Before the rise of PayPal, Venmo and dozens of other new payment solutions, banking probably didn’t look at the payments function as the epicenter for innovation. But times have changed. Digitalization of front, middle and back office processes, plus an explosion of fintech experimentation around the world, have turned the payments function into a competitive weapon instead of a cost center. In parallel, the rise of contextual embedded finance means that payments innovation is changing the operation models for banks and the industries they serve.
The pandemic only accelerated change that was already taking place. In response to the World Health Organization (WHO) advice that physical cash would increase the risk of disease transmission in March last year, there was a larger shift towards digital payments in ten weeks than in the proceeding five years, according to Mastercard. (WHO later clarified that the “advice” was an off-the-cuff statement and not meant as official advice, but the matter was set in motion.) Contactless and mobile payments around the world exploded, and the convenience factor of “card on file” scenarios has accelerated the adoption of mobile wallets. According to research by ACI Worldwide, global mobile wallet adoption rose to 46% in 2020, up from 40.6% in 2019 and 18.9% in 2018.
To get a perspective on the way banks, merchants and intermediaries across the payment ecosystem are responding to consumer and business behaviors, we interviewed Mike Cook, global payments leader at IBM. We discussed how the center of transformation in banking is focused on payments, and how legacy financial institutions are prioritizing the shift to digital to protect current revenue streams, and searching for new ones through a fully digitized customer experience.
Can traditional financial institutions compete with firms like PayPal, Venmo, Square and Stripe?
Mike Cook: I think it’s critical for every banking organization to find the lane that they’re going to play in. You’ve seen the rise of Stripe, a private company with $100 billion market cap and incredible consumer traction, that needs to get deeper into services. So, they sign up with Goldman and JPMorgan Chase for banking as a service. We see PayPal announcing the desire to become a “super app” offering more currency and payment options as well as an expanded array of banking services to hundreds of millions of users.
To compete head to head suggests all organizations have the same assets. In the past, banks have always had the incumbency and the clients. What we see now with these mega paytech organizations, is that they also have a magnitude of client relationships. And they have orders of magnitude more working capital to create innovation, with a market penetration incentive.
There’s absolutely a role for banks to play here. But they’ve got to pick a lane and focus capital allocation on that lane.
Has the primary financial service moved from a checking account to a payment app?
Cook: Through history we would define the “primary financial institution” by whatever institution had the checking account. But now we have an interesting dynamic, where not only do consumers have more than one transaction account, but the foundation for the consumer relationship of the future may be more centered around the payments function. In some cases, this payment provider may not even be on the normal list of payment providers. Starbucks is an example. That’s a payment app, and they’re holding a lot of deposits.
Most of life’s big events have a punch line … and the punch line is paying for something. Consumers may recognize that as a bad part of the transaction. But, where the digital transformers have created a change is that they have made the payments part seamless. One of the best examples is Uber. Uber is recognized as having extraordinary customer experience and the joy at the end is where a rider just walks out of the car – and the payment is invisible.
I see that paradigm coming into every transaction. Wouldn’t it be great to close on a house where the payment is invisible? That’s the experience. That’s delightful. We used to get checking accounts so we could write checks. We’re now transcended that into another level of digital innovation with digital – and sometimes embedded – payments.
Is the foundation for innovation in payments simplicity, speed, cost and embedded?
Cook: Yes, making the experience really positive, where there’s no derailment factors from waiting or wondering where the money is. The magic with the new players coming into the market is that they’re not burdened with that legacy set of rails and applications and payment hubs. They have built apps that are cloud-native, forward-thinking, experience-driven, and having all the architectural components in place to do that. Matching that is the challenge for some of the incumbent payment providers.
No one gets fat, rich and happy upgrading old technology. So, we’re back into a capital allocation problem of, “I need to invest in these great, wonderful experiences. But I also have to change the underlying architecture.” Most of the new entrants have gone straight to the cloud with cloud-native offerings that have all the API [application programming interfaces] structures they need to tie into whatever transaction experience they want to get.
What role does cloud technology play in updating payments infrastructure?
Cook: The cloud plays an enormous role here. The data we look at says that there’s only about 20% penetration in banking moving to the cloud. And much of this transition has been in relatively simple categories of work. The actual workload of core banking and payments has seen very little penetration globally. Part of this is because of the perception of risks of the cloud not being mature, secure or compliant. These perceptions are beginning to change, however. There are several cloud solutions that are entering the market that are built specifically for financial services. They address many of the concerns.
For instance, IBM has built a cloud solution for banking that leverages learnings from banks as well as from independent software vendors. We built a solution that eliminates much of the replication that we know all banks and credit unions would need to answer as they moved to the cloud, eliminating a ton of time and effort, but leaving the flexibility that all financial institutions want.
As opposed to a complete rip out and replace mentality, financial institutions have embraced a notion of progressive modernization with a structured value-driven approach, where they do a piece at a time that drives some value – defined by making the customer experience better. Organizations can also reduce their operating efficiency ratio in a measured way that doesn’t cause massive disruption.
Mike Cook on the role of cloud technology within payments:
“As the amount of data and insight from digital payments expands exponentially, the importance of using cloud technology becomes a requisite for traditional and non-traditional payments providers.”
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Is it better for institutions to partner rather than taking on modernization themselves?
Cook: Definitely. Digital transformation and payments modernization is a high-risk poker game. And it’s really tough to do it all on your own. It causes stress on your organization, stress on your strategy, stress on your capital and stress on your balance sheet. So, determining a bank’s specific value proposition, and who the partners are that can deliver this proposition, become crucial.
I don’t think anyone can do it on their own anymore.
Do you see the trend of embedded payments expanding?
Cook: Absolutely. Everyone in the payments business is creating their own business model – and we’re running into a period of so many options – evolving as real time comes to market and cross border real-time comes to market. At the end of the day, the average consumer or business just wants to make a payment. They want to be secure in the fact that it’s going to be a good payment, it’s going to happen on time, and they’re not going to pay a whole lot of money for it.
This is where banks can help. They can create the central hub to move money, taking advantage of their brands and trust. They can create the APIs to PayPal, Venmo, TransferWise, Alipay, Tencent or any provider. The customer gets the peace of mind they want in the embedded transaction and all the icky stuff will be managed by the bank.
How do we deal with increasing fraud in payments?
Cook: Any provider in the real-time payments space is using AI and machine learning to identify the patterns as they’re happening and building a response to it. Unfortunately, we’re finding that many legacy banking organizations aren’t ready for this. I have a fraud algorithm that can take weeks or months to respond. We need to allocate capital to real-time fraud response.
We need machine learning at the core of the counter fraud switch, sensing and identifying patterns of behavior. It’s doing something that humans can’t do. We need to get there through the use of AI and inference engines to help automate the processes.
“Big data, AI and machine learning will not only help in securing the payments ecosystem in the future, but improve the customer experience by anticipating future purchases and helping categorize payments already made.”
— Mike Cook, IBM
Can AI and machine learning also help improve the payments experience?
Cook: We have an enormous set of payments metadata to improve insight and customer experiences. This includes data to make the actual payment experience better, as well as data to help with future payments not yet made. For instance, when payments are digitized within the ISO messaging stream, you can provide a Nirvana state of automatic financial reconciliation of what the payment was, and where it went. Closing books won’t happen three or four weeks after the quarter ends … but automatically. The other component is to assist the customer with what they may need in the future based on what they did in the past.
How do you see the payments ecosystem changing in the future?
Cook: First, the ongoing trend of declining check and cash use is going to continue. Checks and use of cash are already starting to cause pain because they are increasingly an exception payment mechanism as opposed to the norm. And the pandemic was just kerosene on the fire pit that accelerated these trends. As a result, any part of the payments ecosystem that is structured to deliver digital payments efficiently will have an advantage.
Second, there’s going to be a continued rise in the paytech firms. And it’s whether or not the banks come with them.
Third, for the foreseeable future you’re going to see outrageous valuations for payments providers and facilitators. We’re seeing this in the valuations of Stripe, Alipay, PayPal and Amazon. That’s going to continue for a long time.
Do you see the winners expanding beyond payments?
Cook: The really successful payments players in the future will use their payments capability to launch broader solutions. Platforms like Alibaba, Tencent, Amazon, PayPal and a number of other large fintech players will expand far beyond payments alone. Watch where PayPal gets into the life management business, and Amazon expands into the medical field. They’re going to leverage their extraordinary offerings, extraordinary market penetration, and extraordinary brand, linking payments into life stage engagements. The platforms that have the greatest level of engagement will be the winners.
What are the challenges for payments in the future?
Cook: There needs to be greater uniformity of regulations between what the paytech firms need to follow and the regulations of traditional banking organizations. When we see a market that’s growing exponentially, any regulator or any central bank must protect their economy and protect their citizens. And we should be welcoming that. With risk escalating exponentially and bad players succeeding more times than we prefer, the importance of strong regulation can’t be overstated.