The Case for Relationship Pricing: The Durbin Amendment

Basic Demand-Supply curves can already provide the underpinnings of a platform that can simulate the effect of price of Product A on the performance of Product A. The real challenge is to come up with a platform that can simulate the effect of price of Product A on the entire portfolio of products A, B, C, etc. belonging to different SBUs of the bank. Even assuming that someone cracks the Holy Grail of relationship based pricing, they'd still have to surmount the walls of the silos in which banks are organized today and will likely be well into the future. What might really work is a rewards and recognition system that works at the level of the entire FI, not at SBU-level - that surely sounds like a pipedream already.

Good points Ketharaman. Certainly the silos you describe in your comment are coming down as we speak. Banks know they cannot continue to operate with old core models in the face of new entrants who can scale without such obstacles. Yes, these threats in some ways are a long way off; in reality, the effect of tech on the world we are in means that many players are already too late. 

Further to your point, however, is that in some ways the silos don't need to come down. Banks simply need to operate as if they don't exist, and this is possible with innovation layers (SOA) that can emulate the functionality you would get with core replacement. Renovation is less expensive, less risky, and faster than replacement, and we are seeing greater uptake for this kind of project.

The bottom line is that as long as innovation happens on each side of the equation (banking disruptors vs. banking vendors) customers of banks at least will continue to receive more for less - which is good news for everyone.

@Darren N:

Thank you for your reply.

I agree that SOA provides the technology to let banks remain impervious to their internal silos. However, I don't see technology as the determining factor here. From a business standpoint, given the current org structures and bonus policies, why should banks want to ignore silos?

During the period between the preceding comments, I went thru' an experience that I must share since it highlights yet another barrier in the way of silos coming down: I have a checking account and a fixed deposit at a certain bank. I wanted to open a pension fund account in the same bank branch. According to regulation, I had to go thru' a fresh KYC process. What's worse, monthly checking account statements from the same bank didn't qualify to prove my name and address since, as per regulation, KYC can only happen with third-party documentation i.e. documentation issued by another bank / utility / MNO. I'm sure the regulators have a good reason to formulate such policies. However, it can't be denied that they hamper banks from breaking out of silos even if they (i.e. banks) wanted to.

IMHO, there's a long way to go before banks face clear and present danger from nonbank financial services providers. Many of us will load our PayPal Wallet with a few dollars to buy a coffee or a sandwich. The bolder lot amongst us won't mind using our spare cash to make a few unsecured loans on PROSPER or ZOPA. But, how many of us will move our entire life savings from a bank to a mobile wallet (even assuming it was possible to do so) or lend it out on a nonbank lending website? I could go on with more examples but I hope this shows that the threat posed by nonbanking FIs to traditional banks is highly overrated.

I look forward to the day when silos come down and I can enjoy a superior customer experience while dealing with banks. However, I recognize that there are far deeper issues at play here.

Great points Ketharaman. I agree banks should not ignore silos - my point is more that there are tools they can choose to use and implement that can emulate core banking replacment for certain functionalities, and if that is the case, then why not? Banks like projects with promising ROI and low risk. If the customer experience is improved, the different between being post-silo or apparently post-silo should be unapparent. 

Very good point on the issue of regulation. I'd say this is more challenging. We've seen what less regulation can look like (as a generalization) and so as a private citizen I'd be loathe to move to less regulation. But as a user of banking, I'd prefer that the bank can see me across lines of business. It's a definite challenge.

On the non-bank comment, I have to disagree with you there. Yes, banks have our trust still with respect to mobile banking and payments, but they don't risk being replaced, they risk irrelevancy. If Apple has 250 million credit cards on 1-touch payments, they don't need a bank - they are acting as one. With some stretch of the imagination I start seeing myself purchasing things with my itunes account ID and password. Simple as that. Payments channel through Apple instead of other providers.

My point is more that while we don't know the future, it's hard to imagine a future where non-banks aren't a more normal way to pay for things, at least IMO. And the challenge is that banks and other payments providers I think underestimate this potential future. Square is already disrupting POS. Bottom line, in 10 years, how we pay for things will look a lot different, and I think banks will play a smaller role.

Apple iTunes is a merchant. The millions of cards it has on its file are issued by banks, not Apple. It certainly needs banks to function. Its great UX might sometimes tempt one to buy everything from it instead of facing the friction posed by many other sites - etailers and banks alike - but, unfortunately, one can only buy from iTunes what Apple wants to sell on iTunes.

Even if it braved regulations to enter banking - unlike Google which cited regulation to give up on similar plans - I doubt if Apple would bother doing so: As a tech company, it enjoys better valuation compared to banks, so becoming a bank wouldn't be in the best interest of Apple's shareholders.

Talking about SQUARE, it disrupts POS as you've rightly pointed out. But, in that capacity, it should worry NCR, Verifone and other POS manufacturers. Whether a transaction happens on an NCR POS or SQUARE POS, the bank that has issued the credit card used in the transaction earns the same interchange fees. In fact, before SQUARE, banks had declined merchant accounts to many sellers on account of their low transaction volumes or high risk profiles or both. Now, with SQUARE coming along and taking on the entire merchant risk, these merchants can now accept credit cards which they couldn't before, and banks can earn more interchange fees from their card transactions without bearing any additional acquisition risk. Seen this way, banks should cheer SQUARE along and not be worried about it!

Whether the payer uses Apple iTunes, PayPal, SQUARE or any one of a plethora of mobile wallet offerings, most payments today continue to happen on card network / ACH / RTGS - i.e. "banking rails". Therefore, banks continue to firmly occupy their corner of the four-corner payment model and the newcomers don't threaten their relevance as banks. A couple of years ago, Boku, Zong and other GenY Mobile Payments (GYMPS) seemed to threaten the position of banks by entirely bypassing the banking rails and instead using MNO rails for payments. With many GYMPS recently announcing support for the addition of bank-issued credit cards and checking accounts as additional source of funds, I think that threat has also largely receded.

Really appreciate the debate Ketharaman. Great points again.

I agree that banks currently own the payment rails but I see no reason why that will always be the case. The four corners payments model works today but that does not mean it has to work in the future.

Just look at this:

"We have an interest in these systems being built around structures that are already in the payments system [bank-led processing], rather than creating something that exists outside of the banking system."

That's Jeff Plagge, president of Northwest Financial Corp and chair of the American Bankers Association task force to monitor and advocate for security, bank involvement and interoperability for mobile payments. The group "is pushing for standards that ensure a market that's as open as possible, yet maintains banks' position as primary processors of digital and mobile payments." (link here:http://www.americanbanker.com/issues/177_51/ABA-payments-group-advocates-bank-role-payments-1047488-1.html)

So there is a task force to ensure that Apple and the like use the rails that exist - that doesn't sound like a model that is inherently stable to me.

Moreover I think the threat of Apple and others is real for a very basic reason. What is the purpose of a credit card, anyway? It's to allow a transaction to take place without cash, to guarantee the identities of the parties involved, etc. That's where the value is.

So my point is, if Apple has scale, if Apple has the technology and can guarantee the identities of parties involved in the transaction (for which it does not need to be a bank), why not create your own payment rails (call it iPay) and simply connect it to a bank account. The key is trust (for the consumer) and the integrity of the system. I would not be concerned with the security but trust will likely be an issue for the foreseeable future as consumers seem to have a high degree of trust for banks handling payments. That shift in consumer behaviour will likely be an impediment. 

In any case, I'd be interested in what some of our colleagues think - @brettking @Chris_Skinner @netbanker

This debate has a lot of attention currently - for good reason - it affects a lot of people and there are a lot of fees at stake. Let's keep the debate going!

It's evident that banks own the payments rail today and have done so for decades. While anything can happen in future, the fact that most payments providers still use banking rails for payments makes the guideposts very clear for any crystal ball gazing. Investment, trust, regulation, "why bother" by Apple and other nonbank giants - these are the impediments to any alternative rails. And, yes, I almost forgot to add "non core" to this list, which emerged from a recent deadpool event that took place between our comments: Nokia Money. 

This just came in: "The iTunes Hack Attack, Hiding in Plain Sight". Even if Apple started offering payments - which I strongly doubt for reasons mentioned in my earlier comments - I'm not sure if I'd want to use it. As we fintech professionals are debating about the merits and demerits of retailers entering payments, it's ironic that this article written by a retail industry analyst advises retailers to leave payments to banks and credit card processors!

Well I definitely agree that the impediments to change are significant (particularly inertia), I don't consider the iTunes hack to be one of them. I use a debit card issued by a bank that has been hacked by card readers at both retail outlets and ATM machines. Like the hack described I had not done anything wrong - simply used my debit card as issued by a bank. So it's hardly the case that a sophisticated fraud would only be perpetrated through Apple/iTunes - fraudsters have been making off with our money from technology banks have created for decades already. That fraud has now reached into mobile payments delivered by retailers is almost not newsworthy - if you google anything along the lines of 'debit card fraud' or 'bank card fraud' you will see what I mean (localized search results notwithstanding).

But of course this is more the 'front end' of the transaction, which is presumably always less secure. In any case I'm very interested in how this all plays out. Did you see the new PayPal announcement today?

https://www.finextra.com/news/fullstory.aspx?newsitemid=23528

Darren/Ketharaman,

It behooves me to have a say in this debate.

The fact is this issue has, in part, already been solved. PayPal does $30Bn of transactions that could have been handled by banks in the e-Commerce mix, but aren't because banks thought no one could circumvent their rails. Starbucks circumvented the rails all together and 25% or 26 million transactions a year now skip the exisitng players.

There's 1 million merchants on Square today after just 20 months, processing $4Bn in payments annually - that's 1/8th of all US merchants. That is 1 million merchants that apparently could have been on the existing rails and POS systems if there was a simpler, more cost effective merchant onboarding process provided by the incumbents.

Katharaman - read my book "Branch Today, Gone Tomorrow", it provides proof that 'rails' doesn't mean survival into a new era disrupted by new technology and new behavior.

Consumer behavior is driving expectations that the incumbents aren't meeting fast enough. Non-Bank competitors and new technology layers are filling the gap. The net effect is that the rails have new skins, but the incumbents give up both market share and margin.

You might argue that it's insignificant? 1/8th of US merchants, 25% of Starbucks' in-store payments, and 20% of the online e-Commerce payments traffic! It's just the beginning - we're about to see a few derailments :)

BK

@BrettK:

Welcome aboard!

The position of banks in the four corner payment model is not threatened by any of these brands since, far as I know:

1. SQUARE is only a threat to POS vendors. It's a new channel for credit card usage that brings in more more interchange revenue for card issuing banks without banks taking on the incremental acquiring risk. To avoid repetition, let me refer you to my earlier comments.
2. Every time a non-PayPal member uses their credit card to make a PayPal payment to a PayPal member - contrary to popular misconception in some quarters, such transactions are possible on PayPal - the card issuing bank gets interchange revenue.
3. Even in PayPal to PayPal transfers, the funding transaction from a credit card to a PayPal account fetches interchange revenues for banks.
4. While payment for each coffee at Starbucks disintermediates banks, all Starbucks account top ups made using credit cards does fetch interchange revenue for banks. This is a good thing for banks since they can collect 2% on a US$ 20 (typical amount of top up) with a single transaction instead of 2% on US$ 4 (cost of coffee) five times. 

If a customer tops up a Starbucks prepaid account with cash, I do agree that banks get disintermediated. But, such customers were anyway using cash to pay for their coffees before, so banks were anyway not in the picture even before Starbucks introduced its mobile prepaid account.

Not sure if your figure of "1/8th of US merchants, 25% of Starbucks' in-store payments, and 20% of the online e-Commerce payments" pertains to SQUARE, PayPal and Starbucks transactions. If it does, I must conclude that most of it still continues to happen on banking rails.

It could of course be argued that, by offering whatever SQUARE, PayPal and Starbucks are offering to consumers, banks can acquire an additional source of revenue. That'd be a valid argument to be deliberated by the C-Suites of banks. Some might find it core to their charter and enter it (e.g. Barclays PingIt) and others might find it non-core and not bother. 

Ketharaman,

Square has 1m new merchants on their App - with a link to the banking rails, but they make more on fee than any of the rail partners. Starbucks 50+ million transactions a year going across mobile in a closed loop environment that circumvents the banking rails entirely. But you are trying to argue banks are still winners in this?

The fact is Starbucks has already circumvented the rails.

Square could circumvent the rails at almost anytime (as they already are with 40,000 card case merchants) and the User Experience wouldn't change.

Starbucks and Square own the user experience, therefore control the revenue pipeline. Having the rails is a guarantee of commoditization, not ongoing payments revenue.

The power is at the front-end, and that's where banks are being left behind.

BK 

@BrettK:

As far as I know (a) A seller using SQUARE doesn't need a separate merchant account with an acquirer bank (b) SQUARE takes on the role of the merchant-cum-processor (though not acquirer bank) on behalf all SQUARE-using sellers in the 4-corner model (c) SQUARE pays the merchant discount fee to the other rail partners (d) SQUARE charges the SQUARE-using seller a flat 2.75% of transaction value.

I don't know of any info in the public domain that breaks down this 2.75% fee collected by SQUARE into the % retained by it versus passed on to the acquirer, card network and issuer bank. Since SQUARE performs the role of merchant-cum-processor, I don't see any reason for deviation from the standard card network model whereby SQUARE might make more % than the network, almost the same as the acquirer, but much lower than the issuer. If you can point to any publicly available info that says that SQUARE makes "more on fee than any of the rail partners", I'll stand corrected.

I've already pointed out how Starbucks uses banking rails when coffee-buyers have to charge their Starbucks account using their cards.

Beyond these numbers, I think there's a larger point here: In principle, any company (say, refinery) borrows money from a bank because it's sure of earning a higher return on capital by doing refining than the interest it pays to the bank. That doesn't mean that banks should enter refining because of the higher margins available in this business. Likewise, if somebody like SQUARE offers a superior consumer experience, takes on additional risks, and enlarges the overall interchange pool in the process, I see banks as winning - as long as they do this over banking rails. These somebodies can always shift to non-banking rails in future but the reverse could also happen during the same time: After all, Boku, Zong and other GenY Mobile Payments launched on MNO rails a couple of years ago but have now announced support for credit cards, which brings them into banking rails.

Ketharaman,

There are banks and networks who will participate and make money out of this new digital realization, however, there will be far less banks (and networks) required. 

When you have a more compelling customer experience, old/traditional players either offer value by providing rails or by partnering. Thus, while there will be those that provide the rails and thus provide value, the majority will simply disappear over time because the value chain has shifted.

For sure there are those that stand to win, but I'm afraid more bankers on the whole will lose than those that win. Is this good for the industry? No, but it is good for the consumer.

BK

@BrettK:

Good or bad, survival of the fittest has always been the way of the business world, in payments and in everything else, hasn't it?

From SQUARE and other nonbanks threatening banks, I see a shift in perspective to how banks who offer SQUARE-like products and / or banking rails could threaten other banks who don't. As I'd pointed out earlier, risk-versus-return and core-versus-noncore equations enter the picture when it comes to banks entering SQUARE-like products. As for rails, any bank that issues credit cards - which is a large number - is a provider of rails. 

I happened to stumble upon these comments today. 7 years later: 

• Credit card rails are intact. Visa and MasterCard are very much around.
• Banks continue to be most profitable industry in FORTUNE 500.
• For all their hype, the leading seven neobanks in the USA put together hold total deposit of $1.68 billion, which is just 0.014% of all deposits held in US banks (Source: Silicon Valley Is Eating The Crumbs From The Banks' Lunch).
• Apple has not connected iTunes to bank account or otherwise created its own payment rails. (Actually Apple has killed iTunes).
• Apple didn't bypass banks with Apple Pay. Apple Puts Banks Squarely At The Center Of Mobile Payments
• The new Apple Card is issued by an existing bank (Goldman Sachs) and runs on top of an existing card network (MasterCard).
• Far from iPhone killing plastic, reports are that Apple is planning to use its "plastic" Apple Card to prop up sagging iPhone sales (Source: FORTUNE). 

In short, none of the predicted threats to banking / card network rails seems to have amounted to much even after all these years.