July 22, 2003

The time has come for banks to reassess the true importance of their payments businesses as an industry-unique and critical cornerstone of their relationships with customers and a platform for delivering real value to customers on an ongoing basis. In light of the macro-challenges and market forces shaping the payment-related services that they offer, banks would be wise not to take for granted their role as payment intermediaries. They should make the most of their exclusive opportunities to not only shelter and protect their payment franchises, but to build upon them and take advantage of them as a vehicle for delivery of true customer value.

The primary mission that banks face in providing payment services for their customers is a simple one: Ensure that payments are processed as quickly, efficiently, reliably, and cost-effectively as possible. Fulfilling this mission, however, is far from simple. Banks operate in different countries and regions characterized by different currencies, languages, economic systems, payment clearing and settlement systems, banking laws, and technical infrastructures. These transactions cross continents and time zones, with customers ranging from individuals to the largest global corporations, and occur via multiple instruments ranging from paper-based to real-time electronic mechanisms.

Despite these obstacles, transactions need to unfold with near-perfect accuracy and dependability. Banks must respond to both macro-challenges and market forces in order to meet customer expectations, retain the enormous business opportunities that payments represent for the industry, and stay competitive both with other banks and with non-bank service providers in the payments industry.

Macro-Challenges

The Enduring Legacy of Paper. Paper-based payment instruments will never be eliminated: They will simply continue to decline, slowly in absolute volumes and more rapidly as a percent of the world's total payment mix, as the adoption of new electronic payment mechanisms accelerates. The challenge facing banks is to both drive and be responsive to the demand for newer electronic payment services. At the same time, they need to be transforming their internal product accounting and transaction processing systems from a focus on predominantly paper-based payments to a focus on electronic payments. There is already excess processing capacity for handling checks and other paper-based payments in today's banking industry. Legislation is continuously being proposed and enacted with the aim of reducing the volume of payments cleared and settled via the physical transportation and interbank presentment of paper payment items, and therefore this volume will decline even further among industrialized nations.

The Advent of Electronic Commerce. Due to their unique demands for extremely high levels of security and reliability, payment utilities are dependent upon their own industry-owned and operated systems of closed, proprietary bank-to-bank networks. In these networks, user access is strictly controlled and new developments and standards are implemented, often relatively slowly, by banking industry consensus. This state of affairs is fundamentally at odds with the concept of electronic commerce, which is based on open, publicly accessible networks that are not owned and operated by the banking industry itself and for which new developments and standards are outside of the banking industry's control. The appropriate response to this challenge is the development of technical standards for defining the format and structure of electronic messages associated with electronic commerce-initiated payments. A set of de facto standards is currently in the chaotic process of emerging from the maneuvering, lobbying, sponsorship, claims and counter-claims, proof-of-concept testing, and competition among rules-driven standards, market-driven approaches, and customer-driven, product-centric specifications.

Regulatory and Compliance Pressure. As tactics in the war on terrorism expand to include greater efforts to seize, freeze, and block financial assets and transactions, banks have been positioned as the "first line of defense" by regulators. These regulators believe that one of the best ways to combat terrorists is to deprive them of their financial resources. National governments and agencies around the world are expanding their lists of individuals, corporations, organizations, and nations with whom banks are prohibited from doing business. They are also enacting regulations requiring stringent and proactive efforts to detect and prevent money laundering. At the same time, the critical importance of payment systems to the functioning of the global economy, as well as concerns over the vulnerability of banks' own systems and networks to attack from external forces, has led to tighter system resilience requirements.

Risk and Fraud Control. When a bank acts as a payment agent it incurs a variety of risks, including operational risk, compliance and litigation risk, fraud risk, and systemic settlement risk. Banks typically lack an enterprise-wide focus on payment-related risk because it occurs over multiple payment methods and mechanisms, and over multiple organizations and functions within the bank. Additionally, it is mitigated via multiple methods, both procedural and technological. The amount of payment risk that banks incur will only increase in the future. The number and type of payment processing, clearing, and settlement systems continue to increase; the methods and technologies available to criminals for perpetrating payment system fraud continue to improve; the average payment size, total payment volume, and speed of processing for payments continue to increase; and regulations specifying payment processors' obligations and liabilities continue to proliferate.

Market Forces

Online Services. Online loan brokers, payment portals, bill and invoice aggregators, Web-based trade exchanges, and "digital markets" all threaten to disintermediate banks from their customers and force them into the role of providers of nondifferentiable, commodity-level settlement services. Banks are therefore striving to maintain the high-value portion of their relationships with their payment customers via basic online information and transaction services, "value-added" transaction services (such as electronic bill and invoice presentment and payment and financial electronic data interchange), and support for Web-based trading. Support for online payment-related services represents a two-edged sword for banks. It can be a valuable (although costly) tool for building a bridge to customers and for solidifying the bank-to-customer relationship. However, payment processing is only one part of the complete transaction between buyer and seller, typically the last step following the exchange of information related to inquiries, price quotes, acknowledgments, credit checking, delivery logistics, etc. Thus full automation and support for online commerce entails involvement in the often complex relationships between buyers and sellers, the documentation surrounding the transactions negotiated between them, and their respective banking partners.

Mobile Technology. Without question, mobile payments will play an important part in the bank-to-consumer relationship of the future. While the technology is still in the emerging stages, mobile payments are an inevitable phenomenon. This is especially true considering the widespread global adoption of mobile devices and the investments being made in mobile payments on the part of banks, telecommunications firms, software providers, and wireless device manufacturers. As is typical of emerging technologies, the fundamental element that is still missing is the implementation and adoption of universally accepted standards for mobile technologies and mobile payments interoperability. Once this issue has been resolved, banking customers will demand wireless payment capabilities, and banks that are not prepared for this future wave of demand will forfeit their opportunities in a rapidly developing market.

Customer Preferences and Behavior. The prevailing preferences for certain types of payment mechanisms are the result of a complex combination of a nation's customs, laws, and banking industry structure and procedures over decades or even centuries. Behavioral inertia is strong in the area of payment practices. Adopting new payment mechanisms and abandoning business-as-usual payment customs and routines is difficult, even where the advantages and benefits of a "new way" are clear. There is always an incumbent payment option, inefficient as it may be, and any new payment method must demonstrate overwhelmingly compelling advantages in terms of convenience, speed, or cost, or it will not be adopted.

Banking Industry Metrics. Banks must continually balance their technology investments in new payment services against the demand for such services and the risks involved in offering them. The demonstrated technical feasibility of a new type of payment mechanism or service is only the first step in determining whether offering such a service will be cost-effective for a bank. Banks must take into consideration technology risk (whether the technology itself is proven and sufficiently mature to work at an adequate performance level). They must also consider operational risk (the extent to which the new mechanism or service is disruptive to existing and planned bank operations). Market risk (whether the market is ready to adopt such a mechanism or service, and the risk to the bank's reputation if the new mechanism or service is less than fully successful) is also a concern. Cost factors (the cost of implementing the service, and whether the service enables internal cost reductions or fee-generating opportunities to offset implementation costs) and competitive differentiation (whether the service provides a competitive advantage over banks that do not provide a similar service) weigh into their decision as well.

Conclusion

Banks wishing to optimize their return on the investments made in their payment businesses need to take action according to the following realizations:

* Payments processing is its own vehicle for direct competitive advantage for a bank, and should be managed as such. Investment in appropriate technologies for cost-efficiency and superior customer service can attract and retain customers, and return real financial results.

* Payments processing leads to real value creation beyond the core payments function, and should be managed as an asset that supports other departments, and other lines of business within the bank. Payment-related accounts are typically among the most actively used products within a bank, and often form the foundation of the bank's relationships with its customers.

* Payments processing should be managed across the enterprise. Organizationally, banks need to recognize that even though payment instruments take multiple forms -- checks, wire transfers, card-based payments, and so on -- they are all components of a single payments vision driving execution and service delivery. They should be regarded not as a common enterprise-wide cost burden, but as a strategic asset. At the very least, every bank should ensure that an understanding of the institution's payment costs and revenues and its overall payments strategy has the attention of management at the most senior level.

David Medeiros is director in the global payments practice at TowerGroup, a leading research and advisory services firm focused exclusively on the global financial services industry, www.towergroup.com.