The changing face of debit cards amid COVID-19

February 18, 2021 10:36 AM

Debit cards appear ordinary, lacking the reward programs and prestige of credit cards, the cash flow flexibility of buy now/pay later programs, the anonymity of bitcoin and the coolness of cash.

But debit's one of the few payment methods that has shaken the financial services industry to its core, pitting bank issuers and merchants against each other as they argue over “swipe fees.”

Debit is a powerful tool for consumers, an important revenue source for financial institutions and a critical payment method for merchants, and it's importance has grown during COVID-19.

While large national banks, such as Wells Fargo, Bank of America and Chase, have a multitude of products to diversify income streams, community banks and credit unions don’t have the same luxury as they offer fewer products.

Debit interchange represents roughly one quarter of credit unions’ (27%) and community banks’ (24%) contribution as a percentage of their net income, based on data from the PULSE Network (Discover) 2020 Debit Issuer Study. In other words, any changes to the revenues earned from debit card usage can have a meaningful impact to these smaller institutions. Even the large regional banks generate a sizable portion of their net incomes from debit interchange.

The Durbin amendment, which passed as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, altered the competitive structure of the debit card payment processing industry and capped debit card interchange fees for banks with over $10 billion in assets. In pre-Durbin days, debit fees made up a much larger portion of the net income of regional and national banks.

Due to the Durbin amendment, banks have collectively lost over $90 billion in debit interchange between 2012 and 2019 due to the caps placed by the Federal Reserve, according to the Electronic Payments Coalition(EPC). The EPC reported that each year the lost revenues have grown and in 2019 alone, issuers lost out on roughly $14 billion in debit interchange.

COVID-19 has had a powerful impact in changing how consumers shop and pay for purchases, partly by preference, but also partly by merchants’ demands to keep their employees safe during the pandemic. That has led to changes such as the use of cash in-stores, as merchants have reduced or eliminated its acceptance and as consumers have decided to refrain from carrying banknotes.

Debit cards have benefitted in this move, according to the PaymentsSource Future of Money Survey. Our research found that in September 2020, about 44% of consumers were using a debit card as their primary payment method for in-store transactions compared to 35% during pre-COVID-19 times.

The biggest growth in debit card payment preference was among the two youngest generations, millennials and Gen Z. While millennials had the strongest growth which registered in at 13 percentage points, going from 28% in pre-COVID-19 to 41% during COVID-19, the Gen Z preference for debit was the strongest at 52%, up from 42% before the pandemic.

COVID-19 has had a stronger impact on changing payment preferences among communities of color, based on the Future of Money Survey, driving up debit card usage in-stores significantly. More than three-in-five (61%) Black adults reported using debit cards as their primary in-store payment method during COVID-19, up from almost half (47%) during pre-COVID-19 times. An even larger jump in payment preferences was reported by Hispanic adults who doubled their preference for debit cards in-stores to 60%, up from 30% in the pre-COVID-19 era.

The forces behind this rapid debit card adoption is partly explained by the PaymentsSource data series titled “The data on racial disparity in financial services.” The data series, it was revealed that communities of color had a much higher level of cash usage in stores before the pandemic, leaving them vulnerable to changes in merchant cash acceptance. Further the data series highlighted the FDIC National Survey of Unbanked and Underbanked Households, which reported on the lower levels of credit card ownership. White households had a credit card ownership level of 75.3% compared to 53.9% in Hispanic households and just 47.9% in Black households.

The net effect is that when merchants restricted or eliminated cash acceptance in stores during the pandemic, Black and Hispanic households were less likely to turn to credit cards due to their lower ownership levels and were forced to use the debit cards in their collective wallets.

Gross fraud losses on debit cards used in the U.S. are approximately five cents ($0.05) per transaction across all channels, however, after issuers are able to recoup eligible merchant chargebacks, the net fraud losses amount to just over one cent ($0.012) per transaction based on the PULSE Network study.

Unfortunately, fraud losses vary greatly by channel, with the most fraudulent transactions coming from the channel that is experiencing the greatest amount of growth – card not present (CNP). Despite this being a broad category, the vast majority of these transactions are generated from online shopping with a small amount coming from mail and telephone orders.

The gross fraud losses for the CNP channel are just over 13 cents per transaction ($0.131), demonstrating the high level of fraud being attempted in this environment where buyer and seller are unseen to each other. An additionally important finding about CNP transactions is that issuers are able to chargeback almost all of the losses to the merchant as chargeback rights are the most favorable to issuers on CNP transactions. This is due to the fact that merchants have a higher liability for CNP transactions based on current network rules.

Sen. Dick Durbin (D-Ill.) is advocating to the Federal Reserve to force the networks and the debit card issuers to allow greater usage of PINless debit for online transactions. In Durbin’s July 24, 2020 letter to the Federal Reserve, he said “U.S. merchants could save at least $2 billion per year in debit fees if PINless functionality were made fully available.” While PINless debit may reduce debit interchange, it may make fraud easier to conduct in online shopping.

Since chargeback rules for online transactions clearly favor the banks and credit unions that issue debit cards, it should come as little surprise that merchants have become reluctant to accept them for CNP transactions.

A review of the top 150 U.S. retailers with e-commerce websites, excluding gas stations, healthcare, restaurants, grocery and B2B merchants, in the PaymentsSource December 2018 Online Installment Lending Study, revealed that only 25 accepted debit cards, or just 17%. In contrast, 88% accepted Visa and Mastercard credit cards with almost similar levels for American Express and Discover. PayPal had a 61% acceptance rate which is more than three times that of debit cards.

What is potentially more confusing for consumers is that many of the retailers who don’t accept debit cards online are gladly willing to accept them for in-store transactions. One potential workaround for consumers who really want to use a debit card for an online purchase is to use the debit card to load a PayPal wallet or in conjunction with Apple Pay or Amazon Pay.

The report also found the growing level of acceptance for deferred debit buy now/pay later programs by companies such as Afterpay and most recently from PayPal. In these programs a consumer can contract with Afterpay, PayPal, Klarna and others to split a transaction into four equal installments, at no cost, and have it charged to their debit card in payments every two weeks. Since the merchant isn’t taking the risk in this situation and gets their money upfront (minus a transaction fee), they are willing to adopt these deferred debit programs to help drive online purchases.