27 Feb 2014
I was reading this Wharton paper on Risk Management in Financial Institutions and the lead paragraph struck me
Financial institutions exist to improve the efficiency of the financial markets. If savers and investors, buyers and sellers, could locate each other efficiently, purchase any and all assets costlessly, and make their decisions with freely available perfect information, then financial institutions would have little scope for replacing or mediating direct transactions. However, this is not the real world. In actual economies, market participants seek the services of financial institutions because of the latter’s ability to provide market knowledge, transaction efficiency, and contract enforcement.
How would I adapt this to cover a Financial Institution’s role in Commerce and Payments? Let me share a few background points to provide context:
- Risk Based Pricing (of Consumer Transactions). This is perhaps the #1 “ask” by the big retailers I work with. For example, Amazon, Apple, Paypal, Visa/Cybersource, Google all do a fantastic job managing eCommerce risk. Their fraud numbers are below 20bps. Why do they still get hit with CNP pricing? We know the answer here of course… Each issuer gets to set pricing and there is no network scheme to price based upon demonstrated fraud/risk performance.
- Selective Settlement Risk (SSR – my term… I just made this up). In the POS world, my local Kroger would be quite comfortable taking the settlement risk on my grocery transaction, after all they have seen me purchase about the same amount or groceries for 20 years (using the same debit card). At the POS, Retailers want to be able to leverage their data to take risk on certain transactions, and shift it to other intermediaries when they do not want the risk (big screen TV). This is the central challenge for Target Red Card (and perhaps MCX) in a decoupled Debit model. For those thinking about check fraud, make sure you take a look at the Fed’s 2013 payment study “Checks had the lowest fraud rate by number (0.45 basis points) and a fraud rate by value of 0.39 basis point”. Thats right, checks have a lower rate of fraud than credit and debit cards (not PIN debit in isolation).
- Instant Credit for Commerce Transactions. PayPal’s billmelater , and Macy’s, Nordstroms, Kohls and other leading Private Label Card (with Citibank leading the sector) to a fantastic job of taking credit worthy customers off of Open Loop bank cards. The successful programs are unbelievably profitable for the retailers. With the card held by highest spending, most loyal customers.. and 1500bps on ANR. It wasn’t that long ago that most retailers had their own in store credit (see blog on Private Label), they also accepted checks.
- Authentication. As I outlined in Authentication – Core Battle for Monetizing Mobile, and Apple in Commerce, and Who do you Trust, Authentication is core to the platform (Google, Apple, ..) role in Commerce. With respect to Payments, how does a Bank PAY GOOGLE and APPLE for performing the authentication role (example using handset biometric features)? In this model they are mitigating transaction risk. This is shaping up to be one of the key issues with HCE and Tokens as the new token spec has fields for authentication. I’m not speaking of the technical issues here, but rather the business issues.. how do payment providers compensate an authentication service for reducing fraud? As a side note, for US readers, there is no better service in the market than what Payfone has right now.. with access to both Telecom network integration and Bank ID/Acct verification information.
What makes modern financial markets unbeatable? The ability for many parties to identify and segment risk, specialize and a market which allows all of these specialists to interact with transparency. Consumer Finance in general, and Payments specifically must take on some of these features.
Yesterday Jamie Dimon was quoted saying that Google, Apple, … all want to “eat our lunch” in this metaphor I guess consumers like me are on the menu. As much as I respect Jamie as the best banker on the planet, he continues to miss the consumer view… we are not owned, we migrate to where value is provided. Rather than working to specialize in consumer, Consumer Banks tend to work to build higher walls and create rules which work against the specialization. These walls will become their own jail if they fail to focus on value and specialized risk management. Today, it would be almost impossible for 4 party networks to adopt to a flexible “risk based pricing” model. My view is that Paypal, Amex, and Discover have the infrastructure to support this today.
Surprised? 30 years ago most retailers began to abandon roles in transaction risk… only to be taken to the cleaners. Hence we see investment to reassert their roles (ie MCX, Private Label, …). Retailers have no choice but to build consumer financial networks which allow for the (selective) assumption of risk (settlement, fraud, credit, Authentication…)? This taken together trends of branch closures, prepaid, mass market retail profitability make for a very chaotic environment.. (which is ripe for a new leader that can deliver value).