Small banks and credit unions are fighting the Federal Reserve’s proposed changes to debit card routing rules, which are designed to make it easier for online merchants to choose a low-cost debit network but would make financial institutions largely responsible for implementation.
Merchants claim that because an increasing proportion of consumer debit card transactions are flowing through online and mobile channels, since last year they’ve paid $2 billion to $3 billion in excess fees that are not covered by existing card rules, which are focused on the point of sale.
But card issuers say the Fed's proposal — making banks and credit unions implement new debit-routing options for online transactions — will add costs and erode interchange revenue.
Provisions within the Durbin amendment to the 2010 Dodd-Frank Act require card issuers to give merchants the choice of at least two unaffiliated debit networks for routing transactions, enabling them to lower card acceptance costs.
Those rules were devised when most debit transactions occurred in stores. The pandemic drove a higher proportion of debit card transactions online, where merchants typically do not have much choice in routing options.
The Fed in May unveiled proposed clarifications to Regulation II under the Durbin amendment that would ensure merchants get the same debit network routing choices for online transactions as they do for in-store purchases.
According to the central bank’s own data, the steady growth of e-commerce and mobile transactions in recent years — on top of various technology changes affecting payment processing — means that about 94% of online debit transactions currently flow directly through Visa and Mastercard.
Hundreds of financial institutions and their constituents have filed comments, and many claim that the proposed changes would punish smaller card issuers and community banks, potentially costing them billions in lost transaction fee revenue while increasing expenses and fraud risk.
The American Bankers Association and five other financial trade groups urged the Fed to make key changes to its proposal or withdraw it altogether.
“The proposed ‘enablement’ requirement would force issuers to redirect funds and personnel from critical projects, and this would have a disproportionate impact on small issuers and community banks,” the ABA said in a 17-page comment to the Fed.
In its present form, the proposed rule would cost issuers $27 billion in revenue over the next decade, with the biggest impact on smaller card issuers, according to the ABA. Large retailers would capture the lion's share of the interchange windfall, the ABA contended.
At a minimum, the trade groups urge the Fed to consider changing some of the proposal’s language and its implementation timeline. The trade groups also urged the Fed to remove the proposed wording requiring issuers to “enable” multiple card networks on their cards, which would be a costly and difficult technical hurdle, according to the bank lobbying groups.
Instead, the ABA proposes the Fed retain the rule’s current language requiring issuers to only “allow” multiple networks to process transactions on their cards. The trade groups recommend pushing out the effective date of any new debit-routing rule to four years.
The other banking trade groups signing the ABA’s letter were the Consumer Bankers Association, the Credit Union National Association, the Mid-size Bank Coalition of America, the National Association of Federally-Insured Credit Unions and the National Bankers Association.
The crux of the issue is the complexity of digital commerce. Unlike payment terminals, the card-not-present shopping environment doesn’t easily support the use of independent debit networks online. This causes many transactions to automatically flow over Visa or Mastercard's signature debit networks, according to Sarah Grotta, head of debit advisory at Mercator Advisory Group.
“E-commerce merchants need the authorization to be separate from the posting message because they cannot charge a consumer’s account until goods are shipped, so they need a dual-message transaction — like Visa and Mastercard’s so-called signature debit networks,” Grotta said.
Although the Durbin amendment exempts financial institutions with assets of less than $10 billion from its caps on debit interchange rates, the surrounding costs of ensuring that all merchants are enabled with two unaffiliated debit networks for online transactions could be higher, while their debit card interchange will likely drop, she said.
“It will be smaller issuers, plus neobanks and fintechs that rely on smaller banks with less than $10 billion in assets — that do not already issue debit cards with PIN-less capabilities — that will bear the brunt of the Fed's proposed clarification,” Grotta said.
Smaller issuers that don’t already automatically offer a dual-message transaction path for merchants will need to reissue cards with the new format to customers, and retool their back-office settlement, fraud detection and chargeback processes to match these changes, she said.
“These smaller issuers who don’t already have PINless debit cards will also experience a drop in their interchange as more activity moves online and through these lower-cost debit networks. Large banks will have to comply too, but their interchange is regulated [by the Durbin amendment] so the impact to their interchange will not be that great; they will just see a transaction shift away from Mastercard and Visa,” she said.
In addition to expanding merchants’ options for online debit transactions, the Fed proposes that debit-card issuers for the first time would be responsible for ensuring that at least two unaffiliated networks have been enabled, versus merely making options like Pulse, Shazam and NYCE available.
Among more than 850 comments filed this month in response to the Federal Reserve Board’s move, many are from merchants that generally support the Fed’s proposed rule change.
The Merchants Payments Coalition and the National Retail Federation, each representing thousands of U.S. merchants, favor the Fed’s proposed changes and urge swift action to finalize the rules.
“The NRF is concerned that unless the Board’s clarification of the scope of Reg II is ironclad and not subject to ambiguity, much of its work may prove to have been for naught in future years because Visa and Mastercard are likely to take advantage of any loopholes they may read into the new language,” the NRF said in a recent press release.
