The Coming End of Big-Issuer Hegemony in Bank Card Payments

This is the third installment of a six-part series exploring the growing economic tensions and structural conflicts between acquirers and issuers in the bankcard business.

A handful of big issuers dominate the bank card business and command the lion's share of merchant-acceptance fees. Just about everyone else in the payments industry is beginning to question whether that makes sense any more?especially acquirers, which do the lion's share of the work and get relatively little compensation for the effort.

The disparities are pretty clear: All-in, in 2007, bank card issuers pocketed nearly $24 billion in interchange, or about 75% of total merchant-acceptance fees. Visa and MasterCard kept another 10%, and acquirers, processors, and ISOs earned the remaining 15%. The top 10 issuers, in turn, captured more than 80% of that $24 billion in interchange (not to mention nearly 90% of bank card revenue, other than interchange, of more than $90 billion). As they say, “It's nice to be rich.”

Historically, this one-sided relationship was based on the high initial costs of credit underwriting, authorization, and risk management as the credit card business evolved from merchant-by-merchant credit granting to syndication by bank card associations. Over the nearly three decades since electronic draft capture and terminalization were completed, however, fraud rates have declined to a few pennies per $100 in transaction value, while electronic network and computing efficiencies have dropped some marginal processing costs for banks to less than a nickel per transaction.

Given all the work done by acquirers and processors, which face daunting price compression (Digital Transactions News, Aug. 6), why should issuers continue to get the lion's share of the largesse from merchants? This question is particularly relevant in e-commerce, where the merchant bears most of the costs and all the liabilities for fraud, and especially so with signature-debit card use, where the issuer's risk is materially lower because it can see the funds in the account at authorization.

Alternatively, in the face of mounting legal and regulatory challenges, why wouldn't issuers be more amenable to reducing interchange, particularly given all the efficiencies gained through digital processing over the years?

The answers lie partly in what issuers do with the money they make from bank cards. For example, chargeoffs due to sub-optimal credit granting and extensions of “credit” on signature-debit cards (in return for lucrative non-sufficient-funds fees) have grown over the years to an estimated $35 billion a year. Beyond that, Diamond Consulting has estimated that 44% of merchant interchange goes to fund rewards programs for consumers as issuers compete aggressively for each incremental card and transaction. And issuers continue to dump 6 billion direct-mail solicitations a year on tapped-out consumers. No wonder merchants complain that they are paying for unconstructive business models by issuers.

But the simple truth is that the big issuers have been getting away with gobbling up the bank card industry's largesse because they can. That industry dictum might not be true for much longer, however. For, among other things, the bank card associations, which put into motion big-issuer strategies and economic aspirations over the years, now seem bent on behaving more like the public-reporting companies they've become (more on that in Part Five).

Another reason the feast may soon end for big issuers is a growing awareness among the 17,000 other smaller banks and credit unions (and their processing partners) that they no longer need to be satisfied with getting just the crumbs that fall of the bank card table (more on that next week). Processors and alternative-payment providers are busily tooling them up for participation in the many market niches that are poorly served by signature-based cards.

A third threat to the big-issuer status quo is a growing movement in the industry to offer fundamental alternatives to the notion of interchange itself! This movement?kept quiet until now for obvious reasons?is fueled both by the increasingly liberal access to bank networks (think of the decoupled debit card offerings by Capital One and HSBC), and the growing realization among acquiring processors that the industry can self-insure against most chargebacks and fraud if it sets prices according to specific market-sector characteristics.

On-us possibilities abound now, too, with the associations in retreat on several fronts on rules that restrict payment choice and use. Acquirers, once chastened by the First Data/Visa suit over an embryonic version of on-us processing, are busily exploring newer versions of this concept for electronic and mobile commerce. Target pricing will be based on?gulp!?actual risk, costs, and market demand!

But the ultimate undoing of big-issuer hegemony in bank card payments will be defections from within. Some of these issuers are also invested in the acquiring side of the business, and realize that volume growth will come from more enlightened penetration of new sectors of demand with products and prices that drive adoption and use.

With Congress joining merchant law firms in blasting the walls of the signature-based card fortress, any big issuer not prepared to shift to contingency strategies that foster greater payment value and choice might soon find its plate at the table of bank card largesse filled only with diet food.–Steve Mott