On Wednesday the Fed issued its "final" Durbin regulation, Reg. II. The release is 307 pages. Amidst many details about subaccounts, fraud costs and routing options, there is a clarion wake-up call to the retail banking industry.
The Fed calls out what many bankers failed to notice:
Highly successful, rapid growth products labeled as "prepaid cards" are not in fact prepaid cards.
These so-called prepaid cards therefore will not qualify for the exemption from interchange restrictions accorded by Dodd-Frank to prepaid cards.
The "prepaid cards" sold for instance by Green Dot and NetSpend are in fact electronic transaction accounts.
These products are transaction accounts, says the Fed, because the money deposited into them can be withdrawn in ways that have nothing at all to do with a "card." For instance, money can be withdrawn by checks, ACH, or P-2-P and other account transfers.
According to the Fed's release a "prepaid" card is exempt from Durbin ... "only if the card is the only means to access the funds underlying the card." Hence, "...prepaid cards that provide access to the funds underlying the card through check or ACH" (p. 162) will be subject to the Durbin interchange restrictions.
These electronic transaction accounts compete, avidly and effectively, with the bank accounts that are generally referred to (increasingly incorrectly) as "checking accounts." Namely, these so-called "prepaid cards" seek to serve as the household hub account through which income and expenses flow. The business strategy is to supplant branch-based consumer checking accounts with a much less expensive alternative, also perceived as less risky by many consumers.
In general, the business model proceeds as follows:
First, the nonbank lays its plastic on the customer, either for free or for a small price. Mostly this has happened at retail locations, such as Wal-mart or CashAmerica. The apparent immediacy is stunning. Here's a consumer who's probably been turned down for credit cards-after long waiting. He can go to a bank branch, put in money, apply for a checking account — and possibly get a debit card sometime later.
But Green Dot and its fellow marketers, with their retail partners, offer a card right now. (Never mind that it may be a temporary card, and only activated after Patriot Act requirements have been met.)
Second, the new transaction account marketers have been way ahead of banks in recognizing the crucial importance of getting direct deposit of the customer's pay. They emphatically promote incentives for this. They have the advantage of structuring a new relationship that offers multiple selling opportunities-for instance, at activation. (When I ask bankcard marketers what they sell at activation, the most common response is: "Nothing. The activation people don't work for us, they're Operations.")
Third, having carried out the initial payments, usually through a retailer, these companies are agile at moving the customer away from expensive bricks and mortar (payments at partner locations, from which they scarcely profit) into low cost and highly flexible electronic withdrawals — P-2-P, bill pay, account transfers. To banks, such payments by "checking account" customers are an expensive nuisance. In the new electronic transaction accounts, such payments are the key to saving the customer money and time, consolidating a stable hub position.
Finally, the electronic transaction accounts generally don't charge anything like an overdraft fee. So, the consumer feels safe. He won't be surprised by large penalties.
Furthermore, many people just don't like doing business with banks, and the fact that these accounts are advertised by nonbanks (but with FDIC insurance!) is actually a selling point.
This business model is not perfect. Many customers don't continue for long. Pricing is declining rapidly. But for sure the product has been highly profitable up to now. The most profitable customers for the new accounts are the ones who have been profitable bank customers — and whom the banks would prefer to keep. Often these people have had inactive bank checking accounts.
It's always possible to find small or hungry banks willing to domicile the electronic accounts for a small fee, without involvement in marketing or operating risks. You can also expect the "prepaid card" issuers to buy or open banks.
So, how can banks respond to this unconventional product and pricing competition?
Charge more, maybe $10 per month for a checking account — when the transaction accounts are going down to $0 and some include unlimited free payment by check? Open hundreds of expensive new branches because "That's what (some!) customers want"? Wait for the CFPB to limit check overdraft fees?
No, banks must compete with electronic transaction accounts the way they have started to compete with fully electronic, Internet savings, money market and CD accounts: by offering the better mousetraps first offered by these new competitors, with their much lower cost structures, to which consumers have already beaten increasingly well-traveled paths.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of Providian Financial Corp. He can be reached at akahr@creditbuilders.us.com.
