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The Quarterly Journal of The Clearing House Q3 2015, VOLUME 3, ISSUE 3

STATE OF BANKINGWith Bill Rogers, CEO of SunTrust

MY PERSPECTIVEBy Bob Steen, Bridge Community Bank

WHY IS SILICON VALLEY INVESTING IN PAYMENTS?

GLOBAL REAL-TIME PAYMENTS

MOBILE WALLETS

GLOBAL BANKING’S BLINDSPOT: SARs

ENSURING CONSISTENT CONSUMER DATA PROTECTIONS

HOW TO SUBMITBanking Perspective welcomes your submissions. Articles should be between 2,500-4,000 words and should support an identifiable position in the context of bank policy or bank payments issues. While technical in nature, articles should be clear, concise, readable, and accessible to individuals with varying degrees of knowledge of the banking industry. Authors should avoid undue focus on any individual financial firm. The Clearing House will copyedit all accepted submissions with the full cooperation of the author. The author will have final approval of all content. Once published, The Clearing House retains the right to publish and distribute material at its discretion.

To submit an article for consideration, e-mail [email protected].

HOW TO SUBSCRIBEBanking Perspective, the quarterly journal of The Clearing House, is a forum for thought leadership from banking industry executives, regulators, academics, policy experts, industry observers, and others. Articles focus on themes in the bank regulatory landscape and innovation trends in bank payments, providing timely analysis of the most important issues shaping today’s banking industry.

To subscribe, visit: theclearinghouse.org/publications/subscribe-banking-perspective.

Coming Up for Banking PerspectiveThe fourth quarter 2015 issue will feature analysis and commentary on the role of banks in society and the economy. Historically, the banking industry has facilitated economic growth in the United States by providing access to capital, taking deposits, and facilitating payments, among many other functions. The upcoming issue of Banking Perspective will include articles from Ross Levine, Haas School of Business, University of California Berkeley; Stephen Cecchetti, Brandeis International Business School; and Robert Wright, Augustana University in South Dakota, among others.

The Quarterly Journal of The Clearing House

3rd Quarter 2015 | Volume 3, Issue 3F E A T U R E D A R T I C L E S

22 The Challenges Facing a Global Real-Time Payment System

The clamor for real-time payment systems is growing louder every day, as users expect instant, on-demand access to many service offerings. Delivering real-time payments across borders, however, is a large challenge for banks and regulators.

by David Sayer, KPMG U.K.

30 Why Is Silicon Valley Investing In Payments?

In 2014, start-up payment companies received $1.6 billion in venture capital, as investors saw the payments space as an opportunity for new fintech offerings. Why is payments suddenly a “hot” sector, and what advantages do banks have over start ups?

with Don Kingsborough, Capital One; interviewed by Russ Waterhouse and Greg MacSweeney, The Clearing House

38 The Future of Digital Wallets Digital wallets are finally entering the mainstream following

a few recent major product announcements, as well as advancements in technology that allow for greater functionality. Payments, of course, are a central fixture of digital wallets and there are a few traits that all successful products possess.

by Kausik Rajgopal, McKinsey & Co.

50 Ensuring Consistent Consumer Data Protection in Payments

During the past few years, the nontraditional payment provider market has experienced explosive growth. However, the legal and regulatory protections designed to protect consumers’ financial data may not cover all new payment products and could place personal data at risk.

by Rob Hunter, The Clearing House

56 Global Banking’s Blindspot: Suspicious Activities Reports (SARs)

Financial institutions serve as the gatekeepers of the financial system and report suspicious transactions and activities to government authorities. However, rules limit a bank’s ability to share SARs within its own organization, which limits a firm’s ability to uncover illicit activity. TCH requests that FinCEN issue additional guidance on sharing of information with branches and foreign affiliates.

by Alaina Gimbert, The Clearing House

14 Bill Rogers, SunTrust Jim Aramanda, CEO of TCH, interviews Bill Rogers,

Chairman and CEO of SunTrust Banks, Inc, who discusses the strengths of the U.S. economy, the importance of financial literacy, the intersection of branch and mobile banking, and cybersecurity.

S T A T E O F B A N K I N G

4 BANKING PERSPECTIVE QUARTER 3 2015

Banking Perspective is the quarterly journal of The Clearing House. Its aim is to inform financial industry leaders and the policymaking community on developments in bank policy and payments. The journal is a forum for thought-leadership from banking industry executives, regulators, academics, policy experts, industry observers, and others.

Established in 1853, The Clearing House is the oldest banking association and payments company in the United States. It is owned by the world’s largest commercial banks, which collectively hold more than half of all U.S. deposits and which employ over one million people in the United States and more than two million people worldwide. The Clearing House Association L.L.C. is a nonpartisan advocacy organization that represents the interests of its owner banks by developing and promoting policies to support a safe, sound and competitive banking system that serves customers and communities. Its affiliate, The Clearing House Payments Company L.L.C., which is regulated as a systemically important financial market utility, owns and operates payments technology infrastructure that provides safe and efficient payment, clearing and settlement services to financial institutions, and leads innovation and thought leadership activities for the next generation of payments. It clears almost $2 trillion each day, representing nearly half of all automated clearing house, funds transfer and check-image payments made in the U.S.

EDITOR Greg MacSweeney

DESIGN & PRODUCTION Big Yellow Taxi, Inc.

Copyright 2015 The Clearing House Association L.L.C. All rights reserved. All content is owned by The Clearing House Association L.L.C. or its licensors. The views expressed herein are not necessarily those of The Clearing House Association L.L.C., its affiliates, customers or owners. Any use or reproduction of any of the contents hereof without the express written permission of The Clearing House Association L.L.C. is strictly prohibited.

1114 Avenue of the AmericasNew York, NY 10036212.615.9250

1001 Pennsylvania Avenue, NWWashington, DC 20004202.649.4600

The Clearing House

D E P A R T M E N T S

8 For the Record TCH CEO Jim Aramanda calls on the industry to deliver

a next generation, real-time payments platform that will serve as a foundation for payments innovation for many years to come.

12 My Perspective With the community banking industry at risk and facing

many challenges to its business, smaller banks must offer new payment products, such as real-time payments, to further improve strong customer relationships.

by Bob Steen, Chairman and Chief Executive Officer, Bridge Community Bank

64 TCH AnalyticsTCH’s Quarterly Risk Barometer.

66 By the Numbers A numeric look at payments in the economy.

68 Research RundownHighlights from academic and policy research on issues in the banking and payments industry.

78 Featured MomentsImages from the 2015 TCH-SIFMA Prudential Regulation Conference, as well as the TCH Annual Spring Leadership Dinner.

82 In the VaultAn early image from TCH’s 162-year past.

82


Alaina Gimbert

Alaina Gimbert is SVP and Associate General Counsel at The Clearing House and she provides legal support to TCH’s wire, ACH and check image businesses. Gimbert also engages in AML, sanctions, and payments law

advocacy efforts for TCH owner banks and is the principal staff advisor for The Clearing House’s AML and OFAC Committees. She is responsible for following regulatory and legislative developments in the payments, AML, and sanctions space and engaging with regulators, other trade associations, and industry participants to advance the interests of TCH’s payments company and its owner banks. Prior to joining The Clearing House, Gimbert was counsel to the Federal Reserve Bank of Atlanta, providing legal support to the Reserve Banks’ national ACH and check services. She received both her B.A. and J.D. degrees from the University of North Carolina at Chapel Hill.

Rob Hunter

Rob Hunter is the Executive Managing Director and Deputy General Counsel and serves as the senior lawyer supporting The Clearing House’s ACH, wire transfer, and check-image payment networks. Hunter is also actively involved in counseling payments executives on numerous industry-wide product development initiatives in a variety of payments-related areas. As principal staff advisor on payments law issues for The Clearing House Association, the nation’s oldest banking association, he is frequently engaged in representing the interests of The Clearing House owner banks on a variety of payments law issues through the filing of comment letters, amicus briefs and white papers. Hunter holds a B.A. degree from Northwestern University and a J.D. degree from

the Duke University School of Law. He is a member of the American Bar Association Business Law Section’s Banking Law Committee, where he serves as Chair of the Subcommittee on Payments and Electronic Banking.

Kausik Rajgopal

Kausik Rajgopal is a Director at McKinsey and co-leads McKinsey’s Global Payments Practice in the Americas, which spans processing, consumer credit, digital payments, and cash management. Since joining McKinsey in 1997,

Rajgopal has worked in financial services and payments, helping banks, payments processors, telcos, technology players, networks, consumer credit providers, and others address strategy, operations, and organization issues. He received his Bachelor’s degrees in Industrial Engineering and Political Science with Distinction from Stanford University and an MBA from Stanford’s Graduate School of Business, where he was an Arjay Miller Scholar.

David Sayer

David Sayer leads the Global

Banking team at KPMG, which

provides audit, tax, and advisory

services to a range of clients. Sayer

has had 26 years of experience as

an adviser and practitioner and is

currently a member of the KPMG

Board in the U.K. A key element of Sayer’s role is to have

regular discussions with banks around the world which

gives a perspective on strategies being adopted in a

challenging environment. He has built global teams in

KPMG focusing on payments, mobile and the use of social

media and most recently led a research study looking at

mobile payments and the future mobile banking.n

Winner of 22 Greenwich Excellence Awards in Business Banking, including eight in Treasury Management

The 2014 Greenwich Associates Commercial Banking Study is with companies with sales of $1MM to $500MM and is based on nearly 25,000 interviews.Branch Banking and Trust Company, Member FDIC. © 2015, Branch Banking and Trust Company. All rights reserved.

Success. It’s all in the navigation.Finding your way to better treasury management is easier with BB&T. Our Payment Solutions team is focused on helping you achieve more automation, improved cash flow, greater fraud protection and expanded information reporting. We’re there every step of the way, sharing our knowledge and insight so you can move forward to greater profitability.

For a complimentary consultation based on your specific business needs, call 1-800-810-5625. BBT.com/PaymentSolutions


BY JIM ARAMANDA,President and Chief Executive Officer, The Clearing House

There can be no doubt that the world of payments is rapidly evolving. New innovations are providing expanded options for payments that are increasingly fast, simple, and more versatile. Mobile technology and the growth of digital commerce are driving payments innovation. Whether it’s a homeowner paying the local plumber, or a company sending a cross-border payment, options are proliferating. Ultimately, innovation wins. We have seen it happen in other industries, such as retail or travel. Innovation improves services, delivers new efficiencies, and provides customers with greater choice. The payments business is no exception.

Think of Netflix first sending Blockbuster into bankruptcy and then successfully cannibalizing its own business model by offering streaming videos. Think of Uber revolutionizing the for-hire transportation business. Considering the recent pace of innovation in the payments space and that technology-driven disruption has upended numerous industries throughout history, the question is whether banks can innovate in the payments arena to compete with newer offerings from nontraditional payments providers. Indeed, how banks respond to this question will have profound implications for banks, consumers, non-banks, and the economy as a whole.

From the perspective of The Clearing House, the ongoing competitive evolution of the payments space is a very real and immediate issue. The demands of digital commerce are driving this revolution in payments. They require faster, more intuitive, easier-to-use, and often “invisible” payments products. Silicon Valley investors have responded and identified payments technology as a hot sector. The Wall Street Journal reports that in 2014 venture capitalists poured over $1.6 billion into payments technology-related startups.

Against this backdrop, new payments providers have shown significant growth. PayPal was valued at $47 billion following its July 2015 IPO. Venmo, just two years after its 2012 launch, processed $2.4 billion in person-to-person (P2P) payments. Overall, the P2P market saw $5.2 billion in payments executed during 2014 and is projected to grow to $17 billion by 2019 (See article, p. 42). Most recently, the social media giant Facebook offered users the option to send and receive payments via its popular instant messaging app, Facebook Messenger.

The positive news for banks is that despite the impressive growth of many new payments providers, the value of payments completed by the existing banking payments network dwarfs the payments volume of the nontraditional providers. In all of 2014, for instance, PayPal’s total payment volume was $228 billion, whereas each day TCH’s ACH network alone handles $106 billion. These numbers demonstrates that, while new payments services are in fact expanding, bank-owned networks continue to have the scale and capacity to serve as the payments backbone for the economy.

It’s worth noting that banks aren’t the only ones observing the new payment players. Regulators are also taking a very active interest in the future of payments, with the Federal Reserve’s Faster Payments Task Force working to identify and evaluate alternative approaches for implementing safe, ubiquitous, and faster payments capabilities in the United States. Other countries, such as the U.K., have adopted or are in the process of adopting faster payment systems. However, no country has a payment system with the size and complexity of the United States. When the Federal Reserve announced the Faster Payments Task Force in January of this year, Federal Reserve Board Governor Jerome H. Powell stated, “A safer, more efficient and faster payment system contributes to public confidence and economic growth.”

http://blogs.wsj.com/venturecapital/2014/12/17/the-daily-startup-investors-fuel-global-boom-for-payment-processing/

http://blogs.wsj.com/venturecapital/2014/12/17/the-daily-startup-investors-fuel-global-boom-for-payment-processing/


At the same time, banks are moving quickly to take the lead in providing a faster, more intuitive and secure payment products to their customers. In the important area of faster payments, The Clearing House is working with its member banks to develop a ubiquitous real-time payments system for the United States that is customer-driven and designed to address unmet payments needs across many different demographics, including P2P, B2B (Business-to-Business), P2B (Person-to-Business), and B2P (Business-to-Person) transactions. This real-time payments system will meet global standards and will also serve as a platform that will generate future payments innovation. As a testament to the objective of expediently delivering new payments options, the specifications for the real-time payments system were developed in only five months with the goal of having the technology architecture finalized by the end of 2015 and work on the platform beginning in early 2016.

Most importantly, this will be the first new payments system in over 40 years and will provide a platform for digital commerce, built with web and mobile channels in mind. While the existing payments network is robust and also supports many of the nontraditional payment products through the existing infrastructure, the legacy payments infrastructure can only move the industry so far. A new payments platform will overcome the inherent limitations of the existing legacy payments system. It will serve as a platform that will support new and innovative products – most of which haven’t even been imagined at this point.

TCH member banks are, likewise, taking innovation seriously. Although much attention has been focused on fintech startups entering the payments space, numerous banks have established innovation centers in locations known as hotbeds for technology innovation, such as Silicon Valley. The innovation and research

centers aim to find new technologies that can provide a competitive edge for banks, as well as locate talented professionals to join a bank’s technology team. Banks have also partnered with leading universities to establish innovation and research centers for financial technology, and bank CEOs have recently stressed the need for technological innovation in their annual letters to shareholders.

Collectively, these developments will ensure that the banking industry continues to deliver on a key element that has historically been at the center of banking

activities: enabling safe, secure, and reliable payments for commerce that are also increasingly fast, versatile, and mobile.

In short, this is an exciting time to be in the payments industry. Banks need to continue building innovative payments products and services that will help accelerate digital commerce and offer added convenience to customers. As many industry observers who focus on the intersection of finance services and technology will suggest, the banking industry is under the threat of potential disruption by new non-bank players in the payments arena. But it is apparent that with a clear focus and rapid execution, the banking industry will deliver a next generation, real-time payments platform that will serve customers and the country with a range of new options for speed, ease, and flexibility for years to come. n

From the perspective of The Clearing House, the ongoing competitive evolution of the payments space is a very real and immediate issue.


TCH-IIF AML-BSA ColloquiumSEP 30 • LONDON

INVITATION ONLY The second installment in TCH and IIF’s biannual AML-BSA colloquium series.

Symposium on Duties of Bank Directors and Executive Officers Through Financial Distress and ResolutionOCT 8 • UNIVERSITY OF DELAWARE, WILMINGTON

INVITATION ONLY TCH and the John L. Weinberg Center for Corporate Governance at the Alfred Lerner College of Business & Economics at the University of Delaware will host a forum to evaluate the paradigm for bank corporate governance and how the new roles and responsibilities of directors and executive officers will manifest in a financial distress and resolution scenario.

Fundamentals of Bank ComplianceOCT 14-16 • BOSTON UNIVERSITY, BOSTON

For the second consecutive year, TCH and the Graduate Program in Banking and Financial Law at the Boston University School of Law will host a robust two-and-a-half day program providing a structural framework for understanding important trends in bank compliance.

Fourth NYU Stern-TCH Gallatin Lecture OCT 23 • NYU STERN SCHOOL OF BUSINESS, NEW YORK

INVITATION ONLY The fourth installment in NYU and TCH’s 2015 quarterly Gallatin luncheon lecture series.

Fifth Annual ConferenceNOV 16-18 • THE WALDORF ASTORIA, NEW YORK

Now in its fifth year, TCH’s Annual Conference is the industry’s leading banking and payments conference, featuring the industry’s senior most regulators, practitioners, and experts weighing in on the most topical banking and payments issues.

TCH-IIF Cross-Border Resolution Colloquium NOV 30 • NEW YORK

INVITATION ONLY The second installment in TCH and IIF’s colloquium series.

Previous Events:• NYU Stern-TCH Quarterly Gallatin Lecture, Feb. 6

• First Annual Operational Risk Symposium, Feb. 11

• GWU Federal Reserve Centennial Series, March 20

• TCH-IIF AML-BSA Colloquium, March 30

• Symposium on Financial Globalization & Balkanization, March 20

• NYU Stern-TCH Q2 Gallatin Lecture, May 4

• Symposium on the Intended and Unintended Consequences of Financial Reform, May 11

• Inaugural Financial Resiliency Symposium, May 28

• NYU Stern-TCH Q3 Gallatin Lecture, Sept. 10

• TCH-Wharton Symposium on Financial Resilience, Sept. 18

2015 Events CalendarTHE CLEARING HOUSE ASSOCIATION


BOB STEENChairman and CEO of Bridge Community Bank

Bob Steen is Chairman and CEO of Bridge Community Bank, an employee-owned community bank located in east central Iowa. His background includes serving as a Federal Reserve Bank examiner, currently serving on the Independent Community Bankers Association’s Bank Operations and Payment Committee, an ICBA/Fed workgroup, and is a member of the Iowa Bankers Association Payments Council. Steen served a three-year term on the NACHA Board of Directors and is currently a board member of Shazam. He is a member of the Fed’s Faster Payment Task force and also serves as a representative for the small bank segment on the Faster Payment Steering Committee.

Bridge Community Bank is a small bank in east-central Iowa, chartered in 1903. The bank is employee owned, and our employee owners share in the bank’s success. For the past 25 years, this arrangement has worked well, and we’re proud of that. The customer base mostly consists of farm and other agricultural family businesses, as well as those who commute to more urban areas, primarily Cedar Rapids and Iowa City. Our customers include all age groups, and all make and receive payments.

We aim to stay up to speed with the latest in payments. At the same time, we are determined to do everything we can to improve security for our customers. The bank has been an early adopter as an originating community bank for ACH, check imaging, and remote check deposit. We delivered check image account statements to our customers in 1996 and sent the first Check 21 FedForward file in December 2004. While that sounds easy today, back then it was a seismic change for older customers who were used to receiving their paid paper checks in their monthly statement. Our customers stayed with us and soon saw the value. We had recognized an easy business case and knew it was an important component to staying relevant in payments. We now offer mobile, electronic P2P, and multiple bill-pay services.

Every other community bank that, in our view, understands the critical aspect of payments offers these services as well. Some community banks, however, apparently still don’t. We hope these banks will adopt these services soon because time is short. We need new payment offerings not because we need more technology or “glitter” but because we believe that our community banking industry is at risk. Data shows that the wellbeing of community banking is in danger. There has been a significant drop in the number of community banks – by the thousands – in the past few years. A focus on payments alternatives is vital to a community bank’s strategy. Same-day ACH capabilities will allow customers to move money on the same day, in contrast to regular ACH payments which are made on the following day.

Our small bank also took early steps to be ready for these changes. Bridge Community Bank participated in the Federal Reserve Enhanced Same-Day ACH product and began the process to originate and receive same-day items. We, like most small banks, are largely dependent on a core system provider. In our case, we challenged our provider’s early response that same-day ACH was not an option for us. As it turned out, all we had to do was ask the right questions or more accurately, ask them of our vendor often and louder. We occasionally receive same day items; although still few and they are commonly low-value items. That is not what we anticipated, but we could and do settle incoming same-day ACH items. It could add a few minutes to our day if we were to return an item the same day. We have the next-day option for returns, so it has not been much of an operational change. From a practical standpoint, there are few same-day receivers so we are waiting on the industry to catch up. Originating a same-day item is otherwise harmless as the Federal Reserve processes at the earliest schedule. If the receiving bank doesn’t have same-day payment capabilities, the item settles the next day. It’s always better to pay attention. The entire process is actually quite simple and it is not that complicated, although some participants do make the process out to be more complicated than it actually is.

Meanwhile, payment choices and speed continue to evolve. That is nothing new, however the speed of change is certainly accelerating. I served as a NACHA board member (2008-2011) and was a loud and ardent advocate of the Expedited Processing and Settlement ballot to move forward on same-day ACH. We heard the arguments about shifting business away from other well-established forms of funds transfers, risk of faster payments, and the cost of “change.” The failed ballot was a major disappointment as it would have advanced the network and faster payments much sooner. NACHA has since tweaked the proposal and it passed overwhelmingly. It is hard to believe that the interbank fee of 5.2 cents allowed the measure to pass, but one reason is as good as another. This will in a small way equalize the value


proposition between the sender and receiver. Our economy always works better with fair exchange. Some think these services should be free. They are not.

NACHA’s recent success to advance the ACH network now depends on the ACH operators and the industry to seize the benefit. Even so, we are not stuck in time, and other non-bank payment providers are innovating quickly and offering alternative payments in many different forms. Many if not most are leveraging ACH. Some offering these alternatives are collaborative efforts with regulated financial institutions, but many are non-financial players, and some are carving out a small piece of the payment process. So far, the result is that end users simply have many choices, and it is just safe and easy to stay with what works — and that’s buying the community banking industry some time. Any comfort in that is short sighted, however. We worry about the integrity of the payment market and believe that the regulated financial industry has to be the foundation from which all payments products are built.

Community banks’ best and probably only hope for leadership is the Federal Reserve. We are relying on the Fed to incorporate NACHA’s new same-day rules and accommodate the inter-bank fee (bank meaning “financial institution” for this offering) that the industry has overwhelmingly endorsed. Again, this is not perfect. Instead it’s a huge step forward. Same-day transactions will give us options in missed and hourly payroll offerings, which will almost certainly help touch at least some of the underbanked. We need to get better at serving the unbanked and underbanked, because the alternatives are almost certainly a poor choice for all of us. Nonetheless, I would argue that most who are unbanked are unbanked for a reason. We have no magical response to move them from: “I just want my money.” For instance, offering same-day payment options might provide an enticing service for unbanked

consumers, but is a same-day payment feature enough to get unbanked consumers to open accounts? Maybe not, but it is a service that many consumers could find very attractive.

Same-day ACH will provide other benefits such as P2P payments that happen in a time frame that end users can comprehend and accept and it will likely provide benefits that we have yet to consider. It will be faster than now for most payments. I believe same-day ACH will soon become the norm.

Although there is a lot of discussion surrounding same-day ACH, many seem to be still confused as to what “same day” actually means. Same day is not immediate or real time. Getting there is very hard, assuming that we need to validate the receiver with some sense of comfort – or regulatory expectation.

Real time is obviously a relative term. Does it mean within the hour, or within a few seconds? Does the message confirming a good funds payment serve the purpose with settlement at some minutes or hours later? Do we need an entirely new payment system, or can we leverage the rails we currently have? Do we already have an adequate electronic and immediate funds transfer system on the ATM rail that requires only a few uniform network and gateway concessions (mostly pricing)? Of course, we already have countless closed-loop options, but they are still closed loop. Universal has to be a main goal along with faster and secure. If we get universal, faster and secure payments, we all benefit.

My take is that our current payment rails work pretty well, however they need to be faster, more secure, and they need to work together more easily. We need to solve the puzzle of the unique identifier that can always be trusted. That will almost certainly expand on all the early work on device and individual authentication. Our bank is working hard to move forward on the real potential of fingerprint and facial recognition. The potential for biometrics goes well beyond the device and it is all about validating and authenticating. We are encouraged by our customer’s buy-in, but less encouraged with the hurdles we must leap to integrate the biometric technology into our core banking system. However, we do not give up easily.

We think we know where we need to go and we believe we can meet the challenges. However we do feel the overwhelming regulatory

burden and it is no secret that community banking continues to dwindle away. We are not at odds with our customers. We want to be their bank and we do everything we can to make all of their banking transactions go smoothly. As a community bank, we pay taxes and adhere to regulations, but think we think that all of our non-bank competition should as well. We understand the importance of reasonable regulation and we want banks to be held to a high standard. At the same time, we also expect there to be fair competition in the payments space, with non-bank payment providers meeting the same payment standards and safeguards that banks offer customers every single day. n

We need new payment offerings not because we need more technology or “glitter” but because we believe that our community banking industry is at risk.


STATE OF BANKING

“In fairness, I think trust is the currency of our industry. Our reputation as an industry has taken a ding from the financial crisis. We’ve got to earn it back, day in and day out.”


JIM ARAMANDA, TCH: Let’s start off by discussing the economy, the recovery, and discuss your local market, and any perspective you have on what it would take to improve economic growth.

BILL ROGERS, SUNTRUST: The U.S. economy is on solid footing. We continue a slow and steady march of improvement with some minor ups and downs. Importantly, we’ve been pretty resilient despite a lot of recent global unrest and stock market volatility. This is a testament to the strength of our economy.

The U.S. consumer is in better shape and they’ve deleveraged. Now, the consumer also is pretty liquid, so they need the confidence to get out and start spending. I think that’ll be a big determinant on how fast we continue the economic recovery.

A category that I’m going to call private domestic investment – business and residential investment – is better than last year, so that’s a positive.

Much of our business is concentrated in the Southeast and the Mid-Atlantic states. We’re seeing some pretty good growth, and if we look at some of our primary operating

states – Florida and Georgia specifically – they were two of the top five job producing states last year and seem to be on that same track again this year. I think job creation is the ultimate determinant. Everything else flows from job creation, for example, housing improvement and other factors.

There are a lot of things on the legislative agenda. Many of those are fiscal and really important, not the least of which is the discussion around a balanced budget, real tax reform, and then clarity around regulation – not just for banking, but for all industries.

SunTrust plays an important role in educating businesses and consumers on the banking system, and certainly, SunTrust accepts the responsibility. We also play a role in funding that growth.

ARAMANDA: Are you seeing an uptick in commercial lending in all segments as well?

ROGERS: I’m seeing an uptick in pipelines, and we’re seeing an uptick in production. For us, the actual outstandings were flat quarter-over-quarter primarily because we had a lot of pay-downs, particularly in CRE, and actually that’s not a bad

Bill Rogers, Chairman and Chief Executive Officer of SunTrust Banks, Inc., discusses the strength of the U.S. economy, the intersection of branch and mobile banking, the importance of financial literacy, and cybersecurity with Jim Aramanda, CEO of The Clearing House.

STATE OF BANKING


State of Banking

thing. The pay-downs came from projects being put out to the institutional market faster than they had been or than we had anticipated because the projects are good and the institutional money has got to go someplace.

ARAMANDA: Could you comment how the low interest rate environment is affecting your business model? One of our owner bank CEOs said that they were going to have to start cutting expenses if interest rates didn’t start rising.

ROGERS: Our 2015 business plan did not anticipate an interest rate increase. We made commitments to improve the efficiency of our company, but we didn’t predicate that on an interest rate move.

Now, we do expect short-term rates to slowly rise, perhaps at the end of this year and certainly slowly rise next year. We’re not anticipating any accelerated pace on rate increases in the short to medium term. I personally think a modest increase in rates is a strong signal. Particularly from the commercial side, it’s a signal that we’re not in an emergency and that the “crisis” is behind us.

We can all debate about the pace and the slope of recovery, but I don’t think it’s debatable that we’re in a recovery. I fundamentally think there’s commerce sitting on the sidelines. I’ve talked to a lot of business leaders, and they would view a rate increase as a signal that we’re in a more pronounced recovery.

Once rates begin rising, I think the hikes will be slower than they were in 2004 to 2006. We’re just in a different period, and I think the Fed will be more cautious

in analyzing the data. Our company is slightly asset-sensitive, so we would benefit from a rate increase. But the real benefit is if business gets better across the country.

Also, the slope of the yield curve matters, so how a rate increase manifests itself along the yield curve is important. The consumer has been sitting on the sidelines in a low-rate environment for a really, really long time. A rate increase also sends a small positive signal for consumers who depend on their savings to earn interest.

ARAMANDA: On a regulatory front, do you have any concerns regarding the current framework?

ROGERS: Across the industry, everybody realized coming out of the crisis that there was room for improvement in our process and execution. We, like others, have made a lot of investments in people, infrastructure and governance to ensure that we were responding appropriately.

The capacity exists to determine relative systemic importance and business model risk, and then adjust regulation accordingly. Dodd-Frank and FSOC created that process, so rather than choosing what I’d call a high common denominator strategy, the rules can be applied more strategically.

If you think about it, the above $50 billion in assets – that arbitrary number from Dodd-Frank – represents a small number of banks. It’s possible to distinguish between the different types of risk at various thresholds at banks. Doing that would free up operating income, but more importantly, free up more capital to deploy. That would be good for the system and good for the economy.

ARAMANDA: Yes. Well said. Let’s move on to the next question regarding technology. How do you see it changing in the way consumers interface with the banks? Is branch banking still going to be central as you look ahead?

ROGERS: Yes. Clients clearly want to interact with us on their schedule, not ours, and we have to make sure that we provide a multi-channel approach. I do think the branch network will continue to play an important role in that channel mix.

SunTrust leaders Allison Dukes and Jenner Wood from the SunTrust Atlanta Division teach young students the importance of financial basics during a volunteer event at Junior Achievement.


All that being said, we’re investing significantly in mobile and online interactive technology to make sure we’re effectively and efficiently meeting client needs. We’ve done a lot of work and study on millennials, and while they transact primarily in the non-branch channels, they do come into branches at key decision points. It’s important to make sure that we understand and react to a variety of different needs.

In the second quarter of this year, more than 60% of the retail banking clients of SunTrust used digital channels. If we were worried about whether the adoption’s happening, we need to stop worrying about that. The adoption has absolutely happened.

Further, we’re investing to make other capabilities more accessible. We’ve introduced SummitView in the private wealth area. It’s an online financial planning platform that gives the client a 360-view of their net worth. It has an aggregation component to it, and it’s a great tool for clients to use on their own, but also with a financial advisor.

It’s interesting because I was also in the private wealth business, and we all were building aggregation tools. At that time, we were building solutions in search of a problem, and now that’s totally reversed. Now it’s a primary component of a client’s expectation. To build an aggregation tool along with the financial planning tool, we had to go to two providers, and we worked hand in hand to put this together.

We’ve integrated our online consumer lending platform for well-qualified clients, LightStream. This is something we invested in several years ago, and it has been a high growth business for us. It’s now integrated into SunTrust.com and available through our branches. So, it’s another example of how we’re leveraging the branch network and the investments we’ve made in both technology and channels to address consumer preferences.

ARAMANDA: I would like to move on to the topic of cybersecurity. Just a couple of years ago it was not something that would probably be on your agenda or any of the other CEOs agendas, but things have changed dramatically in the last couple of years. Is your Board engaged when it comes to the topic of cybersecurity? What are some of the things the industry could do to stay ahead?

ROGERS: Absolutely. We, our Board, our management, and all of our teammates are heavily engaged in understanding, managing, and stress-testing cyber risk. It’s an area that we continue to make significant investments in both technology and people. It has the absolutely highest attention of the Board. We haven’t had a Board meeting where we didn’t talk about cybersecurity in the last two years.

From an industry perspective, the key is sharing information quickly when it comes to these threats. Financial services is doing this well and I think our industry is leading. We participate in virtually every forum from government and business that is designed to share information, including FS-ISAC and all the other organizations. We want to make sure that we’re participating in order to reduce the contagion as fast as possible and to identify best practices.

I do think there’s more that can be done in this space, and we’ve seen some recent actions on the Hill which are positive. We need legislative solutions to improve, protect and incent shared access of timely information. We need the legislative help to ensure that we’ve got all the appropriate and requisite air cover in place.

ARAMANDA: Yes, and we need to share actionable information. Often we get information from the government that we can’t really act on due to its classified nature or other reasons that impair the rapid dissemination of the information.

ROGERS: Right. And again, for financial services, the industry is really working together and realizing that the chain is as strong as its weakest link. We want to make sure that we’ve got a strong chain as an industry.

“We’ve done a lot of work and study on millennials, and while they transact primarily in the non-branch channels, they do come into branches at key decision points.”


ARAMANDA: SunTrust does a lot to promote financial literacy and education. It’s a topic, I understand, you’re passionate about.

ROGERS: Yes. It’s core to who we are as a company. We’re a purpose-driven company. We define that purpose as lighting the way to financial well-being. We want to make sure that we play a role in alleviating the stress that people and businesses feel when it comes to their money.

For us, it’s integral to everything we do. It’s integral to our business plans. It’s part of our operating strategy. It’s something that we measure and reward.

From a company perspective, we do a couple of interesting things. We offer a volunteer day for every teammate with the goal of them being out in the community to advance financial well-being. We also give every teammate a “Day of Purpose” to work on their own financial well-being. We want them to take a day off and make sure that they focus on themselves and their families and do all they need to stay on the path to financial well-being.

We do a lot of training with our teammates to have meaningful conversations with clients. We use social media and the SunTrust Resource Center on our website, which offers a lot of tips and tools.

In addition, we work with third party organizations. One example is Living Classrooms in Baltimore. We’ve been partnering with this organization almost a decade. We recently opened the SunTrust Financial Education Center in a Living Classrooms’ community center. The classes are taught by our teammates, so they have a way to engage and be involved in something that we’re supporting. We provide

basic education on savings, budgeting, and prioritizing on how to meet needs on a limited income.

Another example is a signature partnership in Atlanta along with Chick-fil-A and the Junior Achievement Discovery Center. I think this is really leading the country in Junior Achievement. We have over 35,000 middle school kids come through the discovery center for a hands-on experience in managing finances, and SunTrust is by far the leading company in volunteer hours for that organization.

ARAMANDA: That’s impressive. These examples actually lead right into the next question, and I think you may have partially answered it. How can the banking industry improve its reputation with the public? I imagine your financial literacy program is part of the answer.

ROGERS: Well, it is. Trust is in our name, so obviously it’s an important word for us in terms of how we think and run our company. In fairness, I think trust at the end of the day is the currency of our industry. We work hard to develop long-lasting, deep relationships with clients. Our reputation as an industry has taken a ding from the financial crisis. We’ve got to earn it back, day in and day out.

We start by doing what’s right for clients. Our number one guiding principle at SunTrust – it’s up everywhere for every teammate to see – is client first. We’ve got to remember that that’s the driver. We have to improve our transparency. I think reputational risk and the conversations around a positive risk culture are inextricably linked. We tend to try to talk about them as two separate things, but they are the same thing. For SunTrust and our industry, I think staying focused on full transparency and asking questions versus assuming that we have answers is key. And remember, we’re in a great business, and our teammates make decisions every day that impact the lives of clients and build communities. We just have to be cognizant of that, and be thoughtful about those decisions.

And then – the point you made – be visible out in the community. We want to make sure that the people in the community know that we’re part of this recovery, and we accept our role in making our communities better and making this recovery stronger.

State of Banking

Cyber “has the absolutely highest attention of the Board. We haven’t had a Board meeting where we didn’t talk about

cybersecurity in the last two years.”

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A leading international law firm with 16 offices located in major financial centers around the world, Cleary Gottlieb Steen & Hamilton LLP has helped shape the globalization of the legal profession for more than 65 years. Our worldwide practice has a proven track record for innovation and providing work of the highest quality to meet the needs of our domestic and international clients.

Cleary Gottlieb advises many of the largest and most systemically significant U.S. and non-U.S. banking entities in the world on the full range of banking, securities and related regulatory matters.


State of Banking

ARAMANDA: I happen to think job creation at the end of the day is going to be the biggest help to our industry. If people have jobs and they’re feeling good about their future, they will feel better about our industry as well.

ROGERS: I think that’s right, and it is important to focus on things such as career readiness. Those are other areas where we spend time and make investments to make sure that we can make that matriculation to the job front smoother.

ARAMANDA: The last question, Bill, is regarding payments. As you look out the next five-plus years, how do you see the payments landscape shaking out? Are you concerned about the banks losing their primacy in the payment system?

ROGERS: It’s interesting because I think clients have clearly indicated that they have preferences. We as an industry need to understand what those preferences are, and respond with more alacrity than we have in the recent past. If you think about it, our industry pioneered much of today’s payment system. We were the innovators. Now, that’s more of a shared responsibility. We’ve got some new partners and competitors, so we have an interesting group of companies that we work with to make sure that the payment system is the best for our clients.

The banking infrastructure is the core of the payment system. It’s supported by our capital and, back to your last question, our reputation. While we don’t want that infrastructure to be circumvented, I think the best defense here is a good offense, and that offense has got to really be focused on clients.

The industry actually is moving fast, and The Clearing House has been a leader in helping the industry. We’re responding to consumer preferences for P2P platforms, and maybe even more importantly, the security and the convenience of real-time payments.

So, when it comes to payments, I think it’s a chapter yet to be determined. Our position will be determined by our responsiveness and our flexibility. And very similar to the cyber question, I feel like there’s just a lot more impetus and incentive for banks to work together to create more common thoroughfares that are responsive to what clients want versus what we already have or may think they need.

ARAMANDA: Yes. We need to meet clients on their terms, when and where they are, and I think the same would hold to payments.

ROGERS: Yes. Think about our fintech brethren. They start from the client and work backwards. We need to make sure that we have that same framework when we’re working together to make our infrastructure and our collective platforms more responsive.

ARAMANDA: Yes. Similarly, TCH has made sure that the real-time payments system we are designing is market driven. This is very important.

ROGERS: Again, The Clearing House has been a good forum for banks to work together to ensure the long-term stability of the infrastructure, but also for our collective and relative competitiveness.

ARAMANDA: That concludes everything. Are there any additional thoughts or comments you want to add?

ROGERS: I’m proud to be a banker. We’re in a great industry. Think of the important role we play in the recovery of the economy. I’ve got the privilege of leading 25,000 teammates that are dedicated and get up every day thinking about lighting the way to financial well-being for our clients. This benefits everyone, our clients and communities as well as our teammates and shareholders. I’m proud to be in this industry. n

SunTrust teammates volunteer at elementary schools to teach light-hearted financial lessons on “needs versus wants” and “saving versus spending.”

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Understanding what’s important.

A hunger for growth.

D E P O S I T O R Y A N D L E N D I N G S O L U T I O N S | T R E A S U R Y M A N A G E M E N T | M E R C H A N T S E R V I C E S | C O M M E R C I A L C A R D

Todd StaubCHIEF FINANCIAL OFFICERUTZ QUALITY FOODS

Utz Quality Foods has come a long way from the kitchen of Bill and Salie Utz. Today, they deliver snacks all over the country,

employing thousands of hardworking Americans. At M&T, we’re proud to have aided their recent growth – being proactive with

acquisitions and providing multiple strategic financing options. We not only have the resources they need, we offer the responsive,

personal attention this family-owned company is looking for. Find more of Utz Quality Foods’ story at mtb.com/commercial.

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Understanding what’s important.

A hunger for growth.

D E P O S I T O R Y A N D L E N D I N G S O L U T I O N S | T R E A S U R Y M A N A G E M E N T | M E R C H A N T S E R V I C E S | C O M M E R C I A L C A R D

Todd StaubCHIEF FINANCIAL OFFICERUTZ QUALITY FOODS

Utz Quality Foods has come a long way from the kitchen of Bill and Salie Utz. Today, they deliver snacks all over the country,

employing thousands of hardworking Americans. At M&T, we’re proud to have aided their recent growth – being proactive with

acquisitions and providing multiple strategic financing options. We not only have the resources they need, we offer the responsive,

personal attention this family-owned company is looking for. Find more of Utz Quality Foods’ story at mtb.com/commercial.


BY DAVID SAYER, KPMG U.K.

WW H Y I S R E A L T I M E PAYM E N T S such a big deal?

In today’s internet-focused world, where we all expect 24x7, instant, on-demand access to resources and services, the clamor for real-time payments systems is growing louder every day. The question with which regulators and the banking industry is wrestling is how to deliver a secure, effective, convenient system to send or receive a payment immediately, even across borders, to or from a deposit bank account.

In a typical real-time payment scenario, a consumer or small business wants to make or receive a low-value payment without using a bank-specific acquiring device (e.g., a card reader such as Square) or a physical debit card. The sender needs to know the recipient’s bank account or an associated alias1 and to be able to use the bank’s existing channels – generally internet or telephone banking or visiting a bank branch – to initiate a transaction. Generally, these systems are

1 Alias or proxy services are emerging in a number of countries to provide simplicity for consumers and to protect the recipient’s bank account details. Examples include the Paym in the UK and SWISH in Sweden for mobile transactions.

not designed to handle bulk transactions such as payroll, rather simply to process single, instantaneous payments.

To make an instant, irrevocable payment without a real-time payment system, the current options are using a debit or credit card (a debit collection-based transaction) or paying in cash. A debit card provides a proxy for the user’s account and effectively is a promise to pay the merchant within X days, via an acquirer connected to the card switch. A credit card, similarly, acts as a proxy for a line of credit with a credit institution and the merchant receives funds days (or

Real-Time PaymentSystem Possible?

Global Is a


sometimes weeks) later. Cash is immediate, but carries its own risks and handling costs.

Although consumers are migrating towards convenience, new non-card payment mechanisms (such as Apple Pay and mobile apps) typically rely on the same debit or credit card infrastructures. The pressure on card interchange models has renewed attention on innovation in the non-card payments space. After all, if a debit card is already a proxy for my account, then why do I need a card to reach it if online I can use another proxy associated with this account?

A number of different business and technical models have emerged in several jurisdictions to achieve a real-time payment system, one which supports a customer experience for a spontaneous payment. From a customer’s perspective, this immediately transfers funds from the sender’s bank account to the recipient’s bank account, where the recipient can see an acknowledgement of the receipt of funds, typically within seconds. There are a number of different, innovative ways emerging to achieve this objective. What is no longer in dispute is that there is demand for such services, both to send and receive payments, and that businesses see the great potential of immediate cash flow and instant payments.


Is A Global Real-Time Payment System Possible?

The introduction of Faster Payments in many countries has leveraged what is now “old” technology, commonly used for card switching, and adapted it to deliver a near-real-time or real-time experience (e.g. South Africa RTC, India IMPS). In a small number of countries, the Real Time Gross Settlement (RTGS) system has been adapted to cater for payment types beyond the high-value, systemically important transactions it was designed for, extending RTGS down into the low-value payments where immediate settlement is a critical success factor for that transaction (e.g., in Mexico). Each country has adapted the concept to suit its own market conditions and volumes of daily transactions.

In countries with a low volume of transactions, and particularly where there are a low number of market participants in the central bank’s RTGS system, then it may be most effective to leverage that infrastructure to effect these transactions. In Mexico, the central bank has opened up the RTGS environment to a wider range of participants, including non-banks.

The vast majority of central bank RTGS systems were designed to process a relatively low volume of systemically important, same-day payments intraday across the central bank’s accounting platform (to achieve settlement finality for holders of central bank settlement accounts), and the retail payment systems are typically operated as a separate clearing and settlement mechanism where the net positions of the clearings are transmitted into the RTGS for settlement at predetermined intervals intra-day (or at the end of day in some countries). This approach has been taken to manage risks, collateral costs, and funds availability, not to mention enable effective processing and booking of high volumes of transactions.

THE U.K. EXPERIENCEIn the U.K., following market reviews into competition

in retail banking, the U.K. banks designed Faster Payments as a new payment system, combining a bespoke adaptation of a card switch for clearing with the risk management and settlement processes typically found in an ACH infrastructure. This gives end customers an immediate experience while reducing the participating financial institutions’ settlement costs. This was in large part possible due to the relatively low number of directly participating financial institutions when it went live in 2008. The U.K. model has been widely acknowledged as very successful, with ever-rising volumes. It has created a platform for new businesses and products and contributed to conditions for some new business models to thrive, particularly in the digital and online economy.

As internet banking has taken off, the ability to execute transactions instantaneously has driven new customer expectations, behavior, and demand. Faster Payments in the U.K. is now embarking on a journey to open access to the payment system to new participants, new market entrants, and non-bank providers such as aggregators.

THE U.S. EXPERIENCEThe trend towards real-time or Faster Payments is

visibly gaining traction in the U.S. and across Europe, the two major currency areas where the traditional payment systems have not provided such services in a ubiquitous way for consumers. In the U.S., discussions on the design of Faster Payments are well underway. The Federal Reserve Bank System2 has initiated a multi-streamed activity to examine potential improvements and enhancements to the U.S. payment systems, including the concept of Faster Payments. The Federal Reserve has established a task force to examine how this might best be achieved to meet the requirements of competition, collaboration, and reach within the U.S. market.

Simultaneously, The Clearing House, a private-sector operator of payment systems such as CHIPS and EPN, has initiated a Faster Payments project. According to TCH, the intent is to deliver a “real-time payment system

2 https://fedpaymentsimprovement.org/wp-content/uploads/faster-tf-charter.pdf

It is time to consider joining some dots and creating a wholesale payments clearing value chain that utilizes bespoke

architectures in a more creative arrangement.

https://fedpaymentsimprovement.org/wp-content/uploads/faster-tf-charter.pdf

https://fedpaymentsimprovement.org/wp-content/uploads/faster-tf-charter.pdf


to better meet consumer’s and businesses’ expectations in an increasingly digital economy.”3

ENABLING GLOBAL PAYMENTS IN REAL TIMEGlobal, cross-border interoperability in payment

systems is challenging and requires significant harmonization of business processes and standards. The world is witnessing a wave of standardization, with the ISO 20022 electronic data exchange standard seen by many as the best option for a future-proof common framework for the development of almost all financial messaging. In Europe, the Single Euro Payments Area (SEPA) project has seen the largest migration of users to date to ISO 20022,4 including government, corporations, banks, and non-financial institutions. ISO 20022 is rapidly becoming the standard for payments messaging, but there is still a long way to go to harmonize different systems.

In 2014, the U.S. Stakeholder Group5 – including The Federal Reserve Bank of New York, The Clearing House, X9, and NACHA – examined the business case for migrating to ISO 20022 in the U.S. payment systems. Work is underway to determine how to best achieve such a migration. The connectivity methodology for Faster Payments is at the forefront of this discussion, as there is a strong desire to enable a framework and format that could lend itself to the development of new, data-rich products and services.

It may appear that this is a simple technology challenge, but the adoption of common business process or messaging standards cannot alone guarantee cross-border interoperability of payment systems. The challenge is not simply one of communication, but

3 Any organization undertaking a faster payment initiative should contemplate the broad range of stakeholders in order to be able to meet the needs of all sectors and segments within the payment eco-system. Cyber-security, identity management, fraud, and simplifying integration and speed of access to the payment systems are areas of increased focus and opportunities for improvement. Any system also will need to consider new requirements in the digital market, new security frameworks to protect consumers and businesses, a range of proxy and alias options, and the potential to adopt international standards and processes.

4 https://fedpaymentsimprovement.org/get-involved/iso-20022

5 http://www.europeanpaymentscouncil.eu/index.cfm/newsletter/article/article.cfm?articles_uuid=8B79855C-5056-B741-DBA3D51530FB76ED

primarily of banking and accounting. Cross-border transactions involve foreign exchange (FX) as a basic requirement. In each transaction, the parties can either share the associated spread in the FX fees or one party benefits. In each currency, the settlement of the underlying transaction must take place with legal finality in central bank or commercial bank money. The management of the risk profile in this process is critical.

At all points in the transaction process, client money must be protected from counterparty default or theft and

from cyber-attacks, identity theft, account hijacking, and fraud. In credit card transactions, the identity of the card user is protected through Payment Card Industry Data Security Standards (PCI DSS),6 which is mandatory for all merchants.

The ACH world is moving towards combining multiple solutions. Without international coordination, the adoption of a new solution in one jurisdiction could interfere with regulatory compliance requirements in another, particularly if the third party cannot conduct Know Your Customer’s Customer (KYCC) analysis on the transaction.

The business processes, risk management, and settlement practices within national and currency groups are often slightly different. Ultimately, this is a complex accounting challenge. The funds must be carried into the settlement process in each jurisdiction by a financial institution participating in settlement where finality can be achieved locally. There are a number of third-party market participants that operate

6 https://www.pcisecuritystandards.org/

Global, cross-border interoperability in payment systems is challenging and requires significant harmonization of business processes and standards.

https://fedpaymentsimprovement.org/get-involved/iso-20022

https://www.pcisecuritystandards.org/



similar types of services, namely Earthport for low-value, cross-border transactions and Continuous Linked Settlement Bank (CLS) for foreign exchange and related products. These existing players provide some insight into how such a service might operate.

REGULATION AND THE CONTRACTION OF CROSS-BORDER SERVICES

One of the consequences of a retrenchment of cross-border payments and trade activity by globally active banks has been the contraction of international services available to multinational corporations and individuals that provide reach and depth in all local markets. Increased risk management and regulatory requirements have hightened complexity and costs and, in some cases, it is now impossible to reach counterparties in certain jurisdictions in a timely fashion (if at all) to deliver payments via the traditional banking routes. Individuals seeking to send funds overseas in real time are presented with a myriad of regulatory reporting and Know Your Customer (KYC) questions. Charities seeking to distribute aid in emergencies face this challenge regularly.

Creating a framework to ensure that an individual in one jurisdiction can send funds to an individual or small business in another country – in real time at low cost – is not new: the credit card has long been relied upon by consumers and businesses for this purpose. The consumer never sees the lag in actual settlement or any fee structure (whether interchange or merchant fees), which are borne by the merchant to create convenience and ensure global acceptance. Sometimes this is taken for granted, as the

complexity of processing that sits behind these activities is not transparent to the user.

Historically, the business opportunity, in terms of the number of actual cross-border transactions, was perceived to be low. Indeed, when contrasted with the volumes transacted in any one jurisdiction, the business case for cross-border transactions is often deemed to be weak. (Typically two to three percent of transactions in SEPA were deemed to be from one country to another.7) But the key issue is whether the convenience created by a real-time global payments system would drive more cross-border economic activity. Another question is whether we actually record the volumes of transactions, or whether consumers and small businesses find a workaround to avoid the complexity and charges associated with these transactions. This is where the digital agenda comes into play. The EU Digital Single Market Strategy seeks to encourage the creation of a wider ecosystem to boost GDP within the Eurozone from traditional e-commerce.

If consumer to business payments are the first theme, then the second area is remittances. Many consumers and small business owners struggle to find a secure, cheap, and reliable method to reach their destination when sending payments abroad. In many cases, a worker is sending funds to support family members in another country. The amounts in question are often higher than presumed. Human nature dictates that these transactions will not stop because complex barriers have been put in place, but will simply migrate to other channels, including physical movement of cash across borders at great risk to personal safety. So how do we create a common platform to effectively route transactions across borders?

At this stage, it can be logically assumed that each jurisdiction is likely to develop a national solution, as this appears to be the path of evolution in the vast majority of countries. A lot of attention has been focused on whether these systems can be joined together. This is not as simple as it first appears. Many of the clearinghouses around the

7 https://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000314612/SEPA%3A+Impact+on+structure+of+payments+markets.PDF

The consumer or small business is often less interested in how it happens – they are interested in how fast, how much it

costs, and how timely the confirmation is that the transaction has reached its destination.


world have been seeking methods to do this effectively and efficiently for at least 20 years. We have seen limited success with a number of innovations that address specific corridors and typically utilize a bridging strategy to carry messages and funds across that currency divide (e.g., IPFA8). These solutions have proved highly effective for a small number of participants and for a small number of currencies, but appear limited in reach.

FINDING A SOLUTIONIn order to create a globally ubiquitous service, each

consumer needs access to a domestic ubiquitous service, plus either a foreign service alongside the domestic service or a single offering which routes transactions from the domestic currency to a secondary service to carry that transaction to its cross-border destination. If financial institutions wish to remain relevant in this space, they could seek to create a channel to accommodate such funds transfers via their branded access points. The consumer or small business is often less interested in how it happens – they are interested in how fast, how much it costs, and how timely confirmation is that the transaction has reached its destination. Sounds easy.

It should not be forgotten that making credit push payments across borders is currently possible. There are a number of options available that use current mechanisms. They tend to be expensive, slow, point-to-point, and inconsistent in terms of the remittance data that is sent with transactions. These corridors have often grown to service the needs of specific communities, in the case of remittances, or specific industry verticals. Increased regulation and supervision of Anti-Money Laundering (AML) measures and sanctions are testing the capacity of these business models to provide a timely service in many countries. As these transactions speed up, we cannot lose sight of risk-management requirements.

As payments become a standalone activity from banking in many jurisdictions, customer protection gains greater importance. Consumers may perceive that funds are more secure during a transfer than they may actually be. The industry needs to provide greater clarity of

8 International Payments Framework Association: http://www.ipf-a.org

security during these payment processes so that users can make educated decisions about the risks they are prepared to take and the nature of the organizations they choose to handle these transactions.

It is worth considering that the Faster Payment systems are typically credit-push and not debit focused. There is a move to introduce new capabilities to facilitate a request for a credit transfer. This would enable a business, for example, to send a message with an outstanding invoice and payment details to ensure that a customer could (preferably within a mobile application) create a payment instruction with pre-populated information and pay that business the correct amount, with the correct reference, and with all the information the business needs to reconcile the transaction. This is a very attractive scenario for merchants, whether at a point of sale or where the customer is not present. It may be possible to integrate the use of such messaging (which does not require the sophistication of direct-debit mandate handling and legal protections) across borders and currencies.

The critical question is whether it makes sense to connect the domestic systems, and if so, how? The vast bulk of transactions are typically very local, and most consumer purchasing behavior is fairly predictable, so the industry is seeking to address the exceptions. The business case is potentially weak for each organization to do this independently and to bilaterally connect to each other. A more practical approach is to have one or more aggregators with fast-switching technology deliver this capability between national clearinghouses. This would be

The U.K.’s Faster Payments initiative has created a platform for new businesses and products and contributed to conditions for some new business models to thrive, particularly in the digital and online economy.

http://www.ipf-a.org

http://www.ipf-a.org

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a complex, risk-aware interbank and B2B environment, typically in a domain with short return-on-investment expectations. But, creating such a solution is a long-term infrastructure play.

There are a number of possibilities. A few organizations within the Eurozone already have faster payments-type systems (e.g., U.K., Denmark, Sweden, Poland, and Italy) or are creating Faster Payment services, so this question is there to be solved. Consumers and businesses will increasingly want to reuse this capability across the EU.

A friction could emerge between local versus pan-European or international services if these are developed without a common framework. Banks seeking simplification and a reduction in their clearing and settlement connections are reluctant to return to a situation where they have to maintain a complex architecture with numerous bilateral links and different standards (whether technical or business-model based). There is room for significant simplification in this space. This does beg the question as to whether it is possible to have true competition between payments infrastructures, if effective interoperability is a goal. Each innovation drags away from harmonised standards. If we’re not careful, soon we will need a Single Euro Faster Payment Area (SEFPA), and then a Single Global Faster Payments Area (SGFPA).

Key industry players around the world are engaged in significant dialogue to share experience and learn from each other. Work is ongoing to consider standardization of business processes, messaging standards, and content,

in order to ensure that steps are taken to achieve interoperability before functional designs are completed.

Will interoperability be achieved in five to 10 years? Yes, it is possible, but it will require significant global leadership, investment in a clear vision, and then a practical strategy to achieve it. There are a number of paths and options. This is a complex question, and one that could produce a number of responses by a significant number of players in the market. Clear direction is required, as the cost of developing multiple answers could possibly outweigh the benefits of complex, global interoperability with every operator attempting to meet requirements in specific foreign-exchange corridors.

Another possible model to achieve interoperability or reach is one that is more hub and spoke than is currently envisioned. The complexity of the processing that needs to occur in real time means that repeated handoffs in a bilateral framework would not be ideal. Some currencies have multiple operators (particularly in Europe). Therefore, I think it is more likely that there will be the emergence of a single global bridging platform between all of these systems, in a similar architecture context to CLS. Such a platform could create a third-party processor, one that all financial institutions or infrastructure providers could connect to, in order to move funds quickly cross-currency in real time.

The burning question is how to achieve this end result? Who could build it and when? What are the incentives to do so? Perhaps it is time to consider joining some dots and creating a wholesale payments clearing value chain that utilizes bespoke architectures in a more creative arrangement. It might be possible to create a landscape where ClearXchange, CLS, Earthport, and others, including high-volume clearing and settlement mechanisms in each currency (such as U.K. Faster Payments, The Clearing House, and EBA Clearing), could all play critical roles in delivering specific functionality required to deliver speed and security globally in a more complex world. In the current climate of intense regulatory scrutiny on payments, the ultimate question is: How do we achieve a global regulatory regime that makes such a project feasible? n

Will interoperability be achieved in 10 years? Yes, it is possible, but it

will require significant global leadership, investment in a clear vision, and then a

practical strategy to achieve it.

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GREG MACSWEENEY, TCH: Payments has been a hot area for venture capital in the past couple of years, really since about 2010. In 2014, venture capital invested approximately $1.4 billion in startups and we are seeing similar numbers so far in 2015. Why is so much venture capital flowing into the payment space, and why do investors view payments as being a hot market right now?

DON KINGSBOROUGH, CAPITAL

ONE: The interest you are seeing in payments is actually the accumulation of a market trend that has been going on

for a long time. Since the first iPhone launched in 2007, the mobile phone has really changed how people interact on every level – it has opened up a new world of discovery – changing how people even think about finding what they want and giving them new options and ways to pay. This has been such a transformational period, and while the interest in mobile technology and changing consumer habits may seem sudden, but it’s been building up over the past few years.

We have also seen dramatic changes in the ways that retailers think about their engagement with the consumer,

I N T H E PA ST F E W Y E A R S , payment payments startups have received billions in funding from venture capital. DON KINGSBOROUGH, Managing Director of Capital One Ventures and former head of PayPal’s retail business unit, discusses why payments is attracting so much attention right now and the advantages that banks have in the payment space, with Russ Waterhouse, Executive Vice President, Product Development and Strategy at The Clearing House, and Greg MacSweeney, Publisher of Banking Perspective.

WHY IS SILICON VALLEY INVESTING IN PAYMENTS?

I

expanding their capabilities and their understanding of how consumers now think about discovery and purchase. And of course there have been changes in the ways that technology companies have been working to enable consumers to do everything seamlessly, whenever and wherever they are – whether they’re sitting on their couch, or they’re on the soccer field watching their kids, or they happen to be in a coffee shop half way across the country.

Mobile has been so transformational because it isn’t the device that’s mobile, it’s the consumer that’s mobile. Understanding that the “new normal” for customer engagement means giving customers the ability to buy something wherever and whenever they choose, is a transformational concept.

Today, there is $3.3 trillion of U.S. business that is being touched by mobile (Boston Consulting Group, Jan. 2015: The Mobile Revolution). Mobile is the way people are progressively finding about what they want to buy; almost 80% of all purchases whether in-store or online is impacted by mobile. The closer you get to the moment of discovery the more likely you are to consummate a sale,

therefore you have to be engaged with the consumer at the earliest time possible.

Venture capital is being invested in these companies because this new experience of discovery, engagement and purchase has changed so dramatically. Technology is working in many different ways to make this all possible, from sharing a dinner check with a friend by clicking on your smart phone and transferring cash directly to your friend’s bank account (P2P) to buying a rug in India while you are riding in an Uber car to work – multiple transactions, occurring simultaneously and all being completed with a single click – or no clicks in the case of Uber. None of these examples would have the same impact if people couldn’t actually complete a transaction and “buy” something. Payments are the final link that brings all of these technologies together. That’s why you see such intense interest. It’s also why there has been so much innovation, and why there is so much money coming into new payment technologies and new ways of thinking about paying – because payments play such a critical role in commerce.



Why is Silicon Valley Investing In Payments?

RUSS WATERHOUSE, TCH: Don, in many ways, do you find the value added is around the total experience, and the payment is in many cases incidental?

KINGSBOROUGH: I’d even go further than that. I think the ultimate goal here is to make payments invisible and allow everything else to be the experience. Make it so simple and easy but pleasurable at the same time.

MACSWEENEY: You talk about the transformation that’s going on, the technology innovation, and your last comment about making payments invisible. What are the biggest forces for disruption in payments today? For instance, when there’s disruption, usually that’s when there’s opportunity for new business models or tools to come in. How do you translate all of this into opportunities for Silicon Valley investors and entrepreneurs?

KINGSBOROUGH: Whenever there is a huge transformation, you get disruption. In other words, when disruption is occurring you get a unique opportunity for the consumer to learn a new way to do things. We’re going through a period where disruption is occurring throughout commerce ecosystems. It’s occurring in consumer retail, B2B, online, mobile and throughout most financial services and banking. It’s occurring in acquirers, processors and terminal manufacturers. And it’s happening everywhere simultaneously. We’re seeing people who have achieved success in one area, coming up with innovative new ideas and starting new entrepreneurial companies that are now disrupting the financial services and banking industry.

Over time, as these innovations start to take hold, the real changes will start to occur when larger companies adopt these models, create new innovations, improve existing technologies, create new technologies – and then do it at scale. So disruption begins with an idea of how to do something better, faster, cheaper or more efficiently, and then it evolves to a point where a company that is at scale sees this disruption and then starts to either adopt or improve it, turning what was just an “idea” into a new reality – a new way of doing something – for everyone.

WATERHOUSE: One of the things that Silicon Valley hasn’t done is they haven’t created what we’ll call new payments rails. They’re utilizing existing traditional channels, and they’re creating a digital service layer on top of that. That’s really what’s appealing, and that’s the innovation, either towards the global visibility or just an enhanced experience with new capabilities around it, right?

KINGSBOROUGH: Sometimes there are constraints that make it easier to disrupt at scale in certain aspects of the business more easily than others. For instance, in your

There is $3.3 trillion of U.S. business that is being touched by mobile. Mobile

is the way people are progressively finding about what they want to buy; almost 80% of all purchases whether in-store or on-line is impacted by mobile.

DON KINGSBOROUGH


example you’re talking about the use of the payment rails and that’s a very difficult thing to change completely, but you can achieve disruption using the existing rails with apps like Venmo, or you can get disruption by simply doing things differently. I’d say Starbucks disrupted without using the rails. They used a barcode to essentially disrupt the payment process. Starbucks managed to get 12 million people to do something they’ve never done before – they used their phones to pay with a barcode to reduce queuing in line and to make sure they get that vanilla latte exactly the way they like it.

Disruption happens within the existing structures, but some change also comes from outside. There has been tremendous disruption in the financial services industry. They’ve seen Starbucks. They’ve seen Venmo. They’ve seen card-to-card money transfer. Customers also have the ability to use mobile phones to simply buy online. There has been an explosion of mobile applications, and there are retailers that have adopted single sign-on capabilities to remember credentials so their customers don’t have to sign in every time, but they can still buy whatever they want simply by going to the website.

Some of those disruptions are working within the system and some are outside of the system, but whatever the source, people are taking notice. Companies like The Clearing House and Capital One see that change is happening and they know that they can also disrupt and they can do it at scale. It’s happening in different ways across the industry – there are mobile payment applications for credit cards, there are money management apps and tools to help people understand and improve their credit scores. The next five years will forever alter the world of financial services, banking, insurance, and most other forms of commerce.

This era of innovation and change is driving Capital One – all of these innovations are happening at the company today. And when millions of people experience these types of positive change, it raises the bar for the entire industry, permanently changing the minimum that must be done to compete in the marketplace.

WATERHOUSE: So, the thesis is that we should embrace all this innovation that’s occurring and identify those which we find endearing or valuable to our business models, and start to apply those at scale.

KINGSBOROUGH: Yes, and I’d go one step further. You want to do what your customers want – even anticipating their wants and needs – and do it with the greatest amount of innovation. You, as a big bank, you want to start innovating at the same pace as a startup company. You have to have that same desire, that same commitment, that same level of adoption that you would have if it was the typical two person startup in someone’s garage.

MACSWEENEY: A number of your examples have focused around mobile and mobile payments. I know observers have been predicting that mobile payments would grow quickly when, in reality, adoption has been much slower. Why? And do you see this changing now?

KINGSBOROUGH: I think that is generally correct, but I would argue that, using the evolution of the Internet as a guide, there are strong indications that mobile is becoming the dominant way in which people decide what to buy and that mobile purchasing will increase progressively as mobile acceptance grows. When you can use your mobile phone everywhere you can use a plastic card, that’s when you will see the real power of mobile payments … it is the lack of acceptance that is holding mobile from becoming the most adopted and used payment choice.

As we move from one technology to another, there is an enablement period. The shift to mobile hasn’t occurred in physical stores or in B2B yet, in part because we haven’t enabled the technology to make that possible. It’s challenging for some large companies who have put an incredible amount of work into building their infrastructure to adapt. If takes effort, but as they begin to adopt new technologies and change, they can do it at scale unlike a small company. That’s really the stage that we’re in today. You’re getting established companies who are looking ahead and innovating at a very rapid pace.



As companies innovate and move forward, you start to see scale come into play, and that’s when new technologies like mobile take hold much more broadly. You don’t always have to be first, but you have to be innovative and looking ahead at all times.

MACSWEENEY: Good point. Let’s switch gears and talk about another topic that’s been receiving a lot of VC investment as well. It’s Bitcoin. Over the last 24 months, Bitcoin has gotten a lot of hype. What is your perspective on Bitcoin in particular and blockchain technology in general? Where do they fit in?

KINGSBOROUGH: I separate the two. Looking at Bitcoin as a currency, I think the jury is still out and I think it’s hard for financial institutions and governments to adopt it in its current state. But I think that the underlying technology of blockchain, has potential, so I anticipate that there will be a significant amount of investigation into the blockchain technology by the major banks and financial service companies. But as you adopt these new technologies, it has to be done within the context of financial security, safety, and risk.

MACSWEENEY: Jumping to the next question. Banks have also deployed new payment products for customers. From your point of view, where do banks have an advantage when it comes to payments right now? And where are the banks vulnerable?

KINGSBOROUGH: Nearly everyone who sends a payment is connected to a bank, holds an account with a bank, has a credit card with a bank, and has a relationship with a bank, so I wouldn’t underestimate the strength and impact that banks have – and will continue to have – in this space. One of the biggest advantages that banks have is the number of customers that have financial instruments. Whether they’re business accounts, personal checking, savings or credit cards, most people have a relationship with a bank.

On the other hand, if you think about startups, they usually don’t have any customers. That gives banks a huge advantage. We have millions of consumers already doing business with us, doing billions of “real money” transactions every day. This is can be a competitive wall

of innovation that a technology company will find very difficult climb over. As banks, we should use the customer relationship as our motivation to innovate as fast as any startup. The goal is to give our customers the best banking experience possible; anywhere and anytime they want, and customized as if they are our best friend – today that means innovating and evolving our products, services, and the customer experience to meet and even exceed customer expectations.

When you don’t have the customer relationships, you’re innovating trying to get customers to love your company. I believe that, even when you have customers, you should maintain that same hungry attitude about innovation. It’s a powerful perspective. I think we forget that banks have the relationships and have the ability to innovate at the same time, and I think many banks don’t use that to its best advantage.

Banks also have a deep understanding of their platforms, how the financial markets work, the risk environment, the potential security issues, and they own the connectivity and the relationships with their customers. They know how payments flow, how credentials work – they understand the payments ecosystem.

If you connect all of those elements – we have the customers, we have the core capabilities and we can innovate around all of those core capabilities – that should give banks speed to market. So, if we innovate as if we are a startup, take advantage of our existing platform capabilities, and love our customers like companies who do not have customers but are almost singularly focused on what consumers want, then we can be the winners of new digital commerce.

It all starts with a focus on innovation. I believe that maintaining a clear focus on innovation transcends many of the arguments we commonly hear about banks and predictions that banks will lose out to technology companies … we have the legacy systems, we have all these regulations, we have all these regulators, and oh, woe is us. But I say banks have real advantages – customers, knowledge and scale – and if we innovate and use them to our benefit, we will hold on to that advantage.


MACSWEENEY:What about possible vulnerabilities to startups or new entrants?

KINGSBOROUGH: The beauty of having a clean sheet of paper is you get to design and do anything that you want. For larger companies, there are the practicalities of running a big business and keeping the core business running successfully.

And then there’s a perception problem that banks aren’t innovative. Therefore, a lot of people who perceive themselves as an innovator – you know the person who says “I’m going to change the world” – they don’t necessarily think of going to work inside of a bank. We need to change that perception and bring in more innovative, creative talent to work in the banking industry.

The third thing is that a lot of the established technology companies have the same issues, but may solve it differently. They have a business to run, but they’ll go out and find incredibly creative startup companies and they’ll bring them in – within the technology company itself – and say “innovate here” and we’ll help you do it at scale. I think banks should do more of that and I think it’s something that banks have to do in order to compete with technology companies for the best talent. Lastly, the technology companies see themselves as embracing technology. That’s what made them successful – whether it’s Google, Apple, Facebook, Amazon – they see themselves as a change maker. That view opens up a different attitude, a belief in their ability to create further change. I think that change culture has to permeate an organization to be successful.

What has been most refreshing to me – and what drew me to Capital One – is the fact that it is a company that is doing all of these things and doing them well. It is a company that believes we have to be innovative and we have to change the status quo. To me, that attitude and culture is the path that will allow us to be very competitive to Silicon Valley.

MACSWEENEY: There are dozens of new payment companies entering this space. Who will be the winners in the race to dominate the payments business? Will it be banks

with newer payment technology? Startups with a new, fresh look? A combination of both?

KINGSBOROUGH: Remember when you were a little kid and someone told you the story of the tortoise and the hare? It’s a bit like that. Two things: I don’t think there’s one set of winners, either technology companies or startups or banks. To me, there’s going to be a blend and I think it’s a degree of winning. I think there will be innovative banks who will definitely win and I think there will be innovative startups who will definitely win. But I also think you have to consider winning at scale and how time plays a role. There are lots of people that will get out of the blocks very early and they get great publicity and they get a lot of investment.

Many of these startup businesses don’t have an economic model, and so they end up giving the product or service away, eventually these companies will have problems, get bought, or they die. You see many startups that will give away the commerce side, or give away the payments side, just to get the consumer advertising side. Banks have to be open to different business models and, at the same time, they have to be open to innovating in a different way. This is part of the corporate culture that is hard to change, but when you do you open up a world of possibilities … and that cultural shift may be the thing that makes all the difference for the future of the bank.

In my opinion, it’s going to be a blend. There are going to be some big banks who win, in a very big way. There are

As a big bank, you want to start innovating at the same pace as a startup company. You have to have

that same desire, that same commitment, that same level of adoption that you would have if it was the typical two person startup in the garage.



going to be some startups who create things that haven’t even been considered yet; these companies will win.

MACSWEENEY: Interesting, you mentioned the problem with the business plans. Many startups have really smart people, great technology and really great code, but they have no business plan.

KINGSBOROUGH: There’s a freeing aspect of not having an economic model to go with your technology. It’s freeing from one perspective – and I see this in the Valley all the time – the belief that if “we just get to scale, then we’re going to make money.” It’s quite different for most banks, because, at some point, they must present a plan to the executive team or to the board or the shareholders, to demonstrate that eventually – sooner rather than later, hopefully – the technology will make money. Established companies understand the reality and the need for an economic model that makes sense for the management team, for the board, for the shareholders.

It’s freeing in one sense to think that that a startup is just going to move forward, get to scale and worry about making money later. It doesn’t work as you attempt to create a product or provide services that stands the test of time and will fundamentally change the way in which someone does something.

MACSWEENEY: Beyond just writing a check, what’s the value that banks can bring to entrepreneurs, and what should investors be looking for when they’re searching for a funding partner?

KINGSBOROUGH: This is probably a whole article by itself. To me, there’s a relationship that develops between innovation startups and banks. It can be purely financial – funding the project to get it off the ground – but I think it should be much more.

For me personally, and for the Capital One Ventures team, it is more than just providing a source of funding: it is being the best partner a startup could ever imagine. The goal is to help startups gain traction and evolve their ideas and, at the same time, deliver breakthrough experiences for their customers. It is helping them where the startup cannot help themselves … every day and feeling as though we are part of the company. In many cases, the strategic return on an investment is as important as any financial return. This is what I hope to help bring to reality. I have been an entrepreneur four times and know what needs to happen and I want to help the next generation of entrepreneurs. n

The next five years will forever alter the world of financial services, banking, insurance, and most other

forms of commerce.

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EY can help align a rm’s risk management framework and governance with changing regulations. To learn more, visit ey.com/rg2020.

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Is risk culture today’s business fad or tomorrow’s competitive requirement?


DBY KAUSIK RAJGOPALMCKINSEY & CO.

THE FUTURE OF

DIGITAL WALLETS


D But for many in the payments industry, much uncertainty surrounds digital wallets. PayPal and other early digital wallets achieved scale via online commerce (eBay’s success provided PayPal with a significant subsidy in the cost of customer acquisition), but attempts to bring mobile payments into the physical world have found only limited success. To provide a structured perspective on how digital wallets will likely evolve, this article examines the digital wallet concept through the lens of prior payments innovation launches. McKinsey’s research and extensive experience in working with the payments industry have identified certain markers common to successful payments innovations.

Digital wallets are undoubtedly the latest payments innovation, and arise in the context of what is commonly described as the mobile revolution. The ubiquity of smartphones and other mobile devices means that consumers now have an unprecedented amount of computing power at their fingertips (taken together, two iPhone 6 devices have more computing power than the international space station), and these devices are becoming their personal “control towers” to manage their daily lives – from ordering transportation to listening to music on demand. Digital wallets that provide a way to

DIG I TA L WA L L E T S A R E G A I N I N G A F O OT HOL D in the U.S. and elsewhere around the globe. The recent launch of Apple Pay and its accompanying media attention are bringing digital wallets into the mainstream. Meanwhile, technological developments are making it possible to add greater functionality to these nascent consumer offerings. Even payment networks are showing a willingness to unbundle their offerings to permit non-bank players to use tokenization protocols. In the U.S., EMV technology adoption has accelerated, and consumers are becoming more receptive to digital-wallet-like offerings.

pay, move money, and manage loyalty relationships are a natural part of this revolution. The rise of mobile devices and digital wallets suggest that consumers will be more in control of their everyday payments than ever before.

EXHIBIT 1: DEFINING THE DIGITAL WALLET

The term digital wallet has been variously used to describe diverse forms of electronic payments, even those as simple as prepaid cards. Traditional wallets, however, typically hold much more than cash. They also commonly contain alternative forms of payment and various types of identification that can be digitally stored and accessed. This article therefore defines the digital wallet as a software application that enables users to digitally store money, payments credentials, and more, and to use these to implement a variety of cashless transactions.

MOBILE/E-COMMERCE “CHECK-OUT”Mobile site or

in-app purchases

PEER TO PEER/DIGITAL

GOODSPay friends and purchase music,

apps

BANKING AND BILL PAY

View accounts and transfer money

IDENTITYDriver’s license,

health cards, boarding passes

MOBILE PAYMENTS

Payment process-ing, card swipe

‘sleeve’

MOBILE INCENTIVES

AND LOYALTYCoupons,

location-based offers, ‘pay with loyalty points’

IN-PERSON RETSIL CARD/

CASH ALTERNATIVENFC, QR-codes

DIGITAL WALLET POTENTIAL APPLICATIONS

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The Future of Digital Wallets

MARKERS OF SUCCESS IN PAYMENTS INNOVATION

1. Deliver a step-function improvement in the consumer proposition over existing alternatives

Most payments innovations fail; historically, the failure rate is about 98%. This is because the payments industry is fundamentally defined by the challenges and rewards of creating and sustaining two-sided markets: enabling payments adoption by consumers and payments acceptance by merchants, both at scale. As a result, the payments industry enjoys high customer inertia and strong network effects. In this type of industry, when market entrants present value propositions that are only marginally better than those of incumbents, they generally do not fare as well. The founder of a payments start-up once ruefully observed that “starting a payments company with a slightly better mousetrap usually means you will lose.” Incumbents, by contrast, can simply build on the consumer usage and merchant acceptance they have already earned. Consequently, to overcome inertia and capture wide consumer acceptance, product and service innovations must deliver meaningful customer value. This is particularly true in developed markets, where card penetration is high and payments is not an

unsolved problem. With nearly four cards on average in their wallets, consumers are usually not actively looking for new ways to pay, so a digital wallet must deliver not just a marginal, but a step-function improvement in its consumer proposition to win.

In the U.S., for example, ongoing McKinsey research consistently identifies convenience as the leading factor in adopting mobile payments. Most digital wallets, including Apple Pay, Visa Checkout, and Google Wallet, accordingly present convenience as a leading product attribute in their value propositions. Until now, however, using smartphones to make offline transactions in markets where card penetration is high, as in the U.S., has been only marginally more convenient than using established methods.

To overcome inertia and network effects, motivating consumers to alter their existing payments behavior is the critical challenge. In the online commerce arena, PayPal initially used emails and passwords as a way to bring consumers added convenience. Now, Apple Pay has replaced passwords with its Touch ID fingerprint recognition technology for online shopping.

Despite such advances, the majority of consumers still perceive credit and debit cards as their most convenient payment option for transacting, whether online or at physical points of scale. To succeed, therefore, digital wallets must deliver compelling value propositions that are strong enough to dislodge entrenched card-based payments. And clearly, digital wallets that demand more user effort than currently favored payments methods are less likely to gain widespread adoption. Requiring users to attach cards to the back of their phones or add devices to their phones, narrowly limiting accepted forms of tender, or requiring manual entry of bank information will all hinder consumer acceptance. These theoretically viable ways of driving consumer adoption run into the hard reality of how consumers choose to pay: the devil we know is better than the devil we don’t.

To increase customer convenience, providers can extend wallet functionality beyond basic payments capabilities. Options include adding digital storage for ID cards, driver licenses, and other items carried in traditional wallets (Exhibit 1). The Osaifu-Ketai wallet developed by NTT DOCOMO in Japan, for example, includes electronic

UK

Canada

USA

Brazil

SwedenFrance

China

Germany

India

Spain

0.5

1.0

1.5bps

0% 5% 10% 15% 20% 35%25% 30%

EXHIBIT 2: DIVERSE MARKET CONDITIONS WILL REQUIRE THAT PROVIDERS ADAPT THEIR DIGITAL-WALLET BUSINESS MODELS

Debit and credit card penetration

Card penetration and interchange levels by country — 2013

Average interchange level for credit cards

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money, credit cards, loyalty cards, and electronic fare collection for public transit systems. Card issuers participating in digital wallets can use information and control as a way to differentiate: for example, American Express cards stored within Apple Pay enable transaction updates when the cards are used even outside the wallet; providing mobile controls for the consumer with a live record of all their transactions. A digital wallet might also contain applications that can deliver targeted offers that might redeem automatically at the point of sale – a major convenience for value-oriented consumers. India and other countries are even considering the issuance of personal IDs that could be stored in digital wallets.

In addition to convenience, Apple emphasizes security and privacy as key Apple Pay features. And other wallets, including PayPal’s and Turkey’s BKM Express, address these issues by not sharing payment details with merchants. With major data breaches now a prime concern, advanced security and privacy can be strong consumer incentives.

As the historical owners of most payment instruments, banks have a natural advantage in this arena to engage customers; they already provide loyalty benefits, feature rewards currencies tied to cards, and use customer data to deliver offers. The existing customer proposition they provide and the inertia it generates are therefore a “moat” for banks in payments. But banks must not sit still, and continue to innovate on the consumer experience – examples include the usage of mobile capabilities to set permissions and control credit cards, more relevant rewards propositions and more personalized offer delivery.

2. Create merchant propositions beyond cost reduction – such as conversion, offers and loyalty

Cost reductions are a perennial high priority in the payments business – a fact that is especially relevant in today’s challenging banking environment. The Merchant Consumer Exchange (MCX), for example, which comprises more than 60 U.S. retailers, is establishing a digital wallet platform designed to reduce members’ costs. Its platform addresses members’ concerns about rival digital wallets, like Apple Pay, that index heavily on credit cards and can therefore skew a merchant’s payments mix toward higher-cost methods. But excessive focus on costs

also reduce consumer appeal – for example, by requiring shoppers to disclose information such as bank account numbers that they are unaccustomed to providing for retail purchases. Historically, payments disruptors that focused on cost at the expense of customer convenience have failed to attain scale. So to succeed, digital wallets like that of MCX will need to find other ways to drive revenue growth. Possibilities include improving the customer experience, delivering offers and loyalty propositions more effectively, and collecting and sharing more consumer data with merchants.

For online and mobile commerce, payments and digital wallet innovators like PayPal’s Braintree have recently gained a foothold by delivering seamless customer experiences that dramatically increase purchase conversions. Conversions are highly valued by smaller online and mobile merchants intent on winning new customers and repeat business. Some digital wallets build on the shopping experience developed by retail giants like Amazon and Walmart, which expedite the checkout process by storing and auto populating previously-used payments credentials. These innovators offer this capability and conversion performance to smaller merchants who cannot develop such tools themselves. The payments processor Stripe, for example, minimizes cost while providing easy merchant integration and an uncomplicated customer experience. Extending such merchant propositions to the physical world is another way for digital wallets to offer merchants more that basic cost savings.

For the merchant-acquiring arms of banks, cost remains a significant consideration in the payments business. But with the rise of omni-channel and, in particular, mobile purchase modes, banks must recognize that a new

As non-banks proliferate in payments, banks must thoughtfully manage KYC, AML and related security considerations for these payments infrastructures and the ‘rules of the road’ for use by non-banks.



generation of merchants and commerce ecosystems are equally if not more interested in the conversion and repeat usage of interested consumers. Merchant acquirers must assess and improve their own propositions for all merchants in general, and mobile merchants in particular, to ensure that their business does not become a commoditized transaction processing service that competes only on price, but on other relevant factors that help merchants grow their business. Yet another arena is merchant credit, where merchant acquirers could use the data available to them from the payments stream to help their commercial banking partners extend credit to merchants to augment their working capital.

3. Win decisively as the “way to pay” for specific market segments and use cases first

Consumers’ concepts of digital wallets and their expectations regarding them vary widely, so using broad-scale marketing approaches early on can be risky. A safer approach is to initially pursue specific market segments and use cases that closely align with the entrant’s established core strengths. For example, in India, where cash payments predominate, Paytm is an example of a wallet that enables secure payments for using mobile services such as Uber. This enables closer tailoring of product design, partnering, and marketing strategies, which not only improves the odds for early success and keeps customer acquisition costs manageable, but also lets the wallet provider offer merchants quick access to customer segments, which can be an important incentive.

In this early niche-market stage, issuers can also pursue smartphone users (Android users in the case of Google Wallet; iOS in the case of Apple Pay). These might be frequent users of proprietary mobile apps, and the issuer could, for instance, create a simple link with existing app functionality to avoid confusion between wallet and other apps. Defining and delivering a value proposition for these customers will be critical to gaining adoption early on. Banks provide cards that cover all verticals with ubiquitous acceptance enabled by payment networks, so they are not limited to specific niches. But the question they must address, using the data they already have available from consumer spend patterns, is which verticals are likely to be strategically important to gain greater relevance and a deeper share of consumer wallets.

They could then pursue a variety of initiatives – including ‘pre-set’ card-on-file arrangements with key merchants, auto-enrollment of cards at fast-growing online and mobile merchants, and so forth.

4. Avoid reinventing the wheel, and leverage existing ecosystems and infrastructures instead

Adoption of the tokenization protocol developed by EMVCo (first used by Apple Pay) clearly illustrates the importance of this success marker. By using 16-digit tokens – the same format as today’s credit and debit card numbers – along with other existing data fields, the protocol enables more secure routing of payments via established networks and POS infrastructure while minimizing requirements and network integration costs. Apple could have instead spent significant time and money trying to build a better security approach. By leveraging existing infrastructure, Apple significantly reduced its new payment technology’s time to market and defined a proposition with an emphasis on security.

Wallet-like merchant apps, including those of Starbucks, Otto’s Yapital in Germany, and Target’s Cartwheel in the U.S., also use existing POS infrastructure to drive consumer adoption. Because these products use QR codes, however, related apps do not require near-field-communication (NFC) terminals. By contrast, Apple Pay, Google Wallet, and others use NFC to deliver a seamless customer experience that, in the U.S., has thus far come at the expense of broad merchant acceptance. But, as merchants replace older terminals with NFC- and EMV-enabled models, this obstacle should diminish in importance. In markets such as the U.S. where the EMV terminal replacement cycle is underway, this shift towards ubiquitous NFC acceptance will accelerate sharply over the next few years, transforming the capabilities for payments acceptance at the physical point of sale.

Banks are already invested in the existing evolving payment ecosystem they helped to create, including the shift to EMV-enabled models. The existing infrastructure provides yet another moat for banks. As non-banks proliferate in payments and particularly in the wallet arena, banks must thoughtfully navigate and manage KYC, AML, and related security considerations for these payments infrastructures and the “rules of the road” for use by non-banks.


5. Adapt offerings to other market segmentsPayments markets and consumer segments often

vary significantly along such dimensions as technology penetration, consumer preferences, regulatory requirements, and interchange rates. Nearly a decade ago, AliPay won in China versus foreign entrants with an elegant local market adaptation. In the early days of e-commerce and with variable quality of package delivery, consumer trust in paying before goods were received was low. AliPay introduced an escrow-based payments system, where the funds were held in escrow and released only when the goods were delivered. Similarly, today’s digital wallet providers should proceed cautiously and with respect for local market variations when seeking to extend into new markets. Markets with substantial economic differences, for instance, can present considerable challenges, such as lower levels of interchange. This can make charging incremental fees to issuers (such as Apple Pay’s 15 BPS fee) more difficult, and can also negatively affect tokenization economics. In markets with low interchange fees, such as the EU, where credit card interchange will fall below 0.3 percent, wallet providers might need to find monetization alternatives (Exhibit 2).

In addition to putting pressure on interchange economics, regulations can also present challenges to data-gathering efforts and analytics-based value propositions related to wallets. Apple Pay has said it will not collect payments information, but Google Wallet and others might decide to gather and use payments data, in which case they will face different security and privacy constraints in the markets they enter.

Established consumer payments preferences can also have an impact on digital wallet success. For example, bank account-funded wallets might gain ground faster in markets like India and Germany, where non-card payments methods (including direct bank account access) are more common. Introduced in the Netherlands in 2005, the iDEAL wallet platform, which does not use debit or credit cards, gained acceptance at 100,000 online stores. Conversely, in European markets where rewards play a smaller role, pay-with-points wallet features would likely have less appeal.

From the technology standpoint, mobile wallet providers also need to adapt to differences in smartphone penetration levels and merchant-acceptance technologies. Apple Pay, for example, is likely to have a smaller presence in markets such as China, India, and Korea where iOS penetration is low (Exhibit 3). Similarly, NFC wallets should gain quicker consumer acceptance in places where that technology already has a strong presence, such as Australia and the U.K.

The U.S. represents a different ecosystem from several of these markets, but U.S. banks can consider the evolution of such markets for interesting examples that could be applied and tested in the U.S., such as coalition loyalty models and partnerships with telcos. In considering partnerships with global players, U.S. banks would do well to take a global perspective and ‘stand in the shoes’ of potential partners to understand the full set of their strategic imperatives, and how the U.S. fits in that regard. This posture would lead to better win-win partnerships for both U.S. banks and wallet partners with a global footprint.

6. Tap adjacent profit pools to differentiate offerings and add value

In mature markets where interchange revenues are under pressure, persuading prospective partners to pay for wallet services based solely on transaction volume might produce only modest revenues. PIN and debit cards

iOS share of handset shipmentsPercent of units shipped, 2013

≤5

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EXHIBIT 3: APPLE PAY ADOPTION COULD BE MORE CHALLENGING IN COUNTRIES WITH LOWER iOS MAKET SHARE

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in the U.S. are a good example. Transaction processing economics also remain under consistent pressure for other players in the value chain, such as merchant acquirers and processors. Banks can address these situations, however, by tapping adjacent profit pools. In the U.S., for instance, tokenization fees might be a viable alternative. Although they tap the same revenue stream, they also promise to reduce risk costs throughout the payments value chain.

Wallet providers therefore might need to seek alternative revenue streams that offer more meaningful growth potential – possibly commerce-related revenue streams (Exhibit 4). Coupons and data analytics, for instance, have strong links to payments and transaction data. Taobao’s data cube for merchants provides a subscription-based service that uses transaction data to help provide insight on growing consumer purchase volumes for participating merchants. The recent

partnership between Verifone and Visa is another example of players seeking to add value with data – connecting the dots for merchants between transaction data at physical points of sale and their e-commerce businesses. In fact, the lines between the value chains of payments and commerce have already blurred, as payments processes blend into the purchase order experience – a change exemplified by Braintree and rideshare provider Uber. This could further open adjacent revenue streams to payments incumbents.

Given mapping capabilities at the device and customer levels, tracking the performance of digital wallet marketing campaigns is also easier in the offline world, facilitating the adoption of pay-for-performance models. This can become a winning situation for both merchants and wallet providers, wherein merchants pay providers based on incremental rather than absolute sales, a model that more closely aligns the incentives for both.

It is critical for U.S. banks to innovate in this arena and take a view of the full “consumer decision journey” – from searching to shopping to purchase, payment, and loyalty management. Banks historically have played in the ‘payment’ slice, but deeply understanding the consumer perspective on the journey leading up to the purchase can lead to useful and actionable insights on how to deepen relationships and grow the share of spend on a bank’s cards. For example, what channels do consumers use to shop and compare prices in categories such as apparel vs. electronics vs. grocery? How are purchase modes (e.g., online ordering of goods vs. shopping in-store) changing over time? These are questions that are not about payments, but likely to be just as important in understanding consumer behavior, and the value pools associated with them, in key adjacent areas.

THE DIGITAL WALLET MARKET TODAY The digital wallet space today is still very fragmented

and in its early developmental stage. The historical view of competition has traditionally focused on incumbents (banks, payment networks) versus newer tech entrants (e.g., PayPal). But today, the frontier of competition is defined by the large commerce ecosystems – the “big 5” here are AliBaba, Amazon, Apple, Facebook, and Google. With each having launched their forays into payments and

General purpose prepaid

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General purpose prepaid

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Big Data analytics

Coupons

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Merchant acquiring

E-commerce hosting

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5.0

6.0

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7.0

9.0

10.0

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EXHIBIT 4: LARGE REVENUE STREAMS ARE ADJACENT TO PAYMENTS AND BLUR THE LINES WITH COMMERCERevenue streams, USD Billions, 2012

Bank of America

Bank of the West

Barclays

BB&T

BNY Mellon

Capital One

Citi

Citizens

Comerica

Deutsche Bank

Fifth Third

HSBC

JPMorgan Chase

KeyBank

M&T

PNC

Santander

State Street

SunTrust

TD Bank

UBS

Union Bank

U.S. Bank

Wells Fargo

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each with their own strategic and economic motivations (e.g., device propositions for Apple, transaction data to “close the loop” on search for Google), these players have the potential to pursue unpredictable paths for their wallets, because payments is more an ecosystem service than a core business for them.

The Apple Pay announcement in late 2014 was not quite revolutionary, but has definitely served as an instigator for wallet adoption. While there were just 220,000 supported points of sale at introduction, by March 2015 there more than 700,000 locations in the U.S. indicating a quickening conversion to NFC terminals by merchants. Besides broad acceptance, Apple has succeeded in creating a superior customer experience and increasing security of in-store transactions due to tokenization. Nonetheless, it is hard to see Apple create a winning proposition in the long-term without delivering significantly more customer value than rivals and providing value added services.

Apple’s main competitors are not waiting to see how Apple Pay turns out, but have been actively improving their value proposition. Google, whose first NFC wallet effort did not gain broader adoption, is planning to launch and API framework named Android Pay. This approach should encourage device manufacturers and developers to build wallets on top of Google’s OS. To bolster partnerships with telecom operators, Google also acquired Softcard, a wallet started by major US telcos.

Google’s key partner, Samsung, is working on its own solution named Samsung Pay. This product is directly targeted at Apple Pay with support for in-store payments and relationships with the major card networks and banks as launch partners. To differentiate the product and leverage existing infrastructure, Samsung will support both NFC and traditional mag-stripe technology (gained from LoopPay acquisition) which should make the wallet compatible with more than 90% of existing POS terminals. However, Samsung Pay must still address the question of the compelling consumer proposition that goes beyond ubiquitous acceptance.

Large merchants (7-Eleven, Rite Aid, CVS etc.) have also entered the digital wallet space by forming a

consortium named MCX. Its primary goal is to create a proprietary QR-code mobile wallet (CurrentC) to bypass the interchange fees paid by merchants. If this initiative ends up being rolled out to public (it has been in beta for the last 2 years), MCX promises to pass some of the savings from interchange to end-consumers, something that none of the tech players can offer. MCX must also consider the challenges of limiting how consumers pay in a market where consumer choice of instrument is widely viewed as the norm.

Finally, the longest-standing digital wallet on the market, PayPal, has been trying to enhance its value proposition. In addition to paying online, PayPal customers can check in and pay using their PayPal account in supported retailers. This feature has seen slow adoption, mainly because the value for end-consumer is limited compared to cash/card payment. But through its Paydiant acquisition, PayPal can now support QR codes at a POS terminal and directly plug into the MCX ecosystem, which uses the same technology. The strength of PayPal funding mechanisms and large merchant acceptance could create an interesting proposition for the consumer. PayPal could also offer adjacent credit services through its BillMeLater platform. PayPal’s more recent acquisition of Xoom underlines its global ambitions and provides some customer acquisition synergies (for both Xoom and PayPal) as it separates from eBay.

It is clear that today’s wallet solutions are still largely in the test, learn and scale phase, trying to find the right value proposition for end-consumers as well as merchants. In order to succeed, wallets will need to find the way to differentiate the product (i) versus traditional cash/card payments (e.g., through fast, frictionless and secure process) and (ii) against other competing wallets (e.g., through additional discounts and benefits). Furthermore, rather than tackling the market as a whole, focusing on niche areas with a clear customer use case (e.g., public transportation) might lead to a faster adoption.

HOW BANKS SHOULD RESPONDBanks are the natural owners of the payments

ecosystem, with four major moats. First, they are the default (and insured) stores of value for consumers via deposits, and they provide similar services to merchants.

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Shared vision. Endless possibilities. WilmerHale is proud to support The Clearing House Annual Conference. We applaud the organization for addressing the interests of the commercial banking industry in the United States and helping to chart the course of America’s financial industry.



Second, they are the default suppliers of credit to both consumers and merchants and have economies of skill in credit underwriting, which they have parlayed into successful credit card issuing businesses. Third, they have been trusted intermediaries for consumers as the custodians of financial services broadly, of which payments is a part. And finally, they have also been in the vanguard of defining the ground rules and guardrails for payments in a way that effectively manages counterparty, operational and other risks for safety and security. These moats are unlikely to disappear overnight, but they must be managed effectively to sustain the advantages for banks in the coming era of digital wallets. To do this, banks must pursue four strategic imperatives with regard to digital wallets: innovate on the customer experience, embrace co-opetition, diversify by growing new revenue streams and accelerate speed to market.

1. INNOVATE ON THE CUSTOMER EXPERIENCE

Banks must recognize that when it comes to digital wallets, they are not in control; consumers are. This means that ‘me too’ design and a patchwork quilt of sub-par customer experiences will become increasingly unacceptable and advantage the commerce ecosystem players at the expense of the banks. Banks must invest in UI/UX capabilities, building seamless and delightful front-end experiences for consumers that compare favorably with consumers’ multi-channel commerce experiences today.

2. EMBRACE CO-OPETITION. The tightly controlled bank-owned world of payments is history. Because consumers are in control, banks can expect that consumers will want to make at least some payments where they are, not where banks are. This means that third parties ranging from commerce ecosystems to telcos to messaging platforms will all participate in payments. As the most important stakeholders and custodians of a secure financial services system, banks must manage the security concerns associated with this dynamic. But they cannot afford to look at non-banks just as competitors. A posture of co-opetition, where banks might co-operate on some fronts and compete actively on others, is a pragmatic approach. The “true north” to exercise judgments and make choices about where to co-operate and where to

compete should be customer (whether consumers or merchants) behavior and preferences.

3. DIVERSIFY WITH NEW REVENUE STREAMS

Banks must look to take a page out of the telco book; over the last two decades, the industry moved predominantly from revenues based on voice to revenues based on data. With the advent of digital wallets, banks must relentlessly seek to understand where customers see value, and monetize their offerings there instead of being tied to legacy revenue sources, such as standard processing economics which are eroding. This will require a willingness to experiment, occasionally cannibalize traditional economics, and ‘fail fast.’ For example, how could digital wallets generate revenues from offer redemption, mobile consumer conversion, digital installment credit for purchases? Banks must begin exploring these opportunities now, so that they are ready to scale the ones that have the greatest potential.

4. ACCELERATE SPEED TO MARKET

This may be the most important strategic imperative for banks. Compared with unregulated commerce players, banks move more deliberately. But the pace of technological innovation and consumer behavior shift will not wait for traditional bank planning and project schedules. Banks must find ways to move on digital wallet development and deployment more rapidly, apply ‘agile’ methodologies not just to IT but end-to-end across the business including control functions, and avoid the ‘peanut butter’ mindset of allocating resources across a static list of projects, even those that are clearly failing.

CONCLUSIONDigital wallets hold the promise of that momentous day

when a consumer can leave their home without a wallet. With recent developments ranging from the advent of smartphones to unbundled network tokenization, that day is closer than ever before. The history of payments innovation offers a clear guide to success for digital wallets. The path for banks is more uncertain, but builds on historical moats and clear strategic imperatives. Following them will help ensure the continued relevance of banks even as a broad range of players accelerate innovations around how consumers pay, move, and manage their money. n

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OAlthough these new payment products generally require the collection and transfer of financial account and other sensitive personal information, the legal and regulatory frameworks designed to ensure the privacy and security of such information have not been revised to adequately cover APP activities. Thomas Curry, the Comptroller of the Currency, acknowledged this concern during remarks he made before the BITS Emerging Payments Forum, on June 3, 2015. Curry noted that “regulation adds significant value in the areas that we’re discussing today [i.e., payment technologies and cybersecurity]” and that “efforts are well underway to bring e-commerce and emerging payments systems deployed by non-bank players under greater regulatory scrutiny . . . [to] ensure a more level playing field and protections for customers of non-banks.”2 The existing regulatory gaps in this area have resulted in real consequences for customers, and several reports have surfaced recently revealing data security and privacy

lapses for APPs and mobile payment offerings. The Clearing House recently released a white paper analyzing these issues and recommending reforms. This article provides an overview of that paper’s analysis and its recommendations.

The alternative payments market has seen substantial growth in the last few years, reflecting the increasing amount of consumer funds and consumer data that is being entrusted to APPs. For example:

GROWTH OF PAYPAL. In Q1 2010, PayPal processed a net total payment volume of just over $20 billion, which more than tripled by Q4 2014.3 In that same period, mobile payments on PayPal grew from $750 million annually in 2010 to $46 billion in 2014.4

GROWTH OF P2P MARKET. In 2010, only 4% of web-connected adults used P2P mobile payments,5 and some

OV E R T H E L A ST SE V E R A L Y E A R S , the alternative payment provider (APP) industry has seen explosive growth. Consumers are now being offered new digital means to make payments and transfer money. This growth is only expected to continue, with some reports suggesting that mobile payments will grow annually by 60.8% through 2015, and that the peer-to-peer (P2P) payments market will reach $17 billion in 2019.1 The APP market is also likely to grow through the increased use of so-called “Buy Buttons”– a means of integrating payment mechanisms into social media and search engine websites.

A L E V E L R E G U L ATO RY E N V I RO N M E N T ENSURES CONS ISTEN T DATA PRO TECT IO N

FOR CONSUMERS , R E G A R D L E S S O F T H E PAY M E N T S P ROV I D E R .


Ensuring Consistent Consumer Data Protection

estimates suggest that U.S. households spent an average of just $8 per year on P2P transactions, using mobile channels at that time.6 In July 2013, just over a year after its public launch, Venmo’s user figures were reportedly growing at a rate of 15% every month.7 The mobile P2P payment market totaled a reported $5.2 billion in 2014,8 and as of March 2015, the P2P market is expected to reach $17 billion in 2019.9

GROWTH OF APPS FOR ONLINE TRANSACTIONS.

In January 2014, it was estimated that APPs will account for 59% of online transactions in 2017, up from 43% in 2012.10

GROWTH OF E-WALLETS. That same January 2014 report estimates that by 2017 e-wallets will equal cards in terms of market share, with each predicted to have a 41% share of the payments market together totaling $1,656 billion in payments (as compared to $295 billion in 2012).11

GROWTH OF MOBILE PAYMENTS GENERALLY. In 2010, $16 billion in transactions were processed as mobile payments.12 This total increased to $46 billion in 2011 and $81 billion in 2012. In December 2014, 22% of mobile phone owners reported having made a mobile payment in the prior year, compared with 17% in 2013, 15% in 2012, and only 12% in 2011.13 When limited to smart phone users only, these numbers grow, with 28% of smartphone users having made mobile payments in 2014, up from 23-24% in each of the prior three years.14 Some reports suggest that mobile payments are expected to grow annually by 60.8% through 2015.15

EXPLORATION OF “BUY BUTTONS.” A number of social media sites and search engines have recently

begun exploring the use of “Buy Buttons,” which are intended to allow users to buy products without leaving the application or site and, according to Twitter’s head of commerce, serve as a “bridge between a consumer wanting something and getting it.”16 Twitter started testing its Buy Button last September through a partnership with Stripe, an APP allowing users to buy, among other things, tickets for sporting events and concerts directly through Twitter.17 Facebook has launched a similar partnership with Stripe,18 while Google and Pinterest have acknowledged plans to integrate buying capability into search ads and “pinned” images, respectively.19

APP companies hold many of the same types of data and perform many of the same types of consumer payment transactions as major banks do. Yet the substantive regulations that govern banks’ data security practices are markedly more stringent than those applicable to APPs. Established banks have long offered payment solutions similar to those provided by APP companies, but banks, unlike APPs, are subject to extensive regulatory, supervisory and enforcement scrutiny by their prudential regulators, with respect to privacy and data security. APPs, by contrast, have been providing their products and services by continuing to rely on the backbone of existing bank payment systems, while capitalizing on innovations in communications platforms, thus generally managing to avoid the reach of the traditional financial regulators. For example, while both banks and most nonbank APPs are subject to the data security requirements established in the Gramm-Leach-Bliley Act (GLBA), the two groups are subject to quite different sets of implementing regulations and regulatory guidance. Banks are subject to the more demanding standards issued by federal financial regulatory agencies,while APPs are subject to the more flexible regulations promulgated by the Federal Trade Commission (FTC).

The differences between the data security requirements imposed on banks by the Interagency Guidelines and those applicable to APPs under the FTC’s Safeguards Rule are numerous. For example there are big differences in the level of detail between the two regimes, and that has real implications for the types of data security precautions regulators can reasonably demand from banks, compared

By 2017 e-wallets will equal cards in terms of market share, with each

predicted to have a 41% share of the payments market together totaling

$1,656 billion in payments (as compared to $295 billion in 2012).


to those demanded of APPs. An APP that is subject to an investigation and/or potential enforcement action by the FTC could quite reasonably argue that there are no specific requirements for the technical controls they are required to employ to control identified risks.20 By contrast, no reasonable bank could argue that it should not at least consider access controls, encryption, segregation of duties and other controls that are explicitly identified in the Interagency Guidelines.21

Also, the Interagency Guidelines require involvement from bank leadership at the highest level, including boards of directors and senior business management.22 By contrast, under the Safeguards Rule, APPs can simply designate an employee to coordinate the information security program and train their employees, without having to involve their senior leadership.

The result is not only lighter substantive requirements for APPs, but also lower odds of facing enforcement actions and fewer prospects for substantial sanctions for violations. Other potential sources of APP data security requirements, such as state money transmitter laws or the PCI-DSS standards, fail to compensate for this uneven regulatory landscape, both in terms of substantive requirements and the risks and consequences of enforcement actions.

Similarly, as a practical matter, APPs only face punishment for lax data security practices if they suffer an actual cybersecurity breach that is discovered by the government, because, unlike banks, APPs are not subject to regular examinations, enforcement actions or other oversight by prudential regulators. While banks are subject to frequent examinations by their prudential regulators, which include data security-related examinations, the FTC enforces its authority only through targeted, one-off civil investigative demands (CIDs). This lack of examination makes it is easier for APPs’ security flaws to go undetected prior to a breach. And while both banks and APPs may be subject to injunctive relief for violations of the GLBA’s requirements, only banks face a realistic possibility of civil money penalties, resulting in vastly different consequences for banks and nonbanks for violations of the same statute. Even beyond the regulatory burden, banks often ultimately bear much of the customer

service and fraud costs, even those associated with data security failures on the part of APPs.

We believe that banks and APPs engaging in functionally similar activities should be subject to similar regulatory regimes. A regulatory level playing field of this sort is critical both to ensure that consumers enjoy consistent protection, regardless of their choice of platform, and to protect the safety and soundness of payment systems.

To close the regulatory, enforcement, and examination gaps that exist today, we recommend:

ENHANCING THE SUBSTANTIVE REGULATORY

REQUIREMENTS. The FTC should adopt enhanced GLBA Safeguards Rules, either limited to APPs or applicable more broadly to all the companies subject to the FTC’s jurisdiction.

USING AVAILABLE EXAMINATION AUTHORITY. The Consumer Financial Protection Bureau (CFPB) should issue rules defining the larger participants of the APP industry, thereby granting itself examination authority over those larger participants. The CFPB or other regulators should also exercise any available examination authority they already have over APPs (such as those established as service providers to a financial institution).

ENFORCING EXISTING REQUIREMENTS. The FTC should enforce its GLBA Safeguards Rule more frequently for APPs, perhaps through a CID sweep, among other measures. The Financial Crimes and Enforcement Network (FinCEN) should also enforce existing guidance that would require those APPs that are federally registered as money services businesses to report actual or attempted data breaches to the government in the form of suspicious activity reports (SARs).

Mobile payments will grow annually by 60.8% through 2015, and the P2P payments market will reach $17 billion in 2019.


Ensuring Consistent Consumer Data Protection

Enacting legislation establishing additional data security requirements for APPs. The Data Security Act of 2015 (S. 961 and H.R. 2205) would establish flexible and common-sense standards, based on the GLBA Interagency Guidelines, for firms of all sizes to follow, in order to secure consumers’ sensitive financial information and prevent breaches. These standards would also give the FTC express enforcement authority in this area, while making it clear that the standards are not applicable to financial institutions already subject to data security regulation by the prudential regulators.

In order to exercise any new authority successfully, the FTC would also need more resources to properly staff investigations and enforcement actions.

Additional legislation should also make it clear that APPs are subject to the same type of data security scrutiny as banks, and it should do so by directly giving the FTC or CFPB examination authority (without requiring further regulations), or by directly requiring the CFPB to enact rules defining larger participants in the APP industry. n

ENDNOTES1 Capgemini and the Royal Bank of Scotland, World Payments

Report 2014 at 12; Trevor Nath, How Safe is Venmo and Why is it Free?, Investopedia (Mar. 24, 2015), http://www.investopedia.com/articles/personal-finance/032415/how-safe-venmo-and-why-it-free.asp

2 Thomas J. Curry, Comptroller of the Currency, Remarks Before the BITS Emerging Payments Form (June 3, 2015), available at http://www.occ.gov/news-issuances/speeches/2015/pub-speech-2015-78.pdf.

3 Statista, PayPal’s total payment volume from 1st quarter 2010 to 1st quarter 2015 (in billion U.S. dollars), http://www.statista.com/statistics/277841/paypals-total-payment-volume/.

4 Statista, PayPal’s annual mobile payment volume from 2008 to 2014 9in million U.S. dollars), http://www.statista.com/statistics/277819/paypals-annual-mobile-payment-volume/.

5 Becky Yerak, Smart-phone money transfers are a growing business; trends, Providence Journal (Dec. 18, 2011).

6 Marc Rapport, Advancing from In-Person Cash to Electronic, Credit Union Times (Jan. 12, 2011).

7 Natalie Robehmed, Venmo: The Future of Payments For You and Your Company, Forbes (July 2, 2013), http://www.forbes.com/sites/natalierobehmed/2013/07/02/venmo-the-future-of-payments-for-you-and-your-company/.

8 Trevor Nath, How Safe is Venmo and Why is it Free?, Investopedia (Mar. 24, 2015), http://www.investopedia.com/articles/personal-finance/032415/how-safe-venmo-and-why-it-free.asp.

9 Id.

10 Alternative payments to overtake credit and debit cards globally, Payments Card & Mobile (Jan. 22, 2014), http://www.paymentscardsandmobile.com/alternative-payments-overtake-credit-debit-card-payments-globally/.

11 Id.

12 Crowe Horwath, The History and Use of Alternative Payment Systems and the Risks They Present at 21 (Dec. 11, 2013), http://www.crowehorwath.com/folio-pdf/TheHistoryUseAlternativePaymentSystemsWebinar_RISK14119D.pdf.

13 Federal Reserve Board, Consumers and Mobile Financial Services at 1, 5 (Mar. 2015), http://www.federalreserve.gov/econresdata/consumers-and-mobile-financial-services-report-201503.pdf. For the purpose of these statistics, mobile payments includes payments made by accessing a web page through a web browser on a mobile device, sending a text message, or using a downloadable application. Id. at 14.

14 Id. at 2, 5.

15 Capgemini and Royal Bank of Scotland, World Payments Report 2014 at 12.

16 Sarah Frier, Twitter Testing Buy Button as E-Commerce Plans Take Shape, Bloomberg (Sept. 8, 2014), http://www.bloomberg.com/news/articles/2014-09-08/twitter-testing-buy-button-as-e-commerce-plans-take-shape.

17 Sarah Frier, Twitter Buy Button Pops Up for Event Tickets, Bloomberg (Apr. 20, 2015), http://www.bloomberg.com/news/articles/2015-04-20/twitter-buy-button-pops-up-for-event-tickets.

18 Kurt Wagner and Jason Del Ray, Facebook Is Partnering With Stripe to Power “Buy” Button, Re/code (Sept. 25, 2014), http://recode.net/2014/09/25/facebook-is-partnering-with-stripe-to-power-buy-button/. See also Conor Dougherty and Hiroko Tabuchi, New, Simple ‘Buy’ Buttons Aim to Entice Mobile Shoppers, New York Times (July 5, 2015), http://www.nytimes.com/2015/07/06/technology/new-simple-buy-buttons-aim-to-entice-mobile-shoppers.html?mwrsm=Email&_r=0.

19 Jason Del Rey, Why ‘Buy’ Buttons Will Pose Big Challenges for Google, Facebook, Pinterest, and Twitter, Re/code, (June 14, 2015), http://recode.net/2015/06/14/why-buy-buttons-will-pose-big-challenges-for-google-facebook-pinterest-and-twitter/.

20 See 16 C.F.R. § 314.4(c) (requiring financial institutions generally to “[d]esign and implement information safeguards to control the risks you identify through risk assessment.”)

21 See 12 C.F.R. Part 30, App. B § III.C.1

22 Id. § III.A, F; IT Examination Booklet at 4-7.

http://www.statista.com/statistics/277841/paypals-total-payment-volume/

http://www.statista.com/statistics/277841/paypals-total-payment-volume/

http://www.statista.com/statistics/277819/paypals-annual-mobile-payment-volume/

http://www.statista.com/statistics/277819/paypals-annual-mobile-payment-volume/

http://www.forbes.com/sites/natalierobehmed/2013/07/02/venmo-the-future-of-payments-for-you-and-your-company/



http://www.investopedia.com/articles/personal-finance/032415/how-safe-venmo-and-why-it-free.asp

http://www.investopedia.com/articles/personal-finance/032415/how-safe-venmo-and-why-it-free.asp

http://www.paymentscardsandmobile.com/alternative-payments-overtake-credit-debit-card-payments-globally/



http://www.crowehorwath.com/folio-pdf/TheHistoryUseAlternativePaymentSystemsWebinar_RISK14119D.pdf



http://www.federalreserve.gov/econresdata/consumers-and-mobile-financial-services-report-201503.pdf

http://www.federalreserve.gov/econresdata/consumers-and-mobile-financial-services-report-201503.pdf

http://www.bloomberg.com/news/articles/2014-09-08/twitter-testing-buy-button-as-e-commerce-plans-take-shape



http://www.bloomberg.com/news/articles/2015-04-20/twitter-buy-button-pops-up-for-event-tickets



http://recode.net/2014/09/25/facebook-is-partnering-with-stripe-to-power-buy-button/



http://recode.net/2015/06/14/why-buy-buttons-will-pose-big-challenges-for-google-facebook-pinterest-and-twitter/

http://recode.net/2015/06/14/why-buy-buttons-will-pose-big-challenges-for-google-facebook-pinterest-and-twitter/

© 2015 Davis Polk & Wardwell LLPdavispolk.com

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Our financial regulatory clients rely on the exceptional, collaborative service we deliver. Their success is our focus.Davis Polk’s market-leading Financial Institutions Group represents many of the most important U.S. and non-U.S. banks, broker-dealers, insurance companies, trading markets and investment managers. Our lawyers are at the forefront of advising financial institutions on how new Dodd-Frank Act and bank capital requirements will impact their businesses.For more about our financial regulatory services, please visit davispolk.com or contact:

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TSuspicious Activities Reports (SARS)

BY ALAINA GIMBERT, THE CLEARING HOUSE

GLOBAL BANKING’S

T H E T R E A SU RY R E L E A SE D I N J U N E OF T H I S Y E A R its latest assessment of money laundering and terrorist financing risk in the United States, a significant inter-agency undertaking that involved the analysis of thousands of federal indictments, government reports, Congressional testimonies, and Bank Secrecy Act (BSA) filings.1 The assessments, which were last performed in 2005, conclude that fraud against the federal government, drug trafficking and criminal activity by terrorists and terrorist organizations within the U.S. are the top threats against which the U.S. financial system must guard.2

It is estimated that illicit activity generates approximately $300 billion each year in the United States.3 Whether these proceeds begin as cash transactions – typical for drug trafficking – or as transactions within inter-bank payment systems – typical for fraud – it is essential to the ongoing profits, operations and missions of criminal and terrorist organizations that their proceeds move through the financial system.

Acting Treasury Under Secretary Adam Szubin emphasized in his introduction of the national risk assessments that combating illicit finance is a “pillar of U.S. national security.” He acknowledged that this fight “requires the coordinated and dedicated efforts of policy makers, law enforcement, supervisors, and the private sector, particularly financial institutions.” In fact, aside from law enforcement, no other category of ally in the illicit finance battle plays as frontline a role as financial institutions.


1 2015 National Money Laundering Risk Assessment and National Terrorist Financing Risk Assessment, available at http://www.treasury.gov/resource-center/terrorist-illicit-finance/Documents/National%20Money%20Laundering%20Risk%20Assessment%20–%2006-12-2015.pdf and http://www.treasury.gov/resource-center/terrorist-illicit-finance/Documents/National%20Terrorist%20Financing%20Risk%20Assessment%20–%2006-12-2015.pdf.

2 Other material threats include retail and consumer fraud, securities fraud, human smuggling, organized crime, and public corruption.3 National Money Laundering Risk Assessment, citing to United Nations Office on Drugs and Crime, Estimating Illicit Financial Flows Resulting from

Drug Trafficking and other Transnational Organized Crime, October 2011.

http://www.treasury.gov/resource-center/terrorist-illicit-finance/Documents/National%20Money%20Laundering%20Risk%20Assessment%20–%2006-12-2015.pdf

http://www.treasury.gov/resource-center/terrorist-illicit-finance/Documents/National%20Money%20Laundering%20Risk%20Assessment%20–%2006-12-2015.pdf

http://www.treasury.gov/resource-center/terrorist-illicit-finance/Documents/National%20Terrorist%20Financing%20Risk%20Assessment%20–%2006-12-2015.pdf

http://www.treasury.gov/resource-center/terrorist-illicit-finance/Documents/National%20Terrorist%20Financing%20Risk%20Assessment%20–%2006-12-2015.pdf

Suspicious Activities Reports (SARS)BLINDSPOT:

Under the mandates of the BSA and similar laws around the world, financial institutions serve as watchdogs and gatekeepers of the U.S. financial system, and for global banks, the entire global financial system. The ability of banks to not only identify and report illicit or suspicious financial activity to law enforcement, but also to deny illicit actors accounts and services prevents those actors from mobilizing their financial assets to further their purposes. Indeed, as one expert noted recently in testimony to Congress, in the post 9/11 world, as governments have shifted from “the classic sanctions framework of the past,” to one that focuses on the behavior of financial institutions, “rogue actors who try to use the financial system to launder money, finance terrorism, underwrite proliferation networks, and evade sanctions … can be denied access by the financial community itself.”4

WATCHDOGS AND GATEKEEPERSOne of the vital functions banks and other financial

institutions perform in their watchdog role is reporting to government authorities certain currency transactions

4 Statement by Juan Zarate, Chairman and Senior Counselor, Center on Sanctions and Illicit Finance, to the House Committee on Financial Services Task Force to Investigate Terrorism Financing (April 22, 2015).

and suspicious activities. Specifically, financial institutions must file currency transaction reports (CTRs) when there has been a deposit, withdrawal, transfer or exchange of currency of more than $10,000 by, through, or to a financial institution.5 Additionally, banks must file suspicious activity reports (SARs) when a transaction is conducted or attempted at or through a bank in an amount of at least $5,000 and the bank knows, suspects, or has reason to suspect that the transaction (i) involves funds derived from illegal activities (or is intended to disguise funds derived from illegal activity); (ii) is designed to evade BSA requirements; (iii) has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage.6

This reporting gives law enforcement visibility into private sector transactions and activities, enabling those agencies to identify illicit conduct, follow-the-money in their investigations, and eventually stop the bad actors. This reporting is extensive. In 2014, depository institutions alone filed nearly 900,000 SARs.

5 31 CFR 1010.3116 31 CFR 1020.320 (a)(2). Other financial institutions, such as money

services businesses and casinos also have SAR filing responsibilities.



Global Banking’s Blindspot: SARs

While the primary purpose of these reports is to inform law enforcement about certain high-risk or suspicious activities, the reports – and SARs in particular – are also critical to another role that banks play: gatekeepers to the financial system. In this regard, regulators expect that banks will use SARs as part of their ongoing customer due diligence processes. And beyond these regulatory expectations, banks themselves “have grown acutely sensitive to the business risks attached to illicit financial activity and [have] taken significant steps to bar it from their institutions.”7

In their gatekeeper roles, banks use SARs to inform their risk assessments of their customers. The risk assessments in turn determine the kinds of controls banks use to manage the money laundering and terrorist financing risks of their customers. Banks will more closely monitor the activities of higher-risk customers, and may limit the level or kinds of services that those customers can use. In some cases, banks may determine to stop providing services if a customer’s risks cannot be reasonably managed.

These anti-money laundering (AML) and counterfinancing-of-terrorism (CFT) controls are an important means of preventing illicit funds from entering the financial system. The National Money Laundering Risk Assessment notes that the movement of illicit funds into the financial system is the “first and critical step in the money laundering process” and the step that banks are “most vulnerable” to enabling.8 Once illicit funds enter the financial system they can move readily from bank to bank, “further obscur[ing] their criminal origins facilitat[ing] their integration into the system.”9 Hence, SARs are not just “snapshots” of suspicious activity that financial institutions provide to law enforcement, but also an essential source of

7 Statement by Juan Zarate.8 National Money Laundering Risk Assessment (2015), p.369 Id.

information for financial institutions themselves in their guard of the global financial system.

Given the importance of SARs to the AML and CFT efforts of banks, and the well-recognized fact that many illicit actors have international operations, one might expect that the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Treasury charged with safeguarding the financial system from illicit use, would fully empower banks to use SARs within their global corporate organizations. Unfortunately, this is not the case.

THE SECRECY OF SARSAs a general rule, banks are prohibited from disclosing a

SAR and any information that would reveal the existence of a SAR, except to certain federal, state, and local law enforcement agencies.10 This broad confidentiality mandate stems from a BSA provision that prohibits financial institutions from notifying a person involved in a reported transaction that their transaction has been reported.11 In other words, financial institutions may not “tip off” persons who may be or become the subject of law enforcement investigations.

There are also other policy reasons to prohibit SARs from being shared. As FinCEN and the Office of the Comptroller of the Currency have articulated, disclosure of SARs could (1) compromise ongoing investigations; (2) chill the willingness of banks to file SARs and provide an adequate level of detail that would be useful to law enforcement; (3) make banks reluctant to report or may motivate delayed reporting for fear of disrupting the client relationship; (4) provide insight into a bank’s process for uncovering criminal conduct; and (5) compromise personal or otherwise sensitive information or damage reputations. The agencies also have recognized that disclosure of a SAR increases the risk of retaliation by persons whose criminal conduct has been reported.12

It is these concerns that underlie the regulatory expansion of the statutory prohibition against “tipping off ” to the broader regulatory prohibition against sharing

10 31 C.F.R. § 1020.320(e)(1)(i) and (ii)(A)(1). Banks may also disclose SARs to federal and state regulators that examine banks for compliance with the BSA.

11 31 U.S.C. 5318(g)(2). 12 See FIN-2012-A002 (March 2, 2012) and 75 Fed. Reg. at 75,578.

Locking SARs safely at headquarters while denying this key intelligence to

frontline troops undermines global AML and CFT efforts.


a SAR with anyone beyond law enforcement. In the context of preventing third parties from having access to a bank’s SARs, this broad prohibition makes good sense.

Within a bank’s own corporate organization, however, different policy considerations come into play. First, with respect to the risks of disclosing SARs noted above, such as jeopardizing ongoing law enforcement investigations, chilling the willingness to file SARs, fear of disrupting client relationships, exposing bank AML/CFT processes, and compromising sensitive information or retaliation by persons whose activities have been reported, these risks either do not exist or are very low when SARs are shared within a banking organization. Banks and their affiliates routinely handle sensitive information and do so in a highly regulated environment that mandates strict controls. Banking organizations have policies, procedures, and controls that determine who gets access to information and how the information can be used, all of which is verified through the supervisory process. Thus, the potential risks related to SAR disclosure are effectively mitigated within a bank’s corporate organization.

Second, as discussed above, SARs are essential to a financial institution’s own efforts to understand and manage the money laundering and terrorist risks of its customers across its corporate structure. FinCEN and the banking regulators acknowledged this when they issued guidance in 2006 allowing banks to share SARs upstream within their corporate organizations for purposes consistent with their AML and CFT mandates. Specifically, the guidance permits depository institutions to share SARs with (i) their controlling company (whether domestic or foreign) and (ii) U.S. branches or agencies of foreign banks with their foreign head office. Noting that the question of whether a depository institution may share SARs within its corporate structure is a “critical issue, particularly in a global context,” FinCEN and the banking regulators reasoned that SAR sharing with a head office or controlling company enables such an entity to “discharge its oversight responsibilities with respect to enterprise-wide risk management and compliance with applicable laws and regulation.”13 However, controlling companies

13 Interagency Guidance on Sharing Suspicious Activity Reports with Head Offices and Controlling Companies (January 20, 2006).

and foreign head offices are not permitted to further share SARs or the existence of SARs with entities within their corporate structure.

In 2010, FinCEN, in consultation with the banking regulators, revised its SAR regulations to further expand the ability of banks to share SARs, “for purposes consistent with Title II of the Bank Secrecy Act,” within their corporate structure.14 In guidance issued contemporaneously with the revised regulations FinCEN stated that sharing SARs with affiliates that are themselves subject to SAR filing requirements is consistent with the purposes of Title II of the BSA as such sharing “facilitates the identification of suspicious transactions taking place through the depository institution’s affiliates that are subject to a SAR rule.”15 However, only U.S. chartered banks and bank branches, offices, or agencies located in the U.S. are subject to the SAR filing requirements of the BSA. Hence, under the rationale of FinCEN’s 2010 guidance, there is no purpose consistent with Title II of the BSA for a U.S. bank to share SARs with foreign branches and affiliates. Today SARs must remain secret between a U.S. depository institution or a U.S. branch of a foreign bank and the U.S. entity’s foreign siblings.

14 31 CFR 1020.320(e)(1)(ii)(B).15 FIN-2010-G006, Sharing Suspicious Activity Reports by

Depository Institutions and Certain U.S. Affiliate (November 23, 2010).

NUMBER OF SARS FILED BY DIFFERENT TYPES OF FINANCIAL INSTITUTIONS IN 2014Depository Institutions 886,927

Money Services Businesses 720, 985

Casinos 46,575

Securities and Futures Firms 22,448

Insurance Companies 2,897

Other (Futures Commission Merchant, Loan and Finance Companies, Housing Government Sponsored Enterprises) 46,899

Source: FinCEN SAR Stats – Quarterly Update (April 2015), available at www.fincen.gov



WHY IT MATTERSSimply put, SARs are a key piece of information that

banks use in their risk assessments of their customers. These assessments ultimately determine what transactions a bank will facilitate, i.e., for whom the gatekeeper opens the gate. While banks are permitted to share facts, transactions, and documents that underlie a SAR,16 this information does not carry the same significance as the fact that a SAR has been filed. It does not communicate to a foreign branch or affiliate that its U.S. sibling has determined that a particular activity is concerning enough to merit an alert to law enforcement. From an enterprise-wide risk perspective, the prohibition on sharing within a corporate family denies globally active banks the ability to share an internal, key risk indicator with others within their corporate groups that have a need-to-know.

Although U.S. depository institutions can share SARs with a foreign controlling company and U.S. branches of foreign banks can share SARs with foreign head offices, as explained above, those upstream entities cannot further share SARs or reveal the existence of SARs within their corporate structure. While it is very useful from an oversight perspective for these upstream entities to know that SARs have been filed regarding certain customers or activities through their banks, this is only part of the AML/ CFT equation.

Equally important is the ability of operational subsidiaries – other banks and financial service providers within the corporate structure – to know that a SAR

16 31 CFR 1020.320(e)(1)(ii)(A)(1).

has been filed regarding a customer or activity that is common to their business and their U.S. sibling’s business. After all, it is these operational entities that are the gateways to the financial system. Locking SARs safely at headquarters while denying this key intelligence to frontline troops undermines global AML and CFT efforts. Thus, the ability to share SARs with a controlling company or head office is not enough. U.S. depository institutions and U.S. branches of foreign banks need to be able to share SARs directly with their foreign counterparts.

The prohibition on sharing SARs with foreign branches and affiliates requires banks to contort both their automated information systems and AML/CFT reporting structures to “wall off ” or “curtain” SARs and information that would reveal the existence of SARs from their foreign siblings. It causes duplicative internal reporting, as banks must re-create and edit SAR narratives into a format for foreign branches and affiliates that will not indicate that a SAR has been filed. In sum, the prohibition is inconsistent with enterprise-wide risk management, creates inefficiencies in banks’ global AML/CFT programs, and may enable illicit actors to continue activities at foreign branches and affiliates that their U.S. siblings would not permit.

RE-ASSESSING IN LIGHT OF THE BIGGER PICTURE

The fact that a SAR has been filed matters because it uniquely signifies that activity has occurred within the financial system that is related to illicit activity, is designed to evade money laundering or terrorist financing controls, or appears to have no lawful purpose. From a risk management perspective it means that the customer or activity that is the subject of the SAR merits close scrutiny. When a U.S. entity has filed a SAR regarding a customer or activity that is common to the U.S. entity and its foreign sibling, the foreign sibling is handicapped in its AML/CFT efforts if it is left in the dark about the SAR.

It must be acknowledged that there is some risk in allowing a SAR to be shared outside the U.S. Foreign jurisdictions may not provide the same protections from disclosure as U.S. law. It is possible that SARs could be revealed to third parties in other jurisdictions,

FinCEN’s current approach to the secrecy of SARs within a global banking organization hampers the ability of

banks to manage AML/CFT risk on an enterprise-wide basis and their ability to

assist in the battle against illicit networks.

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potentially triggering the litany of SAR disclosure risks noted above. This is a fair concern, although one that FinCEN has already addressed in its 2006 guidance allowing SAR sharing with controlling companies and foreign head offices. FinCEN stated in that guidance that U.S. entities will need to address the potential for disclosure requests under foreign laws by entering into confidentiality agreements and arrangements with their foreign controlling offices and head offices. The same approach could be applied to foreign branches and affiliates.

While confidentiality agreements and arrangements would not guarantee SAR secrecy in foreign jurisdictions, they would go a long way towards mitigating the risks associated with SAR disclosure. These mitigated risks must in turn be assessed in light of the bigger picture. As emphasized in a Congressional hearing in June 2015, the international nature of illicit networks requires international AML/ CFT efforts, including information sharing:

Illicit financing networks, like the business of most enterprises, almost always implicate more than one financial institution. … For the illicit financing networks of most pressing concern, transactions often cross multiple jurisdictions. Identifying, tracking and tracing these networks therefore depend critically upon information-sharing across financial institutions and across borders. 17

To be effective, AML/CFT efforts cannot be parochial. Instead, they must be global. FinCEN should be willing to accept the potential risk of foreign disclosure in light of the actual activities of illicit networks that must be guarded against every day.

FinCEN should recognize that although a foreign branch or subsidiary does not have an obligation to file a SAR in the U.S., the sharing of SARs with such entities in the context of managing risk for common customers or activities is nevertheless consistent with the purposes of the BSA. This is because in practical terms, the BSA is about more than financial institutions serving as

17 Statement by Chip Poncy, Senior Advisor, Center on Sanctions and Illicit Finance, to the House Committee on Financial Services Task Force to Investigate Terrorism Financing (June 24, 2015).

conduits of information to law enforcement.18 While BSA reporting is a crucial part of how governments combat money laundering and terrorist financing, the BSA regulatory regime, as instructed by international standard setting bodies and as implemented by U.S. regulators, also expects that banks will use all information available to them to manage the risks of their customers in an enterprise-wide manner.

As stated in the June 2015 Congressional hearings, financial institutions “are also the end users of BSA recordkeeping and reporting, relying on such information to identify and manage all manner of illicit financing risk for purposes of protecting the integrity of the financial system.”19 When properly equipped, banks can achieve through enterprise-wide risk management what it may take governments or law enforcement years to accomplish – disrupting the supply lines of funds that feed illicit enterprises. As an expert recently observed, “the policy decisions of governments are not nearly as persuasive as the risk-based compliance calculus of financial institutions.”20

In conclusion, FinCEN’s current approach to the secrecy of SARs within a global banking organization hampers the ability of banks to manage AML/CFT risk on an enterprise-wide basis and their ability to assist in the battle against illicit networks. The policy rationale that underlies this constraint on information-sharing within a global banking organization is outweighed by the critical need for banks to use all the intelligence at their disposal to identify and address sophisticated, multijurisdictional, and evolving illicit networks. As The Clearing House has previously requested,21 FinCEN should issue guidance allowing U.S. banks and U.S. branches of foreign banks to share SARs with foreign branches and affiliates. n

18 In fact it has been suggested that the BSA be revised to explicitly include as its purpose “protecting the integrity of the financial system” – in addition to the historical purpose of requiring “certain reports or records” – since such protection is “an essential objective in its own right.” See Statement by Chip Poncy.

19 Statement of Chip Poncy.20 Statement by Juan Zarate.21 Letter to Jennifer Shasky Calvery, Director of FinCEN, from Paul

Saltzman, President of The Clearing House Association (March 13, 2015).

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Concerns about financial stability and buildup of risk are at the forefront of regulatory agenda. Since the financial crisis, a series of regulatory initiatives have been implemented or proposed with a specific goal of boosting stability of the banking sector, focusing on capital and liquidity as well the ability to withstand stressful events. TCH Risk Barometer attempts to assess changes in risk among the largest banks in the U.S.

Banks have been building capital cushions to absorb losses and improving the quality of portfolios, thus reducing the likelihood of losses. Since 2009-Q3, there is a significant increase in both CET1 capital ratios and significant reductions in non-performing loans and charge-offs.

Most of the metrics in the TCH Risk Barometer have continued to improve or essentially remained unchanged over the last year. However, the metrics related to risk

weights have declined and this is most likely due to a change in the regulator-set definition for calculating assets included in various risk weight categories starting in 2015-Q1. While this change negatively affects the measure of assets with zero risk weights, it has similar effects on risk-based capital ratios by increasing the risk-weighted asset component of the ratio. As a result, comparisons of metrics using risk-weighting between the periods before and this definitional change, like those in this barometer, have limitations.

As represented in the chart below, each “diamond” in the Barometer indicates a percentage change in the specific indicator between 2009-Q3 and 2015-Q1. In this version of the TCH Risk Barometer, we have added a new reference point for readers: the red diamond represents what the TCH Risk Barometer would have shown one year ago. The bars around the diamonds indicate statistical uncertainty. n

TCH RISK BAROMETER FOR BHCS WITH ASSETS $10B+

-100% -50% 0% 50% 100%

Charge-offs

Non-performing loans

Assets with zero risk weights

Total capital / total assets

Total capital / RWA

Tier 1 capital / total assets

Tier 1 capital / RWA

CET1 / total assets

CET1 / RWA

Percent change relative to 2009-Q3

2014-Q1

2015-Q1

RELATIVE TO 2009-Q3, MEMBER BANKS ARE…

...better prepared to absorb losses,

• Significant increase in high-quality capital (CET1) relative to risk-weighted assets and total assets

• Increase in Tier 1 capital

…and less likely to experience losses.

• Large increase in fraction of zero risk-weighted, high quality assets

• Considerable reduction in non-performing loans and charge-offs

1

2

© 2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International. NDPPS 401430

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on a returnReal-time payment processing is moving forward, influenced by changing consumer expectations and new industry players. To get in the game, banks will need to transform their business and operating models. At KPMG, we understand how this challenge can become an opportunity. By adopting the right strategy, banks can implement a real-time payment investment capable of driving new revenue streams, enhancing the customer experience and increasing efficiencies, while improving competitiveness against disruptors. To learn more, please visit us at kpmg.com/us/payments

2003 2012

42%

20%

17% 21%

49%

20%

20%

11% ChecksCredit Cards Debit CardsACH

ChecksCredit CardsDebit CardsACH


SOURCES1 - https://www.theclearinghouse.org/payments/image-exchange2, 3, 4 - http://www.federalreserve.gov/econresdata/consumers-and-mobile-financial-services-report-201503.pdf5, 6 - http://blogs.forrester.com/denee_carrington/14-11-17-us_mobile_payments_will_reach_142b_by_20197- http://www.frbsf.org/our-district/about/sf-fed-blog/despite-apple-pay-buzz-cash-is-still-popular/8- https://www.frbservices.org/files/communications/pdf/research/2013_payments_study_summary.pdf

Percentage of non-cash transactions by payment type8

40%of consumer transaction activity is made in cash7

35% The Clearing House processes

$1,630,000,000a day between CHIPS, ACH, and Check Image exchange1 52%

of smartphone users have used mobile banking in the last 12 months2

of respondants with bank accounts use mobile banking4 $5.25 BILLION

in person-to-person mobile transactions in 20146

U.S. mobile payments amounted to

$52 BILLION in 20145

28%of smartphone users have made a mobile payment in the last 12 months3

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Research Rundown provides a comprehensive overview of the most groundbreaking and noteworthy research on critical banking and payments issues and seeks to capture insights from academics, think tanks, and regulators that may well influence the design and implementation of the industry’s regulatory architecture.

ResearchRUNDOWN


Value of Large Banks

BORROWING COSTS OF TBTF. The Office of Financial Research (OFR) has released two papers that examine borrowing costs of large financial firms. The first paper compares funding costs of large financial firms to large nonfinancial firms and finds that any size-related benefits are not specific to the financial sector. The second working paper uses five-year CDS spreads to investigate whether market participants are giving large banks a discount on borrowing costs based on the expectation that governments would consider them “too big to fail.” The paper finds a negative relationship between systemic importance and CDS spreads. Furthermore, the study notes that market participants focus on asset size rather than G-SIB designation, substitutability and interconnectedness.

Ahmed, Javed, Christopher Anderson and Rebecca Zarutskie (2015), “Are the Borrowing Costs of Large Financial Firms Unusual?” OFR Working Paper, 15, 10, (May).

Cetina, Jill and Bert Loudis (2015), “The Influence of Systemic Importance Indicators on Banks’ Credit Default Swap Spreads,” OFR Working Paper, 15, 09, (May).

IT’S DIFFICULT TO BECOME A LARGE BANK. A report produced by two NY Fed Staffers demonstrates why it is uncommon for banks to reach sizes at which they will be considered systemically important. The paper finds that this difficulty stems from the fact that a majority of banks are either acquired or fail before they reach the $50 billion asset threshold, and of those that do survive, very few actually become large. Additionally, the few banks that become SIFIs have accumulated assets for more than a century and have outgrown nonfinancial firms in almost all time periods, not just following episodes of deregulation. Moreover, becoming a large bank requires decades of superior performance relative to other firms in the industry.

De, Rajlakshmi and Hamid Mehran (2015), “Becoming a Large Bank? It’s Not Easy,” Web blog post. Liberty Street Economics. Federal Reserve Bank of New York, 12 Jun. 2015. Web. 18 Aug. 2015.

TCH WHITE PAPER RECOMMENDS LEVEL PLAYING FIELD FOR ALL PAYMENT

PROVIDERS. The Clearing House (TCH) white paper addresses the regulatory gaps relating to the data security practices of the Alternative Payment Provider (APP) industry. Banks are subject to extensive regulatory, supervisory, and enforcement scrutiny by their regulators with respect to privacy and data security, APPs, by contrast, are providing their products and services by continuing to rely on the backbone of existing bank payment systems while capitalizing on innovations in communications platforms, thus generally managing to avoid the reach of the traditional financial regulators. Additionally, APPs only face punishment for lax data security practices if they suffer an actual cybersecurity breach that is discovered by the government, because unlike banks, APPs are not subject to regular examinations and enforcement actions by regulators. The paper contains detailed recommendations to close the regulatory, enforcement and examination gaps that exist today, including using available examination authority and enforcing existing requirements as well as enacting legislation establishing additional data security requirements for APPs.

The Clearing House Association (2015), “Ensuring Consistent Consumer Protection for Data Security: Major Banks vs. Alternative Payment Providers,” (August).

TCH PUBLISHES UPDATED GUIDING PRINCIPLES ON ENHANCING U.S. BANKS’

CORPORATE GOVERNANCE. The Clearing House Association’s (TCH) Governance Principles aim to help provide a framework for bank corporate governance that seeks to facilitate more effective board oversight, enhance bank safety and soundness, promote confidence in banks and encourage consistent supervisory guidance. The document expands upon the original version TCH released in 2012 to reflect various industry, legal and regulatory developments that have taken place in recent years. While effective board oversight requires an appropriate level of director interaction with management, the Governance Principles stress that a central tenet of good corporate governance is the distinction between the board’s responsibility for oversight of the business and affairs of the banking organization and the board’s delegation to management of the responsibility for the day-to-day operations.

The Clearing House Association (2015), Guiding Principles for Enhancing U.S. Banking Organization Corporate Governance,” (June).

FROM OUR SHOPResearch conducted by The Clearing House


http://financialresearch.gov/working-papers/files/OFRwp-2015-10_Are_Borrowing-Costs-of-Large-Financial-Firms-Unusual.pdf



http://financialresearch.gov/working-papers/files/OFRwp-2015-09_Influence-of-Systemic-Importance-Indicators-on-Bank-Credit-Default-Swap-Spreads.pdf



https://www.theclearinghouse.org/publications/2015/ensuring-consistent-consumer-protection-for-data-security-white-paper

https://www.theclearinghouse.org/publications/2015/ensuring-consistent-consumer-protection-for-data-security-white-paper

https://www.theclearinghouse.org/issues/banking-regulations/dodd-frank/corporate-governance/20150624-tch-revises-guiding-principles-on-corporate-governance

https://www.theclearinghouse.org/issues/banking-regulations/dodd-frank/corporate-governance/20150624-tch-revises-guiding-principles-on-corporate-governance


Research Rundown

DID DODD-FRANK END TBTF? In part one of a two-part series, the NY Fed looks at whether Dodd-Frank has reduced TBTF perceptions from the perspective of three rating agencies: Moody’s, Standard and Poor’s (S&P), and Fitch Ratings. The answer according to Fitch Ratings is “yes”, “maybe” according to Moody’s, and “not yet” according to S&P. Part two looks at whether Dodd-Frank has reduced TBTF perceptions among bond market participants, to find that bond market participants have doubts about the ability of Dodd-Frank to solve for the TBTF issue.

Alfonso, Gara and João Santos (2015), “What Do Rating Agencies Think about “Too-Big-to-Fail” Since Dodd-Frank?” Web blog post. Liberty Street Economics. Federal Reserve Bank of New York, 29 Jun. 2015. Web. 18. Aug. 2015.

Alfonso, Gara and João Santos (2015), “What Do Bond Markets Think about “Too-Big-to-Fail” Since Dodd-Frank?” Web blog post. Liberty Street Economics. Federal Reserve Bank of New York, 1 Jul. 2015. Web. 18. Aug. 2015.

OECD: TOO MUCH FINANCE HARMS ECONOMIC

GROWTH. The Organization for Economic Cooperation and Development (OECD) investigates the role the financial sector plays in economic growth. “Finance is a vital ingredient for economic growth, but there can also be too much of it” says the OECD in its policy paper. When discussing bank regulation, the report notes that “strong requirements on lenders to maintain large capital buffers reduce the extent to which banks can fund lending through liabilities that benefit from public support, such as insured deposits or other forms of debt at too-big-to-fail (TBTF) lenders.” On breaking up TBTF, the report notes that a large number of small banks could conceivably accumulate as much systemic risk as a small number of TBTF banks.

Cournède, Boris, Oliver Denk and Peter Hoeller (2015), “Finance and Inclusive Growth,” OECD Economic Policy Paper 14, (June).

TWO REPORTS FIND LARGE SIZE OF U.S. BANKING

SYSTEM STYMIES ECONOMIC GROWTH. A study released by the IMF suggests that the large size of the U.S. banking system stymies economic growth. Additionally, the Roosevelt Institute has published a report by Nobel

Laureate Joseph Stiglitz arguing that, “[t]he finance industry has shifted away from its essential function of allocating capital to productive uses and has moved toward predatory rent-seeking activities. In addition to catalyzing the 2008 financial crisis, these activities have slowed growth, increased the risk of future crises, and moved income ... to the top, increasing inequality.”

Sahay, Ratna, Martin Čihák, Papa N’Diaye, Adolfo Barajas, Ran Bi, Diana Ayala, Yuan Gao, Annette Kyobe, Lam Nguyen, Christian Saborowski, Katsiaryna Svirydzenka, and Seyed Reza Yousefi (2015), “Rethinking Financial Deepening: Stability and Growth in Emerging Markets,” IMF Working Paper, 15, 08, (May).

Stiglitz, Joseph E. (2015), “Rewriting the Rules of the American Economy: An Agenda for Growth and Shared Prosperity,” Roosevelt Institute, (May).

Bank Culture

CORPORATE FINES CONCEAL ETHICAL AND

REGULATORY FAILURE. The author posits that banking crises occur because bankers routinely abuse the financial rules knowing they will be exempt from meaningful personal penalties. Therefore, the paper argues that regulators must impose a series of graduated penalties on individuals who violate these rules.

Kane, Edward J. (2015), “Unpacking and Reorienting the Executive Subcultures of Megabanks and Their Regulators,” (April).

BANKERS CAN’T BE SCARED INTO DOING THE RIGHT

THING. A study conducted by PwC and the London Business School found that managers at financial services companies are more than twice as likely to act unethically when they feel anxious when competing with colleagues. The study found that rule enforcement systems can, many times, create the behavior they were designed to avoid. Moreover, the study found that creating excitement about winning, rather than a fear of losing, is a key driver of innovative and ethical behavior.

PWC and London Business School (2015), “Stand out for the Right Reasons: Why You Can’t Scare People into Doing the Right Thing,” (June).

http://www.oecd-ilibrary.org/docserver/download/5js06pbhf28s.pdf?expires=1439924507&id=id&accname=guest&checksum=F931080775C9581011E6BF516158FEC1



http://www.imf.org/external/pubs/ft/sdn/2015/sdn1508.pdf






http://static1.squarespace.com/static/5547c707e4b0e8aadbc53a05/t/55520236e4b0872f41a7058a/1431438002852/Rewriting+the+Rules+Report+Full+Report+-+Single+Page+Final.pdf



http://poseidon01.ssrn.com/delivery.php?ID=446005007069125120113109031095115093121054088068002056077030097087123114088065082110030012116061009062052102007125089002102084039039001011046064116015120075068000007055115080095005102005093073126098092091087068109124112103094030013072030067029001&EXT=pdf



http://www.pwc.co.uk/financial-services/financial-services-risk-and-regulation/why-you-can-scare-bankers-into-doing-the-right-thing.jhtml



©2015 Morrison & Foerster LLP

While they may not have always been easy to follow, there was a time when the

rules relating to financial services were relatively clear. The financial crisis brought

forth a period of unprecedented change. Many of the world’s largest financial

institutions count on Morrison & Foerster for advice on such regulatory matters.

Learn more at www.mofo.com/regulatory-advising/.

Who said thatthey’d be easy to follow.

Rulesare rules.


Research Rundown

WHAT IS CULTURE AND CAN IT BE CHANGED? The paper presents a framework for analyzing culture in the context of financial practices and institutions. The author defines culture, how it emerges, and how it is shaped and transmitted over time individuals and institutions.

Lo, Andrew W. (2015), “The Gordon Gekko Effect: The Role of Culture in the Financial Industry,” (June).

FINANCIAL MISCONDUCT DESTABILIZES GLOBAL

MARKETS. The paper argues that financial crime and misconduct is a source of global systemic risk and urges international regulatory cooperation to reduce systemically significant misconduct.

Skinner-Parajon, Christina (2015), “Financial Misconduct as Systemic Risk,” (June).

Financial Stability

HOW TO MEASURE BANKING SECTOR

INTERCONNECTEDNESS? The Bank of England released an article explaining the different ways in which banks can be interconnected, how interconnectedness can be measured, and the implications for financial stability. Of note, the paper explains that while direct interconnectedness between banks and interbank credit exposures has decreased since the crisis, indirect interconnectedness has likely increased. The paper does note that several regulatory initiatives since the crisis have mitigated financial stability risks caused by bank interconnectedness, citing the obligation of banks to clear standardized over-the-counter (OTC) derivatives contracts through CCPs as a key mitigating initiative.

Liu, Zijun, Stephanie Quiet and Benedict Roth (2015), “Banking Sector Interconnectedness: What Is It, How Can We Measure It and Why Does It Matter” Bank of England Quarterly Bulletin, Vol. 55, No 2, (June).

RICHMOND FED UPDATES BAILOUT BAROMETER. The Richmond Fed released its Bailout Barometer asserting that sixty percent of all financial-sector liabilities are either explicitly or implicitly guaranteed by the federal government as of year-end 2013. The report categorizes the following liabilities as implicitly guaranteed: total liabilities

of the four largest U.S. banking organizations minus insured domestic deposits; short-term liabilities (fed funds, repurchase agreements, commercial paper, and other short-term liabilities as reported in banking institution financial reports); and uninsured domestic deposits of banks and S&L holding companies with assets greater than $50 billion.

Marshall, Liz, Sabrina Pellerin and John Walter (2015), “Bailout Barometer, 2013 Estimate,” Federal Reserve Bank of Richmond, (May).

Capital and Liquidity

OFR PAPER OFFERS FRAMEWORK FOR MONITORING

AND PREDICTING SYSTEM-WIDE COLLAPSE IN

MARKET LIQUIDITY. The Office of Financial Research (OFR) has released a paper highlighting liquidity regimes across a broad range of financial markets that can be used for characterizing periods of market stress and identifying underlying predictors of liquidity shocks. The paper suggests that this regime could have allowed for meaningful predictions up to 15 trading days before the 2008 financial crisis and offers that the methods in this paper could serve as a potential framework for monitoring and predicting a system-wide collapse in market liquidity, which could signal a collapse of liquidity in the funding markets and a broader financial crisis.

Flood, Mark D., John C. Liechty and Thomas Piontek (2015), “Systemwide Commonalities in Market Liquidity,” OFR Working Paper 15, 11, (May).

ILG HAD NO IMPACT ON BANK LENDING. The authors study the effect the introduction of the Individual Liquidity Guidance (ILG) had on banks’ balance sheets in the UK. The paper finds that banks adjusted both their asset and liability structures to meet tighter liquidity regulation. The paper does not find evidence that the tightening of liquidity regulations had an impact on the overall size of banks’ balance sheets, nor that banks reduced the quantity of lending to the non-financial sector in response to tighter liquidity regulation.

Banerjee, Ryan N. and Hitoshi Mio (2015), “The Impact of Liquidity Regulation on Banks,” Bank of England Working Paper, 536, (July).

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http://lfe.mit.edu/wp-content/uploads/2015/06/culture_9.pdf

http://lfe.mit.edu/wp-content/uploads/2015/06/culture_9.pdf

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2616042

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2616042

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2015/q2prerelease_1.pdf




https://www.richmondfed.org/~/media/richmondfedorg/publications/research/special_reports/safety_net/pdf/bailout_barometer_current_estimate.pdf



http://financialresearch.gov/working-papers/files/OFRwp-2015-11_Systemwide-Commonalities-in-Market-Liquidity.pdf



http://www.bankofengland.co.uk/research/Documents/workingpapers/2015/swp536.pdf



IMPACT THROUGH SPECIALIZATIONOliver Wyman is a global leader

in management consulting that

combines deep industry knowledge

with specialized expertise in strategy,

operations, risk management, and

organization transformation.

Visit us at: www.oliverwyman.com


Research Rundown

TLAC CAN BE ACHIEVED WITH A HIGHER

REGULATORY CAPITAL REQUIREMENT FOR CRITICAL

BANK SUBSIDIARIES. The American Enterprise Institute paper analyzes strategies which a G-SIB can employ to meet the 2014 FSB proposal for minimum TLAC requirements. Rather than imposing minimum TLAC at all subsidiaries and restricting how TLAC funds can be invested, the author proposes that the regulatory capital requirement on critical bank subsidiaries should be set equal to the TLAC minimum, and G-SIB parent holding companies should be allowed to fund the new capital injection with TLAC-qualifying debt.

Kupiec, Paul H. (2015), “Will TLAC Regulations Fix the G-SIB Too-Big-to-Fail Problem?” AEI Economic Policy Working Paper 15, 08, (July).

Systemic Risk

UNIFORM REGULATIONS MAY INCREASE SYSTEMIC

RISK. The authors examine whether the imposition of a uniform set of regulations on G-SIBs, by the FSB, led to uniform behavior and similar performances across G-SIBs. They use the banks’ credit default swap spreads and Fitch ratings to gauge the probability of each individual bank failing. They also study whether the joint probability of multiple banks simultaneously defaulting rose, based on changes in correlations of asset prices, V-Lab’s systemic risk measure, and the dispersion of accounting-based performance measures. The study finds that for G-SIBs nine of the 11 bank performance measures became more alike after they were designated as G-SIBs. Additionally, after the implementation of harmonized bank regulations, the default risks of G-SIBs increased relative to other large banks during unstable years, and the probability of multiple simultaneous bank defaults rose as well.

Dewenter, L. Kathryn and Alan C. Hess (2015), “Harmonized Regulations and Systemic Risk: Evidence from Global-Systemically Important Banks,” (July).

WHAT CAUSES SYSTEM FAILURE IN COUNTERPARTY

INSOLVENCY? The study shows that a counterparty insolvency is not caused by balance sheet size and a bank’s position in the interbank network. Instead, the onset of the

system failure depends on the ratios of interbank assets to total assets and loss absorbing capital to total assets.

Birch, Annika, Zijun Liu and Tomaso Aste (2015), “A Counterparty Risk Study of UK Banking Systems,” (April).

Stress Tests

OFR PAPER DEFINES INTEGRATED APPROACH TO

STRESS TESTS. A new OFR brief discusses how four types of shocks (credit, funding, liquidity and collateral shocks) that can affect banks could be incorporated into stress tests. The author posits that taking into account funding and liquidity shocks, the new Basel liquidity ratios, and potential spillover effects onto other banks from a stressed bank’s behavior could strengthen the stress testing regime for large U.S. banks.

Cetina, Jill (2015), “Incorporating Liquidity Shocks and Feedbacks in Bank Stress Tests,” OFR Brief Series 15, 06, (July).

FINANCIAL SYSTEM RESILIENCE IS DIFFICULT

TO MEASURE. The author gives a brief overview of the essential differences between the traditional microprudential and the “new generation” macroprudential stress tests. The paper argues that making macroprudential stress tests more effective would entail using a variety of analytical approaches and scenarios, integrating non-bank financial entities, and exploring the use of agent-based models. Furthermore, the author writes that macroprudential stress tests should be treated as complements to other tools and combined with microprudential perspectives.

Demekas, Dimitri G. (2015), “Designing Effective Macroprudential Stress Tests: Progress So Far and the Way Forward,” IMF Working Paper 15, 146, (June).

Macroprudential Regulation

ASSESSING BASEL COMPLIANCE EFFECT ON BANK

PERFORMANCE. The authors evaluate how compliance with the Basel Core Principles for Effective Supervision affects bank performance for a sample of 863 publicly listed banks. The paper finds that although compliance

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https://www.aei.org/publication/will-tlac-regulations-fix-gsib-too-big-to-fail-problem/






http://financialresearch.gov/briefs/files/OFRbr-2015-06-Incorporating-Liquidity-Shocks-and-Feedbacks-in-Bank-Stress-Tests.pdf



http://www.imf.org/external/pubs/cat/longres.aspx?sk=43043.0



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A CRITICAL BALANCEFor every well-run company, striking the right balance between risk and reward is always critical. Today, unprecedented regulatory changes and obligations make doing so more challenging than ever.

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Research Rundown

has little effect on bank efficiency, increasing regulatory constraints may prevent banks from efficiently allocating resources. Furthermore, the authors note that “there is no broad cross-country evidence as to which of the many different regulations and supervisory practices employed around the world work best.”

Ayadi, Rim, Sami Ben Naceur, Barbara Casu and Barry Quinn (2015), “Does Basel Compliance Matter for Bank Performance?” IMF Working Paper, 15, 100, (May).

NEW FINANCIAL REGULATIONS TO HAVE LIMITED

IMPACT ON MONETARY POLICY. A new report submitted to the Bank for International Settlements by a Working Group established by the Committee on the Global Financial System and the Markets Committee finds that the combined impact of key new financial regulations should have limited and manageable effects on monetary policy. The Working Group identified these four regulations: liquidity coverage ratio, net stable funding ratio, leverage ratio, and large exposure limits as most likely to significantly affect monetary policy implementation.

Committee on the Global Financial System and Markets Committee (2015), “Regulatory Change and Monetary Policy,” CGFS Papers, 54 (May).

EXAMINING THE FED’S PROPENSITY TO BIAS

ITS DISCLOSURES. The study authored by a group of Carnegie Mellon professors, examines regulatory disclosure effects in light of the fact that the Fed may bias the reported results of stress tests to promote desirable market outcomes. The paper finds that regulators bias their disclosures upwards in order to prop up banks, but they bias reports downward to discipline poorly capitalized banks.

Bird, Andrew, Stephen A. Karolyi, Thomas G. Ruchti, and Austin Sudbury (2015), “Bank Regulator Bias and the Efficacy of Stress Test Disclosures,” (June).

DO REVISIONS TO DODD-FRANK DERIVATIVES RULES

FORETELL A CHANGING REGULATORY DYNAMIC? The authors provide an overview of the major regulatory rollbacks of the post-Dodd-Frank financial regulatory

regime that have occurred within the last year. The authors analyze: (i) the repeal of the Swap Push-out Rule; (ii) commercial end-user exemption to the margin requirements for uncleared swaps; (iii) postponement to the implementation of the Volcker Rule; (iv) postponement of transaction-level swap requirements to non-U.S. swap dealers; and (v) Volcker rule exemption for activities conducted “solely outside of the United States.”

Kalbaugh, Gary E. and Alexander F. L. Sand (2015), “Cutting Back: Revisions to Dodd-Frank Derivatives Rules,” The Journal of Law Investment & Risk Management Products, The Futures & Derivatives Law Report 35,6, (June).

BANK-BASED FINANCIAL SYSTEMS ARE BAD FOR

STABILITY AND GROWTH. The authors hypothesize that systemic risk tends to be higher in bank-based financial structures. They find that because Europe’s capital markets have barely grown, Europe’s financial structure has become strongly bank-based --far more so than in other advanced economies. Therefore, the authors conclude that financial systems dominated by the banking sector are associated with more systemic risk and lower economic growth. In order to avoid excessive reliance on banks, the authors suggest stronger bank regulation and completion of the EU capital markets union, which would complement the newly established banking union.

Langfield, Sam and Marco Pagano (2015), ”Bank Bias in Europe: Effects on Systemic Risk and Growth,” European Central Bank Working Paper Series 1797, (May).

Bank Funding Cost

DEBT SERVICE BURDEN HAS NEGATIVE EFFECT

ON OUTPUT & CREDIT GROWTH. The paper finds that interaction between leverage and the aggregate debt service burden is essential for understanding dynamics during credit boom-bust cycles. The authors observe a “growthless credit boom” that follows from low leverage and high debt service burden.

Juselius, Mikael and Mathias Drehmann (2015), “Leverage Dynamics and the Real Burden of Debt,” BIS Working Papers, 501, (May).

http://www.bis.org/publ/cgfs54.pdf










http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1797.en.pdf



http://www.bis.org/publ/work501.pdf



It becomes clear

© 2015 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

Your current situation. The path forward. Your real options. Your needs and responsibilities.

PwC’s Financial Services Regulatory Practice assists top tier financial institutions in managing and implementing regulatory change.

To meet our client’s evolving needs, we combine our deep team of senior ex-regulators with experienced industry executives and unparalleled industry knowledge. We are advisor and auditor to the top global banks, asset managers and insurers.

Dan Ryan, Financial Services Advisory Leader (646) 471 8488 [email protected]

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MW-15-2346-The Clearing House Ad.indd 1 5/8/2015 10:47:21 AM


Featured Moments2015 TCH-SIFMA PRUDENTIAL REGULATION CONFERENCE

Attendees fill a conference hall at Covington & Burling’s Washington D.C. offices to hear the opening session at the TCH-SIFMA 2015 Prudential Regulation Conference.

AIG’s Nicholas Kourides speaks during the panel “Systemic Risk outside the Banking Sector: Identification and Regulation.” Pictured (L to R): H. Rodgin Cohen, Sullivan & Cromwell; Nellie Liang, Federal Reserve Board; Kourides; Merrie Faye Witkin, DTCC; Barbara G. Novick, BlackRock; and Patrick Pinschmidt, Department of the Treasury.

The OCC’s Martin Pfinsgraff speaks during the opening panel session “The Dodd-Frank Bank Prudential Framework: Implementation and Related Supervisory Issues,” as fellow panelists (L to R) Michael Wiseman, Sullivan & Cromwell; Brent Hoyer, FDIC; Timothy Clark, Federal Reserve; and Gregory Baer, JPMorgan Chase & Co.; listen.

The OCC’s Kevin Walsh and the Federal Reserve’s Christine Graham listen to Covington & Burling Partner John C. Dugan during the panel “Capital and Liquidity Regulation: Domestic and Global Developments.”

SIFMA Managing Director Carter McDowell offers closing remarks at the TCH-SIFMA 2015 Prudential Regulation Conference on June 9.

TCH Managing Director John Court also delivers a few closing comments at the TCH-SIFMA 2015 Prudential Regulation Conference.

TCH President and CEO James D. Aramanda introduces the event’s keynote speaker, Thomas J. Curry, Comptroller of the Currency.

Thomas J. Curry, the Comptroller of the Currency, delivers his keynote presentation at the TCH-SIFMA 2015 Prudential Regulation Conference.

Our cross-border legal team pieces together the puzzle and navigates the complex, interlocking financial regulatory requirements of the US, UK, EU and beyond.

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TCH 6th ANNUAL SPRING LEADERSHIP DINNER

TCH President and CEO James D. Aramanda welcomes attendees at TCH’s Spring Leadership Dinner on June 11.

Attendees from TCH member banks converse in the library at the New York Palace Hotel before the Spring Leadership Dinner and keynote presentation.

Kevin McCarthy, BNY Mellon; H. Rodgin Cohen, Sullivan & Cromwell; Edward O’Keefe, Moore & Van Allen; and Steven Reich, Deutsche Bank at TCH’s Spring Leadership Dinner.

Attendees from TCH and its member banks mingle prior to the Sixth Annual Spring Leadership Dinner.

Dr. Ross Levine, Senior Fellow and Willis H. Booth Chair in Banking and Finance at the University of California-Berkeley, delivers his keynote speech on the economic contribution of banks to society.

Alexey Levkov, SVP and Director of Quantitative Analytics at TCH, introduces the keynote speaker, Dr. Ross Levine, from the University of California-Berkeley.


Featured Moments

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Assembly RoomThe Assembly Room at The Clearing House’s

old headquarters at 77 Cedar Street in downtown Manhattan could accommodate 100 people for large meetings. The chairs were designed by Tiffany Studios, the rostrum and doorways were crafted of sienna marble, and the woodwork was mahogany. The podium, portraits of past presidents, and the chairs have been preserved in a storage facility.


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