Economic transactions have historically been characterized by asymmetry of power and information. Although free market competition has created pressure to innovate and improve productivity, producers have historically held a near – monopoly of information and, therefore, power over consumers. The information technology revolution, and above all the internet, have now turned this on its head, so much so that we are currently witnessing the democratization of commerce: For the first time, the customer is genuinely king. This is transforming the relationship between banks and their customers.
A double challenge for banking
Bankers are already facing major constraints on their business as policy makers and their regulators try to prevent a recurrence of the recent financial crisis. Responding to all this while coming to terms with truly transformational change in their customer relationships will be an enormous undertaking. It is evident that banks are yet to fully appreciate the rate and implications of it.
For better or worse, the payments business holds the key to the transformation facing banking. At the moment, payments is seen as a matter of back-end, back-room transaction processing. The priority is often to manage it as cheaply and efficiently as possible, preferably by centralizing it in some low-cost operational center, often off-shoring it to a low-cost economy. But the business of payments is a core banking function and it underpins all others. Nothing happens without payments, which are at the heart of all economic transactions. What is immensely significant is that technology is going to revolutionize the use or function of payments in the consumerist age: Reducing costs, lowering barriers to entry, increasing functionality and yielding higher quality information.
Power will shift to customers, transaction processing will be commoditized and traditional franchises and revenue pools will either be disrupted or evaporate. Welcome to the new world of payments.
New entrants and innovation
We are already seeing that traditional banks no longer have a monopoly of the payments business. Many new payment service providers are entering the field – think of PayPal, Google Wallet and Square to name a few – some of which have become massively successful in a very short time. In 2011, for example, PayPal counted 106 million active accounts in 190 markets, and processed a net total payment volume of US $118 billion. One key characteristic underlies the success of these new entrants: innovation.
Traditional banks are slow to innovate. This is a consequence of historical conservatism and is a function of complex corporate bureaucracy; historically, there has also been a lack of competition and no real imperative to innovate. As a consequence, it is often necessary for regulators to press banks to respond more effectively to consumer demands and needs. The example of Faster Payments in the UK is a case in point, being introduced only as a result of regulatory pressure. Until then, the concepts of automated clearing owed more to the technology of the horse and carriage than the computerized process. Real innovation in payments is being stimulated by new entrants creating dynamic business models to respond to changing customer requirements. Traditional banks are now having to respond. The loss of trust in banks following the crisis has significantly increased regulatory scrutiny and pressure at the same time as customers have become more demanding. And it is not just retail customers. A number of large corporations are acquiring banking licenses themselves – Siemens for example, which is now able to go directly to the European Central Bank for liquidity and deposit surplus cash there.
Banks’ historic franchise is therefore under attack from many directions at once. In the payments field, this raises three questions: To what extent is the threat significant? How and to what extent can the banks respond? And what will the industry look like in 10 years’ time?
To answer the first question, it is instructive to consider why so many new entrants are converging on payments. To some extent, of course, it is because setting up an in-house payments capability is complementary to the core business. PayPal, for example, was acquired by eBay in 2002, with obvious benefits both for the online auction business and for its customers. But there are other benefits.
First, there is the purely financial value of attracting mass customer payments and deposits: Processing transactions, even if the great majority of them are cleared rapidly, can generate massive liquidity, and very cheaply.
However, far more significant in the longer term is what the intelligent application of information technology can deliver when allied to a payments system. This is especially true of systems with mobile capability, for example, when allied with mobile phones. Traditional payments instruments – think checks – provide little information about a customer. By contrast, information technologies can in principle deliver massive amounts of detail about individual consumer habits, preferences, interests, purchases and physical locations: Where they shop, where they live, where they visit on the internet and what they buy. The potential for tailored marketing, cross-selling and up selling is enormous.
To give evidence of change, in April 2012, Google acquired the payment technology company TxVia to broaden its digital payments offering. As a result, Google Wallet will be potentially accessible to all Google users, including users of the 100 or so significant businesses Google now owns such as YouTube, Picasa and the Android Smartphone operating system,3.4.
Can traditional banks respond?
In the early days of this challenge, there is substantial mileage to be gained in improving existing systems and business models. As we have seen, conventional payments are indeed becoming more efficient and responsive. But at some point, radical change will be necessary, and banks are going to find this hard.
Even as retail banks work hard to establish a single customer view and to get a customer’s name right more consistently and more reliably in their communications than ever before, the new kids on the block are delivering 70-100 points of consumer-driven data personalization in their current customer interactions. They are currently investing in next generation algorithms and data strategies. The imperative to invest in payments will, of course, present challenges to organizational structures and to traditional investment processes: It will have to compete with other demands and avoid being crowded out by the mandatory ‘dead hand of regulation’; it will also need a new culture and a new approach.
One irony is that banks may soon be caught out for a second time in how they respond to these technology challenges. As we have seen, in the last decade or so, the typical pattern for the payments function was to centralize it in areas where economies of scale and skill could be maximized, far remote from the customer. Now, in response to the need to reconnect with customers, the trend is moving into reverse. Functions are being restored to the front line; direct contact with the customer is becoming paramount. But this is happening just at the point when technology is becoming capable of really significant individual personalization and connection.
Advanced payments and communication technology, when effectively implemented, can provide the customer with a rich and tailored experience which is simply unavailable otherwise. And it can do so at the point when they most need credit or access to payments.
The future payments landscape
We have seen where innovation is leading and where payments innovators are heading. By contrast, we are concerned that conventional banks, for a variety of reasons, will find it hard to respond. And so that leads to the final issue: What are the implications for the structure of the payments industry in a decade? Two conclusions can be drawn: First, it is likely to be very different; new entrants to payments will also be offering other core banking services. We have already seen this in credit cards; deposit services and lending are next. Second, if traditional banks do not respond rapidly and effectively, the major payments players in the future will include companies such as Google and Apple or perhaps Wal-Mart. With their closer connection to the customer, their entrepreneurial culture and superior customer service, they could truly threaten banks’ existence. The looming threat from such massive global players should make any bank think long and hard about its business model for payments.
The future of payment systems
Payment technologies and companies currently operating outside the regulatory framework of financial institutions are beginning to behave more like banks as they diversify into new technologies and services. This will gain the attention of the regulators and as they come under focus of the regulators and face regulation it may lead to a change in their business models.