Despite the fanfare ushering in new payment technologies such as e-cash, smart cards, and credit card transactions on the Internet, the economic significance of the payments industry and the structural changes it is experiencing are seldom fully appreciated. Few even view payment products and services as an industry. But $84 billion a year is generated by the US payments system (Exhibit 1)—equivalent to 40 percent of the total revenues earned by commercial banks, savings and loans, and credit unions in America today.

Almost $33 billion is earned by intermediaries such as banks, credit card processors, and payment networks from the fees paid by consumers and businesses to make their transactions. The remaining $51 billion comes from the interest earned on customers’ balances. Traditional financial institutions and payment processors still control 99.9 percent of these revenues. Yet the explosive growth of technology and the arrival of nonbank entrants are bound to erode this dominance with the shift to electronic payments, rendering much of today’s costly banking infrastructure obsolete.

Surprisingly, senior executives at financial institutions have been slow to grasp the importance of the changes that lie ahead, perhaps because they still view the industry in a piecemeal fashion rather than applying the integrated business perspective brought to retail banking or brokerage. Rare is the banker who thinks of trying to increase his or her share of all the revenues and profits being captured by the various intermediaries from the moment the consumer pays at the checkout until the funds are transferred into the retailer’s account. When banks ruled the payments system, this narrow outlook might not have mattered: as long as a bank held your checking account, it controlled all payment revenues. But now, a range of communication, network processing, and software companies with competitive cost structures and a different business mentality have caught the scent of opportunity and are circling to attack.

In some areas, such as credit card processing and card issuance, these entrants have already made a killing. In others, such as check intermediary revenues, the battles are yet to begin. Though it is impossible to predict their outcome, it is clear they will be fought on five different fronts: consumer credit cards; processing revenues and payment networks; check revenues; business payments; and employee payroll transactions (Exhibit 2).

All US payment institutions will need to think about how—or indeed whether—to compete in each of these areas of the industry. Within this article, that industry is defined as the transactions, instruments, networks, and players that facilitate the delivery of commerce to consumers, businesses, and governments. Excluded are cash transactions of less than $2 and payments related to equity and debt securities and international commerce.

Consumer credit cards

Consumer credit cards are the most mature and pervasive form of electronic payment. Their conversion from a paper-based to an electronic product has had an enormous impact on the structure of the payments industry, and may offer lessons for other sectors of the business. Consumer credit cards account for almost half of the total US payments industry, with $43 billion collected by a broad range of banks, card issuers, and merchant acquirers (the banks that sign up merchants to accept credit cards). Although much of this revenue comes from interest on card balances, $16 billion derives from the interchange fees charged to merchants and the fees paid by consumers (Exhibit 3).

Credit cards have been one of the fastest-growing businesses within financial services. Revenue has grown at roughly 20 percent per year for the past five years and is likely to continue showing double-digit growth even while the overall growth rate of consumer debt slows as consumers increasingly turn to the convenience of plastic for their transactions. But powerful nonbank competitors are winning mounting shares of this business. Already, credit card processing and payment networks have consolidated into a $12 billion industry dominated by a handful of players. And in the credit card issuance business, dedicated nonbank companies such as Advanta and First USA have won market share with their superior marketing skills and technological advantages.

The development of electronic processing of credit card transactions unlocked the hold banks once had over the product and the customer. Bank branches and paper processing backshops were no longer needed to deal with all the carbon slips; similarly, a large physical infrastructure was no longer needed to process transactions. That allowed new processors to enter the market—and banks chose not to compete. As most were regional or state based, they decided they could not capture the economies that national electronic data processing could deliver, and they exited the business during the course of the late 1980s and early 1990s. Perhaps they did not appreciate just how much value was at stake.

Banks have failed to build up extensive databases, and lack the skills to exploit the customer information at their disposal

They certainly did not appreciate that electronic data processing meant the credit card business was about to become a marketing, rather than a banking, game. Credit card companies have developed large databases crammed with demographic details about their customers, which they use to target increasingly narrowly defined segments of the market. Pricing, rewards, and affinity and co-branding programs are now the key success factors for new offerings. But with few exceptions, banks have lost out in this sophisticated marketing game, having failed to build up extensive databases of their own, and lacking the marketing skills to exploit the customer information at their disposal.

Given the economic value at stake, the battle for control of consumer credit card revenues is likely to continue to be fierce for the foreseeable future. Although volumes are expected to grow, so too will pressure on profits. Reward programs that encourage purchases and keen competition over product pricing have already had a noticeable impact on margins. In addition, an economic downturn would mean losses on assets as increasing numbers of customers default on their payments.

In the longer term, credit card revenue will be threatened by newer consumer electronic payment instruments. Online debit cards, smart cards with micro chips that store information, "e-cash" instruments for shopping on networks—all could eventually combine sufficient consumer appeal with low processing costs to undercut the economics of credit cards. Credit card issuers will then be forced to adapt their products to keep up, and may find themselves facing new and as yet unknown corporate competitors.

Processing revenues and payment networks

Payment processors that keep account of all transactions, together with the private payment networks that allow the transfer of funds, control about $12 billion of payment revenues. Some 40 percent of this sum passes directly through the processors and networks to other players in the chain; what remains is a $7 billion industry with large, powerful competitors.

The processing business has changed dramatically over the past decade, evolving from low value-added, regional activities controlled by banks, to an industry dominated by national players with large scale economies, whose major competitive advantage is quickly becoming the information they amass from the huge flows of transactions that cross their systems. Some of these new players are making aggressive moves to spread their reach still further. Having made nine acquisitions since 1993, processor First Data Corporation has built a payment powerhouse with annual revenues of $4 billion. With its purchase in summer 1995 of First Financial, the second biggest US processor, FDC has created an institution with unmatched information power touching almost half of all credit card transactions in the United States.

Similarly, Visa, a payment network owned by a consortium of banks, is attempting to extend its ability to compete. It is seeking to bolster its traditional business by allowing debit and smart card transactions to be carried on its network, and it is working with Microsoft to develop encryption technology for secure payment transactions on public or private networks. The company is also expanding into new areas with Visa Interactive, its home banking and nationwide electronic bill payment platform, providing infrastructure and processing services to allow customers to conduct their business without visiting a bank. The product will help smaller financial institutions compete cost-effectively with large banks that have many more branches.

In credit card processing, competition is so intense that it is probably too late for banks to re-establish a strong position

In the credit card processing business, competition is so intense that it is probably too late for most banks to re-establish a strong position. They will have to accept that the processors that now dominate are cost-effective industry utilities that provide a useful service, but they should take steps to protect their customer franchises and retain control over customer information.

By contrast, banks and other financial institutions still reap most of the economic value from processing checks, though here too they will have to manage their interests carefully. New check processors such as EDS and FiServ could begin to win significant business, perhaps with a heavy investment in imaging or other technology capable of cost-effectively capturing valuable information from checks, such as the names of payees. Bearing in mind what happened when they quit the credit card processing business, banks should consider the potential information value of check processing as well as its direct costs when deciding on future strategy.

Finally, it may be possible for a few banks to find a niche in one or more processing businesses. In contrast to the consumer payment processing business, there are no entrenched players in the electronic commerce arena, and banks may find they are well placed to serve heterogeneous customer segments with specific needs, such as in healthcare.

Check intermediary revenues

After cash, checks are the most common payment instrument used by consumers. Over 32 billion are written in the United States every year at the point of sale and from consumers’ homes, earning financial institutions annual fees of $8.3 billion dollars and $16.3 billion in interest from customers’ balances. The revenue generated by these transactions is still largely controlled by banks, savings and loans, and credit unions, though it too is under attack from new competitors offering alternatives to traditional bank checking and ATM (automated teller machine) accounts.

Checking accounts are likely to become less useful to customers as new products, instruments, and technologies allow them to manage their cash and liquid assets more effectively, often bypassing banks entirely. While they might continue to deposit their pay checks in a bank account to deal with everyday expenses, they could transfer any excess on a weekly basis to a nonbank player to invest on the money market. Or they might use a data network and software products to shop for the best deal on offer from a whole range of financial institutions for a mortgage or an insurance policy. Again, this weakens the business link between banks and their deposit account customers.

Banks may lose their most profitable customers as new players lure them away with the promise of lower fees

Fees will also succumb to the pressure of competition, and banks may lose their most profitable customers as new players lure away those who maintain healthy bank balances with the promise of lower fees. Citibank, for example, is offering free home banking and bill payment services to customers with a $3,000 minimum balance; and Merrill Lynch’s CMA (cash management account) offers affluent, low-risk customers higher interest rates than are normally paid on checking accounts.

So, although checks are likely to remain the dominant consumer payment instrument for the foreseeable future, banks will have to learn to compete much harder for both their cost position and their revenues. The costs of check processing, sales, distribution, and servicing will have to be cut to new levels. And if banks are to retain their share of revenues, they will need to improve their marketing skills and offer more differentiated products and better value for consumers—the very factors that have characterized the leaders in the evolution of the consumer credit card industry.

Business payments

In total, business-to-business electronic funds transfers, checks, and cash transactions generate less than $6 billion in intermediary revenues (Exhibit 4). Although the gross payment flows produced by businesses match those for consumers, businesses tend to have fewer and bigger transactions and to pay intermediaries less than do consumers (Exhibit 5). The battle for the business payments of large companies is practically over, having been won by a small number of banks and nonbanks with their own extensive networks (AT&T, GEISCO). Most large companies now transfer funds electronically where possible, and have squeezed the profit margins of the handful of big banks and companies that control the market.

But the battle for the business payment transactions—most of which remain paper based—of millions of medium-sized and small businesses could be on the verge of hotting up. Converting these payments to electronic channels would produce significant labor savings for smaller companies, as well as generating timely, integrated information on payments and receipts that would help them manage their liquid assets. Almost 60 percent of small businesses now have PCs which they use for simple billing and accounting applications, and a variety of new and established players are developing interfaces to allow these PCs to pay bills electronically and communicate with each other over open networks such as the Microsoft Network, the Internet, and telephone networks.

No cost-effective solution yet exists, but it seems likely that one or more will emerge within the next few years. It is also probable that at least some of the economic surplus will be captured by the application and software developers that redesign the basic payment processes. Banks need to carve out new roles for themselves in this arena if they hope to retain their strong business payments franchise.

Employee payroll and benefit transactions

Businesses make payments worth about $3.6 billion to consumers each year, mainly in the form of compensation and employment benefits. About 6.4 billion payroll transactions are made annually, some 35 percent of which are electronic bank deposits. Most of these are made on behalf of large corporations that encourage direct deposit; only about 9 percent of employees in small businesses use this method (Exhibit 6).

Converting consumers to direct deposit will not reap great economic benefits in itself. But these deposits do generate account revenue, and customers are likely to stay with the financial institutions that receive their pay checks. They also buy more products from these institutions. Employees who do not yet use direct deposit therefore represent an important opportunity for banks and nonbanks alike.

The pace of change

By far the most critical factor in the overall battle for payments revenue is the pace of technological change. Three waves of technological development have been identified in financial services.1 The first wave—the penetration of ATMs and powerful data processing capabilities—is almost complete. The second, current wave is witnessing the growth of PCs and online services. During the third wave, interactive video, broadband networks, and new payment instruments will become available.

If we view the payments industry in this light, we have just come through the first wave. The emergence of electronic networks eliminated carbon paper credit card slips, and advances in computing and data storage technology led to database marketing. As a result, value shifted from banks to new credit card issuers and national processors. Most banks either could not win under these conditions or did not realize just how much value would be at stake.

Transaction data could become more valuable to processors than the actual transactions themselves

The payments industry is now riding the second wave. Explosive growth in PCs, data networks, and software capabilities is likely to drive fundamental change on several fronts over the next five to seven years. Payment processing and networks will enjoy rapid growth as card transactions continue to increase and network costs fall. Perhaps more important, the ability to capture and utilize transaction data will also expand. Such information could become more valuable to processors than the actual transactions themselves as targeted advertising and marketing become more cost-effective than they are today.

The payment transactions of small and medium-sized businesses could also be transformed in the near future as the technological hurdles blocking a major shift to electronic transactions tumble.

As the second wave gathers momentum, the companies in the most powerful position may be those that control the gateways to electronic payments, such as software companies Microsoft and Intuit. Already, both have staked out strategic positions that could put them in control of vast chunks of the payments business. Intuit has formed alliances with a number of banks that use its software package to allow customers to pay their bills electronically, and has bought electronic bill processor National Payment Clearing House (NPCH) to process all the transactions. Microsoft has delved still deeper, entering alliances with companies along the entire payments chain—NPCH, network provider GEISCO, and merchant processor NABANCO—to enable businesses using its software to transfer funds electronically.

One area unlikely to see a massive shift to electronic transactions before the end of the decade is consumer checks. The huge volume of checks in the US economy, especially in point-of-sale transactions, is likely to persist. In parts of Europe, check volumes have been driven down by powerful groups of banks or merchants seeking to lower their own transaction costs by encouraging electronic payments. But in the United States, where the banking industry is far less concentrated, few institutions will be inclined to carry the costs of transition to such new instruments as debit cards and smart cards.

So, while profits from traditional checking accounts are likely to come under pressure, new instruments such as smart cards are not expected to make an impact in the next five years. In the meantime, banks and other traditional financial institutions can take action to retain their best customers and reduce their costs before check volumes actually shrink. That will probably happen in the third, still distant, wave when electronic mechanisms take over (Exhibit 7).

To survive the technological onslaught, payment institutions will have to decide on which fronts they can best compete. They will need to make choices about whether to lead and shape the change taking place, whether to follow, or whether to decline to participate. They will need to take decisions about when to go it alone and when to form alliances. A few will leap ahead and help define the industry’s evolution. But for the vast majority of institutions, and especially traditional players like banks, the right choice will probably be to focus on protecting their customer franchises by being quick followers, outsourcing actively, moving into attractive niches, and using alliances and consortia to further their objectives.