By Marc Abbey, Chris Sanson and Casey Merolla
First Annapolis Consulting
Interchange regulation has been somewhat of a hot topic in the payments industry of late. The to the 2010 Dodd-Frank Act made its initial impact in late 2011, limiting the interchange some issuers are able to receive for debit transactions.
More recently, the announcement in July that Visa Inc. and MasterCard Worldwide have reached a settlement with a class of retailers may create another temporary interchange reduction event, not unlike the 2004 "Wal-Mart" settlement involving debit interchange. While the basic impacts for issuers and merchants are clear, subtle factors, specifically related to the Durbin Amendment, could impact acquirers for years to come.
One of the key components of the Durbin Amendment is the small issuer exemption, which limits the interchange caps to financial institutions with $10 billion or more in assets.
Under the Durbin regulations, the Fed uses an annual test of assets to determine exempt or nonexempt status, that is, whether the bank is above or below $10 billion and whether the interchange caps apply to the bank.
If an issuer no longer qualifies for the small issuer exemption at the end of a calendar year, the newly regulated issuer must begin complying with the various elements of the Durbin Amendment, including interchange caps, no later than July 1 of the following year.
In the case of an acquisition of an exempt bank by a nonexempt bank, the Fed recommends that the nonexempt issuer comply with the interchange fee standards as soon as reasonably practicable, but generally no later than 30 days after the date of acquisition.
The list of regulated institutions is not static and will fluctuate year to year based on organic growth or contraction and acquisition activity. For example, four banks crossed the $10 billion threshold from exempt to nonexempt status in the fourth quarter of 2011 and first quarter of 2012 and became (or will become, at the end of the calendar year) regulated entities.
Two of these banks crossed the threshold organically, while the other two passed the $10 billion limit due to acquisitions (though both were so close to the limit prior to their acquisitions that they may have crossed organically anyway).
Ignoring mergers and acquisitions, eight banks will cross the threshold in the coming eight quarters if the banks maintain their current rates of growth. Another 11 banks are so close to the threshold, that simply higher rates of growth corresponding to macro-economic recovery and a healthier environment could push them over the threshold into nonexempt status in the coming quarters.
Collectively, all the institutions just mentioned represented nearly $215 billion in assets as of the end of the first quarter 2012. To put that in perspective, these banks are analogous to a portfolio the size of Capital One Corp., the 13th largest bank in the United States.
Additionally, given the rate of combination between community and regional banks, institutions will certainly cross the threshold by virtue of their merger and acquisition strategies. Over the past year, 11 banks with less than $10 billion in assets (representing $6 billion in total assets) were purchased by banks that were already over the $10 billion Durbin threshold and were therefore already nonexempt by today's standards.
As mentioned earlier, over the same time, two banks representing $24 billion in post-closing assets came to have assets greater than $10 billion by virtue of an acquisition.
Therefore, if these rates of combination were to continue, over the next two years, approximately 25 banks representing $60 billion in assets would migrate from exempt to nonexempt status, in addition to the 23 banks with $215 billion in assets described above and likely to migrate due to organic growth.
There may very well be offsets, too, although it appears much more likely banks will cross above the $10 billion threshold due to positive growth than the converse. There were no instances of banks crossing from above the $10 billion threshold to below it in either the fourth quarter of 2011 or the first quarter of 2012, though this has occurred in the past.
In addition, there are three banks with assets totaling $34 billion that will back down under the threshold if they continue their current, negative rates of growth over the next two years. In April, Visa revealed a revised interchange schedule, which reduces rates on several categories of exempt issuer signature debit interchange, which we estimate will reduce Visa signature debit interchange by about $0.04 to $0.05 per transaction, on average.
Even with this reduction in exempt interchange rates, a differential of over $0.20 per transaction on average still exists between the interchange rates of exempt and nonexempt debit issuers.
All of this serves to illustrate the long tail of the impact interchange regulation will continue to have on the market. Quarter by quarter, banks will grow to exceed the asset limits set by the Durbin Amendment.
As they do, and so long as a pronounced gap between the interchange rates for regulated and nonregulated debit transactions still exists, a portion of their interchange revenue will be redistributed across the payment value chain.
Banks differ substantially from one another in terms of the degree to which they are consumer-oriented and their level of aggressiveness with debit card issuing. But as a general statement, becoming a nonexempt financial institution tears a hole in a bank's payment revenue due to the lower interchange rates the bank can earn on its debit products.
By making some general assumptions about likely debit purchase volumes based on asset size, the interchange reduction for the roughly 50 banks that have crossed or could cross the Durbin threshold in the next two years approaches $100 million in aggregate.
This is about a basis point on industry volume or 1 to 2 percent of acquiring industry revenue, as a frame of reference. Some of these funds will be passed on to merchants, and much, at least temporarily, acquirers will retain.
Debit interchange in this context is a zero sum game, and the reduction in interchange revenue to these banks accrues to the benefit of merchants or acquirers. This phenomenon illustrates the difficulty for acquirers to forecast their interchange expenses and to be precise in their pricing in bundled pricing structures.
Other things being equal, acquirers should experience a general decline in interchange rates due to banks becoming nonexempt. Acquirers differed substantially in terms of how they reacted to the Durbin Amendment and how much of the reduced interchange they passed through to merchants, and likewise, the margin improvements suggested by this phenomenon will accrue unevenly across acquirers.
Additionally, as merchants churn from one acquirer to another over time, their pricing will likely be marked to market, losing any exceptional margin on debit transactions. Nevertheless and despite the heartburn this migration will cause impacted regional banks, acquirers will continue to face a modest tailwind and improved margins from the long tail of the Durbin Amendment for some time to come.
Marc Abbey is Managing Partner of First Annapolis and responsible for its Acquiring Practice, Casey Merolla is a Senior Manager in the Deposit Access Practice, and Chris Sanson is a Senior Analyst in the Acquiring Practice. They can be reached, respectively, at marc.abbey@firstannapolis.com, casey.merolla@firstannapolis.com and chris.sanson@firstannapolis.com.
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