Financial Services

PAYMENTS ARE CHANGING, BUT HOW PREPARED ARE RETAIL BANKS?

POINT OF VIEW

AUTHORS

Sean Cory, Partner

Pontus Mannberg, Principal

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INTRODUCTION

The Nordic retail banking sector is as healthy as ever. The large financial institutions show a return of around 15%

(after tax) on equity for their retail business. All have managed to increase capital ratios, tackle (at least part of) the

cost base, and started their journey towards becoming more customer-centric. Compared to their south European

counterparts, there are limited amounts of non-performing loans to work out, as the overall economy grows stronger

across all markets. At first glance there seems to be no major threats on the horizon, but what if this is mainly due to

a previous lack of serious competition and infrastructure advancement.

An example of this situation is highlighted by incumbents losing significant share in the use of credit to facilitate

commerce and transact payments online. We believe Nordic retail banks run the risk of being sidelined, being only

the providers of banking infrastructure to pay utility bills, as consumers will use other forms of payments to transact

and finance the bigger tickets. There have also been some high profile projects failing to deliver on their promise like

Swedbank’s Bart venture and the difficulty to commercialize Swish1.

European retail banks are beginning to take payments more seriously. During the last three years we have seen

budgets for payments projects increasing from about 1% of development spend to above 5%. We believe many

Nordic banks have underinvested in this space, and have highlighted three key reasons for change.

1 Swish is a peer-to-peer mobile payments solution jointly owned by Danske Bank, Handelsbanken, Länsförsäkringar, Nordea, SEB, Skandia, Swedbank and Sparbankerna

Exhibit 1: Share of development spend being allocated to alternative payments

50

100

% OF BUDGET PLANNED

<1

1–5

5–10

>10

2011 2012 2013

0

Source Joint Oliver Wyman and EFMA report - Advanced and mobile payments: What’s stopping you? (December 2012)

Note Q3.2. What percentage of development spend does alternative payments represent? (N = 158)

1. THE DISRUPTORS GAINING SHARE

We believe one of the most important trends, in terms of impact

on overall profitability, is the growth in online retail and the use of

various consumer finance products in this market. The “disruptors”

are taking share of traditional retail banking profits by launching

invoice payments, installment loans and other types of personal

loans. Considering how revenues are split in the payments value

chain, new entrants’ growth and ability to enter the market, and the

specific customer preferences in the Nordics, we see the disruptors

as a threat in the short- to medium-term.

2. REGULATORY CAPS ON CARDS

In addition, the regulatory agenda comes into play with Single

European Payment Area, Payment Services Directive 2 and EU

regulation of interchange fees for card payment transactions

currently being planned (20 bps on debit card and 30 bps on credit

card). The effects of these regulations are yet to be fully understood,

however, we can expect them to impact not just retail banks but

everyone in the ecosystem, with lower margins as an outcome.

3. APPLE ENTERING THE WORLD OF PAYMENT SOLUTIONS

On the 9th of September 2014, Apple entered the world of payments. Having already agreed deals with MasterCard,

Visa and American Express (in addition to a number of US retail chains), we believe Apple Pay has the potential to

radically restructure the payments value chain. Although currently only launching in the US, considering the high

volumes of iPhones in the Nordic countries, a Nordic expansion does seems likely and so we believe banks should

watch this space closely.

Exhibit 2: Apple Pay

• Apple Pay is a check-out solution, based on NFC technology, enabling o�ine and online commerce via your Iphone

• This app keeps hold of your credit and debit card information and is currently supported by three major networks (American Express, MasterCard, and Visa), issued by most of the larger US banks (Bank of America, Capital One Bank, Chase, Citi, and Wells Fargo)*1. Apple Pay will automatically launch your preferred card in-store and in-app

• The app (expected to be launched in October 2014) is also supported by some of the major retailers in the US (Bloomingdale’s, Disney Store, Duane Reade, Macy’s, McDonald’s, Sephora, Staples, Subway, Walgreens, and Whole Foods Market)

• Apple might have succeeded where others have failed, by bringing together a coalition of stakeholders spanning issuers, merchants and networks (previous/current e�orts, such as MCX, Softcard/Isis, and Google have been blocked by their apparent support for one set of interest groups at the expense of other parties)

• There are still a lot of unknowns in terms of how the economics will work out, but according to the industry news site Bank Innovation, Apple will receive 15–25 bps of payments volume that goes through its system, paid for by card issuers

• Key features include− Consumer friendly check-out for both o�ine and online commerce via one touch payments and

finger ID recognition− Improved security (compared to cards without Chip and Pin)

*1 Representing 83% of the credit card purchase volume in the US

Source Apple press info: Apple announces Apple Pay (September 2014)

This report looks at some of the trends in the current payments landscape, both for cards and alternative methods

(offline and online), and how these may impact the Nordic banks.

PAYMENTS REGULATION

SINGLE EUROPEAN PAYMENT AREA (SEPA) PAYMENT SERVICES DIRECTIVE 2 (PSD)EU REGULATION OF INTERCHANGE FEES FOR CARD PAYMENT TRANSACTIONS

• Regulation of euro retail cash flows, affecting both retail banks and payment institutions

• Technical and business requirements cover standards for euro credit transfers, direct debits, payment schemes and frameworks for electronic payments

• Support the digital agenda across EU

• Cover EU, Iceland, Liechtenstein, Norway, Switzerland, and Monaco

• Regulation of payment initiation services that operate between the merchant and the purchaser’s bank, affecting all retail banks and payment institutions, as well as, card issuers

• Contains guidelines on interchange fees for card-based payment transactions

• Regulation to be transposed into Nordic law

• Interchange fees cap on domestic and cross-border transactions

− Credit cards: 30 bps of the transaction value

− Debit cards: 20 bps of the transaction value

• Price honesty regulation

− Discrimination based on issuing retail bank is not allowed

− Merchants are prohibited from steering customers to more efficient payment instruments

− Acquiring PSPs must provide at least monthly statements of fees to merchants

− Merchants must reveal to their customers, fees they pay to payment services acquirers

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OFFLINE COMMERCE

The Nordics are among the most advanced markets in the world in terms of penetration of card and electronic

payments. According to a recent report from the Swedish Bank Association (Svenska Bankföreningen), only 22% of

the Swedes normally carry cash with them. In addition to that, Swedes make on average 240 card transactions per

annum with similar figures for the other Nordic countries, compared to an average of 65 in the rest of Europe.

Source Swedish Bank Association: Kortbetalningarnas betydelse i samhället (March 2014)

Exhibit 3: Number of card transactions and point of sale (POS) terminals per head

200

100

300

NUMBER OF POS TERMINALS PER 1000 PEOPLE

0

400

NUMBER OF CARD TRANSACTIONS PER HEAD

50400

Nordics

2012 SELECTED COUNTRIES

Iceland

ItalySpain

Finland

Norway

Denmark

US

Sweden

Ireland

Cyprus

UK

FrancePortugalBelgium

NetherlandsEstonia

Luxembourg

302010Non Nordics

Source Norges Bank: Annual report on payment systems 2012 (June 2013) and ECB Note POS terminals estimates for US and Iceland from 2011

1. CARDS

Growth in the number of cards issued and POS terminals installed has been solid over the last 10 years and although

it appears to be slowing, just looking at the sheer number of card transactions and POS terminals used, we do not

foresee cards being replaced in the near future. In the medium-term there could be possibilities for new entrants to

install invoice payment solutions as an alternative option to the POS terminals, such that they compete directly with

credit cards in that market. Considering upcoming caps on card fees, this could of course become a reality sooner

rather than later.

The key issue is whether or not to stay in the merchant acquiring space. For many retail banks, consumer facing

payments businesses might become less attractive as regulatory caps on card transactions will pressure acquiring

margins. As a consequence, we believe banks should either substantially grow or exit the merchant acquiring

space in the medium- to long-term. We have recently seen SEB selling their merchant acquiring business Euroline

to private equity investor’s Nordic capital, and foresee more M&A activity, also cross-border mergers, as a

probable scenario.

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Exhibit 4: Growth in number of cards issued and number of POS terminals

40

50

30

60

20

10

70

‘01 ‘02 ‘03 ‘04 ‘06 ‘07 ‘08 ‘10 ‘11 ‘12‘05 ‘09

NUMBER OF CARDS OUTSTANDING (MM)

Sweden

Denmark

Finland

Norway

0

400

600

500

300

200

100

700

‘01 ‘10 ‘11 ‘12

0

‘02 ‘03 ‘04 ‘06 ‘07 ‘08‘05 ‘09

NUMBER OF POS TERMINALS (K)

YEARSYEARS CAGR %

6

6

9

1

8

CAGR %

8

7

9

8

9

2. ALTERNATIVE PAYMENTS

Prior to Apple Pay, we believed current mobile payment and the various closed loop solutions were failing to provide

any real value to the end customer. Independently of the numerous brands reportedly making an effort in the

payments space, having a separate card and/or application per store or type of transaction is not convenient.

There has also been a question around what technology to use, with NFC struggling to take off. The result has been

low penetration and high profile solutions like Swedbank’s Bart venture (based on NFC) have recently been closed

down due to low consumer uptake.

We believe that Apple Pay could well become the catalyst of change within this space. We expect them to compete

by offering merchants lower transaction fees and, even though it requires an initial investment in the NFC

technology, things could move very quickly. For the consumers in the Nordics (where all cards have Chip and Pin),

the preliminary benefit would be marginal to using a credit card both from a convenience and fraud perspective. But,

if Apple uses the data available to help consumers gather loyalty points for all their purchases, as well as, keeping all

their receipts in their phone, that would be a game changer. From the banks perspective, Apple Pay will put pressure

on margins. Even if the banks were still required to do the merchant acquiring (i.e. the main part of the revenue

pool), the concern has to be that Apple could launch a closed loop solution, with every consumer sending money

to an Apple Pay Wallet, cutting out the bank’s interface with the end customer. For the banks in the Nordics, which

could well be a likely expansion market, our recommendation is: do not let Apple (or any other solutions provider)

control the customer interface. Even if Apple Pay has been marketed as a “bank friendly solution”, we struggle to see

the long-term benefit for the banks.

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If the Nordic retail banks are going to keep pace with these recent developments we would recommend they join

forces and develop their own infrastructure. Nordic retail banks have industry leading mobile banking solutions,

with a high and growing user-base. Ensuring that these are loaded with value added services, such as payments,

spend analytics and loyalty schemes, would be a more customer-centric solution. As a consequence,

a key area to focus on would be how to commercialise Swish (or similar solutions) to be an option for on and offline.

These sorts of applications can, to some extent, also be used as a CRM channel. The question is how to make money

out of it. Banks could charge for it (at least for certain segments), meaning that they should model pricing, value

proposition and segmentation to optimise profitability.

Exhibit 5: Emerging payments topics

Mobile payments Apple Pay, Google Wallet, SEQR, WyWallet

PayPal and digital wallets PayPal, V.me

GPR prepaid NetSpend, Walmart MoneyCard

Mobile acquiring Square, iZettle, Bart

EMV*¹ EMVCo

P2P payments Swish, SEQR, WyWallet

Merchant-issued payment cards TARGET 2, REDcard

Virtual currencies Bitcoin, Amazon coin

Mobile billing BilltoMobile

Closed loop stored value Starbucks Coffee

*1 Europay, MasterCard and Visa

CONCLUSIONS

Disruptive technologies at POS (such as invoice solutions) could become a problem at some point, but we do

not foresee cards being replaced at POS in the near future. The important question is whether to grow or exit the

merchant acquiring business.

Apple Pay’s eventual market entry will not only put pressure on margins, but also threaten to take over the customer

interface. Banks should focus their efforts on developing and commercialising consumer-friendly mobile solutions,

that connect mobile payments with mobile banking.

Relative importance

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ONLINE COMMERCE

Compared to other European markets, Nordic countries have one of the highest percentages of online shoppers

and number of online purchases. In 2012, €11 BN was spent online in the Nordic markets, with around 80% of the

population being online shoppers. These numbers have – as in the rest of Europe – grown substantially and more

and more Nordic consumers are shopping online, each of them spending on average €683 over the year. The main

reasons cited by most consumers for shopping online was the convenience and potential time saving. Sweden is

the largest market in the region, driven by strong retail brands and increasing investments from retailers into online

sales capabilities.

Exhibit 6: Total online purchases across Nordic markets

1 25

2 50

3 75

0 0

4 100

Sweden Norway Denmark Finland

€ BN %

Online purchases 2012

Online shoppers 2013 in %

Source PostNord: Ecommerce 2014 and Makesyoulocal

1. CARDS

Looking at the online value chain for a credit card transaction, banks are currently controlling the most revenue

generating steps (acquirer and issuer) and as a consequence recoup about 90% of the total profits generated.

This position is being threatened by a number of alternative business models. As previously mentioned, considering

what upcoming EU regulation of interchange fees for card payment transactions might mean for banks’ (and card

schemes) profitability, placing a bet on an alternative payment method is advisable. This will of course also impact

the disruptors as well, since the benchmark cost to the merchant will go down after the caps are in place, making

relatively more expensive solutions like Klarna and PayPal look even more expensive.

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In the online world Gateway/PSP represents the starting point, and thus customer-facing (in a B2B and B2C

scenario) position in the value chain, with Apple Pay looking to compete in this space. We believe ownership of the

customer interface is very important and think retail banks should consider what impact this could have on them.

The question is whether to enter directly into the PSP space or how (and with whom) to form strategic alliances. The

new competition is targeting this area and as a consequence we see developments in a number of ways. Gateways/

PSPs are aggregating merchants to drive fee reduction for acquiring services. This would mean that Gateway/PSP

providers acts as an intermediate, owning both the acquirer and the merchant relationships. The benefit of this

structure is a close relationship with merchants which allows for driving discounts on acquirer fees by aggregating

volumes across merchants. Another similar example, is offering an extended gateway (the so called “checkout

solution”), which is an alternative way to provide acquiring services. Checkout products offer settlement through

“virtual acquiring” and we believe this is what Apple Pay will do. The way it works, is that the PSP or payments

company does not acquire itself but has an acquiring partner (i.e. no agreement between merchant and acquirer),

once again aggregating volumes and taking share of the traditional acquiring profit pool.

For companies applying for a credit market institute license, further expansion within the value chain is a possibility.

This includes products like instalment loans, financial guarantees, factoring services, as well as, taking up retail

deposits (to be gathered either directly or indirectly through a third-party).

Exhibit 7: Earnings generated by online card transactions within the payments value chain

MerchantGateway/payment

service provider (PSP)

Clearing organisa-tion (e.g. Visa and

MasterCard)Acquirer

Acquiring processor if outsourced

ACQUIRING SERVICES

Issuing bank

ISSUING SERVICES

Issuing processor if outsourced

Description • Provide merchant software for transaction capture and routing

• Transmit transaction data to the acquirer

• Requires a payment institute license

• Hold deposit accounts for merchants

• Authorisation

• Responsible for collection of transaction information and settlement

• Processors connect the merchant to payment networks by providing systems and operations

• Provide network for transaction routing

• Connects and switches transactions between merchants and card processors

• Promote brand acceptance

• Holds contractual agreement with cardholder

• Bear credit risk

• Everything but balance sheet activities can be outsourced

Revenue split*¹, ² ~5% ~45% ~7% ~43%

Revenue sources • Transaction fee

• Software fee

• Transaction fee

• Merchant servicing fees (e.g. terminal management)

• Scheme fee • Interest revenue on revolving balances

• Other fees and commissions

• Interchange fee

• Scheme incentives and fee rebates

*1 Nordic merchant service fees (MSC) are the same for credit and debit card transactions, but the interchange fees set by clearing organisations differ between the two payment methods

*2 Based on a 1000 SEK online card transaction for a SME merchant. Total revenue divided across players is approximately 2% of the transaction volume

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Exhibit 8: The Nordic Gateway/PSP market

PayByBill, Bill Me Later, ViaBill

Digital River, epay, Paynova, QuickPay, Cyberbit, Pensio,

CyberSource, Wiredge, Samport, Payer, Dibs, CertiTrade

Euroline*1, Handelsbanken, Nordea, Teller*2 , Valitor Evry

ONLINE INVOICE AND FACTORING SERVICES

GATEWAYS/PSPS ACQUIRERS (WITH ONLINE CARD PAYMENT OFFER)

ACQUIRER PROCESSORS

Swedbank

Klarna, PayEx, Svea

Nets

*1 Recently acquired from SEB by Nordic capital

*2 Owned by Nets

2. ALTERNATIVE PAYMENTS

Compared to the rest of Europe, the Nordic markets (at least the Swedish and Finnish ones) differ in terms of

preferred payment methods when shopping online. Based on a survey conducted by TNS SIFO, invoice is the

preferred method for online purchases in Sweden and Finland, whereas card payment is the most popular in Norway

and Denmark. Interestingly Sweden and Finland also show similar characteristics in terms of having a higher online

banking penetration.

Exhibit 9: Share of consumers per preferred payment method

50

0

100

Debit/credit card

Invoice

Online banking

PayPal and similar

Others

Sweden Norway DenmarkFinland

IN %

Source PostNord: Ecommerce 2014

Note Based on survey conducted by TNS SIFO on consumers in Nordic markets, only one answer was possible

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We believe that the Nordic retail banks should start paying more attention to the growing online retail channel,

as well as, the invoice and installment loan products, which are very popular online. This is the area where new

competitors like Klarna and PayPal have been hugely successful. These business models are largely based on

creating a separate online value chain that closes out the traditional participants (i.e. banks and card schemes).

Most of these new competitors are offering various “buy now, pay later” consumer credit products, which takes a

share of the banks’ profits and new loan originations. The pitch to the merchant is about improving conversions,

not just because of the “pay later” option, but because they optimise the whole buying experience, making it easier

for the consumer to perform a payment. For some of the bigger ticket items a personal loan or mortgage top-up

would traditionally have been used as a means to raise credit for consumption. We see more and more types of

goods moving to the online channel and as a consequence the corresponding payment transaction.

The new competition will continue to provide user-friendly invoice and installment products, as well as, various

consumer credit solutions, which will have an even greater impact on the profitability of banks, as online retail grows

in importance. As new payment providers become profitable, they will grow and most likely increase their scope of

services, moving into traditional personal loans, deposits etc.

CONCLUSIONS

The online value chain for card transactions is under threat. Banks should consider how this will impact their

revenues and where to play, since although profits might currently sit in the acquiring and issuing space,

this will change and staying close to the customer will be crucial going forward.

The arena where consumers are making their payments is changing. Online retail is gaining share and how

consumers prefer to pay online differs from offline. Banks should consider how to challenge the new competitors.

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SUMMARY OF CONCLUSIONS

The payments arena is changing. Online retail is gaining share and how consumers prefer to pay online differs

from offline. Apple Pay’s eventual market entry will not only put pressure on margins, but also threaten to take over

the customer interface. Retail banks should consider how this will impact their revenues and where to play, since

although profits might currently sit in the acquiring and issuing space, this will change and staying close to the

customer will be crucial going forward. Retail banks should also consider how to challenge the new competitors:

disruptive technologies like invoice and various mobile payments solutions will become a problem at some point.

Retail banks should focus their efforts on commercialising consumer friendly mobile solutions that connect mobile

payments with mobile banking. Because even though we do not foresee cards being replaced in the near future, new

market entrants and upcoming regulations will fundamentally alter the economics of the cards value chain (online

and offline).

Recommended next steps:

1. Analyse how new regulation will impact the financials of the cards value chain (online and offline) and where areas of relative competitive advantage might occur

2. Develop the strategy for what role to play, and whether to maintain or exit the merchant acquiring side

3. Define the scope of ambitions and design a consumer friendly mobile solution that enables the retail bank’s mobile banking app to process mobile payments and provide credit online

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