What Can DDA Lead To?
by Kenneth Cline
Banking Strategies, BAI
November 10, 2004
Payments experts set big-picture issues aside and urge banks to focus on building value for the deposit account.
The gradual shift from paper-based to electronic transactions creates a host of new business opportunities, but also raises a few fundamental questions: How do financial institutions protect their customer relationships as consumers gravitate toward real-time, electronic payment forms increasingly provided by nonbanks? Who will have the leverage in this new era of payments?
For insights and answers, Banking Strategies turned to some of the top payments consultants. The following Q&A presents the highlights of an animated discussion that quickly centered on the critical role of the demand deposit account (DDA) in a bank's payments strategy. Rather than viewing their payments offerings from a siloed perspective in which separate products are valued for their individual revenue streams, banks were encouraged to focus their resources on the functions that serve to bind customers more tightly to the DDA.
"The ins and outs of payment settlement systems are only relevant to a handful of large institutions and industry associations," says Andrew M. Dresner, vice president, First Manhattan Consulting Group. "The real issue is the same as it's always been: how do you attract and keep deposit customers?"
For Carl Rutstein, an officer with Boston Consulting Group in Chicago, the key to growing DDA-based revenues is to make more effective use of the customer data that can be obtained from payment transactions. "How do you use that transaction flow to attract deposits and loans? To date, no one has really done that systematically and effectively, in part because of technological issues, but mostly due to organizational barriers."
The consultants discounted worries that banks are in jeopardy of losing control over the payments system per se, given that banks still make the rules that govern the players, both bank and nonbank. "Banks very much set the operating rules and determine the playing field," says Tony Hayes, Boston-based managing director for Dove Consulting.
Steve Ledford, president of Atlanta-based Global Concepts Inc., pointed out that while banks no longer dominate specific businesses within payments, such as credit card-acquiring, "these are largely businesses that banks chose to exit."
However, Steve Mott, principal of BetterBuyDesign in Stamford, Conn., raised some concerns about banks losing control over payments networks, particularly in the online environment. On the Automated Clearing House network, for example, "lots of things are being done that banks don't have much control over, such as pricing and who uses the system."
A major threat to banks in the online payments arena comes from fraud. "Payment fraud is about 15 times higher in the online world than offline," says Avivah Litan, a Rockville, Md.-based vice president and research director for payments at Gartner Inc. Noting that banks have little incentive to change that situation as long as the liability burden rests on merchants, Litan warns that continued "phishing" attacks and other forms of electronic fraud "threatens the future of online transactions like online banking, bill payment and shopping."
The following roundtable was convened at BAI's TransPay 2004, where all six participated in a panel discussion on the future of payments.
Banking Strategies: Are banks losing control of the payments system, and is this something individual institutions need to be concerned about?
Litan: I personally think that statement is really overblown. I don't see anyone going into the payments system — in terms of clearing and settlement — other than banks, who are the only ones authorized to do it. Certainly, we've seen the advent of value-added services and new ways to move in and out of the banking system, but they don't pose real threats to banks.
Dresner: I'd agree. Over the last 15 years, we've had warning after warning that companies like Quicken, CheckFree, Yodlee and PayPal would disintermediate the banks. Yet none of those companies currently threaten banks' fundamental control over the payments system. They can play an important role in the system, but banks still control the underlying customer relationship.
Mott: But I think the potential exists now, particularly in the online environment, for banks to start losing control over how their networks are being used. On the Automated Clearing House network, for example, lots of things are being done that banks don't have much control over, such as pricing and who uses the system. Banks have associations like NACHA to provide rules and policies, but in many cases, the users have moved ahead of those policies.
As the world drives relentlessly to real time, guaranteed payments, users will figure out which banking network will help provide that. And if the banks don't, the merchants will find a way to do it themselves.
Ledford: When we say the banks are losing control over the payments business, we have to ask: did they ever actually control it? And to the extent it was control, was that necessarily a good thing?
There are definitely bits of business that the banks no longer dominate, credit card acquiring, for example. But these are largely businesses that the banks chose to exit.
In the future, you'll see both banks and nonbanks becoming dominant in some elements of the business, but it will be hard to tell the difference. These players will become dominant players because the more electronic you get, the more you can achieve economies of scale. But I don't see it as a bank vs. nonbank issue.
Mott: The underlying economics won't support the payments operations of 9,000 banks. So you're going to have tremendous concentration over time. If you're a $1 billion-asset bank with a small portfolio of payment products, you've got to be worried about what's happening to you. Those institutions don't have any control.
Hayes: It all depends on how we define control. If we define control in terms of who the players are, I would agree banks are losing control. If we define it as who's establishing the rules by which everyone plays, then I think banks still very much set the operating rules and determine the playing field.
Rutstein: To the extent that payments all revolve around the demand deposit account, and the DDA is something banks alone have access to, banks aren't in danger of losing control. They can always claw back pieces that they have outsourced if it's strategically important.
For example, CheckFree Corp. had a dominant share of the online billpay market. But large banks are now starting to pull that back in-house. When something begins to erode the economics or competitiveness of bank DDAs, banks will start to exert control.
Dresner: That's happening with PIN debit networks as well. Now that First Data Corp. controls STAR via the Concord acquisition, some banks are transitioning to industry-controlled networks.
Rutstein: That's a great example. Big banks would rather work with Visa than First Data for this strategically important, DDA-related transaction. It's mostly economics, but the banks also see First Data as a competitive threat. Wells Fargo & Co., U.S. Bancorp and others have re-issued Interlink cards.
Litan: PayPal comes to mind too. PayPal is acquiring merchants that banks don't want to acquire. And as soon as banks decide they want to acquire those merchants, they'll come up with the rates to accomplish that.
As Tony said, it really depends on the definition of control. My definition is: who sets the rules? In the end, banks have the last word.
Ledford: Some of the most profitable areas of the payments business, like balances and fees, are still controlled by banks. For the typical bank that doesn't want to become a category killer in payments, this is a good deal — you get the account balances and fees and the relationships associated with the account, and somebody else is willing to do the hard transactions work for almost no margin.
Banking Strategies: How do you see the Check Clearing for the 21st Century Act (Check 21) law impacting various segments of the industry?
Ledford: The most enthusiastic supporters of image-based clearing are very often the small banks. It's because they can do it. It's real easy for them. And since they don't like clearing checks, they want to get on with imaging so they can make money at what they do best, which is lending to small businesses and consumers.
Hayes: When discussing Check 21, most people just focus on the check side of the equation: when and where to image the paper? But Check 21 will impact the payments world more broadly.
Check imaging at ATMs will transform this channel, allowing more ATMs to accept deposits, since they no longer need a daily pickup by an armored courier, and it will create new businesses around check cashing. Also, when consumers write a check at the store and it's handed back to them, they'll soon stop writing checks and move to card-based payments. So ironically, by making check processing more efficient, we may accelerate the demise of checks!
Litan: Check 21 can level the playing field across participants in check processing applications, and commoditize bank services along the way.
For example, it can shift more power to the corporations, the enterprises and the retailers. When corporations start imaging their own checks, they no longer have to pick their bank based on location and proximity.
Dresner: Proximity is a key issue. Every other time in this industry that transactions have moved from paper to electronics, we've ended up with a massive concentration among a handful of big banks or nonbanks. The same thing will happen when check processing becomes fully electronic because the need to be physically close to where the checks are presented will disappear.
I don't think check imaging levels the playing field in the sense that smaller banks can now compete for big national accounts. On the other hand, I don't think that's particularly relevant to a small bank. As long as the costs go down, they're thrilled. They're only interested in the DDA balances in their communities; everything else is cost to them.
Ledford: Small banks, for the most part, don't see themselves as being in the payments business. Payments are sort of a background service they must provide to keep their customers happy. They want the DDA balances, the lending relationships.
Mott: But all this technology and change means small banks are going to have to work harder to manage that DDA in the future, because consumers want more flexibility, more ways to do things, with the DDA.
Dresner: I'm not sure of that. If you look at what small banks are using as their technology base, it's all off-the-shelf software and generic outsourcers. All the money that the big banks have invested in Internet technology has not resulted in any material shift in share toward them. In fact, our research shows that small banks have actually been gaining share in consumer core deposits.
Being the leaders in deploying that technology brings, at best, a temporary increase in market share. Vendors eventually match it and it's available to all the small banks to keep them competitive.
Ledford: One of the things we've discovered in some of our research is that payments are very personal. People have preferences, often for no rational reason. And very few banks do a good job of satisfying all those preferences. That plays to a niche strategy, which small banks are very good at.
Rutstein: That's a good point. It's important to remember what Check 21 is and is not. It doesn't mandate image capture or exchange; all banks have to do is accept the image replacement document (IRD), which fits into existing IBM sorting machines.
The business case for Check 21 really lies in lower transportation costs for paper checks, since the customer proposition is suspect and the economics are very light. But that only represents about a 1% improvement in DDA profitability. So I think, in general, that Check 21 is a big distraction and a lot to do about nothing.
Dresner: The last time we looked at it, item processing at a typical regional bank was about 4% of noninterest expense. So if you cut that by a third, you haven't gained a massive advantage in your ability to re-price, especially since all your competitors have just got the same savings in their infrastructure costs. Basically, the benefits will go to the consumers, not the banks.
Rutstein: In absolute terms, it's real money. But relative to a top 20 bank's economics or even the economics on the DDA, it's not that significant. You can't turn that into higher interest rates or premiums to get customers to shift share.
Litan: Twenty years from now, when we look back at Check 21, I don't think we'll see it as a great thing for the banking industry. It reminds me of the breakup of the AT&T monopoly, which was good for consumers but not for the phone companies.
Check 21 will be really good for corporations and retail customers because of pricing pressure, more choice and increased competition. But in the end, it will probably be a bad thing for the banking industry.
Ledford: I think it's going to be very good for the banks that take advantage of it. That's really the key.
Litan: Yes, there will be a few winners.
Banking Strategies: Beyond Check 21, what other forces at work out there do you see having the greatest impact on the payments business?
Hayes: Right now, debit is the big growth category. It has been growing at over 20% per year, and will likely continue to grow at that rate.
The battle between the two debit products, PIN and signature, continues in terms of differential pricing and acceptance. But we're also seeing a lot of convergence there. The speed of settlement is converging between the two products, as are acceptance and price. Additionally, a lot of innovation in the payments world is with debit-like products, such as prepaid cards, payroll and money transfer cards.
From a bank point of view, many institutions are developing and implementing payment strategies to convert their customers from writing checks to using debit cards. This converts a cost into revenue. We'll see more movement to real-time, electronic payments that tie back to a transaction account. And invariably that transaction account will be managed by a bank or credit union.
Dresner: The one thing I might disagree with is that the banks won't necessarily dominate some of those stored-value product areas. With payroll cards in particular, the battle is not over. Banks are trying to issue them, but they tend to be limited by geography when it comes to serving the big national employers. Some of the payroll companies could easily dominate, if they ever get their act together. A number of nonbank players are targeting that market and other stored-value niche markets that the banks have just ignored to this point.
Hayes: Gift card is obviously dominated by retailers, and probably will remain so.
Banking Strategies: So how do the economics of this affect the banks?
Rutstein: In the migration from paper to electronics, it's not the cost side that's important, it's how institutions leverage their payments business to get a wealth of information from their customers to grow the revenue side. How do you use that transaction flow to attract deposits and loans? To date, no one has really done that systematically and effectively, in part because of technological issues, but mostly due to organizational barriers.
The banks that leverage that powerful transaction flow will have a lot of interesting things coming out of payments beyond just trying to lower costs.
Ledford: Picking up on what Carl just said, I think financial institutions are going to start thinking about payments as more of a business and using the disciplines that have been used in other businesses, like understanding your customers. That means actually trying to give customers something they want as opposed to trying to figure out how to get customers to take what you offer. That kind of thinking is new in the payments business.
Dresner: With the exception of credit cards, there is a distinction that one needs to make, however, between expecting payments to generate material profits on a stand-alone basis vs. treating them as just one component of an overall value proposition, typically on a DDA account.
The typical returns on most variations of payment products are modest when compared to the total revenue of banks. For example, if you get the DDA account, that's worth about $220 a year to you. Even if the payment product itself is marginally profitable, or underwater to a degree, it may be worthwhile if you can have an impact on your account acquisition or retention.
Litan: When considering the future of the payments business, I look at the retail world very differently from the corporate world.
On the retail side, sellers are offering choice for payments and really driving change in the payments market, not consumers. The Wal-Mart suit shows how retailers are frustrated by the high rates and the monopolistic approach of the credit card associations. You'll see the credit card rates go down and the debit card rates go up and everything's going to converge and get commoditized.
The other thing I see happening in retail payments is a de-coupling of authorization and authentication of customers from guarantee and settlement of the payment. Money moves in the most efficient way and that will be de-coupled from how you authenticate a customer and authorize a payment and guarantee it.
In the B2B world, I think the payment is almost irrelevant. The key issues are purchasing, price breaks and the time value of money. It's not about how you make the payment, which is the least important part. And so banks will become less important in that whole value chain because they're not managing the information.
Ledford: On the B2B side, change in payments occurs not because somebody comes up with a better way of making a payment, but rather because somebody comes up with a new way of buying. If folks start buying things online, they will use payments that are appropriate to that.
Rutstein: You'll find bigger and bigger banks in the B2B space not worrying so much about the direct P&L of the payments piece, but instead trying to get the loans and deposits and other parts of the financial supply chain of their corporate customers, like payables and receivables services, where they'll make a lot of money. Costs of providing payment services are falling and competition will move these services to commodity pricing in highly fixed-cost businesses. So the only real economics play is to use payments to grow the relationship, not as a stand-alone, high-margin revenue source.
Dresner: Payroll cards provide a good example of that. Some of the nonbank vendors say they have trouble competing with the banks on the big accounts because the banks want the cash management relationships. Payroll cards are just one additional service banks can use to tie the customer to a long-term relationship. It's very hard as a nonbank to make a return on those big accounts when you're competing against that kind of value proposition.
Mott: One size surely doesn't fit all anymore. And I think the corollary to that is you can't just do an isolated piece of value; it's got to be an integrated piece of value to really resonate with the changing needs of buyers and sellers.
Banking Strategies: One downside of electronic payments is more and newer ways to commit fraud. How serious a threat is fraud in this arena?
Hayes: The risk on paper checks far exceeds anything in the electronic world. As we move to more electronic transactions, with more ability to authenticate customers and verify funds in real time, the incidence of fraud on a percentage basis will actually decline, rather than increase.
Ledford: Fraud has always been an issue in payments, but we come up with ways of dealing with it. Remember back in the late 1980s and early 1990s when we were getting close to 20 basis points of fraud on credit cards? We found some very effective ways of dealing with it.
Mott: The adage in the payments business has always been, manage your risk to less than 2% of problems with whatever transactional system you have and you'll probably make some money. But as the technology change accelerates and the fraudsters take advantage of that, you do have to work harder to keep the risk under 2%.
Litan: I would agree that the banks have physical world fraud under control, except in the new account area. Payment fraud is about 15 times higher in the online world than offline, but the banks, frankly, are not that incented to fix it as long as they don't have direct liability for it.
The responsibility for solving fraud in the online world is decentralized across thousands and thousands of merchants. And because of the way the rules are set up, at least until "Verified by Visa" and similar programs take hold, fraud can even bring in revenue for credit card issuers. They have no liability; if a merchant reports more fraud, the issuers simply jack up the fees.
But something has got to be done soon with widespread electronic storage of consumer bank account numbers and the threats imposed by hackers stealing this data, sometimes using innocent-looking e-mail communications with customers. We just did a survey that said 57 million Americans, and that's probably understating it, have received an e-mail phishing attack, and over 90% of those attacks arrived in the past year. That's undermining the credibility of the communications channels, so it threatens the future of online transactions like online banking, bill payment and shopping.
Banking Strategies: What advice would you give to bankers to help them negotiate through this new world of electronic payments?
Rutstein: First, figure out your payments economics and the business case to leverage the information. Second, be very careful about pushing the decision-making down too low in the organization, where people can't see the ramifications across the various silos. A very big bank can easily have people doing things which may be good for their own silo but bad for the overall institution.
Third, concentrate on where you make money and have a sustainable competitive edge. And finally, focus on using the payments business to actually grow deposits, loans and other profitable product areas. Use the fact that you're inside the transaction to know your customer better and present them with something that actually releases value and gets them to consolidate their wallet.
Dresner: Except for a handful of players who compete on scale, the real issue is creating value propositions for the deposit account. The ins and outs of payment settlement systems are only relevant to a handful of large institutions and industry associations.
The real issue is the same as it's always been: how do you attract and keep deposit customers?
Hayes: I agree. Viewing payment systems as products is too one-dimensional. They're actually access vehicles to the DDA.
Litan: The information age is well upon us, and we're seeing a power shift to the customer.
Ledford: I've seen a lot of bad decisions made because of bad information, either bad information about where you really do make money, or bad information about what your customers will and will not buy. You really have to dig for the good information.
Mott: To survive and thrive in the transition to a digital lifestyle, financial institutions should focus more on what their customers want them to do instead of what they're comfortable doing.