Payments: The Beating Heart of Banking
The financial crisis of 2008-09 has had less impact on the payments business than on other parts of the banking industry. Payment volumes have increased by around 20% during this timeframe due to a combination of new markets, more transactions coming into the regulated domain and an increase in data required for each transaction. Average unit values have decreased as retail customers increasingly use electronic transactions to help them manage their cash more carefully, making more – but smaller – transactions.
However, margins are unchanged and so payments remains a very positive revenue-generating activity for the banking sector.
Although investment has generally slashed across the board in banking, the payment growth rate, as well as developments in three key areas – risk management, regulation and technology – require bankers to reconsider their strategy and where best to focus their limited time and money.
With the increasing speed of capital movements and wholesale transfers, risk positions can change in minutes. The highly leveraged positions in which some banks found themselves in the middle of 2008 became risk exposures when the supply of liquidity was reduced. The ripples spread rapidly from specific markets (e.g. US sub-prime mortgages) to affect all inter-bank lending.
Banks participating in payments need to understand who their counterparties are and the level of risk exposure of those counterparties. Banks are revisiting the structure of their counterparty and correspondent network, particularly around: contractual obligations, such as service levels and sanctions; reducing the number; and where in an organisation the network is managed.
The dramatic bank collapses of last year highlighted risks that hadn’t previously been considered and that led to a domino-effect demise of many a bank. Now, the main global banks are acutely aware of intra-day and counterparty risk, and even corporates suddenly care about the risk rating of the banks that they deal with. However, there is a shortage of data and systems able to measure these risks accurately across all channels. Consequently, banks have to develop their own.
One way to reduce risk is to decrease the time taken to clear and settle transactions. In Brazil, this was recognised in the late 1990s and efforts were made to reduce all settlement times and to move all systemically important systems and transactions to a real-time gross settlement (RTGS) basis. The same concept has been followed in Russia and the UK, the latter in response to regulatory demands.
Migrating medium-value payments to near real-time (usually a few seconds in practice, but with guaranteed service levels measured in hours) greatly mitigates liquidity and counterparty risks, and offers business benefits to customers. It improves transparency and facilitates the provision of ‘track and trace’ services. But it requires significant infrastructure technology upgrades and a high degree of co-ordination between competing players. For instance, systems to protect against fraud and money laundering must be bolstered in order to avoid a loss of control in these areas.
It is surprising how many countries do not have a core RTGS structure at all, since it exposes both banks and their counterparties to significant risks.
Risk management can also be enhanced by carrying more data within a transaction or linking to other data sources.
Historically, payment networks have developed using very sparse, efficient messaging systems with few message types and the minimum of data. This approach offered high transaction speeds over widely available networks, with minimum processing and hence a low probability of errors. The now widespread availability of high-bandwidth communications networks and the introduction of data structures based on XML and ISO 20022 (Unified Financial Industry Messaging Scheme) enable richer data sets.
Large corporates need to integrate data relating to a transaction from within their enterprise resource planning (ERP) systems long before initiating a transaction. And, recently, smaller corporates and small and medium enterprises (SMEs) have started to seek a slightly lower level of integration with their business management and accounting systems. Consequently, banks must have expertise in both types of systems and types of data required in order to serve both groups effectively.
There is widespread fear of a wave of regulation over the next 18 months, and even if this does not materialise, the expectation is already affecting many banks’ behaviour and investment plans.
There is some conflict between the social agenda of many governments and consultative bodies and the systemic-risk agenda of many central banks and financial regulators. The balance varies from region to region, but experience from the single euro payments area (SEPA) in Europe suggests that many market interventions are likely to increase costs but generate no customer benefit in the short or medium term.
In the US, which is making a point of setting the tone for the world, the largest institutions can expect to be even more tightly regulated. Smaller institutions will also be affected but likely to a lesser degree. In Canada, regulation is generally already much tighter but applied more evenly across company size.
There is a wide variation from country to country within Latin America since regulators stress locally important factors (such as money laundering), as well as reacting to international and domestic (economic and political) pressures.
European central banks are focusing on the specific issues around managing systemic settlement risk, but are coming into conflict with other regulators. It is now almost certain that a European ‘umbrella’ regulator will emerge. Initially it will have poorly-defined powers but will likely become more powerful as national central banks delegate upwards.
There is likely to be increased regional co-operation in, for example, the Gulf Co-operation Council (GCC) and the Communauté Financière Africaine (CFA), while the Saudi Arabia Monetary Authority (SAMA) and Reserve Bank of South Africa (RBSA) are dominant in their respective areas.
There is still only weak co-operation between regulators and central banks in Asia, as the former are likely to focus on the major infrastructure elements and state-owned banks.
The past 12 months have seen a dramatic slowdown in discretionary technology investment by banks. In the US, many projects have simply been cancelled. In Europe or Asia, they are more likely to have been delayed or moved down the priority list. The focus of investment has moved sharply from innovation to reap long-term benefits and also towards efficiency, with small projects that yield short-term benefits gaining a high proportion of the attention and investment funds.
However, some strategic projects, such as mobile payments and security upgrades, do remain on the agenda, particularly in emerging markets and those less affected by the reduction in inter-bank lending. Mobile payments are strategically important in the Middle East, Africa and South Asia, where there are not such strong, existing legacy banking systems. Security services, such as common identity management and two-factor authentication, will also see some investment, since these are important to risk reduction in payments.
In terms of the smaller sums projects banks are investing in – projects that will improve efficiency and reduce costs in the short to medium term – these include closer co-operation with very large customers, partnerships with other sectors and even with other banks. Projects to reduce paper and cash usage have a high priority; however, without support from government and regulators to impose sunset dates, legacy systems must be maintained and cost savings cannot be realised.
It is increasingly possible to perform all payments on a single platform. The trend towards standardisation and ISO 20022 will continue, albeit at a slower pace for the next year or two. With the dramatic cutback in overall investment, it is now more a question of deciding upon consolidation onto which existing platform, than replacement with a new platform.
As the banking industry works toward recovery it is likely to rely more heavily on the high-growth payments sector, which is often seen as one of its more ‘pedestrian’ services. However, the growth in this sector, combined with the expected changes in regulation, puts greater stress on systems and current management approaches alike.
The raging debate centres on appropriate ‘target operating models’ – centralised versus decentralised, number of operational processing centres and where, and control – how best to organise information, processes and decisions to avoid catastrophe amid the increased speed necessary to serve a global market.