The Death and Rebirth of Debit Card Rewards

Debit card rewards may survive in an era of regulated swipe fees, but they'll have to be funded differently.

That reality was reinforced twice in the last few weeks — first when a federal judge ruled that the two-year-old price cap on debit swipe fees must be lowered, and again when a Boston start-up that had been offering consumers a generous package of debit rewards went out of business.

Both developments also made clear that the heyday of cash-back rewards that rely on swipe fee revenue is past. The future of debit rewards — which have long helped fuel deposit growth for many banks — will hinge on the banks' ability to generate money by steering customers to specific retail partners.

PerkStreet Financial, which announced Aug. 12 its plan to shut down, had hoped to lure customers away from attractive credit card rewards offers. "We are obsessed with finding more ways to put more cash back in people's pockets," chief executive officer Dan O'Malley said in a 2010 interview.

Customers signed up online for a PerkStreet-branded checking account. Because the accounts were held at partner banks with less than $10 billion in assets, PerkStreet had a leg up over large banks that were subject to the 24-cent cap on debit card swipe fees. And the firm's branchless business model provided additional cost savings.

But countervailing factors eventually proved fatal.

Year after year of low interest rates made it difficult to make money from checking accounts. There were also drawbacks to being a start-up — incumbent banks had a built-in deposit base, so PerkStreet had to be more generous with rewards to attract business. "It's such a knife fight to acquire customers," O'Malley said in 2012.

Last year PerkStreet stopped offering 2% rebates for customers with at least a $5,000 annual balance. Now the company is shutting down after failing to secure additional funding from investors.

For all intents and purposes, "they're an online bank basically trying to dive into a space that's already incredibly competitive," says Aleia Van Dyke, a payments analyst at Javelin Strategy and Research. "And it's hard to make a lot of money in that space."

CEO O'Malley blames his company's demise largely on regulatory uncertainty and volatility in the banking industry. "The environment of the last several years just made it very, very hard to build a company," he says.

Ever since the passage of the swipe fee price cap as part of the Dodd-Frank Act in 2010, bankers have been looking to rebuild debit rewards using revenue from partnering retailers, rather than the diminished pool of interchange fees.

That shift could be hastened by the recent federal court ruling. The decision is subject to appeal, but assuming it's upheld, it would require federal regulators to cut the 24-cent swipe fee cap for large banks by half or more.

The court ruling also threatens to spark more competition in the routing of signature debit purchases, which in turn could reduce swipe fee revenues for small banks that are exempt from the price cap.

The idea of getting retailers to pick up the tab for customer rewards has undeniable appeal to bankers who've spent many years fighting with merchants over swipe fee revenue.

Merchant-funded rewards programs often use each consumer's shopping history to target specific offers. For example, a checking accountholder who frequently orders pizza from Domino's might get offers for discounts at a local competitor. A consumer who regularly shops in certain stores might earn points redeemable in gift cards.

One of the challenges for banks is proving to retailers that the rewards offers are adding to the merchants' bottom line.

"It's a bit of a chicken-and-egg situation," says Zilvinas Bareisis, a senior analyst at Celent who has written about merchant-funded rewards programs. "You need to bring in cardholders. You need to bring in merchants. And you need to have merchants dedicating significant parts of their budget to this program. That takes time."

The banks that offer merchant-funded rewards are competing with companies like Groupon and Living Social. Mobile wallets are likely to become bigger rivals in the next few years.

One advantage for banks is their control over detailed individual spending data.

Another edge is that banks often have longstanding customer relationships with retail stores. Bankers who are already making small business loans to merchants also have an opportunity to sign them up for a debit rewards program.

"The thing that makes it work is the feet on the street," argues Brian Riley, a payments analyst at CEB TowerGroup.

Merchant funding has been talked about as the future of debit rewards ever since the swipe fee price cap passed Congress, and a number of vendors are building such programs rewards for banks.

"Issuer-funded debit rewards has to fundamentally change from what it used to be," says Jay Valanju, the CEO of fisoc inc., one of the vendors competing to sign up banks.

His company concentrates on enrolling local merchants, arguing that mom-and-pop stores will see that it's worth their while to pay rewards to divert shoppers from Wal-Mart, Target and other big-box chains.

Fisoc's program, known as Buzz Points, begins with merchants and banks sharing the costs, but typically it is fully funded by the retailers within a few months, Valanju says.

Cadence Bank, a $5.7 billion asset institution with branches in the Southeast and in Texas, is among the banks that are using Buzz Points. Cadence's rewards program still relies on funding from both the bank and retailers, says Rick Claypoole, the bank's director of retail product management and marketing.

"It's a mix," he says. "Over time, we will look to shift the balance of that" in favor of merchant-funded rewards.

"The whole notion of ‘merchant-funded' is relatively new," Claypoole adds. "A lot more needs to be learned and proven and tested over time."

PerkStreet's now-defunct rewards program was also funded partly by swipe fee revenue and partly by merchants, according to CEO O'Malley.

He argues that merchant-funded rewards providers need to do a better job of proving to retailers that they are getting a good return on their dollars invested.

"I think we're bullish on the idea of merchant-funded rewards," O'Malley says. "I think it'll happen, but I think it might take two or three years."