In this guest article, global
business consultancy McKinsey shines the spotlight on
European payments – one line of business that is faring well in the
current economic turbulence. McKinsey argues banks must design
appropriate strategies to meet the needs of retail and corporate
customers and prepare for economic recovery.

payments profitabilityAmid the turbulence impacting the European financial
services industry, there is one line of business that is faring
relatively well. The outlook for payments is more positive than the
picture for the overall banking industry and payments’ share of
revenues is expected to rise from just over 30 percent in 2008.

Given the importance of payments, banks in
Europe must understand the impact of the crisis on the business and
design appropriate strategies that meet the needs of retail and
corporate customers and allow for rapid growth once the economy
picks up.

There is much uncertainty surrounding the
dynamics of the banking market. For the purposes of this article,
we use a mid-range economic scenario as context for thinking about
how the European payments sector might develop. We developed this
scenario by considering macroeconomic drivers including real
economic growth, interest rates and inflation, funding and capital
market development, and capital loss/inflows; the industry-specific
drivers were the cost-of-risk cycle, margins, competition, leverage
and regulation.

Where are payments profits

payments profitabilityIn
recent years, profits generated by payments at European banks have
grown strongly. They stood at €25 billion ($35 billion) in 2004,
and rose to €60 billion in 2007. Transaction services profits have
improved steadily as the growth in cashless transactions has
outpaced the growth in cash transactions and economies of scale
have taken hold.

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The main driver of overall profit growth,
however, has been liquidity services revenue, especially from
current accounts, although the growth drivers within liquidity
services have changed over time. Between 2004 and 2006, balance
volume increases accounted for almost 75 percent of profit growth.
In 2007, 60 percent of the growth came from improvements in current
account interest margins, driven by a rise in interbank rates that
was not passed on to consumers.

The evolution of liquidity services
profitability will have an enormous impact on the payments industry
as the downturn develops. In our mid-range scenario, payments
profits in Europe would fall from €60 billion in 2007 to just €19
billion in 2009. This €41 billion drop would be the result of a hit
on liquidity services of €35 billion and on transaction services of
€6 billion.

The €35 billion fall in liquidity services
profits is predominantly linked to a tightening of current account
interest margins following the sharp drop in interbank rates (-€30
billion). The increased cost of risk from overdrafts and revolving
credit will have an additional negative €8 billion impact on
profits, offset only partially (€3 billion) by increasing
outstanding balance volumes on retail current accounts and
corporate overdrafts.

The drop in transaction services profits of €6
billion stems from a €7 billion decline in float income caused by
the lower interbank rates. Meanwhile, more accounts and more
value-added services, such as data mining, will push account
management costs up by €2 billion. These costs, however, will be
more than offset by the solid growth (€3 billion) of some cashless
instruments, such as debit cards, and efficiency gains that banks
should push further.

Beginning in 2010, overall payments profits
will rise again, reaching €50 billion to €60 billion by 2012,
mainly because margins on current accounts are expected to
strengthen when interbank refinancing rates go up following
economic recovery.

Transactional business more

The transactional business is
holding up well in the crisis and is helping to cushion the fall in
balance revenues. In the mid-range scenario, annual debit card
transactions will grow 8 percent between 2007 and 2009. This
growth, together with further penetration and improvements in scale
and efficiency, will allow annual debit card profit growth to
remain solid at a rate of 13 percent.

In fact, debit cards are expected to expand
their dominance in continental Europe as they give consumers better
control over their spending than credit cards, which is important
in a downturn. During the Argentinean crisis at the start of the
decade, debit card volumes grew strongly while credit card use

Credit cards are being hit as the categories
in which they are being used more intensively are those under
pressure in the crisis. Recent McKinsey research shows that monthly
spending by European consumers fell by 7 percent in December 2008,
with the largest cuts coming in leisure spending and purchasing of
equipment. Moreover, should the crisis worsen, the propensity to
reduce spending in these categories would seem to be even higher.
Many people are also trading down within a category (eg, booking a
domestic rather than a foreign holiday), reducing the average value
of credit card transactions and thus transaction fee revenues.

Credit cards are also struggling as a lending
vehicle. Credit card loan profitability had already dragged down
overall credit card profits by an average of 10 percent per year
between 2004 and 2007. The evolution of the cost of risk in the UK
– which held around two-thirds of European bank-issued revolving
balances in 2007 – has driven this decline. Collectively, UK credit
cardholders have pushed up the overall European risk cost of
revolving balances over the past four years.

This increase has outpaced additional margin
growth and the trend is expected to continue through 2009, although
to a lesser extent. Such hikes in consumer credit defaults are not
unprecedented. In Argentina in 2002, risk-cost rates rose to double
the level of 1999, before starting to drop again.

For credit transfers, direct debits and
cheques, the major driver of profit declines will be a reduction in
float income due to lower interbank rates in 2009, while fee-driven
profit growth will remain solid. The underlying drivers of
transaction fees from retail-initiated credit transfers, cheques
and direct debits will remain robust, as these instruments often
satisfy recurring payment needs (loan repayments, rent, utility

On the other hand, although retail payments
represent the bulk of the total number of transactions, corporate
volumes are much higher. Given that the amounts sent by corporates
are falling in the recession, the economic crisis is pushing
average transaction values down, which has a negative impact on the

Retail profits harder hit than

Overall, we believe retail payments
profitability will be more affected than corporate payments. We
anticipate that between 2007 and 2009, retail profitability will
fall 75 percent from €34 billion to €8 billion, while corporate
payments profits will decline more than 50 percent from €26 billion
to €11 billion.

The drop in retail profits will be caused by a
substantial decrease in current account margins due to lower
interbank rates. With the offered interest rate on retail current
accounts close to 0 percent across most of Europe, interest margins
are more dependent on interbank rates than any other type of
deposit. Net inflows to current accounts, as a result of people
shifting money from investment products to more secure deposits,
will only have a limited effect on payments profits. Current
account revenues will drop from €60 billion to €39 billion,
contributing more than 80 percent of the total decline in retail
payments profits.

Corporate current accounts are also expected
to be negatively impacted, with both margins and balances
suffering. Overdrafts will become increasingly important (and
expensive) as a corporate lending instrument, given banks’
unwillingness to issue riskier long-term loans. This will partially
mitigate the negative effect of the increasing corporate overdraft
cost of risk and dwindling corporate current accounts.

Bouncing back in 2010?

While the recovery of overall global
banking revenues is not expected before 2011, European payments
revenues and profits will start to rise again in 2010 under the
mid-range scenario. From €16 billion in 2009, they may reach €50
billion to €60 billion by 2012.

The evolution of balance revenues from current
accounts represents more than 80 percent of this increase. Margins
should pick up when refinancing rates increase following an
acceleration of economic activity, while volumes continue to grow.
As retail current account volumes are about double the size of
corporate volumes and are more sensitive to interbank rates, the
impact will be felt most strongly in retail banking profits, which
will rise from €8 billion in 2009 to €30 billion to €35 billion in
2012. Corporate profits will grow from €9 billion to €20 billion to
€25 billion.

Should the crisis turn out to be more severe
and protracted than the mid-range scenario, profits may fall more
sharply this year in a trend that could continue through the coming
years. Under a more pessimistic scenario, payments will become
unprofitable in 2009, recording losses of €1 billion, falling to a
-€5 billion low in 2010, once again mainly driven by the erosion of
interbank rates. Improvements in current account volumes and
margins will help profits rebound to €15 billion to €20 billion by

Implications for the payments

Payments accounted for 28 percent of
total European banking profits in 2007, and by 2009, its expected
share of revenues will rise to 32 percent. Banks must capture at
least their fair share of this business and design payment
strategies that respond to customers’ changing needs and generate
opportunities as soon as economic recovery kicks in.

We believe that the following areas should be
addressed when redesigning payment strategies.

Engage in the battle for

The crisis illuminates the attractiveness of retail current
accounts, from both a short-term and a long-term perspective. Right
now, steering more money into current accounts will benefit banks’
results by bringing in liquidity and fees.

Current accounts provide a cheap
source of funding compared to saving or term deposit accounts,
where rates are offered to consumers are typically higher.

In addition, a significant share of total
retail current account volumes can be assumed to be at least as
stable as savings accounts and can therefore be transformed into
relatively long maturity lending. This, combined with low consumer
remuneration, means that interest margins on current accounts are
typically higher than they are on other deposit instruments.

In the longer run, banks should also enhance
the fee-earning potential of retail current accounts. A stable
revenue stream, resistant to changing interbank rates, is valuable
in a downturn. Products such as mutual funds or shares also
generate fee income, but inflows are more volatile and do not
generate extra liquidity. It is clear that banks will be well
served by strategies that attract customers to current accounts and
effectively meet their expectations.

A true needs-based product offering leads to
higher sales performance, generates more fee-based income,
increases cross-selling, and reduces customer migration. For
example, UniCredit’s ‘Genius’ current account consists of a set of
bundles, each with different non-banking benefits including
discounts or insurance policies.

In another example, Rabobank tries to meet the
needs of some customers for more control by sending them alerts
when their balance drops below a pre-defined threshold.

Reduce the cost of cash

Reducing customers’ reliance on cash
in the short term would seem to be a challenge at a time when they
are being careful about using credit. However, the crisis may give
the banking community an opportunity to work with government
agencies to promote cashless payment solutions.

The weakened fiscal position of many European
countries gives them an additional incentive to fight cash
circulating in the black economy, and government support could be a
key factor in implementing cashless strategies.

Wouter De Ploey is a director in the
European Business Technology office; Florent Istace is a Payments
Practice Knowledge specialist in the Brussels office; Mieke Van
Oostende is an associate principal in the Brussels office; and
Edmond Vrancken is a Payments Practice research analyst in the
Paris office.