Banks and credit unions that issue debit cards should brace for a range of challenges if the Federal Reserve advances a plan to amend certain regulations for card-not-present transactions.
The Fed has proposed clarifications to the Durbin amendment’s Regulation II, which required the agency to place limits on the fees banks can charge retailers for debit card transactions. The Fed has suggested that one change, requiring that card-not-present transactions must be capable of being processed across at least two competing networks, would be “non-substantive” in terms of new obligations and compliance.
A glance at the more than 450 comments to date shows that this has become the latest battleground between issuers and merchants over interchange and enforcement of Reg II.
If this proposal is enacted with no further clarifications, the implications for issuers could be very substantive from contractual, financial, and compliance perspectives, making this a topic bankers need to monitor closely for a potential impact on their bottom lines.
To fully understand the current environment, a brief history lesson is in order. The Durbin amendment in the Dodd-Frank Act gave rise to Reg II, which established standards to ensure issuers participated in at least two unaffiliated debit networks and that debit card interchange is “reasonable and proportional” to costs for issuers with at least $10 billion of assets.
The result was an immediate and dramatic reduction in debit interchange rates for institutions with more than $10 billion of assets — particularly for dual-message (signature) transactions, which today stand at barely one-third of 2011 levels. In percentage terms, interchange rates remain lower for every major debit category compared to a decade earlier.
The result was a windfall for merchants — at the expense of card issuers and consumers. Though the legislation was sold as pro-consumer, the Fed’s own research suggests merchants did not pass on any savings to consumers. With margins severely curtailed, issuers cut card rewards programs and the number of unbanked Americans rose substantially.
When Reg II was created, the Fed believed the market for card-not-present transactions was not mature enough to have solutions to support two unaffiliated networks for online transactions, so the agency was silent on the issue. While some domestic debit networks now support card-not-present transactions, the business case for enablement is murky, and certain issuers have elected not to opt in. So, the Fed has said it feels such practices are inconsistent with Reg II and must be addressed with this clarification.
In theory, the current conversation is limited to Durbin’s requirement that issuers make at least two network options available for all debit transactions, which has not always been the case for the fast-growing card-not-present category. But industry advocates have used the Fed’s comment window to revisit broader grievances tied to interchange.
Retail associations and merchants like Kwik Trip want the Fed to step in, from an enforcement perspective, and mandate that two networks be enabled as early as the holiday season. They also want the Fed to reexamine the regulated interchange rate, arguing that issuer costs have declined by almost 50% since the ceiling was set in 2011, with no adjustments having been made.
Issuers and associations like the American Bankers Association and the National Association of Federally- Insured Credit Unions caution that the proposal could have unintended consequences for safety and security, and a financial impact similar to the original Reg II rollout. They have strongly suggested that the Fed take more time to analyze the potential impact to issuers and consumers.
Practicality is another consideration. Depending on how the Fed interprets the two-network requirement, the proposal has raised questions around compliance obligations issuers will need to monitor. How can issuers ensure that every merchant accepts both of their card payment networks? Does an issuer need to support all merchants even if one is considered high risk? How will innovation be handled if only one network supports an emerging capability?
The proposal could also prove bedeviling for smaller credit unions and banks. If the past is any indication, the revenue fallout from lower interchange could have the greatest impact on smaller institutions. If card-not-present volume shifts from national card networks to regional card networks, smaller issuers could potentially run the risk of failing to meet certain contractual obligations and commitments with their networks. The net result of this potential change could be rapid consolidation among community banks and credit unions and an increase in unbanked Americans.
While debit interchange rates are not part of the proposed changes, the Fed left the door open, stating it will continue to review the regulation and may propose more revisions in the future. And Sen. Richard Durbin, the Illinois Democrat for whom the amendment is named, brought up the topic of credit interchange in the Judiciary Committee earlier this year and he seeks bipartisan support for further refinements to Reg II, including a potential expansion to credit transactions.
Issuers should watch and plan for the proposed changes by taking inventory of their existing relationships and evaluating the implications of probable change occurring as early as next year.
New contractual relationships should be carefully considered, including commercial terms, given the uncertainty. Issuers should actively engage their government relations areas and make this issue a priority at the local and national level, while working with their associations. We encourage issuers to submit feedback to the Fed by Aug. 11.
