U.S. Retail Payments: Opportunities and Challenges
One of the enduring hallmarks of the U.S. economy over the last nearly 10 years has been its tremendous, in some respects awe-inspiring, growth in productivity. After better than two decades of productivity growth that averaged 1.5%, annual rates of productivity growth jumped to 2.5% for the years 1995 to 2000. Then it accelerated even more through the equity market bust, the recession, and the long slow recovery. Even now, four-quarter growth in productivity is 5.4%, or better than four times what it was just a decade ago.
Clearly, a brave new world in retail payments processing is possible, and we may be on the cusp of that world. But new worlds are never entered into without some form of wrenching change. The transition to a fully electronic retail payment and check collection process will involve challenges. What are they likely to be?
The first challenge clearly involves existing bank infrastructure and investment. The declining number of checks is making the current paper check collection infrastructure redundant. We are confident excess capacity in check processing facilities and check sorters already exists, both in banking organizations and at Reserve Banks. All of us involved in check processing have invested in enormous infrastructures to process paper checks. As check volumes continue to decline, excess capacity will become more apparent in the payments processing business. A reduction in infrastructure will be necessary and unavoidable.
We at the Reserve Banks, for example, will have closed 13 of our check processing sites, or more than one quarter of the total sites, by the end of this year. And we will continue to review our infrastructure each year – we need to be efficient to be sure, but the reality is that as paper goes away there will be less and less for existing staff and machines to do. Further consolidation of processing infrastructure and reductions in staff are certainly options, and we are pursuing those options as are other check processors. But sooner or later, investments in existing hardware and software will have to be written off. That's easy to say but sometimes hard to do, and not cheap.
But that's only half the problem. Investment in new check processing infrastructure still will be required in the near term as the collection process becomes more electronic. The resources needed to prepare for electronic check collection vary from bank to bank. A community bank that is image-enabled today may need to spend relatively little money to be fully capable to convert checks into digital images and process them electronically, while a large bank may have to make some significant investments. However, because large banks process a disproportionate share of large-dollar checks, they also have the most to gain from collecting checks faster with electronics. In this payments system transformation, each bank needs to assess its existing check infrastructure and determine whether to make near-term investments or perhaps to outsource to other service providers.
All of this naturally will have an impact on costs. During the transition from the current to the ideal state, the cost of handling each check could be higher. Banks will have to support a dual infrastructure of paper and electronic check processing for some time. Once that period is over and banks move to fully electronic check collection, it will be much cheaper to process retail payments than it is today. To get there, bank branches may have to be equipped with image-capture technology, and retailers may have to invest in check-scanning devices. Once over the hump, however, all participants in the payments market will benefit.
A shift from paper to electronic collection of checks is a move toward technologies with higher fixed costs, but potentially very low variable costs, and consequently with higher economies of scale. The greater the volume of transactions, the lower the cost per transaction will be. This seems like a win-win situation: user costs will fall without eroding profits to banks providing the services. And in this scenario consumers and businesses can continue writing checks if they want to.
For many bank accounts, checks already are not returned to the checkwriters — a process known as check safekeeping or check truncation — and that trend will accelerate in preparation for Check 21. In many instances, images are sent to the checkwriters instead. Banks see transportation as the biggest cost saving from Check 21, especially for those institutions with a widely dispersed branch network. Check truncation also reduces the costs of preparing and mailing cancelled checks. Initially, the savings are likely to be small. Over time, as all paper is replaced with digital images, all banks — large and small — are bound to reduce their costs.
Now what happens to bank income during the transition? Anecdotal evidence suggests that for some banks, income related to retail payments is a major share of the total. Some of this income comes from payments other than checks, such as credit card interchange fees. However, a not inconsequential portion comes from check-related fees, lockbox processing fees and check float management. Managing the transition from paper to electronics will require the revenue generated from paper to be replaced by fees from new electronic payments products and information services. Banks will have to determine what kind of electronic payments services best fit their customers' needs. The dilemma will be to induce customers to move to the more cost-effective electronic services and simultaneously to create new income streams - a challenge, to be sure, and one that will be addressed differently by different banking organizations.
To summarize so far, the transformation in the payments system will require some investments to be written off and staffs to be reduced; it will require near-term investment to make the paper collection process more electronic; but over time it will free up capital for other investments. Costs in the new electronic payments world will be significantly less than in today's labor-intensive paper processing environment. Banks will lose sources of current income and will need to find new revenue streams to replace this lost income. But now let's think about how integral checks are to broader bank strategies.
Evidence shows that banks are continuing to expand their branch networks. But why do consumers and small businesses go to branches? Often it is to cash or deposit checks. Banks then use this as an opportunity to cross-sell other services. When consumers and small businesses no longer have checks to cash, what is going to happen to all those branches? Will they still be cost-effective channels for delivering and selling services? Could we really be on the cusp of that world we thought was here a few years ago when some analysts thought branch networks a thing of the past? I was dubious then, but perhaps less so now.
The nature of competition in the payments market is changing as well. As electronic payments reach critical mass, non-banks can become more effective competitors. It is easier for non-banks to enter those markets than to compete in traditional paper check processing. In this competitive environment, early adopters of new electronic payments technologies may be the ones to reap the benefits. Online banking and bill payment services have become important factors in consumer selection and perception of banks. Clearly, the competitive environment is shifting.
The transition from paper to electronics is best for the U.S. payments system, for the economy, and even for individual financial intermediaries. It represents yet another opportunity for significant productivity growth in the financial services industry. Electronic payments are cheaper to process, and that cost will be lower as more retail payments are converted from traditional paper processing. Consolidating and over the longer term eliminating much of the paper collection infrastructure today will release resources that might be used elsewhere tomorrow. The process is already taking place throughout the payments market. Those institutions, which adapt to the change in a deliberate way will be more productive and will be able to release capital to be invested in other ventures. These are the firms that may come out as the winners over time.The transition from paper to electronics is best for the U.S. payments system, for the economy, and even for individual financial intermediaries. It represents yet another opportunity for significant productivity growth in the financial services industry. Electronic payments are cheaper to process, and that cost will be lower as more retail payments are converted from traditional paper processing. Consolidating and over the longer term eliminating much of the paper collection infrastructure today will release resources that might be used elsewhere tomorrow. The process is already taking place throughout the payments market. Those institutions, which adapt to the change in a deliberate way will be more productive and will be able to release capital to be invested in other ventures. These are the firms that may come out as the winners over time.