Trouble ahead for US commercial cards?
It may be the world’s largest market for commercial cards but a number of factors are converging which could pose significant challenges to the US corporate payments market. Downward pressure on interchange fees and constrained credit availability may mean current models need to be re-thought, writes William Cain.
The US is the world’s largest market for commercial card spending, but there remains a feeling that the industry has failed to fulfil its potential so far.
This is because, peculiarly, as markets around the world experience declining cheque usage and are in some cases phasing them out, cheques in the US remain a resilient and even preferred method of payment for many businesses.
Around 65% of large and mid-sized companies in the US pay their major suppliers by cheque, compared to just 4% on purchasing cards. This is the result of the development of a much improved cheque clearing system.
Up until the late 1990s, the cheque clearing system required the Federal Reserve to maintain a fleet of 11 aeroplanes to transfer cheques between its clearing centres across the country.
Now, cheques are truncated, sent and processed electronically as a result of reforms to the system in 2005. In addition, corporates in the US are continuing to use them because of what has been described as a “schizophrenic” strategy towards their payments systems.
In order to improve their working capital balances in a credit-constrained environment, corporates are promoting efficiency to speed up their accounts receivable processes while at the same time using cheques to slow down accounts payable.
With cheques popular and still relatively efficient in the US, how do card issuers persuade corporates to implement commercial card programmes?
One of the key strategies has been through a system of rebate incentives offered to corporates on their business-to-business payments. The rebate is paid out of interchange fees charged to the recipients of card payments – typically 2.2% of transaction spend volume in the US.
While interchange is an important source of revenue for card issuing banks they have in recent years become more willing to share some of this revenue with clients in order to drive greater spending volumes.
The value of the rebates can be extremely large, depending on the size of the organisation and their expected spending on commercial cards. A 2010 proposal put together by US Bank for the State of West Virginia (SWV) gives an insight into how these rebates are structured.
The first part of the calculation is valued by using a US Bank matrix which takes into account the organisation’s average transaction size and the volume of payments in the commercial cards programme.
The rebate increases as volume and average transaction size increase. The lowest rebate value is 1.03% of total spending net of credit losses, which corresponds to an average transaction size of $150 and a volume of 100m payments.
Qualifying for the highest rebate, which is valued at 1.5%, requires 1bn transactions at an average value of $700.
The second part of the calculation is assessed by the number of days it takes the organisation to repay US Bank for the credit it provides through the charge card programme.
If SWV repays the bank immediately for purchases made on the cards, it receives a bonus rebate of 0.4% on top of the matrix-derived rebate described previously. This bonus payment declines the longer payment is deferred, reaching zero at 40 days.
In the document, US Bank shows that a $335m net annual charge volume with a $500 average transaction size and a 29-day ‘file turn’ (credit period) would create a matrix-derived rebate of 1.4755% and a 29-day payment deferral bonus of 0.11%.
As a percentage of the $335m annual spend, US Bank says signing up to the programme would deliver $5.3m in rebates to SWV on an annual basis, which works out at $1.3m on a quarterly basis or $26.6m over a five-year period.
The proposal says that efficiency savings in SWV’s expense management systems may exceed the value of the rebates it receives.
“US Bank is committed to providing competitive financial incentives to the state,” the document says.
“We recognise the auditor’s goal of growing the programme. Therefore, we have structured an aggressive rebate to demonstrate the rebate potential of your growing program. If the state would like an upfront bonus, we can negotiate that out of the existing rebate grid.
“The following financial proposal details the volume and speed of payment incentives. The full picture of the financial impact of US Bank commercial card programmes is made up of three components: a competitive incentive programme; proven strategies for increasing programme volume and tools for cutting procurement costs.
“The savings that can be accrued to the state is significant, often far surpassing the rebate dollars that an organisation earns.”
Research from consultancy First Annapolis suggests that a rebate value of 1.4755% is rare and that they are typically paid at around a quarter of the 2.2% average interchange rate – or 55 basis points, because spending tends to be much lower.
Its research, Commercial Card Rebates – A Snapshot from the Public Sector, shows that typically rebates do not start until annual card volume reaches $1m and that rebates vary substantially across different clients and issuing banks.
Michigan state was offered a rebate of under 10 basis points for annual spending of more than $10m per year, compared to Minnesota, which was offered around 85 basis points.
This, according to First Annapolis, highlights that rebates should not be the only consideration when considering a commercial card programme.
“We strongly believe that, while rebates should not be ignored, the supplier savings and process improvements opportunity for an organisation from implementing or re-launching a commercial card programme are worth multiples of any rebates that may be generated,” the report says.
The rebate model has been pursued more aggressively in recent years, according to Gareth Lodge, a payments analyst at consultancy Celent, as banks try to increase their corporate card volumes.
Lodge says the value of rebate offers have increased four-fold in the past 10 years in an attempt to incentivise corporates to use card products more intensively.
However, the business model may come under threat in coming years as regulatory and economic pressures grow. The core elements of profitability from commercial card offerings are interchange and the cost of funds.
Banks offering the products are able to source short term credit at relatively cheap rates in the current environment, with US interest rates at their lowest point in history.
This means the cost of funding credit to corporates on their charge card products is extremely low and has perhaps contributed to the leeway some have been willing to offer on rebates.
Lodge questions how long these two fundamental parts of the commercial cards landscape will stay in place.
“One of the reasons corporate cards and prepaid cards at the moment are so popular and remain a growth market is because they haven’t come under the interchange scrutiny,” says Lodge.
“Banks are still making money on those products as opposed to debit cards which have become a lot less profitable. The profit margin on commercial cards has fallen as more and more people go for the rebate model to drive volume.
“Overall profit is growing but profit margins are falling. If the regulator then intervenes either by raising interest rates – and the cost of funds goes up – and/or they reduce interchange, then that business models around purchasing cards becomes potentially far less attractive.”
Interchange scrutiny in the US is growing after the decision by regulators to reduce the fees charged for debit card transactions.
Lodge says the US move, through the Durbin Amendment to the Dodd-Frank Wall Street Reform bill, marks another big step in the push for more transparent pricing of payments products, which is already underway in Europe and Australia.
Of particular relevance to this is a recent decision taken in Europe to phase out and potentially ban the charging of interchange fees on all SEPA and domestic direct debits.
Lodge says this could pave the way for a similar investigation in the US, potentially placing further downward pressure on interchange fees and, ultimately, the revenues earned by banks on card products.
“It raises the interesting question – why are they treating one payment type different to another?” he says.
“There are a number of people asking, given that there is a new focus on transparency, about why this is allowed to happen in some cases and not in others – why are some very transparent and not others.
“In France, for example, there is a legal obligation to offer cheques for free. That would seem to potentially breach European law. That’s what is happening in Europe.
“If you look at what is happening around the world, there’s a big move in Australia for the growth in transparency of payments. If you look at the US, we have just seen the first wave of transparency and intervention on interchange for debit cards.
“So, while I am not saying it [further downward pressure on interchange] will happen, there’s a growing possibility that there will be some kind of investigation or study into the transparency of products in the US as well.”
This would imply a rethinking of commercial card strategies by issuing banks, requiring a reduction of rebate payment incentives to corporates.
Longer term, it could mean banks would be forced to charge corporates for the products in the same way some are now doing for debit cards.
This may actually lead to more of a focus on the real value-added element of the programmes – to improve efficiency and reduce costs – rather than the level of rebates corporates will earn.
“When you are looking for a corporate programme, how do you choose between one provider and another?” asks Lodge.
“It is going to be around value-add – how well can I integrate it into my accounts payable programme, what formats does it use and how can I upload it into an expenses system etc, so the integration and automation is there.”
As in other Electronic Payments International surveys, the savings and efficiencies generated by greater automation of payments process have become more important in the US since the recession.
Cheques still central
Improving payments systems is one of a number of options considered by corporate treasury departments in order to maximise the working capital they hold.
The biggest focus among chief financial officers of US companies revolve around a number of key areas, according to a February 2011 survey conducted by RBS Global Banking and Markets in North America.
- improving of process efficiency;
- negotiation of better terms with suppliers and buyers;
- improvement of internal information systems through the acquisition of new technology and better integration of existing systems; and,
- provide better sales and collections support operations.
Yet, improving payments efficiency is a double edged sword for corporates. If systems are improved to allow faster access to receivables it should also mean payables are settled more quickly too. The net effect on working capital in this case is zero.
Corporates, then, have an incentive only to improve efficiencies on the accounts receivables side of their business, rather than accounts payable – a trend Lodge already sees in action.
“The credit crisis has almost had a schizophrenic impact on corporate strategies,” says Lodge.
“On one hand, you want to push all of your payers for prompt payment. So you want to receive it electronically because you want to be able to process it quicker and it’s easier to reconcile.
“You also know what you can draw on in your bank account much more quickly so you don’t have to borrow. That kind of liquidity management is important.
“Equally, you want to pay people as slowly as possible. The old saying that the cheque’s in the post – it helps slow that process going out.”
This is one part of the reason cheques remain an integral part of commercial payments in the US, while they remain much less so in the consumer sphere in the US. Another reason is that, following the introduction of the Check Clearing for the 21st Century Act (Check 21), the clearing system for cheque payments has been significantly improved.
The act legalised ‘substitute cheques’ that allowed physical cheques to be sent in electronic form and reproduced from an electronic image if necessary to complete the transaction process.
This allows banks to accelerate collection and reduce paper handling and paper handling costs, according to the Federal Reserve Bank of Kansas City and is particularly popular among smaller banks. It has also allowed the consolidation of clearing centres.
This system is a far cry from the days when the Federal Reserve, which conducts cheque clearing in the US, maintained a fleet of 11 aircraft to transport cheques from one clearing centre to another. It has created an efficient system for cheques which has made migration to alternatives less appealing to consumers and corporates.
“To describe the cheque clearing system as a transformation is probably stretching it a bit too far,” says Lodge.
“But there have been some big improvements in the process and that is one of the other reasons why perhaps the change is not going to go as quickly in some other countries.
“It has made sufficient improvements to make the final leg of migration to other payment formats less palatable, or created less of a driver for it.”
The barriers to migrating cheque payments commercial cards is a theme picked up by the Payment Cards Center of the Federal Reserve Bank of Philadelphia (FRBP).
Its March 2011 report into commercial payments in the US, Getting Down to Business: Commercial Cards in Business-to-Business Payments, says cards have not achieved the same level of adoption as in the consumer environment for a number of reasons.
First, commercial cards have not been a feature of the US commercial market for as long as card products have among consumers.
Secondly, there is the issue of acceptance. Much like the development of consumer card payments, commercial card usage needs to be supported by an acceptance infrastructure.
For travel and entertainment spending, acceptance is not an issue because the types of vendors – restaurants, bars, airlines and hotels – were among the first to accept card payments for consumer payments, the FRBP research says.
In the area of procurement cards (P-cards), creating a wide acceptance infrastructure is more challenging.
The types of organisations which goods and services are procured from by corporates tend not to be consumer-facing and have never had a need to be able to accept card payments.
Research conducted by the Association for Financial Professionals (AFP) in the US looked at the reasons why these business-to-business (B2B) vendors are reluctant to accept card payments.
Among those who did not accept card payments, 18% said the fees associated with interchange were a key reason for not doing so.
Among those who did offer card payment facilities, 68% identified interchange fees as the primary disadvantage of accepting the payments. Around 88% said the main reason they offered card acceptance was because it satisfied their customers’ payments preferences.
The AFP research highlighted other benefits to businesses which accept cards for B2B payments.
They include the faster receipt of payments, decreased number of days of payments outstanding and the elimination of collections activity.
“Over time, some providers to commercial customers may arrive at the same conclusion that many retailers reached several decades ago,” says the report, written by the FRBP’s Susan Herbst-Murphy.
“The cost of card acceptance can be less than managing accounts receivable internally, including the costs of underwriting, billing, receivables, processing and collections.”
The report’s overall conclusion is that commercial payments in the US have yet to enjoy the widespread usage that consumer cards have achieved but remains a market of great potential.
The overall value of transactions made by corporates in the US is three times larger than in the consumer market. Each 1% that migrates to card payments represents $200bn in gross dollar volume to card issuers.
As the value proposition is refined there are possibilities for further growth, particularly as the benefits from value-added services, like management reporting and regulatory compliance functions, become more widely understood by corporates. But the preference for cheques in the US is proving hard to break.