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BirdsEye View

the consumer payments scene - part i

Before Durbin and Dodd-Frank hit our industry, we made near $75B on our checking accounts, with $30B or more of that amount coming from overdraft fees and about $14B from debit card interchange income. The profitability dynamics of our checking accounts have changed dramatically. Durbin alone cost the industry $16B, and overdraft fees still account for about $27B of our near $71B checking account income.

Given the importance of overdraft fees to the industry, it is particularly concerning to note that the CFPB announced in February that it will be examining whether overdraft fees charged checking account users were unfair to consumers. It has since launched a study of 9 major retail banks and their overdraft practices. It's clear that this product is in their cross-hairs.

As we all know, Durbin reduced interchange fee from $.44 to $.21 (plus $.02 for fraud losses), cutting debit card fees in half. One important implication is that signature-debit has an average cost of $.21, which is essentially covered by the Durbin interchange limit (but creates a profit advantage for banks ($10B in assets, for now anyway). PIN-debit has an average cost of $.10, but market acceptance is low.

This trend started with Wal-Mart's successful challenge in 1996 to the networks' policy of "honoring all cards". It's been 16 years in the making, and it's not over. Different from the past, now merchants can negotiate with the networks where their transactions get routed. Visa, which has the majority of exclusive arrangements, has suffered most from this change. Interlink volumes have dropped over 40%, while other networks such as STAR, Pulse, NYCE and others have seen increases of 15-30% in their volumes. No one knows when equilibrium will be reached.

Another impactful legislation is the Credit Card Act. The Act took out meaningful freedoms and slightly impacted profits, but credit cards are still very profitable for the industry. Increased credit card use for transaction convenience and rewards has helped level off interchange income system-wide.

CPFB is also planning an assault on the prepaid card space, an area that many banks are flocking to en masse. Cordray announced in late May that the Bureau was seeking public comments on prepaids and reloadables. He is considering extending Reg E protection to these products. Reg E's provisions include imposing limits on overdraft fees, and require debit card issuers to disclose such fees to consumers. Ref E further imposes liability limits, mandates error correction and recrediting procedures and requires additional disclosures throughout the life of the card. The CFPB interest is to strengthen cardholder protections of prepaid cardholders to resemble those of debit and credit cards.

One figure puts everything in perspective: if you add up the settlements and court losses Visa and MasterCard suffered since 2003, the total is about $24B  a sobering amount. In reality, though, this is about half of the annual interchange revenue. Given the amount of money at stake, it is not surprising that interchange wars are just beginning.

One important factor in reviewing the payments scene is fraud. US card issuers suffered $4B of fraud losses, and if you add the merchant costs the total reaches $16B. Mag stripe authentication is antiquated and promotes fraud, including by Al Qaeda. It will continue to happen as long as card credentials don't change. As mobile technology flourishes, personal identifying information (PII) will only facilitate additional fraud problems. Digital wallets and IDs are the safer alternative, and our payment system's insistence on maintaining status quo is untenable in the medium term. Chip security is the appropriate next stage of PII.

Consumers fuel much of the $296B payments business (53% of that amount is generated from pure fees). Consumer credit cards account for $131B, and, with checking accounts (70% of their revenues are fee-generated), account for 70% of total revenues. The commercial side, while important, is dwarfed by comparison: $38B of DDAs and $22B of credit cards.

Checking accounts are the cornerstone of the banking relationship for the customer, and also a major money maker for the banks. Credit card revenues are expected to decline by $5B, while consumer and commercial DDAs are expected to grow by $20B by 2014. Those checking accounts use increasingly electronic methods of payments, with online bill pay leading the charge (17% household growth between 2006-2009), and biller direct is close with 14% growth. During the same period households mailing a check declined 21%. Bill payment channels and options have proliferated over the last decade, and adoption rates are increasing, despite the drag that paycheck-to-paycheck has on online bill pay options.

Online banking has some limitations. For example, it is not real time due to bank batch-mode processing. Mobile banking offers a more attractive channel alternative for both bank and consumer. It IS real-time and can enable immediate response to alerts. It is even more economical than online and other channel servicing, and is also safer. This real-time, location-aware property of the mobile device can enhance a safer and more efficient payment system. It is universally accessible and can also be effectively used by the unbanked. Plus, the use of digital IDs can finally retire the mag stripe we've been living with for so long, the jackpot for many fraudsters.

Mobile is not a panacea, but it is the hottest payment method for consumers. Adoption rates are unprecedented, almost vertical, even without advertising. Consumer well-being and convenience are too attractive for a wide swath of the population (even older Americans have adopted the technology, since it's the best way for them to see their grandchildren on FaceTime). As more consumers utilize this channel, banks must be vigilant to install prudent security measures even if the regulatory framework has not yet been established for the device. Third parties are ahead of the banking industry when it comes to merchant agreements (AMEX and Wal-Mart, Square and Starbucks) and will continue to displace old paradigm players. These third parties present a major threat to our industry and its grip on the payments system. We need to be proactive and nimble, and to move fast.

One example: The EMV chip. This integrated circuit card was developed by Europay, MasterCard and Visa in the mid-1990s. It can function on for the debit and credit rails, which could ideally result in all cards accepted by all devices regardless to the card issuer, the terminal acquirer and the card or terminal manufacturer  a universal payment system. These chips can be both contact or contactless (those are embedded in mobile devices) and store information, perform some processing functions and add security to the transaction by performing cryptographic functions. The EMV is supposed to protect against counterfeit fraud through strong authentication; establish risk management parameters to reduce the risk of unauthorized payments; and validate the integrity of the transactions through digitally signing payment data .

Our country lags the global standard for the chip. In Canada and Latin America, for example, 20% of all cards have the chip and 66% of terminals, a total of 260 million cards outstanding. In Asia the numbers are even more dramatic, with 317 million cards outstanding, and Europe rules with 708 million. This technology IS the future, and the US will have to adopt it eventually. Major issuers and merchants will drive the change, much like they did with the debit card acceptance, and Starbucks' and Wal-Mart's move is a harbinger of things to come. The major deterrent for adoption is the cost - $5-8B, but the system will have to absorb this cost eventually. Better to do so now and retain market share than to wait until it's too late.