What’s a check?
Claude A. Jr. Hanley
It’s been over 30 years since Dale Reistad coined the phrase “checkless society.” While that vision has yet to come to full fruition, signs abound that the long-predicted migration to electronic payments is under way and gathering steam. But what are the implications for banks and how might they take advantage of this shift in payments? Does this trend raise new challenges for risk management?
Signs of the Migration
Data gathered and analyzed by the Federal Reserve System clearly shows a significant growth in the use of credit cards, debit cards, and ACH among consumers, businesses, and government to make retail payments. As illustrated in the accompanying chart, the proportion of payments made electronically grew from 22.8% of all payments in 1995 to 40.6% in 2000. The shift from checks toward electronic payments is even more evident when the growth trend is viewed from 1979 forward.
While acknowledging that checks currently remain the largest noncash retail payment instrument in volume and value, the Federal Reserve believes that the trend is clear: electronic payments will eclipse paper checks. Indeed, contrasting the check volume figure of 42.5 billion in its 2000 study with the volume of 49.5 million in its 1995 study, the Federal Reserve concluded that volume had peaked in absolute terms sometime in the mid-1990s. Having read the handwriting on the wall, the Fed recently announced plans to downsize check-processing operations at the regional reserve banks to improve operating efficiency.
A subsequent survey conducted by Global Concepts Inc. of Atlanta lends further credence to the view that checks are past their heyday. The study measured check volumes at institutions that collectively accounted for over half of all check volume in the U.S. Extrapolating from those results, Global Concepts Inc. estimated that 41.7 billion paper checks were written in 2001, versus the 42.5 billion that the Fed had estimated for 2000, representing an approximate decline of 2% in check volume.
Some people argue that the peak in check volume has not yet been reached, but their point is purely academic. While it remains to be seen whether check volume has decreased in absolute terms, there is no question that checks as a percentage of total transactions are decreasing and, at some point in the not-too-distant future, electronic payments will become the preferred medium of exchange. While checks will always be needed for some purposes, such as small consumer-to-consumer payments, their role as the central medium of payment in the economy is over.
For banks this is both a welcome and expected development when viewed from the standpoint of operating efficiency. Banks-in concert with many businesses and various government agencies-have intentionally spurred the migration to electronic payments. It’s cheaper and easier to process electronic payments when there are no paper checks to be transported, sorted, reconciled, and distributed. Going forward, banks will continue to employ technology and tinker with processes in an effort to eliminate the need to present paper checks, either inter-bank or to their end-customers. However, a checkless society holds implications beyond operating efficiency for an industry whose most important product is arguably the checking account.
Credit Cards Lead the Way
A checkless society simply requires that money be digitized. The instrument to accomplish this already exists in the form of the common credit card. While the recent growth in debit cards has been impressive, and other innovations in electronic payments have garnered much publicity and do hold promise, the credit card is the most ubiquitous electronic payment instrument. Between 80% and 90% of households hold a credit card (which, coincidentally, approximates the household penetration rate of transaction deposit accounts). Credit cards are already used widely. Fed data indicates that credit cards accounted for over 20% of retail payments in 2000, and plain old plastic is the medium of exchange for nine out of 10 online transactions.
Part of the reason credit card usage is so high is that the cards are backed by risk management safeguards for merchants and consumers when used both online and in person. Also, transaction processing is reliable, and participants in the system are governed by common standards. Fraud loss to consumers is limited to $50, which in reality is zero, since Visa and Mastercard waive the liability de facto. Last but not least, cardholders also receive rewards in the form of loyalty points for charging purchases. Consumers are further incented by high credit limits and low interest rates, including the lengthening of no-payment periods.
Indeed, it appears that the credit card is being used more and more as a payment instrument and not merely to revolve balances. According to various industry sources, 40-50% of cardholders never carry a balance on their cards, which is the highest level in several years. In addition, many services that entail recurring monthly payments, such as health club memberships and cellular phone bills, can be automatically charged to credit cards.
In short, the credit card has become a more convenient and safer alternative to checks and cash. In effect, consumers have made the choice to use credit cards as a preferred payment device. Other than for exposure to identity theft, consumers take little risk in directing payments through the credit card.
Emerging e-Payment Instruments
There are some limitations to credit cards, however. Under the prevailing fee structure, merchant fees can be a significant deterrent to conducting online transactions of significant value. Also, merchants point out that the fees they pay are not calibrated for risk and in general are too high. Consequently, we expect that the fee structure will need to be overhauled or some other form of electronic payment method will emerge to address those issues.
The appeal of other forms of electronic payments, such as point-of-sale and electronic bill pay, will grow as consumers become more comfortable with security and as the payment mechanisms become more commonly accepted by vendors, especially among merchants dealing in small cash transactions. This is already happening. Debit cards are now accepted in the fast food industry. Several major religious denominations now offer e-tithing services to their members. ATMs are being Web-enabled and augmented with new service options, such as the purchase of stamps and tickets, that make small cash transactions more convenient.
The Internet will further spur the development of electronic payments. Admittedly, consumer-to-business transactions are currently small but they will continue to grow. In part, consumers continue to write checks out of fear that someone will intercept their electronic payment or steal their identity. With improvements in electronic encryption, audit controls, and PINs, this is more a problem of public perception than one of technical limitations. When these concerns and misgivings are assuaged, convenience and low costs will continue to entice consumers to use online services. Just as with ATMs, once people become comfortable that the payment technology is safe and reliable, their behavior patterns will change and demand will grow.
In the meantime, consumers are already aware that the use of credit cards is relatively cheap and riskless from their point of view. Consumers seem to have figured out on their own how to get a free ride for grouping payments through their credit cards.
Implications and Opportunities
There are several strategic implications for banks in this slow but steady shift in the mix of payments. First, growth in new payment behavior should create opportunity for new cost efficiencies in the branch network. Opening and closing branches without considering this shift is misguided. The primary role of the branch will continue to shift away from deposit taking and cash disbursement toward product sales and service. To further improve operating efficiencies, banks will continue to modify the layouts and staffing complements of their physical branches to reflect this change.
The real distribution issue is deciding on the overall number of access points, both physical and virtual, to offer customers. Electronic access points, such as Web-enabled ATMs and kiosks, will proliferate over the next 10 years. Competition among banks will sharpen around easy-to-use online banking centers and higher use of Internet access. One important element of banking competition in the next decade will center on supporting the new payments system mix and ease of access.
The substitution of credit cards for cash and checks likely means that consumers will become locked into a new payment system and their transaction relationship will become more inert. For instance, once consumers begin to use their credit card to make payments automatically, it will be difficult and tedious for them to unwind the relationship.
Also, as consumers push more and more payments through their cards, the card statement could replace the checking account statement as the centerpiece for household record keeping and budgeting. It is now as easy to use the Internet or telephone to check on card balances and transactions as it is to do so for checking accounts. It will be advantageous to credit card companies to help consumers convert to and manage authorized payments. We expect credit card companies to begin to position their product accordingly. Visa has already announced its strategy for becoming the preeminent payments system. Also, most card companies have bank affiliates. In time, they could purloin a customer’s entire transaction relationship by tying the credit card to a deposit account. At a minimum, these developments will crimp the electronic bill-payment initiatives of banks, reduce visits to banks’ Web sites, and dampen exposure to their product offers, thus making cross-sell more difficult. Ultimately, banks may have to be direc t issuers of cards to gain revenue or risk losing out.
What does the shift imply for future product competition? Eventually, even credit card payments must pass through a bank. Customers will still need a basic relationship with their bank to monetize payments. But to avoid being reduced to merely the end point in the trail of electronic debits, banks will need to adapt their current product offerings to electronic payments. The traditional checking account will need to be overhauled. The bank must offer transaction accounts that make it easy for the customer to set up electronic debits, track them on the statement, and tie transaction account activity to their credit cards. The price must be competitive with the nearly free ride they get when using credit cards for transaction payments. The key is a bank funding account that interacts with the credit card. For the bank, this reduces expensive check volume; for the consumer, it provides complete record keeping and better protection against fraud.
Ultimately, transaction accounts offering high-yield and low-fee e-payment services will prevail. Several banks are already offering e-checking accounts that do just that. This is a logical outcome as banks use the money gained through improved operating efficiencies to compete on price. From the consumer perspective, distinctions between savings and transaction products will continue to blur as providers continue to link accounts to provide one picture. This is already manifested in the various cash management and asset management accounts currently being offered. Ultimately, customers will seek just one account number and statement of position from which to manage their entire financial situation.
While opportunities do exist for banks to offer payments system services as a free-standing business, such stand-alone payments systems will have difficulty emerging in the face of the free transaction service that consumers are already embracing through the credit card. Banks have had little success in weaning consumers from “free checking.” Charging for credit card transactions may be as difficult.
At the same time, retailers are rebelling at the interchange and discount system of pricing, which is what subsidizes consumers’ use of free credit cards. Consumers even rebel at annual fees for cards, and the high-income segments most likely to use cards as payments devices are the same groups that often have such charges waived. Current lawsuits against credit card consortiums may wind up threatening, if not destroying, this payments subsidy.
So the outlook for stand-alone payment systems, including debit cards, is not as rosy as one would think. Once given a free ride, consumers are highly resistant to paying, unless the new payment device is highly effective, efficient, and economical.
At this point, consumers feel relatively protected when using a credit card because of the often-waived regulatory loss limit and payment reversal rights. But they are becoming increasingly aware of identity theft and privacy violation, since they read horror stories daily about massive data thefts. Identities can be concealed or fabricated over the Internet and all electronic payments systems. Controls on user identity and authorization will become imperative if fraud costs are to be kept under control.
Also, it is no easy task to enforce money-laundering prohibitions for electronic payments.
Because consumers have figured out how to use credit cards as a de facto free payment mechanism, it’s unlikely they would be interested in any system that’s not free. The key, as noted earlier, is to create hybrid transaction accounts whose intrinsic information content and ease of use make reasonable fees acceptable. A complete repricing of credit cards may be the only real solution, since consumers will have to see an equal or better deal if they, instead of the merchants and the banks, are to bear some of the transaction costs.
At the same time, banks must study how to overcome retailer resistance to card discounts and interchange fees to create a high-value payment process that retailers will promote to consumers. This may mean enormous investments in technology along the lines of Visa’s current plans for an ubiquitous high-volume, low-cost transaction system. Banks need to make their debit card a sound alternative to credit cards as a consumer payments mechanism–both from the consumer and merchant perspective.
Finally, security protection will become even more important–not merely because of mandated privacy, money laundering, and identity theft controls, but because electronic payments, though they’ve been around for some time, still are not foolproof. We have only begun to see the emergence of schemes using electronic payments. Operating risk will increase. The real challenge will be how to make these new payments systems as secure as possible.
We face a real challenge in displacing the credit card in the minds and pocketbooks of consumers. But if we ignore the challenge, the problem will go away–along with our consumer profits.
Less Paper: Payment Transactions in 1979, 1995, and 2000
1979 1995 2000
Check 32.8B 49.5B 42.5B
Credit Card 5.3B 10.4B 15.1B
Retail ACH 0.2B 1.4B 5.6B
Debit Card — 2.8B 8.3B
Total 38.3B 64.1B 71.5B
Note: Table made from pie chart
Hanley can be reached at firstname.lastname@example.org; Furash can be reached at email@example.com
[C] 2003 by RMA. Hanley is a partner at Capital Performance Group, LLC, a management consulting firm headquartered in Washington, DC, offering advisory, analytical, project management, and information services; Furash is chairman of Treasury Bank, headquartered in Alexandria, Virginia, offering certificates of deposit, money market accounts, and home loan products.
COPYRIGHT 2003 The Risk Management Association
COPYRIGHT 2005 Gale Group