Payments products deliver 40 to 60 per cent of a bank's total revenues; how SEPA evolves will have an enormous impact on the dynamics of Europe's banking system. This article discusses how banks can form a clear view of the profitability implications of their own decisions in the context of a changing payments environment.
The common vision of the European Payments Council (EPC) in 2002 was clear and simple: payments within 'euroland' were no longer to be considered 'cross-border payments' as they were in the days of national currencies. Instead, the EPC, banks and institutions would join forces to drive through the implementation of a Single Euro Payments Area (SEPA), so that all parties - businesses, individuals, banks and payments infrastructures - would consider payments within the euro area as 'domestic' payments.
The vision is beguilingly simple and masks the enormous complexity of developing new payments schemes and infrastructures that affect the banking systems of 25 European countries. Payments products deliver perhaps 40-60 per cent of banks' total revenues1; how SEPA evolves will have an enormous impact on the dynamics of Europe's banking system. There are so many undetermined factors that no one can be certain how events will unfold. Aside from the large number of commercial organisations involved, the variety of banking markets affected, the rapidly evolving technology, and the emergence of new commercial operating models - there is significant uncertainty over the direction that the political backdrop (the EU itself) will take.
Understandably, bank directors might be inclined to adopt a 'wait and see' approach. But they will not be forgiven by shareholders for overlooking the issue: SEPA will form not just a key backdrop to the development of their businesses - it will be the defining environment. It is crucial that banks develop an understanding of how its evolution will affect their profitability and hence how they should steer their business. To do this, it is necessary to model four dynamic elements:
- The cost of payment propositions. SEPA will inevitably involve significant costs for banks, their suppliers and their customers. Banks must know how their expenditure will leave them relative to their peers and what impact it will have on the profitability of their payment propositions.
- The changing market dynamics. European domestic markets have seen varying levels of structural change in recent years. National governments and institutions will have difficulty protecting their markets from open competition once SEPA is established.
- Revenue from payments products. Although revenue is being driven away from pure payments offerings, the opportunity is growing around ancillary bank services such as the delivery of payment-related information.
- Operating models. Changes are taking place in the way customer propositions are delivered. SEPA will accelerate the pace of change and introduce new banking alliances.
Calculating the opportunity cost of SEPA
Development of the new payment schemes and clearing infrastructures to create a 'domestic' market for the euro will result in significant costs for banks. The costs are not unbearable although more painful now that much of the revenue to oil the transition has been legislated away. Left to their own devices, however, banks would not spend their money in the way they are now obliged; development of a positive business case is easier for many other projects in the payments industry. As highlighted by the ECB's Gertrude Tumpel-Gugerell in September 2004, the end-to-end cost of business payment processes (invoicing, reconciliation, etc) dwarfs the cost of the pure payment (whether cross-border or domestic). Providing services that reduce the larger elements of their customers' cost base would be a better way for banks to spend their money. Likewise, banks and their customers are keen to find ways to improve liquidity management or reduce operational risk.
The cost of SEPA must therefore be categorised as one of regulatory compliance, the goal of which is ultimately political: to create a genuinely open financial services market across Europe in which competition of product offering spurs greater efficiency, both within the market and the wider economy.
For banks, it is the opportunity costs that need modelling: what revenue generating services will remain undeveloped while resources are tied up with the implementation of SEPA? It is ironic, but not surprising, that a pan-European direct debit scheme is emerging just at the same time that some commentators are predicting the demise of the direct debit. It is not beyond the realms of possibility that other non-banks will capture significant market share in some new payment product or service while banks are consumed with SEPA.
Effects of changing market dynamics
There is no doubt that SEPA will have the ultimate 'major impact' on the dynamics of the banking sector: historically, access to payment systems is a major determinant of the structure (and profitability) of the national banking sector. SEPA, together with the EU legislation known as the Financial Services Action Plan, will change the nature of national banking markets, harmonising conditions from one market to another, either encouraging or restricting competition according to how the rules are interpreted.
SEPA will deliver the capability to send and receive payments across national borders as easily as within national borders. Once operational, the need for corporate customers to preserve multiple banking relationships will significantly diminish. This can only lead to a flurry of cross-border banking consolidation; something which has been predicted for many years but has proven slow to materialise.
The banking industry has seen increasing distinction between its various structural elements: customer channel, back office processing, financial product 'manufacture', commoditised service provision, etc. As the financial services market consolidates, banks will be forced to change the focus of their activities, particularly in markets where the climate has, to date, been protective. The inter-bank market for outsourced and 'white-labelled' specialist services will inevitably grow as will the attention to efficiency and performance of operations.
The pace of consolidation in the EU financial services market has been slower than many predicted. An open, low cost, pan-European payment system may be the spark that initiates a surge of alliances, mergers, divestments and collapses. Equally, skilled bureaucrats may devise effective stalling devices that slow the pace of change. For now, the direction seems clear but not the pace of change. Profitability models must capture the effects of the speed of consolidation.
Modelling new revenue streams
SEPA itself will not create new payments revenue opportunities as such. However, in most European countries, payments made by individuals are subsidised by other banking products or by other customer segments. The design of SEPA could either re-balance or entrench the ways in which revenues are generated from primary payment products. Either way, non-conformist banks will have difficulty breaking from the finalised design.
Banks looking to identify potential new payment products and revenue streams will undoubtedly need to collaborate but they will have to look further afield than the discussions of the EPC, which will be consumed with SEPA for many years to come. Modelling the future revenue potential of new payments products in the personal banking sector is a particular challenge. A generation has grown up believing in the right to free banking, outraged when banks have the temerity to make charges. Many first-time small business people are shocked at the scale of bank charges applied to their new business, effectively to subsidise personal customers.
In many countries, governments and pressure groups, aghast by the size of bank profits, support and encourage the increasing downward regulatory pressure on money transmission charges, confident that national banking cartels exist (and thereby ensuring that they do). For this segment it is therefore difficult for innovative payment products to establish themselves, given that their ability to charge personal customers is extremely restricted. In spite of this environment, some agile and hungry players emerge nonetheless. PayPal, for instance, has managed to establish itself as an innovative new provider of payment services though, not surprisingly, it was nurtured in the commercially friendlier US environment.
However, in the corporate sector, the potential for innovative payment products is barely tapped. The next decade will see the emergence of new products that improve payment process efficiency, deliver better liquidity management and analyse the information embedded in the payment. In modelling the revenue generating potential of their current or future payment product portfolio, banks have two main issues to consider.
- How quickly will the product become commoditised? In a rapidly evolving technological environment, today's innovation is tomorrow's discounted feature.
- How strong is the banking relationship that the product delivers? For most customers the difficulty of changing their payments provider is too burdensome to consider. But ancillary products can be sourced from other banks or third parties with increasing ease.
Techniques such as systems dynamics modelling, whereby the impacts of environmental changes are modelled for whole markets can provide valuable insights here, in respect of both the offerings and the mechanics of the markets into which they are launched. They also help to consider the extent to which new operating models will emerge that maximise the capabilities of new technologies.
Identifying the appropriate operating model
SEPA creates significant uncertainties for banks. The cost of building new payment schemes for euroland is unknown and open-ended (actual and opportunity). The effect of new infrastructures, even before they are fully operational, will be to significantly increase the openness of the financial services market in Europe and change the market dynamics. In a wider, more competitive market, the search for new revenue streams will mean new products and services evolve. For banks, the challenge is to understand the profitability implications of the changes and to adapt by optimising their operating model.
In many ways the architecture of the inter-bank payments operating model is a legacy from the paper-based payments products invented in the 19th century. The designer of a replacement model would be inclined to start again with a blank sheet of paper, removing the duplicated procedures from individual banks and placing them in shared operation centres. Indeed, taken to a logical extreme, banks' core accounting systems would be included in a shared infrastructure.
Development of a wholesale payment infrastructure, under the eye of central bankers, is an environment in which a more logical new design can emerge, free from the competitive pressures of commercial rivals. The proposed architecture of TARGET 2 does indeed mark a change in thinking, with central bank accounts held centrally but controlled and managed by their owner. TARGET 2 may provide a clue as to the future payments architectures of commercial banks.
As the implications of SEPA emerge, affected parties, notably national automated clearing houses, are evolving new propositions for their customers. However, other institutions, in particular the larger payment processing banks, will compete by offering more radical propositions to their peer banks. Undoubtedly a period of significant change is imminent.
Clearly the challenge for bank directors created by the development of SEPA is a big one. Banks face a hard enough task grappling with the new payments environment; assessing the relative strengths of their current payment propositions, pricing liquidity appropriately, evaluating the benefit of external alliances, even effecting the appropriate operating model. But, the timing and nature of this proposed brave new world demands decisions to be taken under conditions of massive uncertainty. The most complex part of the challenge therefore lies in the way these issues interact and the approach organisations take to the decision-making process itself.
Banks are unlikely to meet the SEPA deadlines or their own long-term profitability goals by recreating, at a European level, the infrastructures that have worked over the last three decades at national levels. However, it is hard to determine the benefit of alternatives without richer information and greater interpretative certainty and these elements are unlikely to be available before the key decisions are taken.
Traditional approaches to decision-making will flounder accordingly and a new approach is therefore demanded. This must by itself demonstrably reduce uncertainty and subjectivity and give banks sufficient confidence to back their decisions with a long-term commitment. We believe there is sufficient empirical evidence around some of the techniques illustrated to deliver precisely that and they warrant serious investigation by would-be winners post-SEPA.
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1 Economist Intelligence Unit white paper, May 2005: 'An enterprise approach to bank payments'
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