Thinking Through Moves and Countermoves on the Durbin Chessboard

by Bryan Derman on December 19, 2010

in Banking, Banking Industry, Card Issuers, Card Networks, Card Payments, Debit Cards, Federal Reserve, Financial Regulators, Interchange, Regulatory Environment

Bryan Derman - Glenbrook Partners

After months of speculation and hand-wringing, last Friday we finally got a relatively complete reading on how the Federal Reserve will likely implement the prescribed regulation of debit interchange and debit network competition.

My partner, Carol Benson, has also shared a summary of how various payment domains and players might be affected in the near term and I largely agree with those views.

But, I also believe that the impact will unfold in waves over time as initial new rules are put in place and the players impacted by them gradually adjust and optimize their strategies to the new environment.

In this article I will review and comment on what was learned this week and share some initial thoughts on how the chess moves might unfold. As a reminder, what the Fed introduced last Friday was proposed rules – a comment period is now open through February 22, 2011 after which the Fed will consider those comments and announce the final rules (for at least the interchange fee standards) by April 21, 2011 as required by the legislation.

Key Rulings and Interpretation

The Fed offered alternative approaches for comment in a few areas and explicitly asked for the views of commentators in others, but it is fairly clear where they are going. Here is a quick summary with some Glenbrook commentary and speculation:

Debit Interchange Rates. The Fed offered multiple possible approaches here, but the bottom line is that they bracket a range of 7-12 cents per transaction. Think of this as roughly a 75% reduction from current levels. Interpreting the language of the legislation, the Fed concluded the only allowable costs were those borne by issuers for authorization, clearance and settlement – no other issuer costs could be included. Using the Fed’s survey data finding $15.7 billion in issuer debit interchange revenues in 2009, the impact to the affected banks represents about $7.8 billion in lost annual revenues. Piled atop the recent actions to limit overdraft fees and the negative impact of persistently low interest rates on deposit net interest income, you have an entirely dire situation in retail bank economics.

Bear in mind that the proposed interchange rules apply only to the roughly 100 banking organizations with over $10 billion in assets, but we estimate that those large banks account for around two-thirds of current debit volume. Also excluded are certain prepaid cards — those issued in support of government programs as well as general-use prepaid cards that are reloadable and offer at least one free ATM transactions per month (think General Purpose Reloadable cards like Green Dot and NetSpend, as well as payroll cards).

  • Unlike my partner, I believe that the card networks will offer a two-tiered interchange structure that allows small banks (<$10 billion in assets) to earn higher rates. The networks would probably prefer not to do so, but the opportunity for some networks to use this provision to win new business will be overwhelming and will force others to match; the revenue opportunity should also prove irresistible for small banks, even if they are philosophically opposed. Perhaps at some point Congress will come back and unify the situation, but that does not appear to be under discussion right now.
  • The exemption of reloadable prepaid cards seems more problematic, and represents to me the main unaddressed loophole in the proposed regulations. While the Fed took some pains to ensure that large (>$10 billion in assets) banks would not use linked credit/charge cards to circumvent the debit interchange repricing, they left open the option to convert checking accounts to a general-use prepaid card structure and gain the exemption. The rationale for the exemption had been to maintain the efficiency these prepaid programs bring to government transfer payments and the financial inclusion benefits they bring to unbanked and underbanked (and presumably low-to-moderate income) consumers. While there has been no discussion of it, I could imagine new rules or Congressional action to limit this exemption if it were used broadly by large banks to avoid the reduction in interchange rates (e.g., limitations could be placed on the value which could be loaded on prepaid cards that qualify for the interchange exemption).

Network Non-Exclusivity. Here the Fed is actively soliciting comment between two alternatives it offered. The question is whether the use of a single signature debit network and a single, unaffiliated PIN debit network is adequate, or whether issuers should be required to participate in at least two signature and two PIN debit networks, a far more operationally challenging arrangement.

  • Much has been made of the fact that only about 2 million of the 8 million card-accepting locations in the U.S. are enabled for PIN debit. Thus, the first option might not be that effective in allowing merchants to compete down their network fees by steering their volume to preferred debit networks. I think this concern is exaggerated for two reasons: (1) If the benefits of being able to steer volume to PIN networks are significant to merchants, PIN debit is not that expensive or difficult to add; and (2) Merchants are a long-tail business, with most of the card volume concentrated in the largest merchants, most of whom are among the 2 million already enabled for PIN. The exceptions would be the large eCommerce merchants, airlines, hotels and table service restaurants, who generally do not accept PIN debit, but they should also enjoy the dramatic reduction they will experience from the high card-not-present interchange rates they often pay today.

Recovery of Fraud Costs. The Fed took a mulligan here, admitting they needed more time to explore the issue. Whatever they decide, it is unlikely to produce a very significant improvement in the draconian interchange cut they have already introduced.

  • It seems unlikely that the Fed would suddenly try to put some impetus behind Chip and PIN technology at this stage, but they have clearly noted the differences in fraud costs between signature debit and PIN debit and that could well be reflected in their ultimate ruling (e.g., by limiting fraud cost recovery to that experienced on PIN transactions and requiring signature issuers to absorb the incremental fraud of their products).

Okay, so if that is how the pieces sit on the new chessboard, what initial moves will the players will make?

First Order Effects

There is a great deal to adjust to here and much work needs to be done in just the first few months of 2011 (with most of the rules coming into effect in April).

Retail Banks, particularly the large ones, are most severely affected here and need to revise their product and pricing structures in order to preserve profitability against a three-pronged attack (low rates, reduced overdraft income, lower debit interchange). I would expect free checking to give way to pricing structures based on the use of average balance levels to offset a variety of fees – monthly maintenance fees, per-check fees, ATM fees, and perhaps even fees for using tellers, online bill payment, and an annual fee for debit cards. I am not among those who see the world moving backwards, with banks incenting their customers to go back to writing checks. That is a bad consumer experience, a tenuous marketing message, and ultimately a self-defeating move (merchants may be reluctant to accept checks once debit is so affordable).

I would look for large banks to initially experiment with prepaid card accounts as a way to maintain an affordable product for their low balance customers. On the other hand, certain small banks may see a one-time opportunity to gain share and use their interchange advantage to continue offering free checking.

Merchants. As Carol wrote in her analysis, what’s not to like? The merchant victory comes primarily from the interchange reduction, though the ability to choose among multiple debit networks will be an important check on possible increases in networks fees. Thus, the merchant task becomes steering transactions to debit from other forms of payment (the combination of a low cost and a guarantee could make debit the most attractive payment for some merchants).

The interchange reduction proposed is probably dramatic enough to cause some merchants to experiment with discounts for debit cards – could we pull up to the gas pump one day next year and find that the cash discount also applies to debit cards? I would also expect to see an expansion of the ongoing trend of merchants no longer accepting checks. Merchants will need to be careful that they understand their mix of large bank and small bank debit cards (any discounting must apply to all debit cards), but incentives might be particularly prevalent in large metropolitan areas where large banks have the greatest market shares.

Networks and Processors. While the networks escaped direct regulation under Durbin, you never want your largest customers to suffer an exogenous revenue hit, particularly one tied to a product you provide. While these big customers provide a majority of the volume for debit products, smaller banks are still significant and generally pay much higher fees for network services and issuer processing; thus, I believe most networks will provide a two-tiered interchange structure that favors small banks, lest they lose that profitable volume to another network willing to do so.

I had previously believed that network fees would remain modest in relation to debit interchange and thus have no real ability to help offset the impact on issuers. I was wrong. With interchange falling to such a low, fixed level, every penny (and maybe even fractions thereof) of expense will count. Networks and issuing processors should anticipate hard negotiation from their large banks.

On the acquirer/merchant side of their business, networks’ fee revenue will also be pressured, due to the non-exclusivity provision (which applies to all debit cards, not just large bank ones). Having made concessions to their issuers to gain placement on the card, networks will now compete for merchant preference in the steering process. This could involve volume-based incentives and rebates directed to merchants based on the aggregate amount of debit volume directed to a particular network.

Acquirers and acquiring processors should see a neutral-to-positive impact from the new environment, though they may actually find new opportunities to assist merchants in negotiating network incentives and in dynamically optimizing their routing among debit networks. It will also be interesting to watch the small end of the merchant market to see whether ISOs and acquirers use the reduced interchange to pad their own profit margins or set off a new round of merchant churn by reducing bundled merchant discount rates.

Second Order Effects

Okay, allowing for the fact that reality could depart somewhat from the scenario I painted above, what might happen next? In particular, how will some of the players who were negatively impacted in round one try to restore their economic position? My crystal ball gets a little cloudier when I look out this far, but I know that the banking and card industries have historically shown excellent creativity when it comes to finding new ways to be paid for the services they provide (full disclosure: I was deeply involved in the introduction of convenience charges at ATMs back in the 1990s).

A few possibilities to consider:

  • Assuming the Fed or Congress does not act against the loophole, look for large banks to significantly broaden their use of prepaid accounts to meet the needs of former checking customers while earning higher interchange.
  • Large banks will also redouble efforts to put their credit cards in the hands of their depositors. While they cannot automatically charge the payment to a linked checking account (lest the cards be deemed debit cards), they could probably find useful ways to provide balance information through online banking systems and statements to keep customers apprised of their spending and how it relates to their checking balance.
  • Look for renewed activity from virtual banks. I would expect non-traditional players like ING Direct to attempt to leverage their lower cost base (no physical branches) to move more deeply into transactional banking as fee levels at traditional banks rise.
    • Major players will probably use creative, prepaid account structures to avoid interchange regulation
    • We could also see innovative new offers from entrepreneurial organizations operating through small bank charters
    • Also, consider how PayPal, with its growing focus on the physical point of sale, might insert itself in this space. It has recently enhanced its offering to allow account loading via cash and remote check deposits and can easily be configured to function like a virtual bank. However, note that in its commentary, the Fed is clearly thinking about alternative schemes like PayPal and whether they might meet the definition of a payment card network (probably in the form of a three-party model like American Express or Discover).
  • The card networks will work hard and creatively to find new sources of income to offset the pressure they will feel on their debit business. Here are some avenues they might explore:
    • Even more focus on product development and marketing in the prepaid area
    • Higher fees on credit card products, especially from the merchant/acquiring side of the value chain
    • Raising the network fees levied on small bank debit issuers, particularly if those small issuers are allowed to earn a higher rate of interchange

Merchants should remain relatively content with the situation, but might be expected to press their advantage by lobbying Congress and the Fed for certain changes and clarifications, such as:

  • Application of the same cost recovery approach to credit interchange (admittedly unlikely in the near term)
  • Application of the debit interchange regulation to all banks, not just the largest ones (probably also unlikely)
  • Segregation of reloadable prepaid cards into a product line distinct from debit so it can be identified and assigned different consumer incentives (somewhat more likely). Thus, a consumer whose checking account has been migrated to a prepaid card by his bank might no longer qualify for discounts that merchants are offering for debit card payments.

* * *

We’re at the earliest stages of what should be a wild ride. Let me know what twists and turns you could see coming in the road ahead.

How will the proposed Durbin rules impact your payments business? Glenbrook can help you assess the impact and recalibrate your strategy – learn how here.

11 Responses to “Thinking Through Moves and Countermoves on the Durbin Chessboard”

  1. Steve Langhans says:

    Bryan – thanks for the analysis. In focusing on fraud related costs only, it seems that the Fed is heading towards a solution that doesn’t address the costs of the payment guarantee included in the payment service today. Isn’t one logical potential outcome a decoupling of the payment service to remove the payment guarantee?

    Your thoughts?

    • Bryan Derman says:


      Interesting question. Conceptually, the guarantee could be separated from the pure payment transaction (for example, by eliminating the authorization portion of a signature debit transaction), but I don’t see how that separation could be used to improve the economic performance of any of the players.

      I believe the Fed would likely come back, either immediately or in two years as scheduled, and further reduce the interchange rate to reflect the reduction in incremental cost to the issuer. Having priced the entire, guaranteed transaction at 7 to 12 cents, I don’t think they would allow the issuers and networks to remove the guarantee and then sell it as an optional service with a price of, let’s say, 1% of the transaction value.

  2. Bill Barhydt says:

    Good analysis. Why wouldn’t banks and networks simply start charging monthly service/access fees to large retailers for access to their debit networks? The new rules seem to deal with transactional costs but not access itself.

    My bet is that within two years the banks/networks will have found ways around these fee limits and the fed will be spending a small fortune trying to monitor and over regulate.

    • Bill, that access fee you’re envisioning is effectively what interchange is. It’s more complex than that (naturally) – but could be cast that way. What you may not be aware of is that some careful language was included in the legislation to prevent alternative fee arrangements from making up the loss from debit interchange. Of course, the devil’s in the details – but the issue is one that’s very well understood, was anticipated, and the regulator is “on the case”.

  3. Merrill Halpern says:

    I would like to see the Fed initiate a required upgrade of merchant terminals to accept EMV cards. The savings from lower interchange can more than cover the expense (and help reduce overall fraud losses if more issuers would adopt this technology).

    • Merrill, seems that you’re suggesting that the merchant would be willing to spend on EMV POS terminals – based on the savings from lower interchange fees? Not sure they’d agree. Or, were you making a different point?

  4. Asaad Faquir says:

    Very good analysis here. I just recently read subsection 1075, as I have been out of banking for a while and only recently rejoined the fray. My thought on the matter maybe a little Ed Rendell-ish… but TOUGH! Interchange fees while “sweet” aren’t exactly the primary driver of non-interest income. I suspect that at most institutions big or small, this reduction of income eqates to around 9-10% of total revenues (and even that is probably an overstatement). If it’s more than 10% that bank has a whole other set of problems on their hands. So it leads me to believe that such a proportional drop in income will be recouped quickly and from a myriad of sources (many of which you have named, others which you have not), so forgive me if I don’t see the big deal here.

    Going beyond the fact that I don’t view this as such a big deal… I also agree with your partner Carol, the networks will not go two tier. While I don’t knock your argument for why they should. I think broader business perspective will dictate that they don’t back the losing horse, which at the end of the day based on these proposed changes is going to be “debit card” usage.


  5. Eric Haller says:

    Agree with others — nice analysis. I particularly found your notion on the fed loophole closing with a potential “interchange cap” for prepaid card loads interesting.

    If the large retail banks are going to invest in pre-paid offerings, should be the catalyst for market expansion (serve existing base plus expand in to underserved/unbanked market). Opens up more opportunities for competition, differentiation and revenues. My take is “short term, big ouch; long term, not so bad”.


  6. Jammer says:

    Hello Bryan,

    Thanks for a great analysis. Much appreciated. I have a couple questions and would appreciate your thoughts:

    Are there other signature networks that issuers could use besides Visa and MasterCard? This seems critical to whether or not banks could get price concessions. If there is not an adequate substitute besides Visa and MasterCard it would seem like both networks could hold pricing to a degree since issuers do not have an alternative. MasterCard would likely be somewhat aggressive on pricing to gain share due to no network exclusivity, but since MC already has a large signature business they wouldnt price so aggressive that net net they are worse off. However, if there is some other network capable of signature transactions then issuers could use that as a bargaining chip to get price concessions.

    How much of an adequate substitute is ACH? MC said in a conference call that much of a substitute to MC and V because ACH wasnt designed for high volume, small ticket transactions, charge back provisions, and doesnt have the same robust security features. However, it seems like banks have never used ACH because despite network fees that are substantially lower than V and MA of $0.0001 per transaction, the interchange for ACH is $0, which means banks dont get any revenue from an ACH transaction. But, I recently read an American Banker article saying that banks will raise ACH fees as a way of offsetting lost debit interchange revenue ( If interchange on an ACH transaction becomes the same as interchange on a V and MA transaction, yet network fees are $0.0001 for ACH vs on average $0.045 for V and MA, could banks use ACH to 1) disintermediate V and MA or 2) pressure their fees.

    Thanks for your help.


  7. Gary Schubet says:

    I need some clarification on this new regulation and what debit card transactions it applies to. Does the new regulation apply to pin based debit card transactions only? Or does the regulation apply to all debit cards pin based or not from issuer banks with assets less than $10 billion? I work for a University and we do not have any of our terminals set up to accept pin #’s does my University need to install pin based debit capabilities in order to qualify for the new proposed Fed pricing? If we implement PIN capabilities on our terminals and a customer opts to not use their PIN what will the pricing for this transaction be? the new Fed pricing or the exsisting/current interchange % and per item fees? Thank you

    • Allen Weinberg says:


      While the Fed has only released its preliminary position, it is not making any distinction between PIN and signature debit from a pricing standpoint. So in short, no — you’d get the reduced interchange without having to install PIN pads.

      A few assumptions/caveats — first, your acquirer would need to pass the cost savings on to you :-). Second, as you note, the Fed’s new rates would not apply to issuers with less than $10 billion in holding company assets. Visa and MC have not yet announced what the interchange for those FI’s would be. Third, the jury’s still out on all this. Who knows if EMV (chip and PIN) will be part of the ultimate requirements for the lower interchange.

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