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December 10, 2012
The Interchange Fee Cap: One Year Later
Make no mistake about it, I'm a debit card person, and a PIN debit one at that. So I write this under full disclosure of that bias. I haven't written a check at a retail merchant in more than 10 years and no longer even carry a checkbook. Rarely do I have more than $10 in my pocket—just enough for the purchase of some miscellaneous small-value items. I have always found PIN debit to be a highly convenient form of payment due to its reliability, accuracy, speed, and general acceptance at merchants that I frequent. If I forget or lose a receipt, a quick check of my account online will always show the transaction so I can record it in the balance register.
I know I am in the minority preferring PIN debit, as signature debit has dominated the debit card market both in terms of transaction and sales volume. Consumers like signature debit because of its acceptance at significantly more merchants, and they don't have to worry about remembering a PIN. Pre-Durbin, issuers preferred that their cardholders use signature debit because it generated substantially more point-of-sale (POS) interchange revenue than PIN debit. Some issuers encouraged their cardholders to select “credit” when using their debit card so the transaction would be processed on the signature debit rails and qualify for the higher interchange rate. That was the rub with merchants, especially the larger, high-volume ones. Signature debit was more expensive for them to process. In response, merchants with PIN pads programmed their terminals to encourage PIN usage by designating it as the default debit payment method.
Then came the Durbin Amendment (part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) and the resulting implementation through Regulation II in October 2011 that changed the debit card world forever. The rule set a maximum interchange fee for signature and PIN debit and made no differentiation between the two, despite the overwhelming evidence that fraud losses on signature debit transactions were significantly higher than on PIN debit transactions. Although the final rule raised the interchange cap and reduced the fee-income hit to the issuers, forecasts of a diminished role in the market, especially for signature debit and other core bank products, came quickly from the bankers. A number of issuers that had established rewards programs linked to signature debit transactions (no or lower points for PIN debit transactions) announced plans to discontinue or reduce their debit rewards programs. Some major banks announced they would be imposing a monthly or annual fee for debit cards as a way to partially recover some of the revenue lost by the lower interchange fees. Another expected casualty was the free checking account. The banks said they could not afford to subsidize other account services without the fee income from debit card usage and the revenue loss suffered earlier in the year by the opt-in requirement for overdraft coverage for ATM and POS transactions.
Now, just over a year after the interchange cap took effect, what has been the result? There clearly has been a decrease in the number of rewards programs tied to debit cards as issuers sought to reduce program costs. Bankrate's 2011 Debit Card Rewards Study reported a 30 percent decline in debit rewards programs, even though the survey was taken before the interchange cap became effective. Not surprisingly, this study found that of the programs still operating, many were still offering reward points only for signature debit transactions.
Efforts by a number of the larger banks to impose a new debit card fee never gained traction. Many of the fee plans were dropped or modified to provide waivers if minimum balances were maintained. Free checking has certainly been a casualty as Bankrate's September 2012 Checking Survey showed that the number of banks offering free checking with no minimum balance requirement dropped from a high of 76 percent in 2009 to 45 percent in 2010, and then declined further, to 39 percent, in 2011.
Clearly, banks have suffered from the impact of Regulation II, with significant reductions in fee-income revenue through the lower interchange rate, especially for signature debit transactions. And consumers have a harder time finding debit rewards programs, and their account maintenance fees may have increased. The big winners have been the large to mid-sized retailers who have been able to renegotiate discount rates with their card processors. The merchant community says that consumers ultimately benefitted from the lower debit card processing expenses because the merchants have lowered or held steady their prices. However, the merchant claims are virtually impossible to validate since the pricing of goods and services is impacted by a large number of different elements, and interchange rates represent only a small one.
On a related note: the $7 billion class-action credit card interchange fee settlement recently received preliminary court approval amid opposition from some of the country's largest retailers and retailer industry groups. The litigation that originated in 2005 has used many of the same arguments that led to the passage of the Durbin Amendment legislation—primarily, that the interchange rates set by two major card issuers were arbitrary and excessive. Another major issue was that the payment card networks' rules prevented a merchant from implementing a surcharge to offset the increased costs claimed by merchants in accepting a credit card.
Clearly, the subject of interchange fees is not going to disappear anytime soon. What will be the longer term impact, if any, of the debit—and possibly credit—card interchange constraints? Will they impact the conversion of debit cards from magnetic-stripe technology to chip? We would like to hear your thoughts on who you believe are the winners and losers from Regulation II as well as its impact on debit and credit cards going forward.
By David Lott, a retail payments risk expert in the Retail Payments Risk Forum at the Atlanta Fed
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