Compliance Bulletin

Analysis of Dodd-Frank Act: Durbin Amendment (Debit Card Interchange Fee Regulation)
August 16, 2010

A provision of the massive Dodd-Frank Act that could have among the biggest monetary impacts on banks is one that was added unexpectedly at the last minute and that has nothing to do with the economic crisis that the Act is supposed to address. 

Section 1075 of the Act, entitled “Reasonable Fees and Rules For Payment Card Transactions,” adds section 920 to the Electronic Funds Transfer Act. It mandates that the amount of any interchange transaction fee [1] that an issuer may receive or charge with respect to an electronic debit transaction (EDT) must be “reasonable” and “proportional” to the cost incurred by the issuer with “respect to the transaction.” The Federal Reserve Board is directed to prescribe final regulations to implement this fee regulation no later than nine months after enactment (the Act was signed by the President on July 21, 2010), and the regulation becomes effective 12 months after enactment.

The new law affects electronic debit transactions and not credit card transactions (except with respect to an allowable $10 purchase minimum, discussed below). According to industry sources, debit card transactions account for about $1.3 trillion in annual volume as between VISA and MasterCard, the two largest debit card networks. Debit cards have been increasingly popular with consumers in recent years. EDT volume caught up with and then exceeded credit card volume in 2008, and represents by one estimate $11.2 billion in fee revenue to issuers in 2009 based on a blended interchange rate of 0.09%.

The law is intended only to regulate the interchange fee (which accounts for the largest portion of the total transaction fee) and not fees paid to the network on which the transaction is conducted or the fee collected by the merchant’s bank (the acquiring bank) or by processors and other third parties. Nevertheless, the Board has the explicit authority to prescribe regulations regarding any network fee for the limited purpose of ensuring that no network fee is used to compensate an issuer with respect to an EDT or to circumvent or evade the Act’s restrictions. Rules in this regard must be issued within nine months after enactment and become effective 12 months after enactment.

How community banks would be affected by the new law is not immediately clear. The Act exempts from any fee regulation the interchange fees charged by issuers that, together with affiliates, have less than $10 billion in assets. (Government benefit cards and re-loadable pre-paid cards are also exempt, as discussed below). The Act does not define assets; an affiliate is defined any company that controls, is controlled by, or is under common control with another company. Merchants are restricted from discriminating against specific issuers (discussed below); thus exempt issuers’ customers should not expect merchants to discriminate against them. However, it may be a challenge for networks, processors, and others involved in processing EDTs to develop the tools to identify exempt issuers (currently, systems cannot identify issuers by their asset size). The challenge is exacerbated to the extent that exempt banks issue as agents and use BIN numbers of larger issuers. With interchange revenue expected to decrease overall, it remains to be seen what efforts will be undertaken by the various parties to react to the relatively higher fees paid to exempt issuers.

Reasonable and Proportional. The Act requires that EDT interchange fees are reasonable and proportional to the cost incurred by the issuer. Nobody knows how the Board would rule, but estimates of the likely reduction in EDT interchange fees range from 25-75%. Neither term is defined in the Act. It is likely that the Board will have broad discretion when it exercises its authority to regulate interchange fees, and competing industry groups and the public in general are expected to fight over the proposed regulations during the public comment process.

The banking industry will argue that the current rates are “reasonable” in light of the large-scale data breaches that regularly hit retailers. These incidents often result in significant costs and losses to issuers in the form of direct fraud reimbursements and costs to monitor accounts and replace cards. Congress’s use of the term “proportional” suggests the intent to bring EDT interchange fees in line with the costs of other forms of consumer payments, the major forms being credit cards, check, and cash. Credit card interchange fees, according to the July/August edition of ISO&Agent Magazine, published by Payment Source, are roughly twice that of the average EDT interchange fee (about 2%). The EDT interchange fee itself varies by transaction; it is typically higher on signature debit transactions compared to PIN transactions, owing partly to the higher incidence of fraud associated with signature debit.

The Board is specifically directed under the Act, when regulating fees, to consider the “functional similarity” between EDTs and checking transactions that the Federal Reserve clears “at par,” according to the Act. Merchants do not incur interchange or transaction fees for check payments per se (they pay bank account service charges), but check transactions are more prone to fraud and collection problems, funds are not immediately available, and consumers generally do not prefer to pay by check. Significantly, the Board is specifically directed to consider the “incremental” cost incurred by “an issuer” in the authorization, clearance, or settlement of a particular EDT. Also, it is specifically directed not to consider other costs incurred by an issuer which are not specific to a particular EDT.

Among other things, this means that the Board may not consider the fact that EDT interchange fees figure prominently in many banks’ account pricing strategies. As Congress and the regulators put pressure on interchange fees and overdraft fees as well, banks will find it increasingly difficult to offer free or low cost checking accounts with low minimum balances, and may resort to charging for debit card privileges.

This distinction between considering “incremental” and “other” costs has caused the industry much consternation because it could potentially allow the Board to disregard or minimize the total issuer costs of participating in the EDT payment system and focus instead only on the relatively minor costs associated with processing any particular transaction. Here again, it would be incumbent upon the banking industry to bring to light in public comments the significant development, implementation, and maintenance costs associated with delivering a debit card product, and that only through these significant expenditures is an issuer in a position to process any particular transaction for small incremental costs.

Moreover, per-transaction costs differ greatly among issuers depending in part on economies of scale, which raises the question whether the Board in its regulation will seek to account for the actual costs incurred by “an issuer” as opposed to issuers on average. The language of the Act makes it less likely that the Board’s regulation will be in the form of flat fee limits that fail to take account of variations among issuers.

In order to help the Board develop its regulations, the Act invests in the Board authority to require issuers and payment card networks to provide any relevant information it needs. The Board is also required to consult with the OCC, FDIC board, OTS director, NCUA board, SBA administration, and the director of the new Bureau of Consumer Financial Protection. It will have only a short amount of time to consider the very complex interchange fee pricing structure. EDT fees, which are set by the networks, are based on factors that one would expect to be considered in the market, such as the relative richness of reward programs, the relative bargaining power of the parties, the prevalence of fraud, processing costs, and competition. Thus, interchange fees vary based on the card brand, regions or jurisdictions, the type of card, the type and size of the accepting merchant, and the type of transaction, such as whether the card is present in the transaction (in-store) or not (on-line and phone orders).

The Fraud Allowance. The need to compensate issuers for fraudulent transactions has been a major factor in setting interchange fees. The Act authorizes (but does not require) the Board to consider an “adjustment” to the regulated fees as reasonably necessary to account for issuer costs incurred to prevent fraud “involving that issuer.” Here again, the language employed in the Act suggests a regulation that is responsive to individual issuers. Such an adjustment, if allowed, must be conditioned on the issuer complying with a number of specified standards established by the Board. They are: the extent of fraud associated with EDTs; the extent of fraud associated with how the transaction is authorized (signature, PIN, or other means); the availability of economical means to reduce EDT fraud; how fraud costs are absorbed by the parties to a transaction; how interchange fees have driven fraud prevention efforts among the parties; and any other factor that the Board deems appropriate.

The penultimate factor listed above highlights the current misalignment of incentives among the parties with respect to fraud prevention and fraud losses. Most fraud-related losses incurred by issuers are attributable to data breaches at retailers or their processors. Data breaches at financial institutions are relatively rare. But even if retailers view the interchange fee as a loss-shifting fee, they have not necessarily been motivated by the fee to undertake fraud-prevention measures—they are obligated to pay the interchange fee regardless of their fraud-prevention efforts. Issuers are compensated through the interchange fee but they have little control over retailers’ fraud prevention efforts. Retailers have begun to take more responsibility for fraud losses and prevention efforts, more in reaction to pressure from the networks, litigation, and public relations concerns than because of interchange fees. It remains to be seen what, if anything, the Board will do to attempt to align the payment and receipt of interchange fees with the parties’ incentives to prevent fraud and allocate fraud losses. Note again that the Board may consider a fraud adjustment only to account for costs incurred by the issuer to prevent EDT fraud losses involving the issuer.

The Act provides that the Board “shall” issue a regulation pertaining to a fraud allowance (also within nine months after enactment), even though the language in the Act is permissive with regard to the Board adopting a fraud allowance at all. If it does adopt the allowance, the Board must take into account any fraud-related reimbursements to the issuer, including amounts from charge-backs received from consumers, merchants, or payment card networks. Moreover, the Board’s standards must require issuers to take effective steps to reduce fraud, including through “cost-effective” fraud prevention technology. That the amount of the allowance should vary depending on the extent that an issuer adopts such technology and takes other preventative measures suggests again that the Board’s regulation must account for individual bank practices.

Exemptions. The Act includes three main exemptions. In addition to small-issuers, interchange fees related to EDTs where a person uses a debit card or general-use prepaid card provided in connection with a government program are also exempted. The third exemption is for re-loadable pre-paid cards or devices (but not those marketed or labeled as gift cards or gift certificates). The Board has reporting requirements to Congress beginning 12 months after enactment and annually thereafter regarding the prevalence of use of general-use prepaid cards in government programs and interchange and cardholder fees charged with respect to such cards.

Merchant Choice. The Board, within one year after enactment, must prescribe regulations prohibiting an issuer or network either directly or through third parties from restricting an EDT to be processed on only one network or on two or more networks if they are owned, controlled, or otherwise operated by affiliated persons or on networks affiliated with the issuer. This suggests that issuers that have exclusivity agreements with a network to handle both PIN and signature transactions have to begin offering transactions also through another, unaffiliated network.

Also, within one year after enactment the Board is required to prescribe regulations prohibiting an issuer or network from inhibiting any person who accepts debit cards for payments from directing the routing of EDTs for processing over any network that may process them. This raises the prospect of creating a premium on software that automatically searches for the lowest cost network for any transaction.

Further, a network may not inhibit any person from offering a discount or in-kind incentive for payment by cash, checks, debit cards, or credit cards. The Act includes a specific provision pertaining to credit card transactions—a network may not inhibit any person from setting a minimum dollar value for the acceptance of credit cards as long as the threshold does not differentiate between issuers or networks and the threshold is no greater than $10. The Board is authorized to increase the $10 threshold.

Importantly, in offering incentives by payment type, a merchant may not differentiate based on the issuer or network. Nor may there be discrimination against issuers of debit cards within a debit card network or against issuers of credit cards within a credit card network. Thus, small issuers that are exempt from the fee regulation may not be singled out by merchants, but they could suffer to the extent that a network, if composed disproportionately of exempt issuers, is disfavored by merchants. If a merchant uses incentives (to the extent required by law) any incentive must be offered to all prospective buyers and disclosed clearly and conspicuously. Regardless of the above, a network may not penalize any person for providing a discount allowed by law.

The Act also prohibits a network from inhibiting a federal agency or institution of higher education to set a maximum dollar value for accepting credit cards if the limit does not differentiate between issuers or networks.

The regulation is expected to be complex, and the Board has little time to conduct its study and draft a proposal. Even if the Board is able to release a proposal early, there will be very little time before the regulation becomes final for issuers and acquirers to establish the necessary network relationships and perform programming changes to comply with the new law. Banks are encouraged to begin planning early. The text of the Section 1075 and the Act is available here.

  1. The “interchange transaction fee” is defined as “any fee established, charged or received by a payment card network for the purpose of compensating an issuer for its involvement in an electronic debit transaction.”

The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.

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