Debit Revenue Under Fire, Rewards Need a Revamp

Issuers appear to have lost the battle with retailers over debit card interchange fees, but that does not mean they can't compensate, at least in part, for declines in revenue.

Analysts and consultants agree that a cut in debit interchange income will lead to a corresponding cut in the value of rewards that cardholders can earn, a smaller pool of offers from which they can choose and higher program fees.

And retailers are likely to face pressure from issuers to shoulder more costs for rewards programs. Should the merchants balk, banks may not just overhaul some debit rewards programs — they may eliminate them outright.

If "there's downward pressure on interchange, issuers … either need to reduce the value of rewards earned by the customer or they need to do some sort of repricing to make up for the shortfall," said Josh Gilbert, a senior manager with First Annapolis Consulting in Linthicum, Md.

JPMorgan Chase & Co., Wells Fargo & Co., Toronto-Dominion Bank, BB&T Corp. and other debit issuers declined to comment for this story, saying it was too early to discuss whether they plan to revamp their rewards programs if the Fed, as is widely expected, decides to reduce debit interchange rates.

Merchant-funded offers, such as those that enable a cardholder to earn a larger number of points or discount for purchasing from a specific retailer online or in person, are one way issuers could support rewards programs.

Merchant offers have become more common in recent years in retailers' efforts to drive traffic to their websites and stores.

"If a bank can direct business toward a merchant and work on their behalf to increase volume, then the merchant would be willing to pay some amount of money in the form of an offer to the consumer to attract that new business," said Lars Holmquist, the chief marketing officer for Vesdia Corp., a merchant network provider in Atlanta that works with retailers, loyalty program managers and banks.

"This sets up a more attractive economic arrangement that is a quid pro quo where the issuer works to bring business to the merchant and the merchants supply them with an attractive offer to the issuers' cardholders," Holmquist said.

Other ways banks could maintain debit rewards programs include limiting them to customers who use multiple services with a bank, or offering better programs to cardholders who enroll in online bill pay or direct deposit, said Mark Flamme, the director of the Midwest banking practice in the Chicago office of West Monroe Partners, a consulting firm.

Several issuers already have rewards tied to bill payment and other transactions, according to a recent "Bank Monitor Report" from Corporate Insight Inc. that looked at 31 checking account and debit card rewards programs offered by 12 companies.

For instance, a Capital One Financial Corp. checking rewards program offers customers 10 airline miles every time a customer uses online bill pay with the ability to earn up to 100 miles per month, according to Corporate Insight's report.

Flamme also said banks might offer cash-back rewards in the form of prepaid debit cards, which could then become another way for issuers to generate additional interchange revenue when the cards are used.

An agreement this week by conferees finalizing the financial reform bill all but guaranteed that a proposal to give the Federal Reserve authority to set debit interchange fees will be included in the bill. The proposal, which Sen. Richard Durbin, D-Ill., added to the Senate version of the reform bill, would enable the Fed to set "reasonable and proportional" debit rates.

"The rewards on the debit side will definitely not be nearly as rich as they are now, and there were many who would argue that the current debit reward level was low," said Bill McCracken, the chief executive of Synergistics Research Corp. in Atlanta. "What pretty much will happen is if a consumer wants rewards, they're going to have to pay for it in the form of annual fees."

In that sense, interchange legislation shifts the expense of debit rewards from an indirect cost consumers pay in the form of higher prices for goods to a direct cost, McCracken said.

However, measuring the direct impact on rewards programs is still difficult, noted Bryan Derman, a partner with the payments research firm Glenbrook Partners in Menlo Park, Calif., because of other cost pressures issuers face, including the potential loss of overdraft income from the new Regulation E requirements.

"It's not inconceivable, if Durbin had never happened, maybe rewards would have been watered down anyway as a way to mitigate the price increases that needed to happen," Derman said.

The National Retail Federation, a proponent of the interchange proposal, has estimated that merchants paid $20 billion in debit "swipe" fees in 2009.

Mallory Duncan, the trade group's general counsel, said studies show most card rewards go to upper-income people.

However, all consumers have to cushion the cost in the form of higher prices.

"One of the reasons this legislation is being introduced is to help prevent a kind of reverse Robin Hood that takes place when ordinary people have to subsidize the rewards of upper-class people on debit as well as on credit," Duncan said.

The majority of large issuers offer some form of a rewards program to their debit cardholders that enable customers to earn points or a percentage of cash back for debit transactions. These types of programs have become more common as more consumers have shifted from using credit to debit.

In a 2009 survey of 2,449 U.S. consumers by the payments processor First Data Corp., 45% of a subset of 286 respondents reported being a member of a debit card rewards program, versus 34% in 2008.

Issuers likely will reduce the number of points and percentage of cash back cardholders can earn on purchases or to raise the number of points needed to buy merchandise if interchange is capped, Gilbert said.

Fees to participate in a rewards program will go up or be added if an issuer is not already charging one.

Though banks may have little recourse to avoid such actions, they should be prepared to deal with the fallout from any, said Teresa Epperson, a partner with the financial services consulting firm Mercatus in Boston.

"It's going to be challenging, because the market does not like when things are changed," Epperson said. "Once someone is used to receiving a certain level of value or service, it's very hard to take that away from your customers. On the other side, the market is very sensitive to additional fees where the customers are not experiencing additional value. So the challenge-slash-opportunity is for institutions to provide value-added services … on top of these loyalty programs or in conjunction with these loyalty programs."