account analysis that is currently taking place in the market is being mainly driven by issuer s near-term need to understand their portfolio s profitability. However, this exercise should also serves to yield important and valuable information about the make-up of accounts, their depository account interactions, and payment scheme usages. The result can be a roadmap leading to the market opportunities that are present for any issuer, no matter how large or small. Some of the main growth areas we see taking place in the market now and in the near future are: Hispanic Market which will soon represent more than 49M individuals in the United States (according to the U.S. Census Bureau) and is already garnering attention by the financial institution market primarily through payment approaches targeted to unbanked/under-banked segments. However, this strategy may serve to miss the value in this market to depository institutions since it also represents a higher sustained constituency of employed individuals and entrepreneurs. Micro Business Market which is often hidden behind a consumer curtain, but recent estimates by the Bureau of Labor quantifies the market at 9 million businesses. More dependent upon traditional credit cards and debit cards to manage their spending, a strategy that offers single owner businesses hybrid products and financial services migration paths can also serve to establish an emotional connection between an individual entrepreneur and their service provider. Unbanked/Under-Banked Market which is just now coming into focus, thanks to recent studies by organizations such as the FDIC, CFSI, and Pew Research. Once relegated to the fringes of financial services providers, this segment represents pockets of opportunity, but products need to be designed specifically for them and take into consideration some of their unique characteristics. 9

10 Some Things are Clear, Others Not So Much Financial institutions facing the challenges and opportunities present in the current market are well served to maintain a sure focus on their organization s specific needs along with the characteristics of their individual market. However, in general, there are a few major themes that bear consideration across these segmentations. First, regarding challenges: While overdraft regulation is now in effect and we are seeing the near-term market results, the effect of the Durbin Amendment, as well as the Consumer Financial Protection Bureau, is still very much unknown. The Durbin Amendment has the potential to disrupt much of the core business model in which the debit card issuing and acquiring market operates. The CFPB on the other hand represents a sustained oversight of financial services products for decades to come and each change it may introduce will have to be assessed on its own merit. Non-traditional financial service providers are continuing to expand in the market as we see alternative debit providers reach the next stage of market development. We would anticipate that new alliances will be formed for some of these providers and all traditional debit issuers should take care when considering such alliances in order to make certain their brand equity is protected. Consumers are still wary and have access to more ratings and review tools than ever before. Consumer confidence in traditional financial institutions continues to be fragile and if social media holds one challenge and opportunity for many issuers, it is in the area of consumer communications and customer service. A missed education or communication opportunity may not present itself again. Consumer attention spans are limited and each interaction a financial institution has, whether it is in a branch, a call center, or online should not be wasted. Continually reinforcing debit card features and functionality can serve to improve each of the major categories of portfolio optimization. On the other hand, opportunities in the market are never that far away, including: Understand and embrace your core competency, then use it to build your brand identity. This strategy allows your resources to be targeted towards your best customers, which are those consumers and businesses that will provide sustainable value to your organization. When determining how to set fees, consider the value of your services and price (or not) accordingly. Establish your pricing models in such a way as to encourage account holders to select your services based on the value to them rather than just the price. 10

11 Knowing your demographics on as granular a level as possible will be a key component to growing your portfolio in a highly competitive market. Consumers have come to expect that financial services meet their specific needs, which requires a deep understanding of their payment and account management behavior. Think of Personal Financial Management as a series of events, not necessarily a single tool which allows you to offer services that support savings, bill pay, and online transaction reporting for example. This lets your accountholders ease into what can be a daunting task, yet reinforces your partnership in their financial services lifecycle. When defining new fee schemes, rewards programs, or new services, make certain to establish metrics and measure against them. The market for financial services in the United States on one hand has never been better. Product innovation is taking place at a rapid pace and consumers are in need of products and services that help them understand their finances, but which also can be used whenever and wherever they need them. The headwind generated by an unfavorable economic environment and increasing regulatory oversight however requires that financial institutions take a measured and cautious approach to addressing the changes taking place in the market. For many organizations, the market is forcing them back to the fundamentals of continually educating consumers on the value and benefits they have always received from the traditional financial institution industry. Copyright Notice External publication terms for Mercator Advisory Group information and data: Any Mercator Advisory Group information that is to be used in advertising, press releases, or promotional materials requires prior written approval from the appropriate Mercator Advisory Group research director. A draft of the proposed document should accompany any such request. Mercator Advisory Group reserves the right to deny approval of external usage for any reason. Copyright 2010, Mercator Advisory Group, Inc. Reproduction without written permission is completely forbidden. 11