Damage to Banks from Debit Card Ruling Goes Beyond Lower Fee Cap

The first part of last month's market-shaking court ruling on debit card fees was troubling enough for the industry.

U.S. District Judge Richard Leon essentially told the Federal Reserve Board to lower its cap on swipe fees to roughly half the current level. For larger banks that are subject to the price cap, the consequences are fairly easy to quantify: the 50 biggest card issuers will lose $3.3 billion in annual swipe fee revenue, according to an analysis by the Aite Group.

But that's not the half of it.

Perhaps just as significant, but less discussed, the judge also ruled that retailers must be given the choice of routing each signature debit transaction, as well as each PIN debit purchase, over at least two card networks.

That decision is obviously a major victory for retailers, which would gain the ability to play the card networks against one another on signature debit sales. It also has negative implications for Visa (NYSE: V), whose stock price plummeted following the ruling, and mixed ones for MasterCard (MA), whose share price rose. And it may signal trouble for community banks that are exempt from the two-year-old statutory price cap on debit card fees.

"There is a slippery-slope scenario where interchange fees for the community banks slide," says Eric Grover, a payments industry consultant.

The district court ruling may not be the final word. The Fed has not said whether it will appeal. A status conference before the judge Wednesday may provide clues about the agency's intentions.

But even some staunch opponents of the 2010 amendment to the Dodd-Frank Act by Illinois Sen. Richard Durbin say the judge's decision is unlikely to be overturned.

"Success on appeal looks slim because Judge Leon's greatest sin was to give an accurate reading to a perverse statute," writes New York University Law Professor Richard Epstein.

What follows is a look at how the court's decision on routing rules is likely to affect the multi-billion dollar debit interchange market.

How do the debit card routing rules work today?
The Durbin amendment required the Fed to write rules ensuring that merchants have the option of at least two or more unaffiliated networks over which to route debit card purchases. The idea was that allowing merchants to choose the lower-cost option would put downward pressure on swipe fees.

In response, the Fed wrote a rule that allows debit cards to carry only one PIN debit network and only one signature debit network, as long as the two networks are unaffiliated.

Before the rule took effect, Visa held a dominant position in the U.S. debit card market, with some card issuers using only Visa's PIN and signature networks. After the Fed's rule took effect, those exclusive arrangements were no longer allowed.

One effect of the Fed's new rule was that Visa lost market share in the PIN debit market to MasterCard, as banks added a second PIN network to their cards, giving retailers more choice. But Visa also found ways to mitigate the impact of the rule.

The Fed's rule has not had much impact on signature debit transactions, which make up more than 60% of the total market. Most debit cards currently carry one signature debit network, either MasterCard or Visa.

What does the court's ruling require?
Judge Leon concluded that the Fed must allow retailers the choice of two unaffiliated networks for each individual purchase — whether the consumer elects to make a signature or PIN debit transaction.

"Congress's focus was on the number of networks over which each transaction — as opposed to each debit card — can be processed," he wrote.

 "It is clear that Congress intended to put an end to exclusivity agreements and increase merchants' choice among debit-processing networks, not restrict that choice or even preserve the status quo."

In many cases, debit cards already carry two PIN networks, so there may not be much impact there. But the ruling is expected to have a significant impact on the signature debit market.

"It'll mean, in some form, competition on signature transactions," says Douglas Kantor, a lawyer who represents merchants in the suit against the Fed.

Wait a second. Does that mean we could see debit cards that have both the Visa and MasterCard logos on the front, the way most debit cards today have multiple PIN debit network logos on the back?
Not necessarily. Depending on how the rules are revised, an issuer may have to let the merchant route a signature debit transaction on more than one network, but it probably won't have to advertise that fact to the consumer. A card might still say "Visa" only on the front, and as far as the cardholder is concerned it would be a "Visa card," but behind the scenes, the merchant's computer systems would allow processing the sale on MasterCard's wires.

So how is the signature debit market likely to change?
On July 31, the day Judge Leon announced his decision, Visa's stock price fell by about 6%, while shares in MasterCard rose by the same percentage.

Investors appear to be predicting that market share in the signature debit market will move closer to a 50-50 split between the two giant card networks as a result of the judge's ruling. Today Visa has about two-thirds of the signature debit market, while MasterCard has about one-third, according to analysts at Barclays.

"In a scenario where you have a second network added to a card, you probably open up the possibility of MasterCard taking up some market share," says Sanjay Sakhrani, an analyst at Keefe, Bruyette & Woods.

But it's not all good news for MasterCard. Analysts warn that network fees on signature debit purchases — which retailers pay to the network that routes each transaction — are likely to fall as a result of the new rule.

"The network fees are going to get squeezed, and that squeezing will be significant," Grover predicts.

Are other networks likely to become players in the signature debit market?
There is a third signature debit network, which is owned by Discover Financial Services (DFS), but it does not have a significant presence in the market.

A new rule requiring that each debit card carry at least two signature networks could offer an opportunity for Discover. "I think Discover would be a player, and I think they'd be aggressive," Sakhrani says.

In an email, a Discover spokeswoman said the judge's ruling reopens the debate over debit network competition, but also declined to speculate about the ruling's impact on Discover's business. "We prefer to compete on a level playing field, and will continue to champion competition whatever the outcome of this case may be," she wrote.

Another possibility is that one of several other companies that currently operate PIN networks will launch a signature network to compete with Visa and MasterCard.

What is the likely impact on community banks?
Banks with less than $10 billion in assets are exempt from the Durbin amendment's price cap. But following the law's passage, community bankers predicted that the new two-tier pricing system would not hold up, and that small banks would eventually receive the same lower interchange fees that their larger counterparts get.

So far that prediction hasn't been borne out. In the three months after price cap took effect, interchange fees at large banks fell from an average of 50 cents to 24 cents, while at small banks they fell only from 45 cents to 43 cents, according to research by the Kansas City Fed.

But a revised rule by the Fed could put new downward pressure on signature interchange fee prices at banks with less than $10 billion in assets.

That's because retailers, when presented with at least two routing options, will have an incentive to choose the lower-cost choice. Any new routing rules would also apply to the bigger banks, but because of the price cap, their swipe fees will already be low enough that there won't be as much room for price competition.

"The fact that the merchant will have the choice of which of those four networks to route the transaction at the point of sale will put the community banks at a severe disadvantage," says Camden Fine, president of the Independent Community Bankers of America and an ardent opponent of the Durbin amendment. "That's horrendous for the community banks."

On the other hand, the card networks will not want to lower interchange fees to the point where card-issuing banks begin to look for a new network to align with.

"The issuers have some ability to keep the interchange fees from falling," Grover says. "Certainly the retailers would love to find a way to attack that pool of higher interchange fees, but it's difficult."