The Fed's Impact on Fraud FundingInterchange Move May Push Banks to EMV, New Solutions
The Fed's ruling imposes a fee cap of 21 cents per transaction and five basis points, which is multiplied by the value of the transaction. [See the Fed's ruling.]
The fee adjustment aims to offset interchange losses called for in the highly contested amendment proposed by Sen. Dick Durbin, D-Ill., to the Dodd-Frank Wall Street Reform and Consumer Protection Act - losses card issuers have said would adversely affect their abilities to absorb fraud related to debit transactions. A card issuer that invests in "new and improved" fraud prevention solutions tied to debit now could receive 24 cents per transaction, up from the 12-cent cap originally proposed in the legislation.
The Fed also extended the effective date of the fee cap from July 21 to Oct. 1.
Jim Schlegel, senior product manager for ACI Worldwide, says most banks will count on getting the 1 cent incentive. "A lot of institutions today have broad fraud services that they access and use, so I think the idea is to evaluate those systems against the interpretation that's come out by the Fed," he says. "Is our investment level acceptable, based on what the Fed has put out?"
Fraud Investments?Most banks budget for fraud losses. But with less income from debit interchange, they'll have to realign not only their budgets but also their thinking. "From my perspective, the cost of [debit] fraud is going to become extremely difficult to absorb if the income financial institutions count on from their interchange channel gets reduced," says Smart Card Alliance Executive Director Randy Vanderhoof. The Smart Card Alliance is a non-profit global association that supports smart or chip-based payment technology providers. "When the percentage of fraud against the revenue those transactions generate significantly changes, I think banks and card issuers will be looking for solutions that can offer greater fraud reduction."
That could mean more interest in investments in advanced card technology, such as EMV - the Europay, MasterCard, Visa standard. The Fed won't mandate that move, as some had speculated earlier in the debate. But banking institutions may have more incentive now to initiate investments without regulatory pressure.
"If they're just expecting to lose that money, I would imagine that someone within the bank needs to look at the fraud losses those vice presidents and directors are expecting every year and figure out a way to start pumping that money back into the system," Schlegel says. "Now they need that additional funding, because of the cut in interchange income, which had helped to cover those losses in the past. I think we'll see some additional investments in fraud prevention tools as a result, and it could be EMV tokens or neural networks."
Shortly after the Fed's June 29 announcement, Frank Keating, president and CEO of the American Bankers Association, issued a statement, saying the Fed's steps were significant toward reducing harm to the financial system. "We commend the [Federal Reserve] Board for recognizing that there are a whole range of costs for which banks should receive reimbursement, including fraud losses, network fees, certain fixed costs and fraud prevention costs," Keating states.
Regardless, he notes the interchange fee reduction severely cuts into banks' revenue streams, and the end result likely will force banks to limit debit offerings. "The final rule still represents a 45 percent loss in revenue that banks use to provide low-cost accounts to our customers, fight fraud and maintain our efficient U.S. payments system," he writes. "This remains a real concern to banks everywhere and the consumers and communities they serve. ... Consumers will see higher fees for basic banking services, and banks - particularly community banks - will still feel the revenue pressures that this rule will cause."
Long-term ImpactThough the interchange reduction only affects card issuers with more than $10 billion in assets, most agree it's only a matter of time before the fee cap trickles down to the mid and small tier levels. "When you start looking at the whole two-tiered system, it creates competition," Schlegel says. "We're creating two kinds of ecosystems here, and I think most people are not happy about that. It splits the industry: The big banks are effectively put into their own separate class, so you now have to replicate a system that allows one group of companies to function under the old way and then the other group under a new set of rules."
The interchange adjustment creates disparity, when the intention was to create equality.
The interchange fee structure, which is overseen by Visa and MasterCard, is complex, and is based on transaction volume at the merchant level and card issuance at the bank level. The tiered system currently sets different fee rates for different organizations. The Durbin amendment aimed to level the playing field for smaller merchants and banking institutions. Between $14 billion and $19 billion in annual debit revenue card issuers collect from merchants will be affected by the change. Under the present system, merchants typically pay card issuers and their sponsoring financial institutions, as well as the networks, between 44 cents and 47 cents per debit transaction.
Dillon Shea of the National Association of Federal Credit Unions says credit unions have been preparing for an expected cut in interchange. "Many of our member credit unions fall under the exemption, but we feel this eventually will impact all institutions," Shea says. "We've been advising our members to prepare as soon as the law was passed. It's not going to happen overnight, but eventually those rates are going to get squeezed down. ...It's only a matter of time before that cap rate becomes industry standard."
Compliance by October will be a stretch, too, as a number of relatively large-scale changes related to new fee structures and fraud-prevention practices have to be reviewed. And then banks will have to ensure they comply with requirements for network exclusivity, which mandate debit card purchases be enabled by at least two unaffiliated networks. That mandate must be complied with by April 1, 2012. "That's a huge undertaking," Schlegel says. "But at least we have clarity. This thing has been ambiguous from the start."
The Fed did say card issuers could comply by having one network for signature-debit and one network for PIN-based transactions. Again, more market division, Schlegel says.
"That's going to force some reissuance of cards and renegotiation of contracts. If you have to do all of that, if you're going to have to invest in reissuing cards and signing new deals, why not just invest in something better than what you're doing today? That could be incentive to move to EMV."
Editor's Note: Jeffrey Roman contributed to this article.