SEPA: Why Should Banks Take a New Approach to Direct Debit?
The single euro payments area (SEPA) is an ambitious project for Europe and one that will have far reaching implications as the European Union works to create an economy that operates on single market principles.
Unsurprisingly, a project with such towering aims and consequences has created an enormous volume of discussion and a general air of confusion among European banks, vendors and city analysts. While the financial services community recognises the need to address the issue of SEPA, it is only slowly progressing from discussion to implementing solutions. One of the key reasons behind this lack of action is that many banks do not have a sufficiently matured understanding of the implications and opportunities of SEPA. One area that is of concern is how SEPA will affect direct debits, with much industry analyst evidence suggesting that banks have paid scant, if any, attention to the implications of the legislation on this payment instrument.
As the financial services industry moves from theoretical discussion of SEPA to practical realities, it is essential that the full implications are appreciated in order to formulate plans appropriate to the new environment. For the direct debit instrument, SEPA means that any SEPA creditor (originator) can obtain a direct debit mandate from any SEPA debtor and be able to process, clear and settle the transactions with a six-week deadline for disputes. The deadline for this was originally 1 January 2008 but with the delay in approving the Payments Services Directive (PSD), the direct debit will also be delayed.
The change to the risk model for direct debits is without doubt the most critical implication of SEPA’s introduction, as SEPA brings with it new risk factors while simultaneously highlighting low-level risks associated with legacy direct debit schemes that will be intensified in a SEPA environment.
The direct debit payment is operated with asynchronous clearing. In other words, while ideally the transaction should follow the logical clearing then settlement sequence, the reality is that direct debits are settled first with the originator (creditor) being credited ahead of the debtor’s account being debited. A delay of one or more days then follows before the funds are actually cleared from the debtor bank. If funds do not clear, the banks must retrospectively attempt to debit the originator (creditor), which leaves the creditor bank with credit risk during this period.
Furthermore, should the debtor subsequently challenge the validity of the direct debit, the debtor bank will automatically refund the debtor’s account, initiate a corresponding debit transaction on the creditor bank and challenge the creditor bank to demonstrate authorisation for the direct debit mandate. By doing so, the creditor bank is subject to a significantly increased credit risk and also administration risk over an extended timeline.
The new factors that will influence bank risk as a result of SEPA stem from the provisions of the PSD and the allocation of risk laid out in the European Payment Councils (EPC) scheme rules. In comparison to some of the existing national legacy schemes, the new SEPA principles significantly alter the allocation of risk among the various bank participants and require both consideration and a proactive preventative response from banks.
From these frameworks, it can be seen that risk increases for each individual bank on the basis of the implicit increase in inter-bank formality associated with the SEPA rules. The structure of the rules together with the penalties and incentives given therein to the various participant banks, lend themselves to a very rigid and inflexible interaction between what will, with SEPA, become a dramatically increased number of bank contact points. In response, banks will require complex systems to ensure rule compliance. This will be for each bank’s individual operations and to validate direct debit rule compliance of the many third party banks, which SEPA obliges the bank to interact with.
The impact of these risks on banks even extends beyond the potentially serious credit consequences. Such events also create brand risk, administration risk and fraud risk exposures for banks. Furthermore, when banks suffer such events the response is often manual and highly time-consuming, which in turn can itself be error-prone. Risk management and exception response is an integral part of every bank’s payment operations and direct debit justifies an equal amount of attention as other payment instruments in this regard.
The direct debit is a somewhat neglected payment instrument, with trust concerns historically hindering usage and poor corporate-to-bank interfaces meaning many businesses view direct debits as extremely admin intensive. These external factors have been coupled with the fact that the banks themselves rarely viewed direct debits as a competitive payment product. With the financial implications of SEPA on bank profit margins being recognised as a highly significant concern, a change in attitude to direct debits could prove lucrative.
Direct debits have steadily increased in volume and popularity. Being able to manage this growth within existing payment systems has not been particularly onerous for banks. To date, developments within the direct debit instrument have been insignificant, as national borders limited the innovative influence of product competition. Service improvements did occur but were minor; an example in some countries was providing debtors with online access to their direct debit mandates, usually restricted to simple cancellation functionality. Now that SEPA will make the direct debit payment process much more competitive, banks should reconsider how they position this payment process within their wider business model.
This becomes even more essential when considered against the backdrop of the estimated cost of SEPA compliance to the European banking industry with TowerGroup suggesting €8bn while Accenture is predicting €3bn for the top 90 banks alone. These costs pale in comparison compared to the €29bn these same observers predict the industry could lose from their payment revenues. With such an impact on the bottom line, banks must plan how they will effectively adapt their payment processes and systems to meet regulatory requirements while simultaneously making adjustments to their business objectives to find innovative ways to increase revenue from unconsidered sources.
In many countries, the poor standard of direct debit service provided by banks has led to a majority of originating corporates employing the services of bureaux or third party service providers who act as intermediaries to the banks. Banks have to-date struggled to compete in this value-added space between themselves and the originating corporates. Upon the introduction of SEPA, banks have an opportunity to reconsider how they wish to handle the direct debit process and reflect on whether seeking a specialist provider and/or outsourcing partner would increase their competitive advantage and profits from direct debits.
How banks choose to handle the direct debit process will further be affected by an additional threat opened up by SEPA, which is one that has been mooted as a general knock-on effect for all SEPA-related transactions. That is the potential for a few banks or other institutions to convert themselves into highly competitive specialised payment factories. Such institutions would thrive from the ability to undercut the existing market by offering advanced payment products at minimised cost margins where profit is achieved through sheer scale volume.
For corporate direct debit creditors, the use of such payment factories would be a very attractive cost saving and functionality enhancing measure. For individual banks, the ability to compete on a cost and product basis could be extremely difficult.
It can be seen that financial institutions face considerable challenges in terms of both the core requirement to be able to process and manage SEPA direct debits, and the associated business challenges that SEPA raises. As such, SEPA has meant that direct debits have suddenly become one of the more complex payment instruments for banks to offer. Effective and efficient ways to handle them must be an imperative and, with the deadline for compliance now extended beyond 1 January 2008, banks have more time to make sure the direct debit process is addressed properly and a strategy implemented.