Big Revenue Hit Coming as Fee Plan Stuns Banks

WASHINGTON — The Federal Reserve Board's proposal to restrict interchange fees on debit cards came out much tougher than expected on Thursday, causing one industry representative to dub it "horrendous" policy and spurring a stock drop at the two largest payment networks.

The proposal left plenty of room for the Fed to maneuver as it works on a final rule, but suggested the central bank is seeking to cap such fees at 12 cents. That is far below current levels, according to Fed analysis. On the average debit card transaction of $40, for example, the fee is around 24 cents.

Industry representatives strenuously objected to the plan, warning it would set precedents for government price controls in other industries.

"It's much more erroneous than we anticipated," said Richard Hunt, the president of the Consumer Bankers Association, who said the plan was "horrendous, horrendous policy."

But it was not just bankers who were upset.

The stock of Visa and MasterCard took a hit in the afternoon, with Visa's shares closing down 12.7% at $67.19 and MasterCard's shares closing down 10.3% at $223.49.

Visa declined to comment on the proposal. MasterCard issued a press release that said the Fed had failed to follow Congress' "statutory directive to consider the full range of costs incurred by issuers."

Noah Hanft, the general counsel for the Purchase, N.Y., payments network, said consumers would be the biggest losers in the regulation.

"This type of price control is misguided and anticompetitive and in the end is harmful to consumers," Hanft said. Tien-tsin Huang, an analyst who covers the payments networks for J.P. Morgan Securities, said in a research note Thursday that the Fed's proposal did little to clear up the potential negative results Visa and MasterCard face.

Under the proposal, the Fed said banks could receive a potential safe harbor for rates of 7 cents or below, but would be allowed to set them up to 12 cents to pay for processing costs of the transaction. Under another option, the Fed would not offer a safe harbor but would still cap rates at 12 cents.

A rate of 7 to 12 cents per transaction represents an 80% to 90% cut in the "blended average" for current signature and PIN rates, Huang said.

Several debit card issuers, including JPMorgan Chase & Co., Wells Fargo & Co. and Capital One Financial Corp., declined to comment.

Jaret Seiberg, an analyst for the Washington Research Group, said in a note to clients that "we have trouble seeing much that is positive here" for banks.

"Issuers will lose more on higher cost purchases and may gain on very small purchases," Seiberg said.

Ken Clayton, the senior vice president of card policy for the American Bankers Association, said despite the fact that Congress required the Fed to write interchange restrictions, the central bank could have taken a less restrictive approach.

"Setting a safe harbor at 7 cents will result in a very significant reduction in the kind of bank revenue that supports fraud prevention, low cost banking services, and the ability to make reasonably priced loans," he said. "The 12 cents is still significantly below what the marketplace currently permits."

Retailers, who had successfully pushed Congress to adopt a provision in the regulatory reform bill that required the Fed to set debit card rates that were "reasonable and proportional," were more pleased.

"Today's announcement is a step forward for the effort to bring relief to merchants and consumers who for too long have faced excessive fees and unfair rules imposed by big banks and credit card companies," said Katherine Lugar, executive vice president for public affairs for the Retail Industry Leaders Association. "Proposed cost reductions will undoubtedly result in savings for consumers."

But it was an open question whether that was true.

Some on the Fed board suggested consumers were unknowingly paying more for many services regardless of whether they were using debit cards.

"It's highly likely that all consumers — whether or not are they are using a debit card for their purchase — are paying more at the store and paying more at the pump because these interchange fees are getting passed on to them," said Gov. Sarah Bloom Raskin.

Raskin also noted that this kind of regulatory intervention is "unusual," and such directive means that the market is "working less than competitively." She said that is partly a result of recent consolidation in the credit card issuer market, which is now dominated by a few players.

But Fed staff also noted that banks use revenue from interchange fees to offer reward programs and cut costs on deposit accounts. As a result, banks could trim reward programs and raise fees on consumers if the proposal is finalized.

"The banks use the revenues from these interchange fees to offer more effective deposit account terms to their customers, including in some cases rewards for making payments with debit cards," said Robin Prager, an economist at the Fed's division of research and statistics.

Fed officials indicated they would listen very carefully to comments on the plan, noting that this is a new area for the central bank.

"Sometimes when we put out a proposed rule, we're pretty convinced that we basically got it right absent something we didn't expect getting in," said Fed Gov. Dan Tarullo. "The difficulties in implementing this legislation, the subtleties the staff have had to deploy trying to come up with a proposal both suggest to me that we should be more than perhaps usually open to a variety of comments."

Fed staff made it clear that the impact of the proposal would depend largely on how merchants and banks implemented the new rules.

"It's somewhat difficult to tell how ultimately this will change the competitive landscape going forward," said Louise Roseman, director of the division of the Reserve Bank Operations and Payment System.

The proposal would also seek to limit network exclusivity. Under one alternative, a card issuer or payment card network would have to ensure a debit card transaction could be carried on at least two unaffiliated networks.

The Fed said that could include one signature-based network and one PIN network as long as those networks were not affiliated.

Under another alternative, an issuer or card network would have to ensure a debit transaction could be processed on at least two unaffiliated signature-based networks and two unaffiliated PIN-based networks.