Payments in Europe: a Tower of Babel with Construction Problems

The business of payments involves far more than the transaction of money using cash, cheques, credit cards, direct debits, and transfers. Also integral are the instruments needed to make a transaction, such as the transactional accounts that companies and consumers keep as well as the liquid balances – whether positive (deposits) or negative (overdrafts and credit card loans) – that payment users must hold in order to be able to transfer value.

By this definition, Europe’s payments business is a large industry in its own right. With total revenues amounting to €125bn,¹ it is bigger in Europe than airlines, mobile telecommunications, or pharmaceuticals, and only slightly smaller than the chemicals industry.

Exhibit 1: Payments are one of Europe’s Major Industries, but Often Remain Hidden

* Germany, France, United Kingdom, Italy, Spain, Netherlands, Belgium, Sweden, Poland
Source:IMS, Eurostat, WEFA, Euromonitor, McKinsey’s Payments Practice

But although payments represent about a quarter of European banks’ operating revenues, they also account for more than one-third of the banks’ operating costs while generating less than 12% of their overall profits. Owing to this imbalance between cost and revenues, payments have a negative effect on banks’ cost-to-income ratio of about 8%.

Where Does the Money Come From?

Payments revenue comes from five main sources:

1. Transaction revenues. These are the fees directly linked to the execution of a payment. They can be levied both on the sending and the collection side, either as a fixed amount per transaction or as a percentage of the transaction value. Examples are the merchant commissions on card payments and fees paid for credit transfers.
2. Float revenues. When money is in transit between two accounts, both payer and payee forgo the interest. This creates a de facto income for the banks. This float revenue can be split between technical float (i.e. the time it takes to process a transaction) and value dating (i.e. the delay that a bank’s accounting system imposes on accounts). The high cost of cash transactions, which in total incurred losses of €20bn, and cheque transactions, which lost an additional €4.4bn heavily outweighed the combined returns from debit cards, direct debits, and transfers. As a result, transaction and float activities led to a combined loss for European banks in 2004 of €17.8bn.

3. Secondary fee revenues. Theseare charges that customers pay to secure access to payment services, irrespective of use. Typically these are annual or monthly fees paid for ownership of card or current accounts.
4. Balance revenues. The interest margin that banks generate from balances held for the purpose of making transactions is considered as balance revenue. These margins can arise from deposits on current accounts or from liquid loans such as overdrafts or revolving credit cards. Indeed, both types of balances are held by banking customers to enable them to make payments. The combination of account fees and interest margins on current account deposits yielded a profit in 2004 of €11.3bn.² This was not enough to bring the system into profit, however. Only when revenues from overdrafts are added (€9.4bn) payment accounts scrape into the black, reaching €2.9bn in profits. Credit cards, which can be seen as independent of current accounts, generated €4.4bn from transactions and annual fees and €2.3bn from interest. These sums contributed to a total profit for the ‘regular’ system in 2004 of €9.6bn.

5. Incident fee revenues. These include all of the fees banks can charge customers for exceptional events or services not covered in the regular package, such as correction costs for wrongly initiated payment transactions, indemnity for refused transactions (bounced cheques, returned direct debits), and fees covering for non-sufficient funds. Incident fees generated €7.1bn in profit in 2004, almost doubling the profit generated by the regular payments system. Thus the total profit from payments among the EU9³ can be estimated at €16.7bn.

Exhibit 2: Balance-related and Credit Card Profits Compensate for the Losses in Account-related Transactions

*Germany, France, United Kingdom, Italy, Spain, Netherlands, Belgium, Sweden, Poland
** Includes annual fees for debit cards
Source: McKinsey Payments Profit Pool

Payment Profitability Varies Across Europe

The profitability of payments systems differs enormously between member states. Three countries – Italy, the UK and Spain – together generated profit of €16.5bn, or as much as the whole of the EU9. Germany and Poland, by contrast, showed losses of €1.7bn and €0.7bn respectively. All countries made losses on transactions and accounts, excluding balance revenues, showing that payments are a heavily interest-focused business.

Exhibit 3: Overall Results Differ Widley Across Countries

Source: McKinsey Payments Practice Profit Pools

It is not only the level of profitability that differs, but also the way in which different markets approach payments. Broadly, there are two categories of approach:

• Markets that focus on maximizing payment revenues by levying significant fees. Spain and Italy are the main examples. The United Kingdom and France also fall into this group, owing largely to their sizeable incident revenues.
• Markets that focus on reducing the cost of their payments by maximizing the efficiency of their systems or by moving customers to an optimal payment mix.The Benelux and Nordic countries are in this category.

The profitability of any given market does not depend on the category to which it belongs. Some revenue-focused markets, such as Poland, lose money because the high fees on cashless payments cannot compensate for the losses made on cash transactions. Nordic markets, by contrast, are among the most profitable in Europe, even though their fee levels are relatively low, because the use of cash and cheques has been successfully reduced and overall efficiency of the payment system is high.

Exhibit 4: To Run Their Payments Business, some Countries Focus on Efficiency while Others Rely on Pricing

Source: McKinsey Payments Profit

Cross-subsidies Increase Vulnerability to External Changes

Despite their differences, a common element in all the European payments systems is that they have reached a state of equilibrium by using cross-subsidies. Unlike other industries, which aim for profitability on all the products they sell, the payments business uses profits from some areas of the market to cancel out losses in others.

Although all countries rely on cross-subsidies, these tend to take very different forms. There are subsidies between products, subsidies between revenue types, subsidies between transaction and balance revenues, subsidies between accounts and credit cards and subsidies between customer segments.

European markets’ reliance on these various forms of subsidy makes them vulnerable to destabilization by external shocks in the form of regulatory initiatives or macroeconomic shifts. Where countries depend on card transaction fees, for example, anti-trust inquiries into interchange would have an impact, while pro-consumer inquiries into penalty charges could change the nature of the accounts business in countries that are focused on incident revenues.

The threat of intensified competition looms too. The disappearance of domestic barriers through initiatives such as SEPA will make it easier for international banks to compete in the area of corporate and small and medium enterprise (SME) accounts outside their home countries. Banks in countries that depend on the business segment could eventually be left with a mostly unprofitable retail payment franchise.

Macroeconomic trends play differently from country to country. For example, markets with a high dependence on deposit interest revenues would suffer the greatest exposure to reductions in interest rates. A margin reduction of 1% would result in an overall loss of revenue for the EU9 of almost €14bn, with France and the Netherlands being most affected.

Meanwhile markets that rely on revolving card loans, such as the UK, would be highly vulnerable to changes in consumer spending cycles, and even more to the deterioration of credit risk on revolving consumer loans. The increase in cost of risk from 2.0 – 2.9% of balances caused the UK credit card business to lose about €800m in card interest between 2002 and 2004, on a total of €1.6bn.

Exhibit 5: UK’S Dependency on Credit Ccard Lending makes it Vulnerable to Increased Credit Card Risk

*Excluding incident revenues
Source: McKinsey Payments Profit Pools

Toward a New Equilibrium

To pull off the transition to a new way of business, payment operators need to obtain clarity about where they are going and how they are going to get there. Although some pieces of the puzzle have been provided, such as the PSD positions on float or the work of the European Payments Council on direct debit interchange, many important questions remain to be answered. Moreover, regulatory initiatives and inquiries, as well as delays in acceptance of European law, are adding to the confusion.

Above all, the European payments industry now needs a sense of leadership, a clear set of guidelines that form the starting point for a new business case in a post-SEPA Europe. Toward this end it could emulate the securities industry by devising a code of conduct laying down the obligations of all parties to a common accord. After the already huge effort of alignment driven by the EPC, this would provide the next important, but very challenging, step for the market, enabling payment players to build a strategy for the future.

Failure to create a common sense of direction and to fix the rules of the game would eventually lead to a visible loss of traction for the SEPA project. In that case, clear and decisive regulatory action would be the only way left to achieve the politically defined SEPA goals.

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