Debit Cards on the Offensive
There’s a resounding call to action in the banking industry on debit cards, the burgeoning substitute for checks and cash that produces an interchange fee with every transaction. In an otherwise sobering forecast for consumer banking in 2007, debit offers one of the few bright spots in deposit fee revenue growth. Already, the debit card provides the second-largest DDA fee source for many banks, behind overdraft fees.
Given the vast market potential and crucial revenue role for this product, it is no wonder that distribution considerations have taken center stage. For many bankers and experts, it’s all about getting debit cards in the hands of customers, encouraging activation and usage, and promoting direct deposit and debit bill pay.
Such efforts no doubt will be helpful in the short term. But strategies beyond broad card distribution soon will be required. The level of per-transaction fees for debit usage is coming under sharp pressure, for example, implying a much more disciplined approach to product development and rewards programs. The role of the debit card is expanding, from an add-on to the checking account to an anchor of the emerging “payments account.” And new features will unleash a host of new debit card applications.
These forces are setting the stage for a new era of debit card competition that will hinge on payments innovations specifically designed for target customer groups. Increasingly, the most successful players will be the ones who learn how to use debit cards offensively, i.e., to gain profitable market share. Critically, product innovations also must elicit more financial support from the customers themselves, lessening the reliance on merchant interchange fees.
Success will hinge on a nuanced understanding of customer profiles, needs and behaviors, and associated revenue streams, implying not one but a family of debit-based offers from the institution. This is quite different from today’s “one size fits all” campaigns, which fail to distinguish among users — overlooking household profiles, what card users buy, their preferred payment methods and selection motivations, and how they likely will behave under different program options.
In our view, shotgun campaigns will not optimize debit usage and debit fee revenue, nor will they provide a distinctive strategy in the face of more sophisticated competitors. They risk accelerating the shift from signature debit, which carries the highest transaction fee, to PIN debit, whose fees are two-thirds lower. And indiscriminate campaigns risk cannibalizing bank credit card usage as well.
In the look-alike banking industry, rapid commoditization is a distinct possibility as institutions plunge into the new debit opportunity. Progressive players both small and large will avoid this trap by looking beyond the product to the major types of customers who will use it.
Certainly, there’s a lot of justifiable excitement about debit cards. Novantas projects that the debit card will be used for more than 22% of U.S. personal consumption expenditures by 2015, for example, up from roughly 12.5% in 2005.
Much of this growth will come at the expense of paper checks and cash, which will fall from roughly 52% to roughly 31% in the household payment mix. Automated clearinghouse payments and prepaid card payments also will undermine paper.
Several factors are contributing to this explosive growth. One is the proliferation of electronics at the point of sale. With the dramatic drop in telecommunications costs and the growing presence of the Internet, card capture capabilities now are feasible at many additional points of sale, where installations previously were uneconomic. In particular, low-cost radio frequency identification (RFID) technology is enabling many establishments that traditionally were “cash-only” to accept card payments. As a result, the number of purchase locations that accept plastic cards has skyrocketed.
Meanwhile, the debit card is enfranchising a substantial portion of the banking population that either doesn’t want or cannot obtain a credit card. As part of the nationwide rollout of free checking, millions of people gained debit-based electronic payment functionality when they opened their accounts. Now they have a card for personal identification, on-site payments and also online payments.
The debit card is also riding the crest of an overall shift to electronic commerce. For those who prefer cards and online bill pay over cash and checks, debit is a welcome addition to the new order. This segment already encompasses perhaps 20% of the population and represents an even larger share of debit card usage.
As if these factors weren’t enough, banks are pouring on jet fuel with rewards programs. There’s an entire base of loyal credit card users who typically pay off their balances each month and just use plastic for the sake of payments functionality and to earn rewards. With rewards increasingly offered for debit, an equivalent payments vehicle, customer loyalty to the credit card is being challenged, shifting transactions to debit cards from credit cards.
So powerful are these trends, and so encouraging are early results, that it is enormously tempting to view debit as a veritable assured opportunity, with the principal challenge being how to increase the number of users and transaction volume. But in fact, this opportunity must be managed quite carefully.
First, in preparing for the future debit market, it’s important to consider the changing economics and business model for this product. In what might be termed the “legacy” portion of the debit card business, signature-based verification generates a fee of roughly 180 basis points per transaction — not quite the level of credit cards but still healthy revenue — funded by the selling merchants who receive the payments.
Continued returns at that level would indeed foster a production approach, but the fact is that signature debit fees are under assault. Merchants dislike their growing outlays for debit transactions and are working to slash fees by any means possible, including filing lawsuits challenging interchange levels, exerting regulatory and legislative pressure, and scouring for payment alternatives. They also are coaching customers to use PIN debit, whose interchange fee is two-thirds lower, roughly 60 basis points.
Meanwhile, consumers have spontaneously embraced PIN debit, feeling that it offers greater security and convenience than signature debit. So strong is this sentiment that many people are willing to forego signature-based rewards programs in favor of PIN debit, whose usage is strongly rising. In fact, we foresee PIN debit growing as much as 4.5% faster than signature debit over the next three years.
The upshot is that banks increasingly must look beyond merchant interchange fees for the revenues needed to sustain the debit business. And fortunately, debit card users present a number of potential sources of value independent of interchange. These include DDA balances, credit needs and demand for advanced fee-based services.
There is yet another imperative for debit programs: customer acquisition. With free checking now commonplace, banks have little — primarily the density of their local branch network coverage — to distinguish themselves in the quest to capture new deposit customers. An aggressive search is underway in retail banking for differentiators in the marketplace, and the debit card certainly has a place in the offensive arsenal.
While product innovations typically are copied over time, progressive banks still can capture meaningful short-term advantages in the debit arena. Some of the new ingredients for debit innovation include:
- Additional reward features, such as “instant rewards” at the point of sale;
- New access vehicles, such as cell phones with card-swipe capabilities;
- Promising new authorization processes that let users set criteria for payments, such as a particular person, location, time, and type of merchandise.
These new capabilities can be combined in new payment products that meet a variety of convenience and security needs, and attract new customers. We see six basic characteristics along which new products can be developed:
- Certainty — standby provisions that assure card payments will be made even if funds are not immediately present.
- Control — Ability to restrict, monitor and control how funds are spent.
- Identity protection — Authentication of the funds recipient and/or user of payment products.
- Rewards — Ability to customize loyalty/ reward characteristics of an electronic payment product.
- Seamless bill pay — Integrate recurring billing into online bill pay platforms.
- Customer-to-customer transfer — Ability to securely transfer funds to another person and/or electronic payment vehicle.
To realize more non-interchange value from debit customers, capture new business and capitalize on new capabilities, banking companies must shift their emphasis from card distribution to customer profiles, needs and behaviors, and the associated revenue streams. And this is where segment insights come into play.
As part of BAI’s landmark Quest for Deposits study, BAI Research and Novantas identified six major categories of deposit customers, evenly split among “utility” and “relationship” groups. Utility customers tend to be younger, have fewer resources, and are more detached from their financial services providers. By contrast, relationship customers are more affluent, less price conscious, and have more of an appetite for in-depth service within a relationship context. (Fig 1: Debit Strategy: Much Depends on Customer Segments)
Today’s most avid debit card users primarily come from one segment, youthful Self-Servers. An up-and-coming subset of the utility customer group, these people are from the Internet generation and love all things having to do with electronic payments. They spend a lot, often carry larger credit card balances, and tend to carry lower DDA balances. The revenue formula for this crowd entails continuous debit card feature innovation, along with tight integration with electronic banking and bill pay. (Fig 2: Electronic Payments: More Than Individual Products)
By contrast, people in two other utility segments, Minimalists and Skeptics, are indifferent to online banking and bill pay. Having fewer resources and lower balances, many would benefit from a form of debit-based overdraft protection that is less costly than for paper checks.
They also might appreciate a borrowing option that allows them to postpone payment of debit charges on a month-to-month basis. Such a credit facility might seem the functional equivalent of revolving credit, yet that view would miss the important point that many consumers in this segment see the traditional revolving credit model as a trap to be avoided. Instead, they are looking for occasional repayment flexibility without the perceived dangers of becoming credit card addicts.
Within the more affluent relationship customer group, Sophisticates and Traditionalists carry large DDA balances and tend to pay off their credit cards each month, primarily using credit cards for the payments functionality and the opportunity to earn rewards. Especially given the tight retail banking market, we anticipate that banks increasingly will use debit-based rewards programs to lure and retain these valuable DDA balances. A side effect for debit rewards-promoting banks that also have credit card units, however, is the risk that lucrative credit card interchange fees will be cannibalized as customers shift transactions to the debit card.
Another example of a segment-based debit card scenario centers on parents. Consider the “traveling student” debit card, which accesses the parents’ DDA account. It might be configured to permit disbursements only for specified expense categories, such as food, lodging and transportation, and set a limit on total funds access. A contingency feature might allow additional purchases, with notification either e-mailed to the parents’ online banking account or text-messaged to the parents’ phone. The card might further provide emergency funds when authorized by the parent. Such products enhance the control and protection of the consumer’s financial affairs.
Yet another debit card constituency is composed of the merchants themselves. The best debit card strategies will benefit both the merchant and the consumer at relatively low cost.
For example, “instant rewards” at the point of sale offer a particularly fertile area for product development. To date, merchants have operated such programs internally, requiring consumers to carry the store loyalty card. By contrast, new debit card functionality will allow the accumulation of store rewards for use at the merchant POS (or merchant network, i.e. community card).
Such initiatives will allow banks to work together with merchants. In the end, merchants want to steer purchases toward themselves, as opposed to a competitor. As local banks begin to figure out how to link the purchases of their depositors to target merchants, they might find natural allies among merchants for rewards programs that carry higher interchange fees.
Based on all these examples, it is clear that the positioning and configuration of new debit products is a segment play. Long-term, this is the only way banking companies can avoid having the debit card lapse into commoditized payment vehicle whose value has been competed away to the consumer or merchant.
Building the New Debit Team
There are numerous management implications in responding to these opportunities.
The first is a shift in emphasis from production knowledge to customer knowledge. While segment-based product development is prevalent within the retail bank, it is relatively new to the payments space, where the rigors of high-volume paper check processing fostered an internal production orientation. The debit team of the future will build the business around numerous value propositions — clusters of customers, needs and products — much in the same fashion as the credit card business.
Second, in many banks there will be a capabilities gap in the deposit product management organization. Deposit product managers have not had to deal with developmental challenges related to electronics at the point of sale, plastic authentication and control, and larger customer payment needs.
Those skills have resided in the credit card organizations, but the consolidation of that industry into the hands of just a few major players has left many banks bereft of card-related developmental proficiency. Management has an immediate need to beef up its skills, both to understand plastic payments behaviors and to begin the tailored product development activities that are characteristic of customer-focused card organizations.
Executives must tread carefully and let empirical marketing techniques guide their path. Initiatives based on erroneous assumptions about what consumers want — and the profit implications — may lead to significant cannibalization or uneconomic transaction behavior. The organization should test its way into debit opportunities and be ready to capitalize quickly on the ones it finds most attractive.
Finally, more work will be needed to overcome persistent product splintering in electronic banking and payments. Most banks still operate their card and online services as collection of separate applications, with neither the customer nor the institution able to view a unified picture of accounts and transactions.
At a management level, executives need a detailed view of the customer’s total accounts, activities and relationship value. This is critical information for developmental activities, and to anticipate how the bottom line will be affected by potential product and promotional changes. An “improvement” in one area may cause a setback elsewhere, such as the interchange impact of a rewards-fueled migration from credit card payments to debit card payments. The debit card is a cog in a larger wheel.
From a customer perspective, banks need to integrate the electronic tool set, of which debit is only one piece. In many cases today, third-party software such as Quicken actually integrates information about the customer’s transaction activity better than the bank itself. Frequently, people who are most serious about electronic banking are the ones with the highest transaction volumes and largest investment balances, and the profit potential in their patronage warrants the technological pain of integrating accounts online.
As part of the ever-increasing use of electronics at the point of sale, banking customers have become much more comfortable in using plastic to access their demand deposit accounts. In turn, such receptivity provides fertile ground for innovative, DDA-based card products that can be used offensively, to attract customers, and proactively, to diversify the revenue stream beyond interchange fees. This trend will gain further strength with the emergence of innovative control and authentication functionality.
At a time when banks are struggling to differentiate themselves in the battle to drive checking account traffic to their branches, DDA-based payments via the debit card is emerging as one of the fastest-growing and most exciting fields for innovation. The same product innovation that took place in the credit card industry is now likely to take place within debit — with the payoffs skewed to first-movers.
Bankers cannot afford to let the opportunity pass by unexamined. But mastering this card trend will require the same developmental prowess seen in other realms of retail banking. And while all banks will benefit from higher debit growth, effective segmentation and differentiated offers will separate the superior from the average.
Rick Spitler is a Managing Partner, and Jim Bramlett and Lee Kyriacou are Partners at Novantas LLC, a management consultancy based in New York City.