ach week, it seems, there is another announcement of a new payment offering or enhancement to an existing payment service. This research report by the Federal Reserve Bank of Chicago provides an understanding of the business drivers that motivate banks, processors and payment systems innovators to risk investments in order to create or adopt these payment innovations.

The authors of the white paper acknowledge that while banks still control the settlement process, profit opportunities are shifting to non-bank innovators, which identify and overlay value-added services to both mainstream and underserved markets.

The authors of this report attempt to answer the question in the title by referencing published innovation research findings and drawing their conclusions from a series of interviews they conducted with executives across the payments industry.

The results of this research offer all members of the payments community insight into why we experience so much change; and criteria for judging which payment enhancements, as they move through predictable stages of the innovation adoption lifecycle, are likely to succeed.

Executive Summary

Before addressing the central question of this white paper, the authors first define the following fundamental terms used in their argument:

Payment: A transfer of money from the payor to the payee that results in a change in the account balance for both parties in a bank. Both parties are referred to as transactors.

Payment System: A means by which transactors can make interbank transfers within a legal framework that defines the rights and responsibilities of all parties.

Payment Innovations: New payment methods and various value-added services complementary to the funds transfer-including payment-related information.

Business Drivers for Payment Innovations

The authors define the following four investment strategies that drive innovation in this field:

1. Decrease Cost: Achieving savings over traditional payment practices is a major motivator for making payment improvements. Two classic examples cited were the original justifications for the Visa authorization system: BankAmericard Service Exchange (BASE) I and the BASE II interchange and settlement system. BASE I initially cost $3 million and generated $30 million in savings its first year. BASE II cost $7 million and saved member banks more than $12 million in postage savings its first year.

2. Increase Revenue: The example given for this type of business driver is the increased interchange revenue generated by card issuers each time a debit cardholder makes an off-line debit purchase. This example also makes the point that excessive revenue at the expense of merchant transactors would eventually be corrected in the marketplace or courts, as was the case with off-line debit cards.

3. Customer Acquisition: Here the business driver is the prospect of product differentiation leading to new customer relationships. Competitive advantage is difficult to maintain in the payments space as outsourcers or processors quickly develop close alternatives to serve clients seeking to protect their current customer base.

4. Customer Retention: The interviews showed that this was a primary driver for banks in adopting new payment improvements. Retaining existing customers and selling more to them is thought to be more cost effective than investing in the recruitment of new customers.

The other dimension of new service extensions is the widely held belief that the more service relationships you have with a customer, the greater their switching costs in finding an alternative. To support their reasoning, the authors cite the classic example of stored-value cards issued to a retailer's customers by a processor.

The prospect of re-issuing those cards and transferring the files containing current balance information represents a formidable obstacle to losing that merchant relationship. Payment Innovators, Providers, Processors The authors also describe the different types of institutions that create and adopt payment innovations.

Banks

As a rule, banks do not maintain a research and development staff to create refinements in payments. This is in spite of the fact that the revenue mix for the industry is moving away from interest income to fee income-primarily from payment services. Payment revenues are estimated to be as high as 42% and growing.

Smaller banks tend to serve niche markets-both in terms of customers and geographical coverage. They are often very sensitive to customer feedback within those niches-especially if it concerns retaining the relationship. Because they tend to rely on processors or outsourcers for services, they listen to their customers and then go back to their processor to help support their customers' needs.

Larger banks also tend to purchase solutions from third parties and seldom from other banks. Because of the isolated nature of their different product lines, large banks have a handicap in making payment innovations. Often referred to as "silos," they cause considerable frustration for customers who can't understand why the bank representative on the phone doesn't know that their payroll was deposited yesterday.

Payment innovations are more frequently information-based, so large banks are forced to build shared databases that receive transaction feeds from a growing list of payment types.

Non-bank Innovators

These are relatively small firms that create and market new payment products. For example, PayPal [now owned by eBay] is considered a non-bank innovation driven by traditional payment methods (excluding merchant agreements) for individuals or very small businesses that were doing business over the Internet via auction sites such as eBay. PayPal created critical mass by initially rewarding new customers with small free deposits.

Aggregation is another emerging new innovation being refined by non-bank providers. Aggregation is the ability for consumers to link and display their various financial services from different service providers on a single screen. This capability is evolving to enable seamless funds transfers across these different institutions.

Certain customer niches such as high wealth individuals and their financial advisors are adopting this technology. And banks interested in serving these customer segments are now adding this innovation to their online banking capabilities.

Joint Ventures and Consortia

Innovations made by joint ventures tend to differ from those developed by an individual company. For instance, they often leverage the participant's core competencies or brand recognition. The Starbucks stored value card is a classic example of a successful alliance between a retailer and a giant bankcard processor.

Card associations, ATM networks and payment networks (such as NACHA) all represent different organizations in which members work through committees to achieve their individual objectives. By necessity, these organizations take considerable time to accommodate change-often with many compromises along the way. Yet they do represent a means of sharing costs and risk to create a platform upon which many users can share in the innovation.

Required Conditions for Successful Payment Innovation

Payment innovation tends to move through a predictable set of stages, beginning as a proprietary technology and ending up as a commodity. Across this continuum are stages in which pricing and profit margins tend to start off high and shrink as the market grows. Research has shown that payment innovations require the following conditions to exist for them to succeed:

• They must create demand and supply at almost the same time; security and liability issues need to be satisfied, but typically in a transparent manner.
• They also need to provide tangible or perceived benefits for both transactors in order for the innovation to gain market acceptance.
• Finally, they tend to launch from a niche market that is most sensitive to the benefits offered.

The Innovation Timeline

There are three phases to this adoption process:

Phase 1: Innovators

A set of banks and nonbanks typically come together to seek a first-mover advantage to either tap new market segments or steal existing customers away from competitors.

Innovators face higher investment risk, and they expect compensation for this risk in various combinations of the four drivers mentioned earlier in this summary.

There are advantages to being first to market including the ability to establish reputation/brand awareness; a learning curve gained from mistakes that serves to create a barrier to entry and critical mass, which tends to provide profit margin advantages difficult for followers to match when it comes time to face competition.

Phase 2: Followers

Competitors start to enter the market; those with relevant skills typically make the leap and begin offering close substitutes to clients that are unable or unwilling to obtain the innovation from its originator.

As banks or processors begin to make the innovation a source of differentiation, their competitors start looking for suppliers that help them protect their customer base. Some banks and processors pride themselves on coming late to innovation and learning from the mistakes of their predecessors.

Phase 3: Economies of Scale and Outsourcing

This is the final stage where the new service moves toward becoming a commodity, and product competition shifts from differentiation to lower cost and service-level importance.

This is when the players that are processing payments internally become pressured into outsourcing the function to large national processors.

Conclusion

This document contains a rather extensive bibliography for anyone who wishes to delve deeper into any of the concepts described above. The report is well presented-both in terms of the framework for explaining such a complex aspect of our industry and the range of examples and interviewer quotes used to demonstrate those points.

Web Sites for More Information

http://www.chicagofed.org/paymentsystems/index.cfm Federal Reserve Bank of Chicago: Emerging Payments and Policy Resource Center

http://www.phil.frb.org/pcc/index.html Federal Reserve Bank of Philadelphia: Payment Cards Center

http://www.tawpi.org/membership/Council.htm The Association for Work Process Improvement: Remittance Processing Check Council

Eric Thomson is Executive Vice President of Profit Source Advisors. He can be reached at eric.thomson@profitsource.us.