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Reserve Accounts: It's a Matter of Prudence

By David H. Press

As an ISO, you should set up reserve accounts for your merchants, especially the high-risk ones. At Integrity Bankcard Consultants (IBC), we make portfolio risk assessments on behalf of our ISOs, and we've observed that in most cases they have set up adequate reserves for their high-risk merchants.

However, we've also seen numerous situations in which the ISO either holds excessive reserves on high-risk merchants or holds no reserves at all.

In some cases, it's counterproductive to hold reserves beyond what is prudent and necessary because you might increase the processing risk by restricting the merchant's cash flow. This can lead to fulfillment problems such as failing to issue returns to cardholders in a timely matter or inadequately staffing your customer service department.

Don't put yourself in the position where you continue to hold back the same percentage of the merchant's processing volume month after month without reviewing how much you have in reserve compared to your actual risk and exposure.

At IBC, we've seen a countless number of ISOs' good and highly profitable merchants go elsewhere simply because the amount of reserves the ISOs held was unreasonable.

Unfortunately, some of our merchant clients, which retain us to develop processes and procedures to eliminate their chargeback problems, have had some very bad experiences with ISOs and reserve accounts.

For instance, some ISOs don't have the funds available to pay the merchant the amount held in the reserve account as promised or pursuant to the merchant processing agreement.

Some have used the merchant's reserve to fund the ISO's reserve requirements with its processor or member bank. Other ISOs have created bogus or inflated fees/fines to justify not returning the funds in the merchant's reserve account.

The merchant processing agreement should provide reserve account language similar to the following:

The ISO "will establish and maintain a non-interest bearing account ('reserve account') in the name of either bank or merchant at a federally insured financial institution, with sums provided by merchant that are sufficient to satisfy merchant's current or future obligations as determined by ... "

Rather than hold the merchant's reserve funds, set up these accounts as individual accounts in the merchant's name.

It's important that merchants establish "ownership" of these funds and believe that they will get their money after the processing relationship ends.

Otherwise when their processing agreement is ending, merchants might run fraudulent transactions or fail to fulfill in order to get "their money" back.

You should maintain the reserve account for a minimum number of days after the termination date and for any reasonable period (i.e. two months with no chargebacks) or for such time for which cardholder disputes may remain valid.

Consider being reasonable and willing to gradually release funds to the merchant based on the chargeback experience after termination vs. the amount of funds being held.

Remember this, too. There are alternatives to holding reserve accounts. While they might be more difficult and time consuming to set up, they might prove easier to administer in your day-to-day operations.

Consider the following alternatives to reserve accounts:

  • Irrevocable letters of credit
  • Lengthening settlement timeframes (extended hold period)
  • Mandate acceptance criteria (i.e. fraud prevention tools, AVS and CVV2/CVC2, Verified by Visa, MasterCard Secure Code)
  • Re-work merchants' fulfillment process or procedures
  • Require merchants to provide proof of delivery before payment
  • Third party or guarantor indemnity
  • Special administrative reserve accounts at member bank
  • Power of personal indemnity
  • Surety, capital retention agreements and insurance products
  • Assignment of service or databases

ISOs too often automatically decide to hold back a certain percentage of the merchant's processing volume as a reserve when there are other and better ways to protect itself by transferring the risk of loss to a third party.

Be creative and work as a partner with merchants; these efforts go a long way in creating profitable and secure relationships with them.

Having policies in place where you do not release funds to new, high-risk merchants for the first deposit and use extended hold period days is a good, practical idea.

Verifying these merchants' actual processing activity is a safeguard for merchants processing anything that you might determine to be inconsistent with the application or agreement.

Insurance (from a reputable carrier) can serve as an alternative to having a reserve account. In fact, most merchants would prefer to pay a higher discount rate to cover the premiums than to be required to create a large reserve.

You can cap the reserve for the deductible amount and be fully protected. You can even make the insurance company be the bad guy when asking the merchant to do something to reduce the overall risk.

Irrevocable letters of credit are a great way to protect your business and are underutilized by most ISOs and processors. ISOs that work with the member bank to develop a letter of credit format and process often find the letter of credit the easiest way to mitigate the merchant risk.

They are more effective than simply getting a "wealthy" personal guarantor to sign and act as another way to transfer the processing risk to a third party.

David H. Press is principal and President of Integrity Bankcard Consultants Inc. Call him at 630-637-4010, e-mail him at or visit

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