By Lee E. Manfred

There seems to exist a perfect storm of financial market, macro-economic, and regulatory upheaval that may leave a permanent mark on the U.S. payments industry. The near meltdown of the financial markets instigated, or at least exacerbated, a global economic recession more severe than we have witnessed since the early 1980s. The election of Barack Obama accompanied Democratic control of both houses of Congress, accelerating an aggressive legislative and regulatory agenda that emerged from the financial industry bailout. All this occurred at a time when the payments industry was still adjusting to its inevitable maturation and consolidation.

Less obvious but highly probable outcomes of this perfect storm include several unintended consequences: a reduction in services offered to low and middle income consumers, increased cost of financial services for most customers, less consumer choice and more consolidation among financial services companies, as the big get bigger and the small get squeezed, and, perhaps most importantly, widespread innovation among financial products and providers.

For the first time, we can clearly see consumers consciously moving credit spending to debit, either for budgeting purposes, or lack of credit availability. The shotgun bank weddings of 2008 concentrated about 50 percent of debit spending among three institutions. Finally, low deposit rates and absence of credit demand challenge profits of retail banks flush with deposits.

Banks are expected to implement several responses to the new regulations. First, 'free' checking, i.e., accounts with no monthly or annual fee or minimum balance with aggressive charges for certain behaviors, will soon be history. In its place will be a return to relationship or bundled pricing, accounts carrying fixed fees unless a minimum balance is maintained. These accounts may also incur fees for transactions over a certain number, or increasing interest for balances exceeding specific limits. Overdraft lines of credit will also be sold more aggressively, as will linking of household accounts. Other banks may migrate former free checking customers to a general purpose reloadable prepaid card product.

Over the Long Term

Over the long term, however, more significant effects may be observed. The controls imposed on banks will limit their pricing options, resulting in more homogeneous structures. As such, high balance depositors will increasingly subsidize the fees of low balance or low income accounts. These subsidies will be in the form of lower rates on balances, monthly or per item fees, and higher minimum balances. In short, a few people will pay less, and many customers will pay more. (Parallels in the credit card space are obvious — restricting the ability to price risky accounts will increase the costs or decrease the incentives for the best customers.) With increased fixed fees and minimum balances, many low income households will be excluded effectively from mainstream bank services. These customers, ironically, will be forced to fringe services, such as check cashers, or to prepaid accounts. Further, fee restrictions increase the risk associated with transaction accounts, forcing banks to screen new customers more rigorously, further limiting low income customers' access to services. Similarly, higher risk borrowers will have less credit available and return to secured and payday lending options.

The long-term implications of the perfect storm for financial institutions are potentially ominous. Near-term profits will be constrained by slow economic growth, high cost of capital, increasing deposit insurance premiums, and the cost of implementing and complying with new regulation. As such, access to capital markets will be limited to only the biggest and strongest institutions, challenging the survival of small and community financial institutions of all sizes in a continuing recession.

Longer term, payments will continue to be a revenue growth engine for banks, as demographic and secular trends drive transaction volume growth. Banks are unable and unlikely to simply turn away from the revenue lost to this dramatic regulatory intervention. As such, the industry will respond with innovations in products, delivery channels and service levels to recapture some of that lost revenue. Ironies abound as the market emerges from the perfect storm. The first, of course, was TARP financing becoming a scarlet letter, instead of a symbol of safety. While the crisis was mostly the result of the activities of the largest institutions, those big banks will likely continue to grow and prosper, while smaller institutions are structurally disadvantaged and may perish. Marginal customers, those most in need of the protections offered by the new regulations, are the ones most likely to be harmed in terms of reduced access to mainstream services. Retailers may ultimately end up paying more for payment acceptance as debit and credit pricing restructures. Others may actually return to the business of private label financing.

Encouraging Signs

Looking ahead, signs are more encouraging. Our collective memories of recent pain will fade, and the consumer will be back driving the economy. Perhaps not driving as fast or as aggressively as before, but renewed confidence will increase spending and borrowing. Banks will then return to profitability, although another crisis is virtually inevitable. The innovations that are being considered in response to a new economic and regulatory environment may be the most lasting effect of the perfect storm. Creative minds will develop payments products and services that add value to customers across the value chain, with pricing structures that allow the industry to offer them profitably. As in most crises, great companies and great fortunes are being made by those who are best able to adapt to the new environment.

About the Author

Lee Manfred manages the deposit access and payment strategy practice as a partner with First Annapolis Consulting, Inc. In this capacity, Manfred advises leading financial institutions, payment networks, card associations, processors, retailers and technology providers on strategic initiatives related to deposit access products and services, including signature and PIN-debit issuing, ATM deployment and network management, ACH and prepaid products.