With online and back-office payments processing systems becoming increasingly accessible, Dan Barnes asks whether banks can retain their grip on this fundamental area of business.
This financial quarter it seems that branch banking is back in vogue. A number of banks in the US and Europe are fighting to differentiate themselves by changing their models of front-end customer service. This is partly indicative of a drive to cut costs by sharing more back-office processing and a push to increase sales through improved customer service. But whether point-of-sale, back office or online, banks are not only struggling with their traditional rivals for a share of the market.
The true threat to both retail and wholesale banking is that retailers are beginning to take processes that traditionally required the involvement of financial services organisations and carry them out themselves.
Two retailers in particular spring to mind: US giant Wal-Mart and web-based auction house eBay’s online payments provider PayPal. Taken side-by-side they are unlikely bedfellows, the world’s largest retailer and the online payments start-up. Yet both are in the payments game. They are doing what banks do (or have tried to) in specific areas without the corresponding overheads from other sectors, such as branch banking, which banks have tried to remove.
Back in the dotcom days, many banks had a go at the online payments game. Citigroup with C2IT and PayDirect from HSBC/Yahoo are two good examples. But none made a real success of the business, the two above closing in October 2003 and October 2004, respectively.
Rival stays afloat
A rival to these, PayPal, had set sail in the same era (founded in 1998) but kept afloat where others ran aground. It had its fair share of difficulties, such as being threatened with patent lawsuits, shareholder lawsuits and class actions typical of the ‘I’ve lost all of my assets – call my lawyer’ dotcom era.
However, following its first reported profits in 2002, PayPal was promptly snapped up by eBay, which kept it moving. Banks had also realised in those years that the move to branchless banking was not going to work and they began to reopen – or at least stop closing – their branches.
PayPal now has 105 million customers worldwide and its growth is strong, with total payment volume up 45% year on year as of 2005. Geoff Iddison, European CEO of PayPal, told The Banker that he was adamant that his organisation intended to remain a partner of the banks rather than a competitor. “We fit directly between banks – any user has to load money from a bank account to a PayPal account,” he says. “We transfer that money between PayPal accounts but the user then transfers that money to another bank account to obtain it.”
Cutting costs and delays
By holding customers’ financial data securely, transactions are essentially carried out in a single pool of liquidity, cutting out delays and charges for interbank transfer. At a recent Centre for the Study of Financial Innovation (CSFI) event on payments, one attendee recounted discussing this concept with a banker, who pointed out that competition prevented banks themselves from creating any such thing. That did not stop many of them from spending several years trying to get into the business. Mr Iddison is keen to stress: “We are in the business of mediating between financial services organisations – not dis-intermediating them.”
However, it is interesting to look at how far this mediation could be pushed back. An individual could have their wages transferred from a company bank account into a PayPal account, then transfer funds to other PayPal accounts (for example, to that of a landlord or to pay for groceries) and not have to liaise with a bank. The latest PayPal offering of micropayments by SMS (mobile phone messaging) has taken it from the virtual world and on to the high street. The use of a mobile phone for making micropayments has been discussed for years by traditional payment providers but few have succeeded in building a viable system and these have often been restricted to specific geographic areas.
In the case of Wal-Mart, the US company has applied for an industrial bank licence in the state of Utah, enabling it to process payments internally rather than use an external bank. Alan Whitchurch, the bank’s president and CEO, said: “We have filed this application so that Wal-Mart can capture the costs currently paid to third-party financial institutions for the processing of debit, credit and electronic cheque transactions.”
Who can blame it? Retailers and corporates regularly complain about the service and other charges that banks apply. As a cost-cutting exercise, it appears to make sense, although figures to confirm this will be difficult to obtain until the company’s bank has been running for some time.
What has been interesting is that many critics (often local community banks) of Wal-Mart’s application are afraid that it will open branches. But adding the cost of providing both front and back office may not be the most efficient route for the company’s operations. It has a huge amount of payments traffic from its retail outlets and enough scale to outsource payments processing from smaller banks, allowing them to cut their back-office costs while Wal-Mart avoids adding front-office overheads.
A precedent to this type of activity, as noted in the June edition of The Banker, is the Chilean telecom carrier Entel, which is providing back-office banking for three medium-sized banks. One participant, Banco Internacional, is looking for a cost/income ratio improvement of 15%. By using the expertise of consultancy DMR and software from core systems provider i-flex, Entel is running a core banking business. The implications for business models are massive.
Enabled by IT
At Boston Consulting Group, senior partner Nick Viner believes that the very core of payments processing via a bank – that is, the absorption of transfer risk – is increasingly being taken on by non-banks, thanks to IT tools. “Technology allows and simplifies authentication, something that was a significant strength of the payments business,” he says.
He points to another commercial model adopted by a retailer: UK-based Tesco has become a front office for banking. “It realised that it had much more contact with the customer than banks did at branches, and that some customers found the prospect of doing their banking at a retailer attractive. You can increase customer loyalty and run some fairly sophisticated CRM [customer relationship management],” he says.
Tesco Personal Finance is a joint venture with Royal Bank of Scotland (RBS), which provides the back end. RBS Group also has interests in online payments, running the merchant online payments company Worldpay, since acquiring it from Santander in June 2002. Simon Fletcher, integration communications manager at Worldpay, stresses his own organisation’s non-bank status but does not see an influx of non-banks harming the traditional players while overall business is on the increase.
“The payments business depends on very large volumes of transactions to make the business model feasible,” he says. “Happily, the indications are that the volumes of card payments are on the increase, particularly with the rise of the internet as a shopping tool – so the business certainly looks set to continue being viable for those involved in it.”
However, he envisages a growing opportunity for new players to become involved in niche parts of the business. “What we are seeing in the payments market now is an evolution of the operating model. It’s no longer just about acquirers and issuers,” he says. “It’s also about processors, acquirer-processors, network providers, multi-currency specialists and so on, each of which will play a part in creating more flexible, converged platforms that can cater for all types of payment – ecommerce, physical, contactless and whatever else. In this more complex, flexible model, new opportunities for mediation are being created all the time.”
Business value grows
The cake is not getting smaller, but there are more slices to be cut from it. Mark Sievewright, corporate senior vice-president, market development, at core systems provider Fiserv, says the current value of the payments business in the US alone is $200bn “with the top five players controlling 75% of the market”.
More specifically, the portion of this created by retailers that could be affected in any large move by them toward internalising payments is $30bn, he says. “This was spent by the top 50 retailers in what I call money transmission, but is really payment processing, and those top 50 drive 40% of all retail sales. Frankly, with margin squeeze in the retail space – particularly for a company like Wal-Mart that operates on razor-thin margins – there is a real issue here.”
PayPal claims its payment volume for 2005, the total value of transactions, was $27.5bn. It is fair to say that the retail industry sector is running a significant portion of money transmission internally. The more established payments industry is also suffering external pressures, such as probing by the regulators: a recent European Commission (EC) investigation into payments cards found that some EU countries had Mastercard and Visa interchange fees that were double those of others, and business fees varying up to 650% for Mastercard and 500% for Visa. The EC claimed that certain players were “preventing competition from developing”. This would seem to be an uncomfortable squeeze.
Few people in the industry believe that banks can leave payments alone. Andy Coulter, business development manager at Computer Associates, says that perhaps the level of work involved was making banks think twice about staying in the transactions business.
“I can see why you might say that and, as far as the cash management part of the business goes, there’s a lot of changes in appetite but very few [banks] want to relinquish their relationships with corporate retail customers, due to the other services they provide on the back of this core service,” he says. “But the technology is there for some corporates to provide certain functions that they would have had to pass on to their financial services partners previously.”
Convoluted processes
Mr Coulter says that the challenges to keep the business operating at an economic level are unique to each organisation. Overly convoluted processes and tools are a common barrier, however. “The traditional players will have to address the costs inherent in their business. It will be different for each one but many will have to look at the complexity of their systems so they have the ability to move to a more efficient way of working. That could be consolidation or system replacement,” he says.
“To take advantage of any new opportunity that opens in the market they will all have to have simpler architectures that also provide lower maintenance costs and lower risk.”
Pressure on established pricing and models, disintermediation from consumer payments and a limited ability to react are a potent combined force upon a vital cash-flow artery for the finance industry. Although the high street may appear to be the frontline, there is fighting throughout the field.
