Volume 23 January

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1 Strategic Commentary 30YEARS Vision, Experience, Partnership Volume 23 January Durbin Debit Dilemma: A Special Report Speer & Associates, Inc Sanctuary Parkway, Alpharetta, Suite 150, GA Tel: Fax:

2 Page 2 January 2011 Durbin Debit Dilemma: A Special Report Assessing the Impact of Fed s Debit Card Interchange & Network Rules The Federal Reserve Bank (FRB) Board s release in mid-december of its proposed rules dealing with debit card interchange rates and network routing requirements represented a stunning blow to debit card issuers and another major victory for the merchant community. Financial institutions in the United States were already reeling from major hits to fee income opportunities due to legislative and regulatory actions over the last six months of The final implementation stage of the CARD Act took effect in August limiting or prohibiting fees being charged for certain conditions on consumer credit card accounts. A month earlier, modifications to Regulation E took effect that prohibit financial institutions from charging consumers fees for paying overdrafts on Automated Teller Machine (ATM) and one-time debit card (POS) transactions, unless a consumer explicitly consents, or opts in, to the overdraft service for those types of transactions. The Dodd-Frank Wall Street Reform and Consumer Protection Act has caused banks to dramatically alter their deposit account pricing strategies and retail financial projections, most notably in the virtual elimination of free checking throughout the country. The Durbin Amendment to the Dodd-Frank Act has resulted in an unprecedented impact on the payments industry due to its intentions as well as its uncertain rulemaking. An indication as to the tone of the proposed rules was sent by the FRB staff to the Board of Governors when, in response to a question from Chairman Bernanke, it was affirmed that in their opinion there had been a market failure with regard to debit card interchange fees. The proposed rules and the detailed FRB Staff Commentary document have sent a clear signal that the scope of these changes may be subject to further expansion in areas clearly outside the current legislative authority such as ATM interchange and credit card interchange. In recent Strategic Commentaries, Speer & Associates, Inc. (S&A) has examined the potential impact of Durbin on the debit card, POS, and network business, anticipating the possible rules outcome. With the proposed rules now in hand, S&A has made an in-depth analysis of these rules and their likely effect on all of the participants involved. In this Special Commentary, S&A will assess and comment on the immediate and future impact facing financial institutions, debit networks, and other stakeholders from the proposed Durbin Amendment rules. S&A will also provide its perspective on the various options proposed and the most likely outcome when the rules are finalized in the Spring of the new year.

3 Page 3 January 2011 Durbin Amendment Background and Directives As most know, the unofficial designation of the Durbin Amendment comes from the amendment sponsored by Senator Richard Durbin (D-IL) that was inserted just days before the Senate approved its version of the Dodd-Frank Act in May of Senator Durbin has been considered a long-time foe of the banking industry, especially related to bankruptcy regulations and credit / debit card fees, often pointedly calling out MasterCard and Visa with harsh comments. The Amendment was strongly endorsed by the major retailer industry groups and just as strongly opposed by debit card issuers and networks in the banking industry. Consumer advocacy groups had mixed positions, although most saw it as an overall negative development for cardholders, fearing the cost of debit card programs would be shifted from merchants to cardholders. By requiring debit card fees to be reasonable, and by cleaning up Visa s and MasterCard s worst abuses, small businesses and their customers will be able to keep more of their own money. Senator Richard Durbin, May 13, 2010 During reconcilement sessions between the Senate and House versions of the bill, some major modifications to the original bill were made primarily exempting prepaid and government payment card programs to its interchange fee restrictions after governmental agencies and prepaid card companies targeting their products to low income customers argued that without such an exemption their programs would be curtailed. Additionally, the original bill would have transferred enforcement from the FRB to the Consumer Financial Protection Agency after its creation, but the compromise bill maintains enforcement with the FRB. The reconciled bill was enacted on July 21, 2010 and the Durbin Amendment is contained in Section 1075 of the Dodd-Frank Act. The legislation adds Section 920 to the existing Electronic Funds Transfer Act also known as Regulation E which is a comprehensive regulation first passed in 1978 that establishes the rights and liabilities of parties involved in EFT transactions. The FRB was charged with developing rules covering the interchange fees, network exclusivity, and transaction routing provisions of the legislation. The proposed rules were released by the FRB on December 16, The FRB has solicited comments from stakeholders not only on the specific provisions outline, but also on a number of related issues that may be subject to future rules. Due to the complexity and controversy over the rules,

4 Page 4 January 2011 the FRB has provided an extended comment period with all comments due by February 22, Final rules are to be issued by April 21 related to interchange fee standards and by July 21 dealing with network exclusivity and routing requirements. While the legislation legally only applies to the 131 financial institutions and holding companies in the U.S. with more than $10B in assets, there is some question as to whether the networks will support a multi-tiered pricing structure allowing the exempt financial institutions to maintain higher interchange rates. As of the writing of this Commentary, Visa announced a dual interchange rate structure for exempted institutions while MasterCard issued a statement saying that it is still evaluating its options. Debit Card Usage and Cost Data In a number of Strategic Commentaries published over the last two years, S&A has provided detailed information about payment card history, statistics, trends and key strategic issues, especially related to debit and prepaid cards. While this detail will not be repeated here, S&A believes it is important to understand some key aspects regarding debit card usage. As part of its investigative effort, the FRB solicited and collected debit and prepaid card information from issuers, networks and merchants using standardized data collection forms. Since the information provided was guaranteed to remain confidential, the identity of those responding is not known and data is only provided in cumulative form. This data collection effort represents the first time such comprehensive information has been collected and served as the quantitative basis for the FRB s positions on the proposed rules. Key data from the FRB surveys included: Responses were received from 89 of the 115 covered FIs that offered viable debit card programs. All of the 14 networks surveyed responded. Overall debit POS transaction volumes, number, and average dollar value for the respondents are summarized below: Transactions Type # (B.) $ (B.) Avg. Amount Signature 22.5 $837 $ PIN 14.1 $584 $ Prepaid 1.0 $33 $ Total 37.7 $1,454 $ Source: Federal Reserve Bank

5 Page 5 January 2011 Average transaction Interchange rates reported by the FRB were: Interchange Fee Type Avg. Fee/Tx % of Avg. Tx. $ Signature $ % PIN $ % Prepaid $ % Total $ % Source: Federal Reserve Bank Signature debit transactions can be processed at about 8 million merchant locations in the U.S., whereas PIN debit transactions are currently accepted at only about 2 million merchant locations Proposed Interchange Fees Interchange rates, both credit and debit, have long been a source of irritation to merchants who argued that the rates were excessive and were non-competitive. Merchants point to the fact that while the network and issuer market became more competitive, which would normally result in lower rates, interchange rates have steadily increased over the last eight years alleging a lack of true competitive pricing forces. Issuers and networks countered that such fees were necessary to incent the issuers to promote debit card programs and cover increasing program expenses, while offering a lower cost, guaranteed payment product to the merchant community. Legislative Directive The Durbin Amendment directs the FRB to establish standards for ensuring that transaction interchange fees are reasonable and proportional to the cost incurred by the issuer with respect to the transaction. Senator Durbin has repeatedly said that the FRB would not set actual interchange rates, although this has turned out to be misleading. One of the more interesting elements in the legislation is that debit interchange rates the fee paid by the merchant acquirer to the card issuer are currently set by the individual networks, not by the issuers. Since the FRB, however, has limited, if any, jurisdictional authority over the networks, the legislation and the resulting FRB rules are being imposed on the debit card issuer which will, in turn, require network compliance. Proposed Fee Options The FRB has proposed two interchange fee options for review and comment. Option 1 has a cap of $0.12 per transaction, but includes a safe harbor provision up to $0.07 per transaction. Under this option, an issuer must validate on an annual basis the collection of any interchange transaction fee

6 Page 6 January 2011 in excess of the $0.07 per transaction that reflects their actual allowed costs, but in no case may the issuer collect more than $0.12 per transaction. The $0.07 safe harbor level was justified by the FRB as being the median variable per-transaction cost reported in the issuer survey responses. Option 2 is a much simpler proposal in that no validation will be required by the issuer, although the issuer may collect only up to $0.12 per transaction. The $0.12 cap in this option, as well as in Option 1, was reported as the median total transaction processing cost reported by the responding issuers. The FRB indicated that 20% of the issuers responding to the cost survey reported allowable transaction costs in excess of the $0.12 level but did not provide the high range of those cost values. In its Staff Commentary, the FRB noted that it had considered an option that would not have a fee cap or safe harbor amount. This option was not pursued as the FRB felt that an unlimited fee would provide no incentive for an issuer to reduce its operating costs; as well as believing that the enforcement effort to validate all the issuer s allowed operating cost computations would be extremely burdensome. The proposed rules limit cost elements to variable costs related to the authorization, clearance, and settlement (ACS) of the debit POS transaction. Fraud is currently being excluded from the cost calculation some industry analysts have estimated fraud at $0.02 per transaction. It is clear that the FRB has taken a very strict interpretation of the term cost incurred by the issuer with respect to the transaction in determining the cost elements that can be included in determining debit transaction expenses. While the legislative language only specified that FRB provide consideration for various cost elements related to the functional similarity of debit POS transactions and paper checks, the FRB did not allow any expenses associated with card issuance, network fees, or cardholder servicing; nor did it allow any provision for mark-up. Issuer Impact While issuers generally expected a reduction in interchange fees, the severity of the proposed rates came as a shock to most issuers. The $0.07 safe harbor level represents an interchange fee reduction of 70% for PIN debit and 88% for Signature debit from current levels reported by the issuers. The $0.12 cap rate corresponds to reductions for average PIN and Signature interchange levels of 48% and 79% respectively. With an estimated $16 billion in annual interchange fees currently collected, if the $0.12 cap is retained, it will represent an overall reduction in fee income to financial institutions of $11 to $12 billion from debit POS interchange fees. Coupled with the earlier fee income losses from the CARD Act and EFT overdraft fee regulatory changes, financial institutions will be forced to find other avenues of replacing this substantial loss of revenue. Since the FRB generally provides strong protection to consumers related to fees and charges, it was unusual that the FRB noted that cardholder fees was a

7 Page 7 January 2011 revenue source that could be used to offset unrecovered interchange income. While Senator Durbin continues to hold fast to his position that the proposed rules do not set a specific interchange fee, other influential politicians involved in the initial passage of the Dodd-Frank legislation have indicated that they are opposed to the FRB establishing any specific fees or range of fee limits. The banking industry, including FIs exempt from the legislation, are expected to make a concerted effort until the final rules are published to eliminate the specific interchange fee caps or increase them substantially. If interchange fees are reduced through government regulation, consumers would face higher costs through annual fees and increasing interest rates, as well as fewer choices. Independent Community Bankers of America This amendment will enhance transparency and help protect businesses and their customers alike from these unfair, hidden fees. Merchant Payment Coalition Other Issues The proposed interchange rates make no distinction between PIN and Signature debit card transactions, although there clearly is a major difference between the volumes for each type of debit POS transaction. The number of purchase points capable of handling a PIN-based debit POS transaction is substantially smaller than Signature debit POS transactions. The Fed s justification for lumping both debit transactions together was that the cost study indicated only a median higher cost of $0.02 for a Signature debit transaction over a PIN debit transaction, excluding fraud losses which are discussed later, although the FRB admitted that the variance in the cost data supplied did not permit them to have a high level of confidence in distinguishing separate rates. It is also important to note that there is no differentiation for CNP (Card Not Present) transactions. The FRB dismissed the option that interchange fee limits be set at the individual issuer level as well as the individual transaction level. The justification for eliminating this option was the introduction of undesirable economic incentives (i.e. no advantage in reducing operating expenses to peer bank levels) as well as the difficulty in administrating and enforcing compliance. Two additional options were mentioned in the Staff Commentary, but not formally proposed, for computing the total average transaction interchange fee. The first would allow an issuer to receive interchange fees in excess of the $0.12 cap for higher risk transactions as long as the overall average for all transactions processed in that reporting period did not exceed the $0.12 cap.

8 Page 8 January 2011 The second option was that individual issuer interchange fees could be set by a network as long as the overall network average interchange fee for all its members did not exceed the cap. The FRB has noted that a network could modify its network fee structure, i.e. lower network fees for issuers and raise them for acquirers, as a means to mitigate the negative revenue impact to issuers. The current position of the FRB is that such an adjustment would not be considered circumvention as long as the adjustment did not result in overall net compensation to the issuer. Similarly, incentive payments or individual issuer network processing fee reductions would be permitted as long as the net effect of such pricing adjustments did not result in overall net compensation to the issuer. Proposed Fraud Adjustment The legislation specifically instructed the FRB to consider adjustments to the interchange fee levels to incorporate allowances for losses related to fraud prevention efforts. It is important to note, however, that actual issuer fraud losses would not be considered as an allowable fraud cost element since the FRB holds the position that the existing EFT Act specifies that adjustments can only be made for activities that prevent fraud. As part of its data collection efforts, the FRB estimated total debit card fraud at $1.4 billion in 2009, which works out to about $0.04 per transaction. As expected, fraud losses from Signature debit were substantially higher than PIN debit with a 85% / 15% mix respectively. Losses on Signature debit were reported by the issuers as averaging 13.1 basis points compared to 3.5 basis points for PIN debit transactions. Fraud losses for Signature debit were reported to be split between issuers and merchants at 55% and 45% respectively. More than three-fourths (76%) of all merchant fraud losses were related to CNP transactions. Fraud Adjustment Proposal The FRB deferred in proposing any specific fraud adjustments at this time, indicating that due to the complexity of the issue it required additional time to determine how the adjustment would be implemented, what costs could be considered, and what minimum fraud prevention standards would be required as a pre-condition of an issuer receiving an adjustment. As a potential baseline, the issuers reported a median average of total fraud prevention activity costs at $0.016 per transaction with an additional $0.002 per transaction for data security costs. The Staff Commentary did not provide any information as to whether there were any significant differences in fraud prevention activity costs based on card transaction type. The proposal outlines two potential methodologies for dealing with the fraud adjustment issue. The first would provide issuers with the ability to recover some or all costs associated with implementing major innovative technologies to reduce fraud losses. Concern has been expressed that under this proposal

9 Page 9 January 2011 the FRB would identify those technologies that would be eligible for this adjustment. To its credit, the FRB did note that such a process could deter the development of technologies not on the FRB s designated list that might actually be more effective than those technologies identified. Technologies such as chip and PIN, tokenization, dynamic data, and end-to-end encryption were mentioned as early candidates for the technology list if such were to be developed. The second approach is to set a general standard of activities that an issuer must perform as a baseline and then to reimburse the issuer the cost of activities in excess of that baseline. Such an approach would prove difficult for the FRB to validate the incremental activity costs, but it does have the advantage of allowing each issuer to pursue those activities that it thought would be most effective in curtailing its fraud losses. The FRB has posed a number of questions soliciting comment from payment systems stakeholders. The full spectrum of these questions indicates the FRB s difficulty in dealing with this issue. The FRB appears to understand the legitimacy and value of allowing such an adjustment, but is struggling with how to allow reasonable adjustments within the confines of the legislation. Some of the major questions posed by the FRB include: What technologies should be required as a minimum? Should adjustments only be made for PIN-based transactions? Should the adjustment only pertain to fraud prevention activities that benefit the merchant? How should the costs of designated activities be measured? Issuer Impact Until specific proposals are confirmed, no solid impact to issuers can be determined. Of deep concern to the industry is the apparent FRB philosophy that the issuer bears the responsibility to develop fraud prevention processes that also reduce the losses borne by merchants. While citing the high percentage of overall fraud losses charged to merchants, it failed to account in their reasoning that most of those losses were related to CNP Signature debit transactions. Such a transaction type is selected by the merchant with the understanding that it is a high-risk transaction and additional liability is shifted to the merchant. The issuers, along with Visa and MasterCard, could take the extreme position of eliminating those transactions, but it would devastate the virtual transaction market, primarily Internet and telephone sales. Chip Card Endorsement? The fact that the FRB has raised the question as to whether a fraud prevention adjustment should be allowed for Signature debit transactions has created a perspective for many industry observers that the FRB could be de facto endorsing a migration to chip and PIN technology. While chip and PIN has been implemented in most other major parts of the world most recently in Canada there generally has been an admission that the implementation costs were not justified based solely on the reduction in fraud, as much of the

10 Page 10 January 2011 fraud activity moved to other channels that continued to use the card s magnetic strip. Merchants would also bear significant expenses in a chip and PIN migration by having to upgrade and certify all their POS terminals to be able to process a chip card. While chip and PIN are intuitively strong fraud deterrents there are examples of markets that have migrated to chip / PIN but have not fully realized the benefits of taming fraud losses. Merchant complicity in fraud as well as POS equipment compromise are cited as reasons for continued fraud losses even as chip and PIN are rolled out. Network Routing Until recently, issuers were generally in control over how their debit transactions were routed. Networks had operating rules that allowed issuers to designate primary networks and acquirers were required to route the transaction through that network. If an issuer was a member of multiple networks, it would generally designate the network that would generate the highest interchange income. Of course, the goal of the merchant was the opposite of the issuer; the merchant wanted the transaction routed through the network that cost it the least amount of network and interchange fees. Over the last few years, enforcement of this priority routing among the Signature and PIN debit networks has slipped considerably as many saw the handwriting on the wall and assumed that a merchant legal challenge would be successful. Routing table technology has improved significantly during this time and has allowed large merchants and acquirers to quickly determine the routing that will result in the lowest cost. While the large national and regional merchants have a major or final say in determining transaction routing, mid- to small-sized merchants depend on their acquiring processor for this decisioning. Since these merchants generally pay an overall discount rate that bundles merchant processing costs including the interchange fee, it is to the acquirer s advantage to route through the least expensive network in order to earn a higher margin. Only Visa and MasterCard have the ability to support both Signature- and PIN-based debit transactions. Since the launch of its debit processing business, Visa has successfully signed major debit issuers to long-term exclusive debit processing contracts for both Signature and PIN transactions. Over the last several years, MasterCard also began to pursue such arrangements with some level of success. It is clear that such exclusivity will not be permitted so issuers with such arrangements with either MasterCard or Visa will be required to secure additional network relationships. Proposed Routing Alternatives The FRB has proposed two network routing options that represent the extreme ends of available options. The first option (Alternative A) would require at least one Signature network and at least one PIN network with the additional

11 Page 11 January 2011 condition that the two networks not be affiliated. Visa is the clear loser in this prohibition with MasterCard to a significantly lesser degree. Merchant routing options are also eliminated as it is the cardholder who makes the decision as to whether the transaction will be PIN- or Signature-based if the merchant supports both types of debit card transactions. The second option (Alternative B) represents a complete disruption of the current Signature debit business environment in that it would require every large issuer to have relationships with at least two Signature networks and at least two PIN network options. If only two networks are selected in each transaction type, the networks cannot be affiliated. Such a requirement would basically destroy the business models of Visa and MasterCard related to the Signature debit business with severe implications to their larger credit card business. The FRB acknowledged the complexity of such a requirement. Additionally, the Act specifically prohibits issuers or networks from interfering with the ability of the merchant or acquirer to route the transaction over a particular network. Under this provision, the network s priority BIN routing rules are no longer valid. Additional Routing Alternative? Many believe there is a strong possibility that a third alternative will emerge in the final rules as a requirement that would represent a compromise between the two current alternatives. This alternative would require at least one Signature network and at least two PIN networks and neither of the PIN networks can be affiliated with the Signature network. Such an alternative addresses the difficulty and severe overall payment systems impact of the two Signature network requirements. It ensures merchants will be able to have a routing option choice on PIN debit transactions while eliminating the exclusivity network arrangements. These requirements can potentially add more complexity and cost in the form of BIN management, transaction routing and POS infrastructure changes. Additionally, if cards are indeed going to carry multiple competing logos there is the cost of re-issue which presumably becomes an issuer expense. Coverage Requirements It is important to note the proposed rules require that in order for a network to be considered on a standalone basis, the network must have complete geographic and merchant acceptance coverage. This requirement will have a significant impact on the mid-sized and small PIN debit networks as most have limited POS coverage. The Staff Commentary sets a high bar related to geographical coverage if the wording accepted throughout the United States is taken literally. Merchant acceptance is based on having both a large number of acceptance points as well as a wide range of merchant classifications where the card can be used. However, the FRB does not provide any objective standards for determining if a network meets that requirement and has solicited comment on how such a determination should be made.

12 Page 12 January 2011 Other Issues The rules also address a number of issues regarding network logos by including the following provisions: Networks are not permitted to restrict an issuer from enabling acceptance at any other network with which the issuer contracts Networks cannot demand that only its brand, mark, or logo be displayed on a card Issuers have the choice of which, if any, network logos will be displayed on their cards Prepaid Card Program Exemption As noted earlier, prepaid cards that are issued as part of a governmental benefit program, as well as general reloadable prepaid cards, are exempt from the interchange fee restrictions. Since the passage of the legislation and publishing of the proposed rules, there has been much speculation as to whether issuers will seek to develop prepaid card products to replace or supplement traditional debit cards as a way to mitigate the reduction of interchange revenue. While it appears that there are ways to craft such a product that would meet the strict language of the law, FRB will likely issue additional language in its final rules that will make it difficult to circumvent the intent of the legislation. Rule circumvention has been a key issue addressed by the FRB, with the expectation that the final rules will contain substantial penalties for issuers found to be engaged in such an activity. Payment Card Restrictions The banking industry additionally lost most of the battles dealing with a merchant s ability to restrict card usage. Included in the legislation are the following specific provisions: Merchants are permitted to offer discounts based on the method of payment, but are not permitted to impose surcharges based on payment type. Merchants cannot differentiate between issuers of the same payment card type. In other words, if a merchant accepts the debit card of one of the larger issuers knowing it will be charged the low interchange fee, it cannot refuse to accept a debit card of an exempt FI where a higher interchange fee may be imposed. Only applying to credit cards, restrictions as to minimum and maximum transaction amounts cannot be imposed by issuers or networks, although the FRB does have the authority to increase the minimum from the current level of $10 that a merchant can set for credit card acceptance.

13 Page 13 January 2011 Legal Issues There is already litigation in federal courts as to the constitutionality of the provision in the legislation dealing with the interchange fees. It can be expected that a number of legal challenges to other aspects of the legislation will surface once the final rules are announced in April and July Some of the key legal issues are described below: TCF Litigation On October 12, 2010 TCF Bank, with assets of $18B and based in Minnesota, filed a legal action in U.S. District Court challenging the constitutionality of the Durbin Amendment section of the Dodd-Frank Act. The first hearing, a request for a preliminary injunction, is not scheduled until April 4, 2011 two weeks before the final interchange fee rules are announced. The main legal claims cited by TCF in its lawsuit are: The Act is a violation of due process as it will prevent TCF from recovering all its costs including a reasonable return and should be considered confiscatory" It is unprecedented for Congress, or any regulatory agency, to mandate a fee charged in the free market that not only denies a reasonable rate of return on investment but actually requires the rate to be lower than the incremental cost of providing the service. William A. Cooper, Chairman / CEO TCF The exemption of thousands of financial institutions constitutes an unlawful regulatory taking by creating an uneven playing field and forcing a substantial financial and competitive disadvantage on TCF The financial institution exemption also creates a denial of equal protection As of yearend 2010, no other party has joined TCF in this action but it would not be surprising to see a number of other financial institution and banking industry groups do so. Price Controls Some contend that the FRB s proposed interchange fee caps represent price controls and the establishment of specific rates, even if only a cap, exceeds the legislative authority that specified the FRB was only to establish standards that would support the determination as to whether interchange fees were reasonable and proportional.

14 Page 14 January 2011 While price controls are relatively new in federal banking regulations, there is a long history of governmental price controls in other industries, particularly utilities and transportation companies, which are generally monopolies and a case can be made for pricing management. Political pressure may become an important factor with regard to this issue as a number of politicians who were key supporters of the overall Dodd-Frank Act have come out opposed to the FRB s suggested interchange fee cap. There is also speculation that due to the transfer in political control of the House of Representatives, there may be efforts to rewrite or eliminate certain provisions of the Durbin Amendment. Finally, the issue of price controls begs the question of the government s role in a free market economy. The U.S. payments market is vibrant and competitive and while regulation is important in steering the market, explicit pricing management can in turn become market disruptive. Network Contracts It is a standard practice for the large debit card issuers covered under the proposed rules to sign long-term (5 10 year) contracts with networks in exchange for marketing payments, transaction volume bonuses, and other forms of incentive compensation. Forcing an issuer to void an exclusive network agreement will have financial ramifications; the extent will be largely determined by the age of the contract. Network National Coverage As noted earlier, the proposed rules require an issuer to support a network(s) that has national coverage; but the FRB has not provided any standards that will definitively identify a particular network as meeting the criteria. Only a few of the PIN-based networks have true debit POS acceptance that S&A would classify as providing national coverage to cardholders. This is causing confusion and will require additional definition by the FRB perhaps to the degree that a network will have to be certified as being national. ATM Applicability Although the FRB has acknowledged that interchange fees for PIN debit card transactions completed through an ATM do not fall within the scope of the current legislation, it has nonetheless requested comment as to whether similar interchange fee reasonableness standards should be applicable to such transactions. Although S&A does not believe such an inclusion will take place in the immediate future, it is an issue that must be closely watched. Predicting the Final Rules Due to the wide range of rule options proposed related to interchange fees and network routing; the deferral of addressing fraud adjustments; as well as a substantial number of questions raised by the FRB on other related issues, it is difficult to predict the final rules that will come from this process. With that

15 Page 15 January 2011 caveat, S&A believes that a number of considerations will govern the eventual development and publication of these rules. The FRB will not back off its assertion that it has the authority to establish specific interchange transaction fees or fee ranges. If contested, the final resolution of this issue will come through the judicial system. The simpler interchange fee cap (Option 2) is likely to be adopted as it will make computation and compliance easier for all involved parties. There will be considerable pressure by the banking industry to increase the interchange cap by justifying the inclusion of some additional cost elements. Fraud adjustment standards will be a contentious issue and will not be finalized until the last half of 2011 and may not be effective until early Issuers and merchants will continue to resist chip and PIN implementation in the U.S. due to increased card issuance, acceptance, and support costs. Issuers will continue to pursue enhanced neural network fraud detection capabilities and other non-chip tools. A blended option with regard to network routing is likely to be developed that will require issuers to have a single Signature debit network and at least two PIN debit network choices, neither of which can be related to the Signature debit network. Winners and Losers There is no question that the various debit card payment stakeholders will be impacted in different ways and to different degrees. Until the rules are solidified and each involved party has its opportunity to respond and adjust, the new playing field is uncertain territory. There are, however, some clear indications of who will emerge with greater powers and who will lose ground. Merchants The overall merchant sector is a clear winner. However, only the large national merchants will truly and directly benefit as most have the ability to negotiate individual transaction fee terms with the networks. With the elimination of the distinction between card present and card not present interchange rates, ecommerce merchants stand to benefit greatly, as long as issuers continue to support acceptance of their cards at such merchants. Merchants will place additional pressure on their processors to develop the technology necessary for intelligent BIN routing tables so that debit card transactions are routed through the least cost method. As noted earlier, small- to mid-sized merchants generally have the interchange fee bundled with other acquirer fees in their flat discount rate. While informed merchants will request renegotiated rates, some acquirers will cite other sources of increased costs to justify holding the discount levels at their current level. It must be noted that there is no incentive for acquirers to price either small- to medium-sized merchants (with bundled pricing) differently or pass on any savings to merchants.

16 Page 16 January 2011 Although merchant trade groups insist that the merchant community will pass along the savings through lower prices, there is, of course, no way to independently prove such an outcome due to the numerous factors associated with merchandise or service pricing. Indeed, the merchant associations have resisted any direct commitment to passing along interchange fee savings to the consumer. There is also little if any industry precedent for consumer savings based on a reduction in payment acceptance costs. S&A does not believe merchants will take advantage of the power to provide discounts to consumers paying with cash or checks over debit or credit cards. Based on previous payment study costs conducted by S&A for merchants, debit card payment costs, when considered on a total basis, are less costly than acceptance of cash or checks with most merchants. A possible exception might be gasoline retailers migrating back to the cash vs. credit card pricing differential that was common decades ago and still exists in certain geographical markets. It will be interesting to see if merchants offer incentives for the use of debit cards over credit cards due to the major interchange differential that will exist between the two. With their resolve strengthened by this major legislative victory, the merchant industry may now target credit card interchange fees. While the level of reduction would not be as severe due to the major differences in risk and funds costs between debit and credit programs, merchants believe the congressional and FRB reasoning behind debit card interchange rate reduction can be applied to credit cards. While such an effort will not be visible immediately, the lobbying effort is already underway. Networks A wild card in determining how significantly the debit payments landscape will change is the networks and the final rule regarding the number of Signature and PIN networks an issuer must support. There will be fierce competition among all the networks as debit payments undergo an extreme makeover to retain their existing members as well as gain new customers. In particular, those networks that are owned by companies providing core bank processing services will have strong growth opportunities in the small- to midsize FI market. While the issuers over $10B represent only about 1.5% of the total number of FIs operating in the U.S., S&A estimates they represent about 50% of total debit card transaction volume. Networks that have large issuers as members may find it difficult to provide a two-tiered interchange fee structure that provides a financial advantage to the smaller exempt FIs (although Visa announced on January 7 that it plans a dual interchange rate structure). On the other hand, the smaller networks will be likely to offer such a structure since the majority of their membership are exempt FIs who clearly want to retain the higher interchange income levels. The small- and mid-sized networks will work diligently to expand their POS coverage area in order to qualify as a national network. S&A believes that further network consolidation will occur in order for these smaller networks to

17 Page 17 January 2011 achieve the necessary level of critical mass. While difficult to foresee it is not implausible to consider the entry of additional payments networks (or new players) into the debit industry on a niche or segmented basis. Networks will be required to modify their interchange rate tables, although the level of change will be highly dependent upon the final rule regarding network routing. Networks may be required not only to establish individual FI interchange rates, but also different card products (debit and prepaid) within an individual FI. Issuers The severe financial hit that debit card issuers will suffer is undeniable, forcing FIs to find alternative revenue sources. Many banks have already projected their revenue shortfalls and have taken steps to mitigate the short- and longterm impact of this outcome. These actions, along with other changes wrought by recent regulation, will alter retail financial service strategies for some time to come. Reviews of network membership will be a critical item in order to maximize network incentive payments. Discontinuation of rewards programs based solely on Signature debit card usage. Issuers that have their own credit card portfolio might actually transfer or enhance credit card reward programs to retain the higher interchange fee revenue. Exploration of the usage of prepaid card programs not directly linked to a deposit account and business debit cards that are exempt from the interchange rate constraints. While the FRB will look at such programs closely, the legislative exemptions to general prepaid card programs permits FIs to develop such programs. Business credit card programs have been successfully targeted in recent years and FIs will develop debit card programs oriented to these same businesses. Additional restrictions on free checking products will be implemented. Limits on the number of free debit POS or ATM transactions; higher balance level requirements; and monthly / annual debit card fees are all possibilities but must be carefully considered from a competitive standpoint. Steering of customers from debit to credit given higher credit interchange. Development of new payment products, e.g. deferred debit that may operate under the aegis of credit regulations (and interchange) Depending on final fraud adjustment rules, issuers may threaten the nuclear option of eliminating zero liability programs to the cardholder and guaranteed payment to the merchant, although the latter is unlikely. Consumers Based on experiences in other countries, consumers will be the overall losers in the long run from the changes currently proposed. As cited in the recent study by the U.S. Government Accounting Office after the Australian government intervened with slashing credit and debit interchange rates in 2004, consumers ended up paying higher costs for card transactions and reduced rewards programs. The study found that increased card product and transaction fees levied by issuers more than offset any savings that were

18 Page 18 January 2011 passed along to consumers. In addition, the legislation allowed merchants to apply surcharges to card transactions clouding pricing transparency. While the final rules will determine issuer, network and merchant strategies, each party will strive to maintain their operating margins in the new debit payments world. Consumers will be required to adjust to new deposit account fee schedules, higher balance requirements, lesser rewards programs, and similar revenue generating or cost controlling initiatives. Senior Management Issues While the final rules will not be released until late April, now is the time for banking management to be assessing the potential impact of Durbin based on the various scenarios outlined in the proposed rules. To wait until the final rules are published would place the bank at a disadvantage due to the lead time required for product development and enhancement, pricing changes, and the evaluation of current network relationships. In preparation for Durbin implementation, senior managers may want to consider some key issues: How will these proposed changes affect my overall consumer payments strategy? How are my current debit card processing and network contractual relationships going to be impacted? What changes do I need to make to minimize network fees and mitigate the loss of interchange income? Has my bank recently evaluated debit card strategies, addressing both Signature and PIN cards, with a focus on branding, customer relationships, and perceived value among targeted segments? Does my bank have a complete understanding of the financial structure of my debit card programs down to the card and transaction type? Have we developed reliable cost analyses for all debit card types and programs considering interchange revenues, cardholder fees, debit access account pricing approaches, and special revenue sources? Have we reviewed our debit card rewards programs to assess the cost / benefit impact of these programs in the new interchange dynamic? Should we modify the program to earn a larger share of the customer s wallet? If appropriate, have we reviewed our merchant relationships and the mix of credit and debit transactions that may be altered in the new debit environment? Have we considered migration to a general prepaid card program to address the needs of selected customer groups and provide an exemption to the reduced debit interchange rates?

19 Page 19 January 2011 For additional information about S&A s consulting services, please contact: Marilyn Parker at Marilyn.Parker@speerandassociates.com Strategic Commentary is a publication addressing the strategic and management issues facing financial services executives. It is produced exclusively for Speer & Associates, Inc. clients and friends. It may not be reproduced or copied without permission. The annual subscription rate is $995. For subscription and renewal information, please call or visit S&A online at