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July 27, 2009

New model for merchant-funded rewards

As consumers increasingly turn to debit cards, financial institutions cannot simply cut-and-paste credit card rewards programmes and apply them to debit cards As such, some banks are now exploring the merchant-funded rewards proposition and expanding their profitability potential, as Charles Davis reports. With more than a quarter of a century of proven results, credit card rewards have driven the growth of the cards industry

By Verdict Staff

As consumers increasingly turn to debit cards, financial institutions cannot simply cut-and-paste credit card rewards programmes and apply them to debit cards. As such, some banks are now exploring the merchant-funded rewards proposition and expanding their profitability potential, as Charles Davis reports.

 

With more than a quarter of a century of proven results, credit card rewards have driven the growth of the cards industry. Now, with debit transaction volume in the United States surpassing credit card volume, financial institutions are turning to debit rewards as well.

The challenge for issuers has been replicating the rewards scheme in a way that makes sense financially, as debit cards do not produce the same income levels as credit cards.

An Austin, Texas-based rewards provider, Image Products, has developed a compelling business model for debit rewards by teaming with banks and local and national merchants to construct rewards networks that build incremental revenue from cardholders through interchange and add-on services like bill payment. The ‘My Rewards’ system adds even more value by analysing consumers’ debit card spending habits and offering customised promotions to the customers most likely to respond.

Banks clearly are interested in debit rewards products. The 2008 PULSE Network debit issuer survey, released this month, said 51 percent of banks had debit rewards programmes, up from 37 percent two years earlier. Another 23 percent were considering adding such a programme. With the shift toward debit cards and away from credit, financial institutions see a real opportunity to capitalise on debit relationships, which are, in essence, an extension of the current/chequeing account product.

The challenge of debit reward profitability

Debit card rewards currently are marginally profitable, at best, at most US financial institutions. About 27 percent of debit cardholders in a First Data survey from December last year participated in rewards programmes, and a large share – up to 40 percent – said they have grown unhappy with offers that lack quality, variety or usefulness.

Industry data suggests that fewer than 20 percent of US debit reward schemes are profitable – which makes My Rewards a stand-out product, as it drives profitability in every deployment. My Rewards has generated about $62 in additional profit for each enrolled current account at participating banks, and the company believes that is just scratching the surface of its potential, because the more data it compiles on spending habits, the more effective its promotions can be at a local level.

Because merchants fund rewards, there is little to no cost per account to the financial institution. Merchants, ever more aggressive in their efforts to bypass traditional credit card interchange models, benefit from partnering with data-rich banks to drive debit cardholders to their stores.

US financial institutions are expected to be spending $18.4 billion a year on rewards programmes by 2010, up from $10.3 billion in 2006, according to recent research from payment consultancy Aite Group. Programme management costs are expected to rise from $600 million in 2006 to $1.15 billion in 2010.

Different objectives for debit

Debit reward programmes demand a different business model than credit card programmes because the goals are adoption and increased usage rather than loyalty. These programmes succeed by mining and segmenting customer data to match consumers with specialised merchant offerings. Customers then are driven to participating merchants by the promise of larger rewards for repeat business.

The benefits to the debit card issuer are multitude: increased adoption, higher usage rates and most importantly, greater profitability on each and every debit purchase. On average, a financial institution can expect about 70 basis points of earnings on a typical debit card purchase, according to My Rewards. With a merchant-funded rewards programme, those earnings get an additional boost from a cut of the rewards value – in some cases, as much as one-third of the rewards value for directing consumers to the merchant’s store.

Evolution of merchant-funded rewards

My Rewards faces a growing number of competitors, including Cardlytics, an Atlanta start-up that is planning pilot programmes with three banks featuring targeted merchant offers sent to customers during online banking sessions, and Jack Henry & Associates’s Big Rewards programme, developed by Saylent Technologies, which allows banks to micro-target pockets of customers with incentives based on their transaction histories.

“First generation merchant-funded rewards programmes don’t meet the needs of banks or merchants,” said Scott Grimes, CEO of Cardlytics. “They are largely untargeted internet-based marketing offers that requires customers to leave the banking site and make a purchase online. Offers are not relevant and have relatively little value, customer response is low and merchants see little incremental sales. Ultimately, they add cost to the card relationship without moving the needle on loyalty.”

With Americans spending $1.4 trillion on debit cards last year, and with that number expected to grow at double-digit rates for the foreseeable future as US consumers slow down on the credit card side, financial institutions have a great deal at stake in debit rewards programmes. As interchange income continues to decline and as the opportunities for acquiring new credit accounts dwindle, these merchant-based income strategies will become even more attractive.

Loyalty programmes

Effects of promoting non-cash rewards

Payment type

Bank interchange revenue on $10,000

Reward expense: gift card

Reward expense: cash

Gross bank revenue

Signature + PIN debit transaction mix*

$116.81

-$45

 

$81.81

 

-$50

$76.81

Credit card

$200.00

-$90

 

$110.00

 

-$100

$100.00

* debit signature interchange rate = ($100 x 1.35%) + $0.10; PIN = $0.65. Credit cards @ 1% purchase to reward. Debit cards @ 0.5% purchase to reward. Source: Mercator Advisory Group

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