Most of this year's chatter surrounding card interchange has centered on the prospects for the Credit Card Competition Act's passage. While this pending legislation remains on the watch list, the plot has taken a sudden twist. The Federal Reserve, at an October 25 meeting, pulled debit interchange squarely back onto center stage.
The Fed formally approved a proposed revision to the debit fee cap that – by most estimates – would reduce covered financial institutions' interchange revenue by roughly 30%. This is on top of a "clarification" to rules for card-not-present debit transactions that took effect in July, the impact of which is not yet fully understood but is projected to be detrimental to all card issuers.
With these scenarios playing out in Washington, financial institutions need to understand the history of the process and the most likely next steps.
Sidestepping Public Comment with a New Process
The Fed has not altered its current cap of 21 cents plus 0.05% of the debit transaction amount since first implementing the Durbin Amendment's provisions of the Dodd-Frank Act in 2011. Those in the business for a decade or more will recall that Durbin's immediate effect was to slice related revenue by roughly half. Debit rewards programs essentially vanished, and research by the Fed has found no evidence of any merchant savings being passed along to consumers.
The Fed's research has found minor declines in the cost to support debit on a per-transaction basis since 2011, but it has not deemed the changes sufficient to enact a cap adjustment…until now. A North Dakota merchant's lawsuit challenging the fee cap, now on the Supreme Court's docket, may help explain the recent flurry of activity.
The Fed's proposal would reduce the fixed fee component from 21 cents to 14.4 cents and the variable component from 0.05% of the transaction value to 0.04%. The rules also allow for a 1 cent per transaction fraud prevention fee "if eligible." The Fed proposes an increase to this component – to 1.3 cents. The net effect would be a roughly $4.5 billion decline in interchange for covered issuers.
Interestingly, after not changing the fee cap for more than 12 years, the Fed intends to do so bi-annually – eliminating public and industry input. The Fed would apply the findings of its cost studies in odd-numbered years, announcing its findings in March and implementing them in July. This unpredictable mid-year turnaround will pose significant budgeting and forecasting challenges for many financial institutions.
A Single Banking Market
Technically, only transactions on debit cards issued by an institution with $10 billion or more of assets, which comprise nearly two-thirds of US debit activity, are covered by the interchange restrictions in the Durbin Amendment. According to the Nilson Report, such covered institutions generated $16.6 billion in debit interchange last year. However, the Fed's data reveals that the pricing of transactions on cards issued by "exempt" FIs (those under $10 billion) is also impacted, following a slight time lag. It's a fundamental economic premise – covered and exempt FIs compete in the same market, so the pricing of either does not exist in a vacuum.
In voting against the proposal, Fed Governor Michelle Bowman questioned the ability to insulate exempt issuers from harm. "Issuers of all sizes use the same payment rails, and smaller issuers inevitably face some degree of pricing pressure, at least indirectly, from the interchange fee cap," she said. "I am concerned that even if the interchange fee cap does not directly apply, smaller issuers will continue to face ongoing fee pressure in operating debit card programs."
There is supporting evidence for this concern, as exempt issuer interchange declined after implementing the original regulation.
Bowman's concerns extend beyond community institutions. The Fed takes a one-size-fits-all approach to setting its debit cap. Since the country's largest banks account for a disproportionate share of debit activity, their scale advantages skew the aggregate cost data. Bowman notes that, according to the Fed's research, a third of covered institutions will be placed in a loss position based on the proposed cap. One can only imagine what this means for the even smaller exempt institutions.
Hopefully, even to those outside of back offices, it's obvious that debit processing is far from a cost-free exercise. Fraud cases are rising, as are customer inquiries requiring significant human intervention and research to resolve.
A Dangerous Proposal
Bowman's dissent cites several of SRM's concerns. "While the proposal suggests that it could result in benefits to consumers, I am concerned that the costs for consumers — through the form of increased costs for banking products and services —will be real, while the benefits to consumers — such as lower prices at merchants — may not be realized."
This proved to be the case in 2011, as nearly one million Americans, mostly those with low incomes, lost access to banking services. Moreover, only the largest merchants saw measurable expense reduction, while smaller merchants received little benefit. Some have speculated that a decrease in debit revenue could force FIs to eliminate certain free checking accounts, which would carry negative implications for financial inclusion. Since debit transactions tend to be the primary form of DDA activity for most account holders, finding a new revenue source to cover the cost of ongoing account maintenance would be a logical response.
It is troubling that the Fed wants to amend this regulation right now. This proposal will further strain the banking system in the wake of recent bank failures, liquidity challenges, deposit flight, macroeconomic headwinds, labor supply issues, and high inflation. The fact that many small, covered issuers will lose money on their debit programs will likely drive more industry consolidation, limiting consumer choice and eroding attempts by many at financial inclusion. Given the current regulatory regime, it is almost as if industry consolidation is the primary goal. Aside from that, the timing is interesting relative to last summer's FedNow launch. After about 12 years, the Fed just happens to further erode debit revenue shortly after launching a network that could compete with future debit transactions.
If there is any silver lining, the cap remains in the proposal stage, subject to public comment. The original Reg II proposal set a cap of 12 cents per transaction, which was adjusted to 21 cents after a broad outcry. The coming months may bring a similar revision, but it won't happen without the financial services industry making its voice heard. The Fed may have been overly aggressive with this proposal, with the intention of finalizing a rule that isn't as destructive.
The Bottom Line
We advise financial institutions to begin collecting relevant data to determine what operational changes a debit fee reduction would require and to give thought to the desired message to regulators before a final decision is reached. Voices from leaders of financial institutions with under $10 billion in assets could prove particularly impactful in swaying regulators' opinions, given the implication that such institutions are somehow unscathed by these rules.
SRM will be closely monitoring further developments. The public comment period will run for 90 days once the proposal is formally published in the Federal Register. We encourage leaders to submit comments, contact elected officials, and collaborate with trade officials. A new cap will go into effect 60 days after the rule is finalized. Depending on the extent of comments and additional hearings, this could still become a budget issue for the second half of 2024.
Myron Schwarcz, Chief Product Officer, and Keith Ash, Managing Director, have two decades of experience in the banking industry, advising leading financial institutions on their strategic initiatives. Further inquiries may be made by emailing Myron at mschwarcz@srmcorp.com or Keith at kash@srmcorp.com.
