A Dec. 16, 2010, meeting of the Federal Reserve Board outlined how it proposes to implement the Durbin amendment to the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The Fed offered two scenarios on how to tackle the amendment's debit card interchange regulation mandate; both scenarios involve capping debit card interchange at 12 cents per transaction.
As summarized by Fed economist Mark D. Manuszak in the live broadcast of the meeting, the first proposal would calculate the interchange fee based on each debit card issuer's costs, but the fee would fall between a cap of 12 cents and a "safe harbor" of 7 cents. The second option would be to impose the same interchange fee for all issuers required to comply with the law (those with assets of at least $10 billion), with a cap initially set at 12 cents, Manuszak said.
He noted that the amendment authorized the Fed to allow for an adjustment to the interchange fee to account for issuers' fraud costs. An additional provision of the amendment charged the Fed to devise rules that would guard against "network exclusivity" over how debit card transactions are routed for back-end processing.
Manuszak offered two proposals: the first would require that transactions be routed over at least two unaffiliated networks; the second alternative mirrors the first, except that two additional networks would be available for each way a debit cardholder elects to authorize a transaction, such as via PIN debit or signature debit. The two routing approaches are designed to promote network competition, Manuszak said.
According to the Fed, the average interchange fee for all debit transactions in 2009 was 44 cents per transaction, or 1.14 percent of the transaction; signature debit was 56 cents (1.53 percent) and PIN debit was 23 cents (0.56 percent).
Wall Street analysts estimate that capping interchange at 12 cents per transaction could reduce interchange revenue to banks by as much as 90 percent. On that news, the stock prices for Visa Inc. and MasterCard Worldwide dropped over 10 percent on Dec. 16.
Payment attorney Paul Rianda said the obvious outcome of the proposed regulations for ISOs is to significantly reduce residuals. If this compensation is actually going to drop "70 to 90 percent, depending on who you believe, that's got to flow down to the ISOs and agents," he said. "And the fact is that about 40 percent of the incoming transactions now are debit. So it's not like it is a 5 percent sliver." To compensate for the lost revenue, ISOs might impose new fees on merchants, such as an annual processing fee or "PCI fees," Rianda said. "I'm sure there's ways they can figure out to make it up. And they're going to have to because they can't just take this hit in income." But Sam Caine, President of Card Payment Services Inc., an ISO based in Frisco, Texas, believes ISOs' residuals may increase in the long run if the 12-cent cap is instituted.
With debit card interchange going down, banks will likely reduce or eliminate low-cost or free checking account programs, which are funded by interchange, he said. Without those incentives on checking accounts, consumers might shift from debit to credit, with banks nudging them in that direction, he added.
Because interchange fees are higher on credit cards than debit, merchants would see their interchange costs "go up, not down," he said. "They'll see a dip initially, but over say three to five years, it will be higher than it is today." Since higher interchange costs mean larger residuals for ISOs, "I see acquirers and ISOs being the least impacted of all the constituents," he said.
However, the regulations will provide safeguards against banks attempting to circumvent the rules, according to Craig Sherman, Vice President for Government Affairs at the National Retail Federation. If banks attempt to make up for lost revenue on debit cards and "increase interchange on credit or find a way to push the transactions onto credit, that's addressed in the Durbin amendment and that would be a violation of federal law," he said.
Sherman added that he doesn't know why banks would want to dissuade or otherwise steer customers away from using debit. "They're still going to have a very healthy profit on the debit cards," he said. "If they want to walk away from that, that's their concern."
Randy Vanderhoof, Executive Director of the Smart Card Alliance, predicted if the debit card interchange cap goes into effect, it will shake up the industry and highlight the benefits of migrating payment systems to the Europay/MasterCard/Visa (EMV) chip and PIN security standard.
Banks have tolerated fraud on debit cards because it has been offset by large profits off the cards, Vanderhoof noted. But that will likely change if an interchange cap reduces banks' profits.
"The fraud is still going to be there at the same levels, but the amount of revenue coming from those transactions might get cut by as much as 75 percent," he said. "That means the percentage of those fraudulent transactions against the revenue that those transactions generate is going to dramatically increase."
The antidote to reducing fraud losses on debit cards is for issuers to adopt the more secure and fraud-proof EMV chip and PIN smart card technology, Vanderhoof said.
Meanwhile, merchants can take the savings they realize from reduced interchange and invest it in upgrading infrastructure, such as installing EMV-compatible POS terminals, he added.
"My understanding is that ISOs have had a hard time just selling the merchants on the idea that they should be investing in chip-based readers today because there's no certainty that the financial institutions are going to move to EMV," Vanderhoof said.
But that uncertainty may soon disappear. "Today, under the current conditions, I think it's easier for the ISOs to make that case," he said. "And, therefore, they'll have the opportunity to upsell those merchants that they're doing business with today because there's now a stronger likelihood that [EMV] is going to be needed down the road."
The Fed has until April 21, 2011, to finalize the regulations, which are scheduled to take effect July 21, 2011.
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