Separation, not divorce

[Dave Birch] The European Commission has, admirably in my opinion, been trying to introduce competition into the payments world, hoping that competition can deliver a better payment system. The Electronic Money Directive and the Payment Services Directive have opened up new regulatory categories for non-banks and while these have yet to make much of an impact, recent events may well have persuaded the public that money issued by, let’s say, Vodafone or Virgin is worth a try when compared to the money pouring out of government printing presses to bail out the bankers! Current issues aside, though, anyone looking at long term business trends must be wondering to what extent the payments industry will remain part of the banking industry.

I wonder if it might not make sense to take more active steps to separate banking and payments further and farther. It is, after all, a historical accident that banks provide payment services. Back in 1999, the Federal Reserve Bank of New York Economic Policy Review said that “Economic theory on the operations of commercial banks cannot, by itself, explain why they provide payment services on such a large scale”. Quite.

But if payment services were taken away from banks, then what else would banks do? Many years ago I contributed to the Centre for the Study of Financial Innovation’s report on the Internet and financial services and I used a simple model of banking to consider the impact of new technology on different banking functions. This model — taken from Crane & Zodie’s Harvard Business Review article on “The Transformation of Banking” in 1996 — posits that banking comprises a relatively small small number of functions.

1. Methods of making payments in order to facilitate trade;
2. Mechanisms for pooling resources to fund large–scale enterprises;
3. Ways to transfer economic resources over time and across distances, as in lending and investing;
4. Methods of managing risk, such as insuring, diversifying, and hedging;
5. Price information, such as interest rates and securities prices, to help coordinate decentralised decision making;
6. Ways to handle incentive problems that interfere with efficient transactions.

I think that the first and the last are the ones to consider here. The first is obvious: if there are no payments then there is no trade and further than, as I have often argued, the existence of cost-effective and efficient payment systems allows markets to exist. The last is less obvious, but in this context it means that transactions that would otherwise not take place can take place merely because a bank is the intermediary: in a sense, the presence of banks in the loop legitimises transactions, a problem that the developers of new payment systems often find themselves wrestling with. They resent the bank taking a cut for, as they see it, doing nothing. The current financial crisis may well causes other stakeholders to reassess the ability of banks to solve such incentive problems, but in any case there are already many markets where payment systems provided by non-banks already have substantial market share and it is not clear at all that consumers are bothered by this: on the contrary, some people already trusted non-banks more even before the current crisis.

These alternative payment providers are also trusted by consumers for Internet transactions – 64% have faith in them, almost the same as the 67% for banks. The research also found that adults aged between 45 and 64 actually trust alternative payments provider more than banks.

[From Finextra: E-payment threat to bank revenue]

The point of the list, though, is to show that banks have plenty to do without payments (which contribute a small amount of banks’ net income — remember payments contribute about 40% of revenues but about 33% of costs as a rule of thumb) and if they were to get better at doing other functions (eg, managing risk) they could more than make up the loss of payments income in time.

So, I would argue, it’s certainly possible to conceive of banks dropping functions that they do not excel at (as they have already done to some extent by obtaining price information from external sources rather than generating it themselves) and focusing on the others. And payments might be one of those. But I think the key reason for expecting the role of non-banks to go through a boom in coming years is that the banks’ ability to exploit new technology is limited. They have other things to spend their money on, all of which generate a better return than marginal new payment businesses. Our friends at Glenbrook made this point in an excellent field report from the NACHA 2008 conference, nothing that

There was what seemed to be a widely held view that innovation sure isn’t coming from within the banks anymore, but rather from “third parties” – primarily start ups. Sure, the payment “system” providers such as MasterCard, Visa, NACHA, and others play a role new product development, but that role was not particularly acknowledged by the non-bankers, nor the bankers for that matter.

[From Glenbrook Partners: Field Report from NACHA’s Payments 2008 Conference]

While the potential for alternatives has been recognised and discussed for years, it could be that the “tectonic plates” beneath the payments industry have begun to shift in such as way as to set in motion and irreversible change of some magnitude. Steve Mott put it even more strongly earlier in the year

But over the summer, the winds of change have finally struck, and alternative payment options are set to move full-sail into the looming battle between acquirers and issuers over the very course of the card-payments business.

[From Digital Transactions | Mott Alt Payments]

I think, while Steve may be occasionally somewhat robust in his opinions, he’s dead right on this. Something has changed.

These opinions are my own (I think) and presented solely in my capacity as an interested member of the general public [posted with ecto]