“I noticed that very intelligent and informed persons were at no advantage over cabdrivers in their predictions, but there was a crucial difference. Cabdrivers did not believe that they understood as much as learned people – really they were not the experts and they knew it.”
–Nassim Nicholas Taleb
Even though we are living in a time of extraordinary change, our industry seems to be caught looking in the rearview mirror to determine what future actions to take. We continue to look to Washington to see what changes we are going to have to react to, regardless of our past experiences. Maybe it’s just because I’ve been reading “The Black Swan” by Nassim Taleb, or perhaps it’s because I’ve just seen too doggone many surprises lately, but I’m thinking that perhaps now might be the time to do a little more “what if” thinking than we usually do. In today’s article, we are going to take a look at some things that we don’t expect to happen, but could. This article will discuss some things we can do to protect against the unknown in our dealings with our third party providers, things that could give you more flexibility and protect your organization down the road.
The following questions are intended to provoke thought about what might happen if longstanding trends start to moderate or even reverse themselves.
What if debit and credit card usage starts to decline?
Our phones are ringing off the hook with questions about what impact the Durbin amendment will have on future income for the debit card portfolio’s at banks. The most common question is, “How will this affect my institution on interchange income?”
One of the key features of this amendment is that it will give the merchants some ability to decide what purchases they have to allow via debit card. This change in my mind is just as scary as limiting our interchange income per transaction. Once a merchant starts discriminating on cards, we could well see the long enduring trend of going to a cashless society reversed. I don’t know about you, but as a consumer, the first time I pull out a card and get told by a merchant that I can’t use it to make a purchase, I am going to start carrying more cash around and be a little less inclined to use that card next time.
So what effect could that have on us? Overall EFT transactions could start declining over time. Are we prepared for that? Interestingly enough, at Cornerstone Advisors we are seeing financial institutions that are currently entering EFT processing contracts wanting to go shorter terms to protect themselves against unknown events that could happen in the future. Sounds good, right? But what if card account holders go down overall in the industry and overall EFT transaction and dollar volumes start declining? In that case, it is almost certain the vendors are going to need to increase their prices to cover their processing costs and protect revenues. In that case, those with longer contracts (assuming their rates are favorable) are going to be much better off. Sounds counterintuitive, but perhaps going longer on EFT processing agreements right now is better than shorter if you can lock in the best rates.
What if EFT interchange rates and signature interchange rates start to decline?
Remember the myth that housing prices could only rise? We all understand how that worked out. But there are other myths just as ingrained into our consciousness. The myth we want to concern ourselves with here is that interchange rates will always go up. What if they don’t, or worse, start to decline?
Out of all of our third party agreements, the ones with our card brand (Visa and MasterCard) and the ones with our POS EFT networks are the only ones where you don’t have the ability to negotiate prices. These are all priced with national interchange schedules that can be changed anytime by the vendor. The agreement is with the vendor for a term, and when you ink one, you are betting that the horse you chose to ride is going to be leading the pack for the duration of the race.
Historically these rates have only gone up as the vendors try to buy business away from their competitors. But what would happen in an environment where these interchange rates start to decline and/or your chosen partner starts falling behind the pack and stays there? With in the neighborhood of 30 cents per PIN transaction and 50 cents per signature transaction on the line as income, financial institutions could start feeling an impact very quickly. To obtain more flexibility, it makes sense to keep these agreements to as short a term as can be managed. Two to three years for these types of agreements seem reasonable to us, unless there are huge incentives that are agreed to for a longer term agreement.
What if charging customers a fee for debit card PIN transactions becomes commonplace?
Another question Cornerstone gets asked a lot is whether it makes sense for a financial institution to charge its customers in some fashion for PIN transactions. These fees generally come in two flavors. The fee can be on a per-transaction basis, or it can be a fee for a customer exceeding so many free transactions.
The overall idea to this point has been to discourage PIN activity and to generate signature card activity, which has a much higher income per transaction that a PIN transaction. This is the other half of the “carrot and stick” approach of trying to influence card behavior. Rewards programs are the “carrot” and the PIN fee is the “stick.” Over time, more and more financial institutions may decide that PIN fee income is a surer way to generate income than through rewards programs alone. In addition, if EFT network vendors start to reduce interchange rate schedules (or our friends in Washington make them), institutions may need to pursue charging customers a PIN transaction fee to maintain profitability in the card portfolio.
Unfortunately, we have just seen our first example of an EFT network coming out with an “Exclusive Network” arrangement that prohibits “any fee that can encourage activity for Signature transactions over PIN transactions.” I.e., an institution that signs up for this EFT network (we won’t name names) for an exclusive agreement won’t be able to charge PIN transaction fees to its customers. Exclusive network arrangements can be attractive for financial institutions because the interchange rates are usually a few cents higher than under a non-exclusive arrangement. However, signing up for an exclusive agreement that gives the institution an extra few cents in interchange income at the cost of not being able to assess PIN fees for the duration of the agreement is a cost of flexibility that really needs to be looked at and discussed with executive management. Hopefully this is not a trend that will extend to the rest of the EFT networks.
While we understand the EFT network vendor position of protecting their turf (as they don’t get a piece of the signature pie), we can’t condone a client giving in to this extortion. For the institution that find value from a card rewards program, Cornerstone advocates separating the card rewards program from the EFT processing agreement and signing a shorter term agreement for the rewards program to protect the institution’s flexibility down the road.
What if charging a customer a fee for Internet banking and bill pay becomes commonplace?
As different fee income opportunities are taken away by our representatives in Washington, more institutions are likely to consider charging for services that are now free. Charging works best, of course, when the customer sees the value and/or there is a clear “stickiness” to the service where it is difficult for the customer to just up and leave. While Cornerstone is only starting to hear our clients talk about the possibility of charging for Internet banking and bill pay, I feel it could be one of the next frontiers pursued for fees after free checking goes by the wayside.
If customers were charged for these services, it wouldn’t take much imagination to see the growth in Internet banking usage leveling off over time. However, an institution may be able to charge for Internet banking and/or bill pay services with a smaller customer base and still make money. If this ever happens, of particular concern would be in the bill pay area. A good portion of banks still pay for bill pay pricing consisting of bundled per-user pricing where a fee per user is charged and then so many (let’s say 10) free bills are included. This billing structure never made sense in the past, and it will be even more onerous in a declining bill pay transaction scenario.
To prepare for this type of an environment, financial institutions will want to make sure they are paying their service providers for bill pay transactions a fair price “by the drink” (unbundled or per-transaction pricing) and that minimums are set 25% to 30% below current usage.
What if inflation goes up (a lot)?
When I started college in the late ’70s, I was ready to buy my first car. The interest rate for that bad boy was 21%, and to this day Paul Volcker is getting kudos for the high interest rates that “ended stagflation.” I wasn’t so supportive of Paul’s approach at the time, by the way. Believe it or not, that was only 1% over the federal funds rate at the time. Will this happen again? Surely not. But, from one who lived through it once, I’m not convinced that we are going to be near zero for the next decade. In fact, it sometimes appears that we have just kicked the can down the road for our nationwide credit abuse to the federal level and have to pay the piper sometime.
In any case, I can’t tell you the number of third party agreements I see that allow vendors to change prices as they choose, or are tied to the Consumer Price Index without any limiter. If we experience a period of above average inflation and the vendors respond by increasing their fees to the maximums allowed under their customers’ third party agreements, it could really throw a bank or credit union’s expense spending out of whack. We strongly recommend to our clients that at their next renewal opportunity, they take a look at the fee adjustment language in ALL of their agreements and start trying to protect themselves in this critical area. If inflation goes up dramatically, those banks that don’t have language protecting fee increases will be subsidizing the services for those that do have the protection.
It is our sincere hope and expectation that the banking industry as we know it won’t change dramatically and that some of the unusual events we have considered today won’t need to be addressed. But it never hurts to be prepared – especially if it doesn’t cost anything to do so. Hopefully our suggestions today won’t cost banks and credit unions anything to implement but will protect their interests if the unexpected happens.
We don’t have a crystal ball, but if you’re thinking about taking preparedness action to combat some of the “what ifs,” Cornerstone Advisors can assist you with that. Cornerstone offers an array of services that can help institutions strategically position themselves against some of the unknowns we’re dealing with in this time of economic uncertainty.
Contact us today to talk a little D.