Payments in Transition: Where Have All the Changes Gone?
For many years, pundits have been predicting the dawn of a cashless and checkless world and the demise of more traditional transaction methods. In the US specifically, the ‘death of the check’ has been heralded and discussed for at least the last 30 years. The reality is, however, that the uptake of new and improved payments products has been much slower than anticipated. Paper-based manual payments systems are still prevalent and most banks are still using payments platforms and architectures that had their genesis in the 1960s and 70s. Given the broad spread acceptance of personal computers and Internet communication, the question becomes why has the payments industry been so slow to change?
By their nature, financial institutions are inherently conservative and risk averse. Barring regulatory demand, change usually takes place very slowly, almost coming to a complete halt without some strong motivation. The typical drivers for change in banking tend to be cost control or efficiency, customer demand (revenue pressure), and risk control. While each of these areas can be affected by transformation of payments systems, the overall impact of these drivers has been less than impressive, in terms of mandating change.
The foundations of much of the current payments system infrastructure have been in place since the 1960s. As business and consumer demand for financial transactions increased in a post-World War II era the public and private sectors, in the form of banks and central banks, joined together to create an incredibly large and sophisticated infrastructure to manage the flow of paper-based transactions, primarily checks. As volumes grew, existing processes were automated to improve efficiency and entire businesses grew up around meeting the needs of the check-processing industry. The end result has been the creation of a large base of fixed costs dedicated to processing manual transactions. Electronic transactions are arguably more cost effective than corresponding paper-based ones, on a per transaction basis. However, when the costs of supporting the existing infrastructure are included, the business case for change becomes questionable. As will be discussed later, this situation is exacerbated by the fact that few banks look at payments holistically. Most banks operate in silos and have created separate operational entities for paper and electronic payments. This makes it difficult to determine the overall economic impact of changes in transaction patterns and results in continued investment in existing systems that have already reached scale economy, rather than investing in newer unproven payments vehicles and platforms. This situation is changing as maintenance costs for ageing payments platforms increases. But at the moment, banks tend to be more focused on increasing the cost efficiency of their existing payments products rather than making extensive investments in new systems.
The economic situation is complicated by the surprising lack of customer demand for newer payments products. Consumers have been very slow to move from paper to electronic payments. Despite a variety of marketing campaigns by banks, retailers, and trade associations, it has only been in the last year that the volume of retail electronic payments, primarily card and ACH, has equalled that of the paper-based market in the US Businesses have been even slower to change their payment habits. Trade organizations, such as the Association of Financial Professionals (formerly the Treasury Management Association), have made it very clear that checks are the preferred method of payment, at least from the disbursement side of the house. This lack of demand has made it difficult for banks to justify huge investments in new payments infrastructure. Faced with taking the risk that ‘if you build it, they will come,’ banks have again focused on improving the overall efficiency of traditional payments platforms, and only making limited investments in newer systems.
The third potential driver of change is risk control. This can be looked at from several points of view. Firstly, it is the issue of transactional risk control. Banks and corporations have spent significant time and money developing technology and processes to control and manage the risk of check fraud. Although check fraud is a growing concern for most banks and many corporations, few consumers see check fraud as a major issue. By comparison, both banks and consumers are increasingly concerned about credit and debit card fraud. Banks have spent large amounts of time and money developing ways to control the risk of card fraud, but losses continue to climb and consumers’ fears, largely due to growing concern about identity theft, continue to increase. As a result, at least for the moment, transactional risk does not seem to be an adequate reason to radically change payments systems. The second point of view is that of operational risk. The increasing cost of maintaining existing payments platforms may be an incentive to move towards newer and more efficient platforms. As previously mentioned, much of the existing payments infrastructure has been in place for 30-40 years. Although the systems and technology have been updated and modified over time, their overall complexity and the related cost of maintenance continues to grow. Despite the increasing cost, however, the existing systems do work, and as the old adage says ‘if it ain’t broke, don’t fix it.’
While the drivers for change may be mixed, barriers preventing it are significant. Here again we can look at risk, revenue or customer demand, and cost efficiency. In each case, there are factors that create potential barriers to any change barring absolute necessity.
Payments are a core function for financial institutions. Various studies have indicated that payments account for 30-40 per cent of total net banking revenue. Understandably, most banks are hesitant to make major changes to core systems in a big bang approach when so much of their revenue is at stake. The risk of potential failure is just too high. Unfortunately, the same complexity and age of existing systems that increases maintenance costs also makes it difficult to make significant changes incrementally. As a result, major changes in existing systems tend to be deferred if at all possible.
Although referred to earlier as surprising, the lack of customer demand for new and improved payments systems is actually not that surprising at all. Most consumers tend to resist change unless there is some strong incentive to make the change. In the case of payments, one might expect this to be an economic incentive, given that electronic payments should be cheaper and more convenient than the corresponding check-based ones. While this might be a true statement on an all-in cost basis, most customers, whether consumers or corporations, do not see it this way, mainly because there is lack of transparency in payments processing costs in the banking industry. Very few bank customers see the actual cost of check writing as a disbursement method. Rather than charging transaction fees, most banks recover their costs through a combination of float and exception item service charges for check writers and deposit charges levied on commercial customers. In fact, many US banks have extensive ad campaigns around variations on the theme of totally free checking. Even for commercial customers, the per-transaction or ‘penny price’ for individual checks is rarely equal to its true cost. This apparent subsidy of check writing by the banking industry provides customers a strong incentive to stay with their traditional habits of writing checks, while check receivers bury their costs in the prices that they charge the end-users.
This lack of transparency is also an issue within most banks. As previously mentioned, most banks are highly siloed when it comes to payments platforms. Very few banks have the ability to look at payments as a whole and have difficulty apportioning costs and revenues across various payment channels and platforms. As a result, decisions are often made based on an incomplete understanding of the impact of change on all payments products. While free checking may be viewed as a needed prerequisite to maintaining demand account balances, electronic transactions are fully charged, resulting in an added customer disincentive to change. Additionally, investment decisions are often made based upon the relative size and importance of the payment channel, rather than on the long-term strategic interests of the financial institution. This tends to favor existing payments systems and platforms that have already developed scale volume.
Finally, from a cost efficiency point of view, payments processing is a highly complex network system. This is especially true in the US, since there are a large number of financial institutions that clear payments. In large systems of this type, participants are highly dependent upon the actions of other network participants. One bank cannot change to a more efficient method of processing payments unless a significant number of the other participants make a similar change. As a result, in a variation on the traditional concept of ‘The Prisoner’s Dilemma’ in gaming theory, the network tends to suboptimize and discourage change. Since everyone can process checks, we continue to process them and there is little movement towards more efficient payment methods.
While the economic transparency of our various payments systems is unlikely to improve any time soon, end-users are finding other reasons to demand incremental, if not overnight, change. Decades of such incremental changes have already had significant effects on both check and electronic payments systems. Over time, we have gradually built an electronic infrastructure that can effectively parallel existing paper-based systems. The increasing age of the existing systems will eventually force a transition as maintenance and operating costs continue to increase. Regulatory issues, such as Check 21 in the US, image processing mandates in parts of AsiaPac, and pricing harmonization in the EU, will only accelerate the rate of change.
We may never see a totally cashless and checkless society, but the transition to more integrated and automated payments systems is happening. Rather than the revolution in payments that was once predicted, we are in the midst of an evolution, a slow sea change that will occur without most of us ever realizing that there has even been a change. How we get there is perhaps not as important as the fact that we will eventually get there. And by then, the pundits will be predicting even more radical changes.
This article is reprinted with permission from the Capco Institute, publishers of the “Journal of Financial Transformation”.