Last month we discussed the Risk / Underwriting "Funnel" and determined the importance of finding an upstream partner who managed this Funnel in line with your business strategy. Managing this Funnel is important, but no matter how conservative the underwriting and how good the risk management department, there will always be losses. Losses are an inevitable element of our business and crucial component of your business planning. When creating both strategic and tactical plans you must take the loss element into account and attempt to minimize its impact through your operations and pricing strategy and policies.
Losses come in two shapes. The first is what I would call normal "Business" losses. Business losses happen daily and are general, everyday occurrences in the course of the acquiring business. These losses stem from merchants going out-of-business or merchants that take chargebacks in excess of money in their account. Business risk is traditionally scored and then modeled on 5 or more of the following factors:
Acquirers use historical data based on past losses to rank a specific business type's probability of future losses. An Acquirer will analyze historical chargebacks, fraud and overall risk levels of specific business types in specific regions and assign a score to a merchant based on the merchant's Standard Industry Code (SIC).
Monthly dollars at risk
The amount charged to a merchant for accepting credit cards (the discount and transaction fee) and a merchant's monthly volume will determine the total amount an Acquirer could lose in processing fees (most of which are still owed to the association and processor) on a monthly basis if a merchant went out of business.
Time from order to delivery of product/service
The farther in advance an order is placed from actual delivery, the greater the probability of chargebacks. Businesses can go under before the product is delivered and buyers can cancel orders.
Method of order
Orders placed face-to-face are of less risk than orders placed on the phone or on the Internet, as the consumer and the buyer are in physical contact confirming the validity of both parties.
Credit or bankruptcy score of the personal guarantor/ business
Businesses and individuals with poor credit, a highly probable bankruptcy score, or with the history of defaults and bankruptcy have a much greater probability of going out of business than companies/individuals without these scores or histories.
Each and every Acquirer will score these criteria, place them in a risk model, and then will make the decision if and/or how they should accept a merchant.
Let us now make the assumption that this is a higher risk merchant based upon a given Acquirer's scoring/risk model of the above criteria. How might an Acquirer minimize the business risk? The savvy Acquirer will make both operational and pricing changes to adjust to the risk of a merchant. The operations department might take one or many of the following precautions:
Billing merchants every day by netting out discount fees from merchant deposits on a daily basis is one of the easiest ways to minimize large losses, especially for retail merchants. By deducting these fees on a daily basis, merchants that go out-of-business can only leave an Acquirer liable for end of month fees. Obviously, trailing chargebacks are still an issue, but for small retail establishments and restaurants where merchandise/food is bought the same day, Acquirer losses are minimized tremendously.
Often Acquirers will ask a merchant for a reserve in escrow to guarantee transactions. These reserves will limit an Acquirer's risk. If a merchant goes out of business, the Acquirer will still have access to this reserve. A skilled risk department manages the amount of reserve in respect to the potential loss.
Delaying the funding of a merchant has a two-fold positive effect on managing risk. First, it allows the risk department to watch a merchant's transaction(s) for multiple days to watch for any abnormal activity. Second, it gives the Acquirer additional time to hold funds and payment, if necessary.
Tighter Risk Controls
The least intrusive method for managing business risk is to tighten the risk parameters on a given merchant. Most risk systems allow the Acquirer to manage velocity settings - maximum dollars and/or transactions, ticket sizes, batch sizes, keyed item/duplicate transaction/return ratios, other variances, etc. By tightening these parameters and settings, a merchant will be looked at and managed more closely by an acquirers risk department.
However, no matter how many of these precautions are taken, there will be some losses. So what can an Acquirer do to minimize the net-effect of these losses? It is very simple, raise the price or assess what I call a "risk premium." As with any loan, a risk premium is always attached. Do not kid yourself. Giving a business a merchant account is giving them a line-of-credit or access to a money machine. Once active, a merchant can receive cash before ever delivering a product or service. This risk premium is minimal for traditional low-risk merchants and most of us just factor it into the net profitability of the account. However, for a high risk merchant, a risk premium should be mandatory. Do we remember Economics 101? For greater risk, there should be a greater expected return.
Why should an Acquirer take greater risk for the same return? Pricing a high risk merchant similar to a low risk merchant is just "Bad Business." Pricing policy plays a very important role in minimizing the net-effect of losses.
The second type of loss that an Acquirer is susceptible to is "Fraud." What is scary is there are no models or SIC codes to key off for fraud. Fraud can happen in any type of business at any time. An Acquirer's only way to combat fraud is to employ a good risk management system, have a good risk management team, work with a good investigative staff and have a little luck on their side. I have seen scams from organized crime, the Russian mob, insiders (merchant or employee), and every-day scam artists. Working together as an industry and through trade/professional organizations, and with the use of the newest technology, we can all work together to minimize fraud.
It is critical to include losses in your business planning. For traditional, not high-risk (off shore, gaming, adult, etc.), Acquirers the more conservative manage their portfolios to have approximately one basis point in loss. The less conservative may manage portfolio losses as high as 5 or 10 basis points of volume. As tolerance increases and losses grow, keep in mind ways to minimize your exposure and price your merchants and your sales force accordingly. I have seen losses put Acquirers completely out of business. Staff a qualified risk department to avoid the fraud and manage your business both operationally and from a pricing stand-point with losses in mind. Losses are a part of our industry and here to stay. The long-term Acquirer will plan for them and implement operations and pricing strategies that allow for minimal net-cash flow effect and long-term business growth.