Response to Finance Canada’s Large Bank Mergers in Canada

Introduction
December 2003
Interac Association is pleased to provide this submission in response to the government’s invitation to comment on the financial sector issues identified in its response to the Parliamentary committees that studied large bank mergers and the public interest. While the government’s June 2003 consultation paper discussed several issues relating to the competitive landscape, our submission focuses on the issue of full functionality of automated banking machines (ABMs), in light of the significance of this issue to the Association and our members. As detailed in the government’s June report, the aim of full functionality would be to enable individuals and small businesses “to conduct the full range of banking activities (e.g. deposits, withdrawals, bill payments, etc.) at any banking machine of their choice, regardless of institution or location.”

As a starting point, we would like to note that Interac Association does not maintain a position of support or opposition to the concept of full functionality at ABMs. Rather, we believe there are important issues of which the government should be aware. Taking consumer and business demand and costs into consideration, this submission will first look at whether a business case for full functionality exists. It will then examine the framework for new service development at ABMs, and whether there are public policy issues that the government needs to address.
Interac Association and the INTERAC Shared Services

Interac Association is responsible for the development and operation of a Canada-wide network of two shared electronic financial services, Shared Cash Dispensing (SCD) at ABMs, and INTERAC Direct Payment (IDP) at the point of sale. Shared Cash Dispensing allows cardholders to make cash withdrawals from ABMs not belonging to their own financial institution, and INTERAC Direct Payment is Canada s national debit service.

Founded in 1984 by five Canadian financial institutions, the Association currently has more than 100 member organizations. While the membership includes banks and other financial institutions traditionally associated with payment services, it also includes a broad array of non-financial enterprises, including technology and payment-related companies as well as one retailer. Striking the right balance between inter-member competition and network-level cooperation has helped make Canada a recognized world leader in consumer payment services.

As an organization that must continually balance the needs and interests of multiple stakeholders, Interac Association is in a unique position to address complex issues in the marketplace, including the issue of full functionality. We hope our comments will be helpful to the government as it considers issues affecting the competitiveness of the financial sector in Canada.
Key Issues

In examining the issue of ABM full functionality, it is important to determine whether the absence of full functionality represents a significant impediment to competition in Canada s financial sector. In so doing, it is necessary to establish whether or not there is a business case justifying a move to full functionality and whether any such move would have a positive or negative impact on growth and innovation in the financial sector in Canada.

The issue of full functionality was examined by The Task Force on the Future of the Canadian Financial Services Sector headed by Harold MacKay, which stated the following in its recommendations:

The members of Interac should take the necessary steps so that the Interac network is fully functional to permit the network to be used for as many functions as the technology permits, including the making of deposits through any ATM to any participating deposit-taking institution.

The recommendation from the MacKay Task Force calls on the members of Interac Association, not government, to take steps to increase the functionality of the network. Importantly, while the House Finance Committee agreed with the Mackay Report s recommendation in principle, the Committee expressed concern that full functionality would encourage greater use of paper transactions, thereby compromising the efficiency of the electronic payment system.

During the time of the MacKay Task Force s work, Interac Association was actively examining whether there was a business case for the Association to offer expanded services, including a shared deposits service at ABMs. As reported to the Parliamentary committees that examined the MacKay Report s recommendations, Interac Association did not find a business case that would justify adding these services. The reasons for this are explained below.
The Absence of a Viable Business Case

The potential market for shared deposits is small and shrinking. Paper-based payments are declining as Web banking and other alternative channels continue to grow. Further advances in the electronic delivery of financial services provide customers with greater convenience and more options in managing their finances, in turn reducing reliance on paper-based transactions. The growth of Web banking removes some of the competitive advantage that financial institutions with larger ABM networks might have over those with smaller networks by reducing the need for large investments in ABMs and the ongoing costs to service them.
The potential market for shared deposits is small and shrinking, as advances in electronic delivery channels provide consumers with greater convenience and reduce reliance on paper-based transactions.

This is illustrated by the example of ING Bank of Canada. In his opening statement to the Senate Banking Committee s hearings into bank mergers and the public interest, Paul Bedbrook, President and Chief Executive Officer of ING Bank of Canada, noted that:

ING Bank of Canada is doing extremely well. We now have over 600,000 customers in Canada. We have over $8.5 billion in deposits. So far this year, we have over $3 billion in new deposits, second only to Bank of Montreal for growth of deposits in Canada this year. We feel that you can be competitive in this market and grow.

Later in his presentation, Mr. Bedbrook discussed ING s decision to exit the ABM market:

We used to have a network of about 230 bank machines. We have just got out of that bank machine business The economics of ABMs is deteriorating over time, as most bankers would know We make the point in our submission that there is excess capacity, and this leads to inefficiencies, creating a larger infrastructure than is necessary, and a higher cost structure, which the public ends up paying for through bank fees and what have you.

If ABM full functionality was essential to the ability of smaller institutions to compete, it would be difficult to explain ING s strong financial performance, including the rapid growth in its deposits.

Cardholder Demand for Enhanced ABM Services

Another factor that would bolster the case for providing enhanced functionality through the ABM network would be clear evidence of any unfulfilled consumer demand. Interac Association s 2003 Benchmark Tracking Study, an annual telephone survey commissioned by the Association and conducted by the market research firm The Strategic Counsel, provides some useful information on cardholders attitudes towards enhanced functionality of ABMs.

There is no obvious consumer interest in enhanced shared ABM services. A viable business case in support of greater functionality would need to rest on higher levels of consumer demand.

The study reveals that there is no obvious interest among consumers for enhanced shared ABM services. A viable business case in support of greater functionality would need to rest on higher levels of consumer demand in order to justify the investments and ongoing operating costs associated with providing shared deposits and other services.

The chart below illustrates cardholders modest interest in shared services beyond the shared cash dispensing service that is presently offered.

It should be noted that the fee for a shared deposits service would also have an impact on cardholder demand. In the U.S., where a number of networks offer shared deposits services, interchange fees for these transactions tend to be between US$2.00 and US$3.00, according to a recent report published by ATM & Debit News, a leading industry publication. In comparison, interchange fees for cash withdrawals tend to fall between US$0.40 and US$0.60.

The substantially higher interchange fees for shared deposits reflect the fact that shared deposits are significantly more costly to process than shared withdrawals. It can reasonably be assumed that the costs to cardholders for shared deposits will also be significantly greater than the costs of shared withdrawals.

Despite the high per-transaction revenue for shared deposits transactions, some U.S. institutions that provided a shared deposits service have decided to discontinue it, citing the weak demand and high costs of providing the service. The NYCE network, one of the largest in the U.S., has made accepting deposits an optional service and now allows its members to levy surcharges to recover their costs. With further innovation in electronic options to handle deposits, demand for shared deposits services at ABMs will likely continue to decline. This may spur more U.S. financial institutions to withdraw from offering shared deposits services.

Small Business Demand for Enhanced ABM Services

The absence of a viable business case for full functionality is further underscored by a lack of interest in shared deposits and other services among small businesses. In a recent survey conducted by the Canadian Federation of Independent Business (CFIB), CFIB members expressed little interest in expanding ABMs as a banking channel to service small and medium-sized businesses, primarily because they do not find them well-suited to meeting many of their business banking needs. According to the survey, a full-service local branch is the preferred way for these businesses to access banking services, with 74 per cent indicating branch access was very important to their business. By contrast, only 30 per cent indicated that access to ABMs was very important, while 43 per cent said such access was not important. According to the CFIB survey,

Business owners preference in how they want to conduct their banking is straightforward: through a branch that is conveniently located and offers the full range of services essential to operating their business There is little importance given to alternative banking methods, such as ATMs, the telephone and the Internet.

The Additional Costs of Providing Enhanced ABM Services

Providing full functionality at ABMs through the INTERAC network would require both common investment by the members of Interac Association as well as individual investment by participating financial institutions. Costs would include the technical changes required to update the INTERAC software and network to recognize and handle these new transactions, and the costs of updating members own processing infrastructures.

The costs of operating a shared deposits service would also be considerably higher than the existing cash withdrawal service. The additional costs arise partly from the requirement that deposit machines be emptied daily, versus re-stocking cash dispensing terminals in many cases only once or twice per week, or as cash is depleted. This is of particular significance in the case of ABMs located in remote locations, where transportation costs may be high. Further, to limit risk, each ABM deposit must be handled, opened and verified by two employees, contributing significant additional administrative expense to processing transactions.

Finally, providing a shared deposits service would require careful consideration of the risk controls needed to ensure the security of cardholders. ABM deposits are, as a general rule, riskier than in-person deposits. This is because while the deposit rests in the machine, there is a period of time where the transaction is unverified. Therefore, increasing the number of deposit transactions at ABMs has the potential to increase the amount of risk present in the system.
ABM deposits are, as a general rule, riskier than in-person deposits. Careful consideration of appropriate risk controls would be needed to ensure the security of cardholders.

Further, while most large financial institutions have highly sophisticated systems to monitor the activity of their cardholders and ABMs in order to detect potentially fraudulent transactions in real or near-real time, there is a limited ability to do so in the shared transaction environment. What this means is that a fraudulent deposit on a cardholder account that would be quickly identified by an individual institution may not be detected until the next day or later if that deposit was made at another institution s banking machine.

In order to mitigate this kind of risk, it might be necessary for institutions to impose holds on deposits made at other ABMs. Further, the relative risk of these transactions would likely be reflected in the fees charged to cardholders for use of the service. In conclusion, the cost of operating a shared deposits service safely and efficiently could necessitate pricing and terms of service that would simply not be attractive to cardholders.
The Competitive Framework for New Services

We believe that consumers benefit most when markets are permitted to operate freely. When that is the case, market participants develop new products and services and make investment decisions based on demand and supply considerations.

The absence of ABM full functionality on a broad scale in Canada is not the result of impediments to competition or innovation, either in the Canadian financial industry broadly or within the INTERAC network in particular. Rather, as highlighted above, it is simply the case that no group of market participants has yet built a positive business case to justify the upfront investment and ongoing operating costs of providing additional ABM services using the INTERAC infrastructure.

However, should Interac Association s members or a group of members identify such a business case, there are many avenues available as the framework for new service development within the INTERAC environment is quite open and flexible. In fact, there are ways to lever the INTERAC infrastructure to offer new services that do not require the approval of the Association s Board of Directors, nor that of its major players or large groups of members.
The framework for new service development within the INTERAC environment is quite open and flexible. Should a business case be identified, there are many avenues to bring a new service to market.

Within the Association, new shared services can be adopted by the Association s Board of Directors. These new services would operate exactly as the existing INTERAC services do today. That is, they would be managed and operated by the Association, and participation would be open to all members on a voluntary basis. No member would be obliged to participate, and none would be excluded.

Where there is no impetus to proceed at an Association level, market participants may create bilateral or multilateral services that take advantage of the INTERAC network and infrastructure. Interac Association s rules provide for any group of two or more members to collaborate to develop a new service that the entire membership may not be interested in pursuing, provided it meets a set of minimum criteria. The members that participate in the new service are jointly responsible for its operation and management, provided that the Association s general technical and security standards are satisfied. Approval from the Association s Board of Directors or from the membership at large is not required to implement a new bilateral or multilateral service.

Finally, when neither of the above options proves viable, a group of market participants may still negotiate to bring a new service to market using the INTERAC network under a flexible arrangement we have developed called proprietary use. Under this option, the participants may enter into an agreement to use the INTERAC software and network for a reasonable fee, and may take advantage of the efficiencies offered by the existing technological infrastructure. One proprietary use application is presently in operation, and we anticipate that additional applications will be added in the future.

What these options allow for is pairs or groups of market participants large or small to use the Association s national network to offer new and innovative services, relying on their own funding, management and operations and setting their own terms of access.
Innovation and Efficiency in the Financial Sector

In its presentation to the Parliamentary committees a few years ago, Interac Association argued that a shared deposits service might hinder innovation in the financial system. Electronic transactions generally provide customers with greater convenience and control over their accounts, while at the same time reducing the cost of providing many services. The introduction of a shared deposits service may be a regressive move, as it would serve to encourage consumers to continue to rely on inefficient paper-based transactions, rather than embracing the new services that technology provides.
The introduction of a shared deposits service could encourage consumers to continue to rely on inefficient paper-based transactions. The financial services sector should be focused on promoting services that are cost-effective and convenient to consumers.

The financial services sector should be focused on promoting services that are cost-effective and convenient to consumers. Members of Interac Association have been actively pursuing such innovation. This is exemplified by an arrangement the Association entered into recently with the owners of CertaPay in order to launch a new INTERAC Email Money Transfer Service for Canadians.

INTERAC Email Money Transfer is a good example of a new service that provides greater convenience and reduces the processing costs associated with a similar paper-based alternative. Using Email Money Transfer, customers of financial institutions can send money via email to other individuals. After establishing that they are entitled to receive the payment, individuals can deposit it to their own account, even if the account is with another financial institution. This service has the potential to replace the comparatively inefficient and costly alternative of sending personal cheques and can provide considerable convenience to the increasing number of consumers using Web banking.

The launch of INTERAC Email Money Transfer demonstrates that the members of Interac Association are committed to pursuing innovative payment solutions for Canadians. It also demonstrates that, where a business case exists, new services will be brought to market.
Conclusions

There is little evidence that the absence of full functionality on a broad basis in Canada is a significant barrier to competition in the financial system, or is preventing smaller institutions from offering services to their customers at a reasonable cost. Neither consumers nor small businesses express a strong desire for enhanced ABM functionality as a solution to their everyday banking needs. The potential market for services such as shared deposits is small and shrinking, given advances in banking technology and the resulting shifts in the way consumers interact with their financial institutions.

Innovation and the electronic delivery of banking services have provided Canadians with many enhanced services, including new ways to send money to one another that do not rely on traditional paper-based payments. Electronic banking offers Canadians greater convenience and provides a more level playing field for competing financial institutions by eliminating the need to make large capital investments in physical infrastructure. The introduction of a shared deposits service without a sound business case might slow the progress of electronic banking by encouraging consumers to continue using paper-based transactions.

In a study conducted several years ago, Interac Association was unable to generate a positive business case for expanding its shared services to include deposits. Given continuing innovation in the payments landscape since that time, we believe that the business rationale for offering shared deposits on a broad basis may be even weaker today than it was a few years ago. In the U.S., where a number of networks offer shared deposits services, fees have been rising and the number of institutions offering these services has been on the decline.

However, should a group of market participants determine that enhanced ABM services would be worthwhile to pursue, the INTERAC framework provides significant flexibility to bring these services to Canadians. Action is not needed on the part of government to remove structural or competitive barriers to new service development. Rather, when the business case is proven, the market will respond. This has been the case with services like INTERAC Email Money Transfer, which offers benefits to Canadian consumers and at the same time improves the efficiency of Canada s financial system.

In conclusion, we believe these issues must be carefully examined and analyzed before any policy action is taken to expand the services provided through the ABM network. We believe the government should mandate full functionality at ABMs only if there is clear evidence that its absence is anti-competitive and that greater functionality, and shared deposits services in particular, would remedy this without adding significant new regulatory costs or harming innovation and investment in the ABM network in Canada.

Trade-mark of Interac Inc