Where do we stand with debit card interchange and overdraft fee regulation?

Revenue from the total of debit card interchange and overdraft fees often accounts for over 50 percent of a given credit union’s total non-interest income. Debit interchange has been heading south for many credit unions of all sizes due to regulatory changes implemented in 2011 that impacted interchange rates and network routing practices. The Consumer Financial Protection Bureau is also looking to further regulate overdraft practices beyond the changes to courtesy pay practices that were implemented in 2010. Regulatory risk continues to persist relative to both of these two important income streams.

Credit unions need to fully understand what is happening and why across the regulatory landscape, and then work closely with their processing and network partners to determine steps to grow revenue and reduce operating expenses to offset the regulatory risk.

Here is a look at how we’ve arrived at the place we are today and some recommendations for how credit unions can respond to protect their non-interest income.

The Story So Far

Debit Interchange

As directed by Congress through the Durbin Amendment, the Federal Reserve Board (FRB) introduced Regulation II in October 2011 with the intention to add competition and fairness to debit interchange fees and transaction routing. Institutions with total assets of $10 billion and above had their debit card interchange revenue capped and had to accept a blended interchange yield drop of over 52 percent. The FRB also included provisions that protected small issuers – those with assets of less than $10B – by excluding them from the interchange rate provisions; however, nothing in the final rules explicitly requires the networks to maintain favorable interchange rates for institutions under the $10B asset threshold.

Payment networks had to become more creative in balancing merchant and issuer expectations and profitability. As we are observing today, these dynamics are producing an impact that the FRB was trying to avoid – negative financial influence for the small issuers who are exempt. All PIN networks with POS capability have introduced the PINless transaction set and most are equipped to introduce signature-based transaction routing options similar to what has been offered by Visa and MasterCard for several decades. The PINless routing schemes are already negatively impacting debit interchange revenues; this trend will only continue to accelerate as competition heats up for each consumer payment transaction.

Post Regulation II implementation, we have observed notable interchange compression on unregulated issuers. About 18 months after the implementation, the blended debit interchange rate was down 13 percent, compared to pre-Regulation II levels. Competition for volume in the network arena continues to put downward pressure on debit interchange yields, with observed reductions of about 5 – 8 percent when compared year-over-year. We expect this trend to only continue into the foreseeable future, and as payment technology and network strategies continue to evolve, they may provoke acceleration.

PAVD (PIN Authenticated Visa Debit)

As a result of the Durbin Amendment effectively banning network exclusivity and, in some cases, requiring financial institutions to add another network, Visa witnessed reduced PIN POS transaction volumes over its Interlink network. In response, Visa decided to leverage an already existing network capability, which was primarily used for international transactions to route a PIN transaction over Visa’s signature network, and introduce that capability to all Visa U.S. merchants. At the same time, Visa restructured merchant pricing, and introduced the Fixed Acquirer Network Fee (FANF), which incents chain merchants to send more transactions to Visa, in order to reduce switch costs incurred by the merchants. This strategy fueled Visa’s transaction volume growth to almost pre-Durbin levels and beyond, pulling volume from other PIN networks.

Network strategies like VISA PAVD, VISA FANF and MasterCard’s Maestro network requirement continue to evolve, with PINless and dual message transactions routed over traditional single message networks only further eroding debit interchange yields for unregulated issuers.

PINless

In an effort to respond to Visa/PAVD and MasterCard/Maestro routing requirements, other PIN networks introduced the ability to submit low dollar value transactions without PIN information. On purchases of under $50, merchants can choose to just obtain an approval and not require the PIN to be entered and authenticated.

PINless was introduced last year in an effort to compete with ‘No Signature Required’ (‘NSR’) transactions from Visa and MasterCard. The merchant roll-out was very successful, and as a result, PIN networks decided to expand the PINless transaction set beyond just ‘Quick Service Restaurants’ (‘QSR’), to most traditional point of sale and e-commerce merchants.

Signature Debit Transaction over PIN Networks

Some PIN networks have started routing signature debit transaction sets (dual message) over their network. This essentially means that a merchant who traditionally has the ability to route debit transactions to VISA or MasterCard, will have another option when evaluating their cost-based routing options for a signature debit transaction. Participation and support for this transaction set is mandated to all Issuers and Acquirers.

Overdraft Fee Income

Nearly concurrent with the regulations that have impacted debit interchange revenue, some significant regulatory movement has also taken place in terms of overdraft fee income.

• Regulation E was modified in 2010, requiring that all financial institutions secure an account holder opt-in in order to charge an overdraft fee for one-time debit card and ATM courtesy pay transactions.
• Since the change to Regulation E and courtesy pay transactions, the CFPB has been evaluating overdraft practices more holistically – encompassing not only debit card and ATM transactions, but also checks, ACH and other transactions that debit funds from a deposit account. It is widely expected that the CFPB will publish an initial rule for comment sometime in 2016.
• The CFPB commissioned the Pew Charitable Trust to handle the research aspects of their regulatory review. To date, a great deal of the Pew research (such as consumer surveys) has involved customers of large banks and not necessarily members of credit unions.

Pew has made three key recommendations for consideration by the CFPB:

1. Disclosure: Provide consumers with clear, comprehensive and uniform pricing information for all available overdraft options.
2. Fees: Make overdraft penalty fees reasonable and proportional to the bank’s cost in covering the overdraft.
3. Posting Order: Prohibit the process of reordering transactions to maximize fees and post deposits and withdrawals in a fully disclosed, objective and neutral manner.

Optimizing Debit Portfolio Performance

With respect to protecting debit interchange income, credit unions can consider several measures to mitigate the downward pressure on this revenue source.

Observation: Issuers need to work to capitalize on current consumer usage trends and the technology influencing where and how they are using their debit cards.

Small ticket transactions are on the rise, as consumers get more comfortable with using their debit cards, instead of cash, for small purchases like coffee shops and movie theaters. At the same time, many networks are expanding the rules around small tickets to include more merchant categories and raising the limit under which a purchase amount requires no cardholder verification, thereby offering a speedy checkout and more convenience.

Recommendation: Reach out to your cardholders making them aware that they can use their card for these types of purchases, and can bring incremental transactions thus driving more revenue.

Observation: Debit card usage has definitely been on the rise in past years, and issuers were able to capitalize on this ‘organic’ growth the cardholders have adopted. However, we are nearing the top of that growth curve.

Recommendation: Take another look at your Penetration, Activation and Usage metrics to make sure you are at least on par with the industry. It is possible to “outgrow” the reduction in interchange from current volume, by finding ways to introduce incremental usage. A strong debit card rewards offer backed by relevant merchant-funded rewards will incent your members to use your debit card more often, keeping your card top of wallet.

Contributing author: Vladimir Jovanovic, ‎Director, Debit and Prepaid Product Management at PSCU