Impending regulatory changes will shake up the European banking industry, threatening the revenues and profitability of established institutions while creating fresh opportunities for new players. In a recent study,¹ we analyzed the implications of an EU plan to combine the present patchwork of national payments systems into a Single Euro Payments Area (SEPA) by the decade's end.

The European Commission has been advocating this move since EU countries adopted the euro, in 1999. The new rules, which will harmonize the use of payments instruments and establish standards for transactions (including current accounts and credit and debit cards), will not take effect until at least 2008. However, since the convergence of standards will likely increase cross-border competition—and lower the fees that consumers pay—Europe's banks should immediately explore new revenue-generating and cost-cutting strategies.

Our research, which examined the payments practices of banks in nine European countries,² found that the current system is largely inefficient. Indeed, though payments made up one-quarter of the European banks' revenues in 2002 (the latest year for which comprehensive pan-European data are available), they accounted, on average, for a mere 9 percent of total profits (Exhibit 1).

In our analysis of the economics of payments operations across different countries, three approaches stood out (Exhibit 2). Institutions in the United Kingdom and France are "balance earners." UK banks earn revenue largely from the interest on credit card balances, while their French counterparts generate income from interest rate margins³ on current accounts.

Banks in the second group—"fee-oriented" banks, including institutions in Italy, Poland, and Spain—charge their customers for everything from transactions to account maintenance. Such activities are largely profitable for institutions in Italy and Spain (2002 profits totaled €3.9 billion and €1.5 billion, respectively) but not for those in Poland. Indeed, the higher costs associated with handling cash (still a substantial part of Poland's developing economy) contributed to a loss of €700 million on payments activities there.

Last, we dubbed Belgian, Dutch, German, and Swedish banks "efficiency focused." They charge lower fees and earn a lower income from account balances but also keep processing costs down—by automating credit transfers, for example.

Regardless of the model, the profitability of banks in each group varied within countries, indicating that no one model guarantees success. Further, we found that most banks use their successful payments activities to subsidize unprofitable ones and that business customers (which generate €6.7 billion in profits) are far more lucrative than consumers (€1.6 billion).

We used these insights to simulate the impact of three harmonization scenarios. If fees were to converge on the current European weighted average, for instance, overall EU bank profits would remain steady, but institutions in some countries would suffer: Italy's banks would lose 29 percent of their payments revenues, and Spain's 12 percent (Exhibit 3).

If greater cross-border competition forced interest rate margins down to the level in the three EU countries with the lowest spreads, some €14.3 billion in revenues would be lost across the region. Banks in Belgium, France, and the United Kingdom would suffer most.

Last, by reducing unit costs to within 20 percent of the levels achieved by the best European institutions, the industry could generate an additional €9 billion a year in profits. Banks could achieve this goal by implementing standardized products such as direct debits and by moving customers to low-cost channels such as the Internet.

But to thrive in a single-payments area, European banks need to grasp the fundamental economics of their operations. By subsidizing loss-making activities (such as check processing) with profitable ones (such as merchant fees from credit card transactions), banks leave themselves vulnerable to new entrants. Attackers, including banks that operate solely over the telephone and the Internet, can process large volumes of payments electronically, without the burden of expensive branches. In advance of harmonization, such banks are beginning to offer high-yield savings accounts to attract customers.

Costs must be tamed, as well. We estimate that inefficient banks could use technology to cut their payments expenses by up to 25 percent; in France, for example, banks reduced their check-processing costs to half the UK level by implementing image-scanning technology at the point of sale. By steering customers to ATMs and the Internet, banks in Belgium cut their costs to 20 cents per transfer. European banks could also appoint a "payments czar" to manage the fragmented payments activities dispersed throughout a typical institution.

Finally, banks could promote more profitable products, such as revolving-balance credit cards. Although these cards are standard throughout North America and parts of Northern Europe, they remain uncommon in other parts of the Continent.