The changing payments landscape

FST. What’s the next big thing in payments for banks and consumers?

RL. It will be more flexibility and more choice. It’s actually part of the same trend we’ve been experiencing in banking for the past 20 years, but the pace is accelerating. In the recent past, we migrated from check to telephone banking to home banking. Now we’re on the verge of another innovation with mobile banking. Consumers will be able to make secure payments from wherever they are with any portable device anytime. It’s analogous to the revolution taking place with television. DVR devices like TiVo take away the time constraint – consumers can view their own programs on their own schedule. At the same time, devices like SlingBox take away the location constraint – consumers can view their home TV from a laptop or mobile device connected to the internet. For TV – and payments – it translates into greater flexibility and more choices for consumers. It’s going to get very interesting.

FST. What about Peer-to-Peer (P2P) or Account-to-Account (A2A)? That is often touted as another payments innovation that will change the payments business.

RL. A2A or P2P will refine the payments landscape sooner rather than later. An estimated 10 percent of all checks written are to individuals, and there just isn’t a good alternative right now. Home banking allows consumers to initiate payments electronically, but most of the payments to friends and family end up as paper checks. Emerging payment mechanisms, such as PayPal, work for individuals, but lack the safety and security implicit in existing payments infrastructures. Support is building for a bank-supported A2A solution for three reasons: First, it’s clear that individuals want an electronic way to pay each other. Second, A2A supports financial institutions’ objective to reduce the number of paper checks processed as the cost of supporting that infrastructure increases. And third, a bank-supported A2A solution reaffirms the central role of banks in the payments process – where safety and soundness are core attributes, secured through Federal regulation and FDIC insurance.

FST. You mentioned mobile banking. When do you see it taking off?

RL. Mobile banking is in its early stages, but there is no turning back. Mobile banking is unfolding in two dynamic ways. First, financial institutions are providing balance and transaction information to customers so they can monitor account activity. Second – and this is not yet a reality – mobile banking will soon include using a cell phone or PDA to make purchases at the point-of-sale by scanning the device at the checkout, much like the “no-swipe” credit cards do now. This capability will evolve to allow funds to be deducted from bank accounts – for point-of-sale purchases and for transferring A2A payments. In short, the marketplace is fluid right now, and there is a lot of healthy testing and adjusting going on. It could be another success story for banks, both in terms of satisfying customers and generating revenue.

FST. Since The Clearing House operates wire, ACH, check and check image systems, you are in a unique position to see how volumes will evolve. What will happen in both the short- and medium-term?

RL. In the short- and medium-term a number of trends are driving growth of all types of electronic payments. First, the global economy continues to expand. And, with more prosperity, more money changes hands. Second, the velocity of the money exchange is accelerating. As companies turn over inventory faster, money turns over faster as well. Consumers, meanwhile, are making more transactions with debit and credit cards, instead of going to the ATM or paying by check. They don’t think twice about buying a cup of coffee at Starbucks with a debit card. That also accelerates the exchange of money, because those transactions are completed in real time. Third, we’re seeing a significant adoption of check truncation and check conversion processes, which is greatly reducing the number of paper checks being processed end-to-end as paper items. From the point-of sale, back office, and teller window – everyone is starting to truncate paper as early in the process as possible. As a result, check image growth will continue to outpace everything else combined, and NACHA will continue to look for new opportunities to expand check conversion.

FST. How much more cost can be wrung out of the payments process for banks? Are we halfway there or almost there?

RL. We’re about halfway there in reducing the number of checks processed end-to-end as paper because of the success of image exchange and the ACH. For 2008, The Clearing House forecasts a 40 percent increase in image exchange volume, with a total send and receive volume to exceed seven billion items. For 2007, total volume was 5.6 billion items – more than triple the volume of the year before. And, at some point, the industry has to eliminate end-to-end paper processing all together or it will be stuck with a big expense. Without incentives or other means, four to five billion checks each year will still need to be processed the old way, which will be a very expensive proposition given the declining economies of scale.

FST. Bankers are focused on electronic payments, but the effort seems to be moving slowly. What should be done?

Banks are moving at a deliberate and appropriate speed, given the risk inherent in change and a century of established business processes. Banks, like the rest of the economy, are dealing with infrastructure that has grown up over many generations. Banks, corporations, third-party processors, and government regulators all have significant investment in the existing process. While it is tempting to say, “Let’s start from scratch,” that’s neither practical nor possible. The disruption and cost would be massive. In fact, banks are identifying areas where innovation can be introduced. Those efforts have succeeded typically because market forces are working in conjunction with investment cycles.

FST. Non-bank payment providers continue to erode the market share of banks. What, if anything, should banks do to respond?

RL. For many years, technology and innovation were the purview of only the largest banks, which typically served the largest markets. Over the past 10 years, falling technology costs have led to more experimentation across the banking industry. That is very good and healthy, and it presages an exciting round of innovation. As an industry, however, we need better mechanisms, such as The Clearing House’s Strategic Payments Forum, to help banks keep track of emerging trends and to assess competitive threats. In particular, the industry needs to look closely at the ramifications of innovations occurring at the margins, which are typically the entry point for new non-bank competitors.

FST. What other payments challenges do banks face in the near future?

RL. The soaring cost of regulatory compliance will likely trigger the next wave of industry consolidation and change. More and more banks – particularly mid-tier institutions – can’t afford the burden which can absorb hundreds of millions of dollars each year and is among the fastest growing costs within banks. Worse, it has no explicit value to customers and provides no offsetting increase in revenue. While regulation and compliance are important to our industry, a new model is needed for sharing costs and information to deal with such issues as knowing your customer, preventing money laundering, and thwarting terrorist financing.

FST. How are independent and mid-tier banks faring in introducing payments innovation and streamlining their payments operations?

RL. Although there are some very notable exceptions, mid-tier banks are in a tough spot. The industry looks like a barbell, with 250 large banks on one end and many thousands of community banks on the other. Institutions on either end are in relatively good shape – the big ones have investment capital and staff to implement innovations, and the smallest ones rely on outside providers that can afford to innovate because of aggregated volume. The banks in the middle don’t have the scale to make the technology investment, but are big enough to control most of their own processing – and incur the associated expense. The mid-tier banks are getting squeezed.

FST. Fraud continues to be a major problem for all institutions.
Strategically, how should banks think about this problem as electronic payments grow?

RL. There has been a philosophical shift in banks’ thinking about fraud. Bankers wisely have realized that pushing fraud from one institution does not stop the problem, but instead causes fraudsters to modify their scams and attack again at their bank or somewhere else. Therefore, rather than withholding information from other institutions for fear of losing competitive advantage, banks are now working together to thwart scam artists. The cooperation occurring at BITS is a model for the industry. Senior bankers from major banks are collaborating regularly on a fraud task force to inform each other of the latest schemes. Working together with the US Secret Service, FBI and other law enforcement authorities, banks are drawing the noose tighter and the results have been good. We need to build on this momentum.

FST. What does the global financial services industry need to do to address the tangle of conflicting standards around the world? Which existing standards do you think banks should support?

RL. Since the Tower of Babel, the world has not had a single language – and we shouldn’t expect to have one now. We don’t even have one global standard for electricity, which seems much less complex than moving trillions of dollars around the globe each day. The focus should be on data compatibility. That is, we accept the differences in core standards in each region or country, but ensure that there are common data elements in those standards that can facilitate the posting and reconciling of payments. If we can abandon the one-size fits all approach, we have an opportunity to map standards and eliminate friction in the global payments system. Industry players such as The Clearing House, Federal Reserve and SWIFT can play a leadership role in helping to facilitate compatibility.

Rick Leander can be reached at rick.leander@theclearinghouse.org.