The Green Sheet Online Edition
July 22, 2013 • Issue 13:07:02
Maintaining equilibrium in acquiring
Most of the approximately 7,000 Federal Deposit Insurance Corp.-insured institutions in the United States do not acquire transactions directly, and fewer sponsor ISOs. Why? Income that is not derived from interest is critical for bank profitability. Let's explore.
In the United States, only banks can be licensed acquirers. Nonbanks like ISOs and even large processors must be sponsored by banks. Several entities like First Data Corp., Moneris Solutions and Global Payments Inc. look and act like members, but each is sponsored to the card networks by a bank.
A main reason Visa Inc. and MasterCard Worldwide haven't accepted nonbanks is financial stability. U.S. banks are highly regulated. They must maintain adequate capital ratios. They are regularly reviewed by a supervisory agency in accordance with their charters. They must produce quarterly financial statements that are publicly posted in standardized format. Finally, in the event of a bank failure, historical precedent protects stakeholders that provide for continued settlement.
This makes the card brands' job easier because by only allowing banks to be licensed holders, they are somewhat insulated, and the regulatory agencies assist them with monitoring.
Using FDIC data as of Dec. 31, 2012, and excluding savings banks, the total number of banks is 6,096. While this number may seem large, if you consider acquiring banks that are actually sponsoring merchant ISOs, that number shrinks dramatically.
A September 2011 First Annapolis Navigator article stated, "Although ISOs can have more than one sponsor, Wells Fargo Bank sponsors 46 percent of the ISOs that identify their bank sponsors on their websites. More than 39 other banks, including HSBC, U.S. Bank, First National Bank of Omaha, Merrick Bank, and Harris Bank, are also sponsors."
Reservations about becoming acquirers
While this study may have overlooked a few banks and some may have been added since 2011, the point is that few acquiring banks also sponsor ISOs. Why don't all banks want to be acquirers? Risk is the obvious answer. Although banks are paid for monitoring and mitigating risk, there are reasons why risk limits financial institutions' involvement on the acquiring side, including:
- Magnitude of risk. An analogy can be made between the payments and travel industries. Our issuing side is analogous to surface driving: there are many different vehicles, and each accident is localized. The acquiring side is more like the airlines; far fewer planes exist, but each accident is likely to be catastrophic. Banks typically like working with a large numbers of diverse customers, thereby distributing their risk.
- Accuracy of fraud modeling. On the acquiring side, it is more difficult to model the probability of default (and price accordingly) than on the issuing side. Moreover, in acquiring, the seasonality of customers is more pronounced than with individual consumers. For example, in December, a retail business may process 10 times its typical monthly processing volume.
A business must modify its entire operations, inventory and cash flow to support such an increase, which exerts further risks and pressures. Consumers may have comparable increases in spend (although unlikely) but would probably not have similar changes in daily patterns; many save throughout the year to support December's shopping.
Additional unique risks, such Payment Card Industry Data Security Standard compliance, exist on the acquiring side and make risks much less identifiable with a fraud scoring model. This article does not attempt to cover the field of acquiring risk; suffice to say that risk exists that is distinct from the issuing side, and because of the smaller customer base and unique characteristics, it is less supported by analytical fraud tools.
- Core offering. Banks view debit cards as a core offering associated with most checking accounts. Not so with acquiring transactions, which have historically been paired or marketed specifically toward commercial customers and checking accounts.
Today, the commercial checking account is separate from the acquiring relationship at most banks. Given these complexities, fewer banks will acquire merchant transactions than will issue debit (or credit) cards.
Reservations about sponsoring ISOs
In sponsoring ISOs, banks can increase their market territory and decrease their marketing costs or servicing costs; acquiring is a scale business, and by utilizing ISOs, acquirers can drive down their fixed costs. Despite this advantage, there are reasons why acquirers may not be eager to sponsor ISOs. For example:
- Territory limitations. Although market territory affects whether a bank will want to become an acquirer, some banks are restricted from growing beyond certain boundaries. Some have defined territories, and their charters, boards of directors or regulators preclude them from venturing outside of established territories.
Because of the processing volume needed to make acquiring profitable, these banks do not consider entering the acquiring business at all, or they reject sponsoring ISOs that have aspirations to sign merchants across the country.
- Quality of earnings. Another consideration is the quality of banks' earnings, which is analogous to what multiple your residuals are worth. In acquiring, a portfolio of retail, card-present, seasoned merchants that is well diversified and has predictable residuals has a higher valuation than a portfolio with residuals from a few large, newly acquired, card-not-present merchants. You could say the first portfolio has a better quality of earnings.
The same is true for bank earnings. Traditional bank earnings are from consumer and business deposits and loans. Those earnings have a higher quality of earnings than income from a merchant portfolio for a community bank.
This translates into a higher price (P) of the stock relative earnings (E), or a higher PE ratio for publicly traded banks; hence it is a reason banks' might shy away from acquiring operations and sponsorships.
- Card brand incentive. The card networks comprise another reason banks (especially small and community banks) shy away from ISO sponsorship. Visa and MasterCard do not have an incentive to increase the number of acquirers and sponsor banks. From their perspective, all the large banks are already acquirers. With only smaller banks yet to court, neither card network has an active acquirer recruitment process.
Approximately 70 percent of all banks have under $300 million in assets, yet these banks have the most difficulty in obtaining a nationwide acquiring license. Both card networks limit the types and volumes of merchant activity acquirers may process based on their capital (or equity). The rationale is simple: with each added smaller bank, the amount of processing does not increase for either card network even though the risk increases.
The risk accelerates because the smaller banks have a greater propensity and history of failing than their "too big to fail" brethren. Even though the number of bank failures is waning, there were still 51 FDIC insured bank failures in 2012 and 14 during the first five months of 2013.
Unlike the issuing side of the business in which both card networks want additional license holders and attempt to woo them to issuing their brands, acquirers are card-brand agnostic.
The card networks know this and consequently do not have a vested reason in increasing the number of community banks that either have full acquiring licenses or sponsor ISOs.
Reasons to support acquirers
The small number of banks committed to the acquiring business and to sponsoring ISOs have built the infrastructure and implemented the risk controls necessary to successfully navigate the acquiring industry. Further, because of the smaller number of acquiring banks, the margin remains elevated.
With every acquirer that exits, an opportunity opens for a new bank to enter. And while at any one point there may be a shortage in sponsorship (which drives up pricing), that higher pricing will entice a new bank into the business, so long as the marketplace does not artificially exclude banks, either through pricing or card network rules.
This equilibrium is fragile, however, and if a card network instituted a large license fee for a new bank or if a large bank received significant discounts because of its size, this equilibrium could be distorted. Although it would be beneficial to larger banks in the short term, it would be detrimental to the card networks and the payments industry (including large banks) in the long run.
The effect would dissuade ISOs from upgrading merchant terminals at a time when this is most needed. The impact would also provide further opportunities for alternative payment providers like Square Inc. Finally, it would marginalize the card networks themselves, as greater power would be given to fewer and larger banks.
I very much appreciate and respect my company's sponsor bank. I hope this article assists you in doing the same.
Ken Musante is President of Eureka Payments LLC. Contact him by phone at 707-476-0573 or by email at firstname.lastname@example.org. For more information, visit www.eurekapayments.com.
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