Pressure from Merchants Compels Credit Card Industry to Build New Business Models

The days of merchant-subsidized credit card rewards programs, rapid increases in interchange fees, and confusing fee structures for credit card purchases are numbered, according to new research by Diamond Management & Technology Consultants, Inc. Consumers are already seeing popular “cash back” and other reward programs being curtailed. Banks are fearful of losing a large fraction of their $19 billion in interchange fees that fund these programs. And if merchants successfully steer customers to competitive payment types, banks stand to lose a significant slice of the transaction volume that drives their card interest income, usually estimated as 70 percent of total credit card revenue.

“Merchants are unhappy with what they consider unreasonable credit card fees and are beginning to take serious steps to minimize their expenses,” said Carl Hugener, a partner in Diamond’s financial services practice. “Left untreated, the landscape of the $150 billion card industry could be altered drastically in the next three to five years and end up costing issuing banks and card associations billions.”

However, there are steps card issuing banks and card associations such as Visa and MasterCard can take now to stem the flow of revenue from their businesses, and even create new revenue sources.

Diamond’s analysis of the changing card payments landscape is outlined in a new report, “A New Business Model for Card Payments,” available by sending an e-mail request to: futureofcards@diamondconsultants.com

Current Interchange Model Under Pressure

Issuing banks have profited greatly from increasing merchant interchange rates in recent years. Merchants have become frustrated with the interchange process as the cost of processing transactions — one of the original reasons for interchange — has dropped to only 13 percent of the total interchange cost.

“The first casualty in a world of lower interchange likely will be issuer rewards programs,” said Hugener. “Rewards are very useful as a competitive weapon in the fight for issuer market share, but they also account for as much as 44 percent of interchange costs — costs paid for by merchants without directly benefiting them or their customer relationships. In fact, these rewards programs drive consumers to payment choices that are the most expensive for merchants.”

Hugener also points to the card issuers’ complex fee structures as a source of contention with merchants. Fees can be charged at more than 100 different rates, depending on the card, who is accepting it and many other factors. The price paid is determined by card type, transaction type, transaction size and qualification and the merchant’s industry.

“Our view is that this level of complexity and confusion is not sustainable in the current legal and competitive environment,” Hugener said. “Merchants are unlikely to accept less than full explanations about what they are paying for, particularly when payment costs represent a high percentage of their profit. Both Visa and MasterCard have moved to reconstitute their price- setting bodies in ways that are likely to be more friendly to merchants.

“Once transparency comes to credit card pricing models — as it ultimately does to virtually every industry — merchants will use the information to force an unbundling of interchange fee structures, and the interchange structure as we know it will disappear,” Hugener predicted.

As for payment alternatives, Automated Clearing House (ACH) payments appear capable of siphoning payment volumes away from credit cards and instilling bargaining power with merchants at the expense of card issuers and associations.

Emerging competitors like Pay By Touch, PayPal, and Google Payments pose a genuine threat to dominant card operations. At one level a credit card is simply an authentication device that proves who its user is and gives access to the consumer’s account. The process through which the user is authenticated begins the routing of the transaction over the card network. But separating authentication from the card would allow merchants to drive consumer payments to low-cost avenues.

“History tells us that once models are taken apart this way, more and more alternatives arise, and the systems eventually fall apart,” Hugener said.

The New Model

The Diamond report notes that there are ways to protect revenue for issuing banks. Adjusting business models by unbundling the interchange components and charging directly for value delivered will enable issuing banks to develop new consumer card pricing models.

“Issuing banks can protect revenue by adjusting their business models now,” said Hugener. “They can develop new consumer card pricing models, forge new value propositions for merchants and consumers, and expand or discard legacy business models. They can leverage the data embedded in the payments stream, not only providing additional services to merchants, but also creating new businesses for themselves.

“By emphasizing their demand deposit account (DDA) and debit card operations, they can not only deepen their relationships with their customers, but also replace much of the revenue that may be lost from credit card fees. And it is hardly out of the question that one or more large issuers will take the card business full circle and create a bank-owned closed-loop network, directly controlling the entire value chain and therefore pricing to the merchant,” Hugener added.

Protecting the Payments Franchise

Hugener urges banks and networks immediately start developing strategies for improving revenue and mitigating risk. At a minimum, banks must:

• Take an enterprise view of payments. Identify current assets that could be leveraged for future uses, including thinking broadly about new uses for old technologies. Emerging players in the payments business are doing this — in particular looking for ways to leverage the ACH network.
• Add value to merchants. Offer bundles of products to merchants, matching the right payment type to the right solution. This will lead to a risk-based pricing model that is both sustainable and beneficial to both sides.
• Provide real incremental value to consumers. Develop rewards programs based on the value of the overall relationship, and use the bank’s knowledge of the consumer to tailor solutions. Information and data analysis platforms have the potential of improving the bank’s ability to serve both consumers and merchants.

The card associations, in turn, should:

• Increase focus on the value of processing assets. These are likely to be real value drivers in the future.
• Invest in platforms that will handle the processing of more payment types and in improving merchant capabilities at the point of sale. Improving capabilities in these areas may require buying emerging players.
• Aggressively pursue processing opportunities in new industries (such as healthcare) and new geographies.
• Continue down the more conciliatory path with merchants that seems to have begun with the appointment of new bodies governing interchange pricing.

“The credit card business has been a bonanza for banks over the past several decades. It will continue to be a great business if the industry recognizes the coming change and adapts before emerging competitors do,” Hugener said.