Fed Proposes 12-Cent Interchange Fee Cap on Debit Cards

WASHINGTON — The Federal Reserve Board is considering a 12-cent fee cap on interchange fees for debit transactions as part of new regulations to rein in merchant costs of processing payments.

But the central bank's proposal for debit card fees released Thursday left more questions than answers as it floated numerous options for regulating the industry.

Under one alternative, issuers could calculate their own fees based on an analysis of certain processing costs, including authorization, clearance and settlement costs.  Issuers would receive a safe harbor for any fee up to 7 cents, and could not charge a fee above 12 cents per transaction.

Under a second alternative, issuers would simply be subject to an across-the-board 12-cent limit.

The agency's proposal was the first step in implementing new reforms from the Dodd-Frank Act requiring debit fees to be "reasonable and proportional" to the cost of processing a payment.

While the proposal appeared to put forward tough new standards, Fed officials said the rulemaking needed to be developed carefully.

"Although it is important for us to act expeditiously, both to meet the requirements of the law and to establish regulatory clarity as soon as possible, the proposal today is one that deserves particularly careful attention from the Board, in light of debit cards' increasingly important role in the U.S. payment systems," Fed Chairman Ben Bernanke said in his opening remarks.

Under the proposal, summarized in a staff memo, an issuer could only use interchange fees to recover "their variable costs that are directly attributable to authorization, clearance and settlement of the transaction." As a result, issuers could not use fees to recover other types of costs, such as that from distributing debit cards, branch costs and overhead.

The proposal stayed clear of a standard "cost-to-fee" ratio for all issuers. Instead, the memo said, that ratio could fall below a safe harbor or cap determined by the central bank.

Under the first alternative, an issuer could determine fees that exceeded the 7-cent safe harbor with a calculation of its "average variable cost for authorization, clearance, and settlement" of transactions. "To minimize burden and facilitate compliance, an issuer would be permitted to rely on a safe harbor, instead of determining its maximum allowable fee based on its costs," a staff memo said.

Even though fees could be higher on average under the second alternative, the Fed said, the across-the-board cap still "provides an incentive for all issuers to reduce costs below the cap in order to retain a mark-up over costs." (The industry has until Feb. 22 to comment on the proposal.)

Although the proposal explicitly exempts institutions with $10 billion of assets or less, community banks have said they will likely have to follow the new restrictions anyway.

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.

During the meeting, Fed officials acknowledged that the issue was complicated, but said the central bank was trying to strike the right balance in the proposal.

"I believe staff's proposal reflects a reasonable approach to implementing these requirements of Dodd-Frank," said Fed Vice Chairman Janet Yellen during the meeting. "That said, we have included a number of questions in the Federal Register notice about alternative approaches to implementing different parts of the rule."

The issue of interchange fees has been a hornet's nest for years. Merchants have complained the major card networks are essentially committing antitrust violations in establishing an expensive fee structure in which a small transaction amount can be eclipsed by the interchange cost.

But banks and the networks claim merchants are simply worried about their bottom line, while the payments system affords the retail industry a huge convenience. Even though the new rules would not affect fee levels for credit card transactions, the provision — written by Sen. Richard Durbin, D-Ill. — still was controversial within the debate on the broader bill, with bankers and merchants mounting aggressive lobbying on both sides.

The bill also gave retailers cover to set minimum transaction amounts for which they will accept a credit or debit card, as well as provide customer incentives for using a lower-cost card network over another. However, retailers cannot favor one issuer over another.