In merchant services, balance is important between underwriting and risk teams. If left unchecked, these two teams can work against each other, making the other’s job harder than it should be.
Each of these teams has clear yet different roles:
Underwriting:
Assess whether applicants adhere to bank, card brand, and regulatory rules. In a nutshell, they are trying weed out fraudsters, money-launderers, and businesses that would pose a financial risk to the institutions processing their payment transactions.
Risk:
Monitors transactions processed after they are boarded. Are they processing transactions outside acceptable parameters? Does the activity make sense given the business type? Is the activity indicating the institution processing those transactions could be at risk, financially or otherwise?
In an ideal world, balance exists between these two teams.
For example, if an underwriting team is heavy-handed and turning away anything that is even a tad bit risky but has the potential to be monitored and managed with a good risk program, we’re 1) not letting the risk team do their jobs and 2) turning away business we could likely take. A real morale and profit- buster.
If the underwriting team is not turning away business that they should, we are over-taxing the risk team’s resources and setting them up for failure. We can expect that we will lose most of these merchants, and we’ll probably incur financials losses.
Why bother boarding them in the first place? Again, not the kind of things risk teams usually get excited about.
Hopefully, now we can see why balance within and between these two teams is critical to both operating well. The balancing act is ongoing… this is something that should be constantly monitored and tweaked.
Category: Underwriting
What is a Merchant Reserve? And How Can You Help Manage them on Behalf of Your Merchants?
What is a merchant reserve, and how can you, as a merchant services sales office or agent, help your merchants manage this part of their processing relationship most effectively? What are the common pitfalls to avoid?
Let’s dive in.
What is a merchant reserve, and when is it put in place?
A merchant reserve is an amount that is set aside to cover unplanned/uncovered merchant expenses such as uncollected chargebacks, debits such as returns, merchant account fees, etc. In a nutshell, it helps the ISO hedge against financial risk.
It is commonly required for higher-risk businesses that want to accept card payments. For example, future delivery businesses, merchants with significant chargeback history, or merchants operating in risky business verticals.
It can be collected as a lump sum amount to be set aside before a merchant even starts accepting payments, or more commonly, as a small percentage of each batch, typically 10-20%.
There are many flavors of reserves– rolling, capped, and more, so you’ll want to understand the terms of your merchant’s specific agreement.
Here’s the most important question to ask when a reserve is involved with a merchant account:
❓Do you trust your ISO to be a responsible fiduciary of your merchant’s funds? True, the funds are held in a controlled account with the sponsor bank, but it is the ISO that normally ends up playing the role of gatekeeper over these funds.
You want to be sure that when it’s time to release reserve funds:
1) Your merchant knows exactly how much is set aside in that account on their behalf. Sloppy accounting will get the better of many merchants.
2) The funds are still there (this is more of a problem than most would like to admit) and
3) They play by the terms of a fair reserve agreement and exercise good judgment.
Unfortunately, merchants that require reserves commonly end up getting mistreated. Sometimes they’re in a desperate place and unsavory payment players will take advantage. We share everything you need to know so that you can advocate for your merchants as their payments champion, protector of all things right and good.
Who Can You Trust to Manage Reserves for your Merchants?
How can you know whether you’re doing business with an ISO that can be trusted with fiduciary responsibility for your merchant’s reserve funds?
In our settlement platform, Pioneer, we can pull up our merchant reserve balance, then log into the sponsor bank where that balance is held, and see that these two numbers are living in perfect harmony… as they should be.
That means that we know:
✔️ An exact merchant reserve balance for every merchant we’re reserving funds for in that account.
✔️ If we drill down for any given merchant, we can see a detailed ledger of deposits and withdrawals that arrive at this balance.
Total Reserve Balance = Total of balances for each merchant = Total of reserve transaction ledger entries
This sounds simple and straightforward, right? The truth is that it’s not. And some players in payments struggle with this. They struggle because of:
➡️ Sloppy accounting. Treating this balance like a lump sum instead of the many important parts and pieces that make up this account. We’ll call this negligence.
➡️ Improper accounting. Treating this balance like it’s a revenue line item instead of the asset and offsetting liability that this is. These funds don’t belong to the ISO and should never be treated this way. This is the exact scenario that led to the bankruptcy and demise of a very large payments player a while back. And unfortunately, that’s not the only case study where reserve funds have been misused.
➡️ Outsourced accounting without verification. They let their processor handle this for them, and they have no idea whether it’s being done properly.
What happens when you don’t know the exact balance that you’re holding for each merchant and how you arrived at it? Well, your reserve account starts to feel more like a Ponzi scheme. As merchants request releases, are you releasing them against their actual balance or another merchant’s? It seems fine and good until the funds run out and there is still someone making claim on those funds.
So here are some qualifying questions you can ask your ISO to ensure they handle merchant reserve accounting properly:
❓ Where are your reserve funds held? (they should be held in a controlled account with the sponsor bank)
❓ How is the balance verified? (they should have to report a reconciliation to the sponsor bank on a regular basis and even better, the ISO undergoes a financial audit each year)
❓ If they’re holding reserve funds for one of your merchants, ask how can you see the balance, including the detailed ledger? You can easily verify this ledger against your merchant’s activity to be sure this is being done properly.
How to Help Merchants Account for their Merchant Reserve
If your merchants are having funds set aside in a risk reserve, it’s important for them to track exactly what’s in that account.
Sloppy accounting gets the better of many merchants because here’s what they do when they book a merchant deposit for $100 sale and a 10% risk reserve is involved:
Revenue $90
Bank Account $90
Hey, wait a minute, where did that $10 go? It didn’t disappear into thin air, and it certainly shouldn’t be considered a cost of doing business. It’s sitting in the service provider’s reserve account on the merchant’s behalf. That means it’s an asset that should be sitting on the merchant’s balance sheet.
Instead, the deposit entry should look like this when there’s a reserve involved:
Revenue $100
Bank Account $90
Reserve Receivable $10
As the merchant services provider adds funds to the reserve on the merchant’s behalf, that amount will climb on the merchant’s balance sheet, and they’ll know exactly what is owed to them in the event they stop processing. When should the merchant expect to get it back? That’s a complicated answer that depends on the unique circumstances of each merchant. In general, the funds should be released as soon as the threat of any financial loss to the provider has passed.
There are a lot of merchants who look at a reserve as an expense– a cost of doing business. And unless they’re planning on burning their merchant services provider by running up a big tab of uncollected chargebacks and high fees and then running, that’s a flawed approach.
Help your merchants properly account for their deposits, and you’ll help them hang onto the funds that are rightfully theirs.
What Happens When Merchant Reserves are Used to Cover Losses?
What happens when a risk reserve gets used for the purpose for which it was intended, that is, to cover losses?
Here’s an example.
My company, ABC Payments has a merchant services agreement with Fun Excursions. Fun Excursions provides exactly what its name describes to travelers visiting a popular vacation destination.
Fun collects payments up to 3 months in advance of the date they provide their services. They process $100,000 a month in card volume and have been doing business with ABC for the past several months, in which they’ve accumulated a $50,000 reserve balance.
A natural disaster wipes out Fun’s excursion fleet, and suddenly they are unable to deliver any of their services. They’ve collected $250,000 in payments for services they have not yet delivered. They start issuing refunds, but Fun has never been great at managing cash flow or their insurance policies, and after a while, there’s no money left in the bank to cover the returns. ABC terminates Fun’s payment processing account for failure to cover its obligations.
Fun customers are still reaching out for refunds, but the number is disconnected. Customers start contacting their credit card issuer to initiate a chargeback.
Fun continues to run up a chargeback tab, but Fun and its owners are nowhere to be found to cover this debt.
ABC can use the $50,000 reserve balance that it collected from Fun, but it finds itself with an additional $70,000 of uncovered chargebacks. Not to mention, it is also stuck covering the fees associated with processing these chargebacks.
Just when ABC thinks it’s done with covering the losses associated with Fun, a year later, more chargebacks trickle in. These have been initiated not by the cardholder, but by the issuing bank that is holding the balance for a delinquent cardholder. The issuing bank is doing what it can to minimize its own write-off debt.
All in all, ABC incurs a bad debt loss of $90,000. Even though ABC thought it was mitigating its risk by implementing a risk reserve, it wasn’t enough.
ABC can pursue Fun to collect this balance, but the chances of collection are slim.
What happens if ABC can’t cover this debt? The liability falls to the next party in line, the last of which is the sponsor bank. That is why the acquiring sponsor bank has the ultimate say in whether a merchant can stay or must go.
This scenario might seem far-fetched, but in the payments world, particularly for providers that frequently dabble in high risk, it happens more often than they’d like to admit.
How to Advocate For Your Merchants that Require Reserves
Set it and leave it – this is the mindset that we have too often in the merchant services industry.
But there’s value in monitoring and checking in with your merchants, especially when it comes to ones that require a merchant reserve.
When a merchant reserve is first established, it is typically done at the start of a processing relationship. The ISO has no direct processing history to rely on. They rely on what the merchant has presented as part of the application package. The merchant could have omitted something, intentionally or unintentionally.
Part of the risk the ISO is covering is that of the unknown.
But there becomes a time when the unknown becomes a lesser part of the equation. The ISO can track the processing and chargeback trends reasonably well enough to better understand the likelihood of risk.
💡 Agents: this is the time to advocate for your merchants.
➡️ If a cap is not in place, you can ask for one.
➡️ You can request a partial release.
But don’t just do this for anyone, or you’ll become white noise. Only ask if you can make a reasonable case for your request. That means doing your homework and giving reasonable background for your request.
This will also help you understand whether you’re working with a risk department that operates within reason. If they immediately dismiss you, you either haven’t done your homework properly or they have a my-way-or-the-highway mindset. If they operate within reason, they will be able to give you some concrete reasons to justify their position.
By advocating for your merchants, you can establish a solid relationship that lasts the length of their business, as well as provide a prosperous referral source.
Merchant Reserves: Everything You Need to Know
If you want to play in the high-risk space in merchant services, you’d better know your reserve terminology inside and out. And you should also understand what’s reasonable and what’s not when an ISO requests a merchant reserve.
Remember, an ISO is requesting to hold a reserve to minimize its financial risk. If they’re requesting a reserve, it should make sense given the financial risk they are exposing themselves to. That risk can vary based on the:
☑️ Business owner’s personal credit
☑️ Business type
☑️ The financial health of the business itself
☑️ Timeline between payment acceptance and service/product delivery
☑️ Processing history
𝗨𝗣𝗙𝗥𝗢𝗡𝗧 𝗥𝗘𝗦𝗘𝗥𝗩𝗘
A merchant must put up a lump sum of money to be held in reserve before they even start accepting payments. This is common for future delivery merchants with a long timeline between payment acceptance and delivery, but can also come into play for other scenarios.
𝗥𝗢𝗟𝗟𝗜𝗡𝗚 𝗥𝗘𝗦𝗘𝗥𝗩𝗘𝗦
A set percentage of each merchant deposit is withheld in reserve and then automatically released after a set amount of time.
𝗖𝗔𝗣𝗣𝗘𝗗 𝗥𝗘𝗦𝗘𝗥𝗩𝗘𝗦
A set percentage of each merchant deposit is withheld in reserve, but not automatically released. Instead, the balance accrues until a set limit is reached.
To be a true advocate for your merchant services clients, study these terms carefully so that you know exactly what an ISO is expecting from your merchant. And if something doesn’t make sense to you, don’t be afraid to ask your ISO to provide justification for their reserve requirement.
Don’t Let Weak Financials Lead to an Underwriting Decline
Have you ever submitted a high volume, low risk deal to underwriting, only to have it declined due to weak financials?
Here’s what you need to know before you spend time working the next big deal.
One of the things always top of mind for acquirers is mitigating financial risk. Higher stakes with large volume deals means more exposure. Add in another risky component like future delivery and the stakes get higher, so the underwriting requirement list starts to get longer.
At a minimum, they’re going to want financial statements and bank statements. They’re trying to assess whether this company has the resources it needs to continue operating indefinitely, that it will make enough money to stay afloat and avoid bankruptcy. They’re also looking for activity on the bank statements that aligns with the company’s business model.
It’s not hard to do a cursory review yourself before spending a lot of time on it. After all, there’s a lot of work involved in assembling a package for underwriting. Plus, it’s not beneficial for you to be involved with failing businesses, whether you hold liability or not.
Here are some quick hits to figure out how healthy a company is:
✅ Current ratio: this measures whether a company has enough assets to meet its short-term obligations. Divide current assets by current liabilities. In general, the larger the number the better, and anything less than 1 can be concerning.
✅ Net income: Are they profitable? If there are losses, are they trending in the right direction? Where does funding come from to cover losses? Do they have enough runway to make it to profitability?
✅ Does the balance and activity in the bank account make sense given the business model? Is there cushion to cover unforeseen circumstances?
✅ Does the company have significant debt obligations that could be difficult to meet with any decline in income?
✅ Do the financial statements make sense given the business type? If it’s future delivery, they should have a liability line item that shows you exactly what they owe for products/services that haven’t been delivered.
Even if you’re intimidated by accounting, you can learn the basics to best position yourself to help the merchants that will be around for years to come.
And remember, acquirers like to come from a place of Yes, too. They like to add volume and margin just as much as you do. But they’re careful to weigh financial risks against potential gain. After all, when things go south, they are usually the ones left holding the bag and covering the losses. And no matter how seldom it happens or how small the dollar amount, a loss hurts just the same.
