Officials of Visa U.S.A. have been urging bankers to set capital standards for the merchant de of the credit card businesses' -- or let the regulators do it for them.
They say the Federal Deposit Corporation Improvement Act of 1991 requires banking regulators to set capital rules for off-balance-sheet activities, of which the processing of merchants' card transactions is one.
Citing an April 1992 directive to national bank examiners, Visa has gone so far as to propose a capital formula, but there is no word on when actual standards will be imposed, said Kenneth Lieberman, Visa's vice president of risk management.
Regulators, too, are uncertain about the rule. But they say it is prudent of Visa to be evaluating the issue of capital adequacy, even if no rule is imminent.
A rule on capital for "nontraditional activity" is being hashed out among the banking agencies. But according to Robert F. Miailovich, associate director of supervision of the FDIC, his agency and the Federal Reserve Board have agreed not to try to impose a formula for capitalizing banks' merchant business.
Comptroller Must Sign Off
All that remains is for the Office of the Comptroller of the Currency to sign off on the proposed rule, which would then be put out for comment, he said.
"The proposed rule says we cannot quantify these things, and they will be looked at case by case," Mr. Miailovich said. "Another section of FIDICIA says, |Agencies shall develop and prescribe regulations' that [apply to] |contingent assets and liabilities.'
"But we believe there's nothing new to be done at this point," he added.
Visa Formula Described
Nevertheless, Mr. Lieberman says it will be helpful for banks to use his formula, which regulators might follow as they assess banks' merchant processing businesses.
"If a majority of banking institutions are going with [Visa's approach] and have a firm belief in this, it will hold up," he said recently.
Under the Visa formula, a bank that processes $1.2 billion of transactions annually would have to set aside about $3.5 million. The risk is the chargebacks that occur when customers lodge complaints or otherwise block payment for merchandise.
For a bank whose merchant clients have a higher-than-average risk of chargebacks more capital would be required, he said.
Adequate Capital Required
Visa is already applying its model, and other tests, in evaluating the adequacy of capital against the merchant portfolios of processing banks, known in industry terminology as acquiring banks.
If an acquirer fails any of the tests, Mr. Lieberman said, the bank is required to secure its membership obligations to Visa.
If a bank fails to meet regulators' capital requirements, the consequences are more significant. An inadequately capitalized bank can be the subject of a cease-and-desist order, a formal order to add the needed capital, or could have to stop offering the service, an FDIC spokesman said.
The first step in Mr. Lieberman's formula is to establish a notional value for the "asset." Since the average merchant sale is subject to recourse for two and a half months, he argues that the asset value is equal to 2.5 months -- about one-fifth year -- of the sales, or $250 million for a $1.2 billion portfolio.
20% Risk Rating
The Visa official argues that on average, the risk in merchant processing is the equivalent of a "short-term noncancelable obligation," which would put it in the 20% bracket.
That risk weighting -- the same given to government securities -- would mean capital would have to be held against $50 million of the $250 million. To qualify as "well capitalized," the bank would set aside 7% of that amount, or $3.5 million, in capital.
Mr. Miailovich questioned whether examiners would accept a 20% risk weighting. He said the exposure could be considered comparable to commercial risk, which carries a 100% weighting.
Impact on Small Banks
For most banks, setting aside enough capital to cover merchant-processing risk is likely to be a non-event, since the amount of additional capital needed would be negligible next to the amount they already set aside. But it could be important to small banks that specialize in merchant activity.
"A smaller bank probably looks more closely at it," said Craig Millington, senior vice president of merchant acquiring at Family Bank, a $13 million-asset bank in University Park, Ill., which processes $3.5 to $4 million of merchant transactions annually. "We potentially could lose a larger percentage" against total assets.
Mr. Millington said Family Bank, which has announced a merger with Bridgeview (Ill.) Bank and Trust Co., currently sets aside 0.2% of every transaction, or about $40,000 a month, as a buffer against chargebacks.
Justifiable to Regulators
He said that is six- to eight-times as much as the bank would set aside under Visa's guidelines, which he views as unnecessarily complex.
Mr. Lieberman said, however, that the Visa model produces a result that is comparable to the 0.04% chargeback rate for the industry -- and has the advantage of being justifiable to the regulators.
Andrew L. Cheskis, vice president, franchise management for MasterCard International, said that association also includes an assessment of whether members have covered the risk of merchant chargebacks.
MaterCard System
If a bank processes $200 million per quarter of MasterCard charges, he said, it must have $20 million in capital. For $1 billion of quarterly volume, $50 million is required. For $2 billion, $100 million of capital is required.
Under MasterCard's system, banks must set aside additional capital to offset riskier merchants. Banks that process for small retailers outside their region need $2 million in capital in addition to their regulatory requirement. Banks that represent riskier categories of merchants, such as airlines, are required to hold up to $25 million in excess capital.
"We think it's an approach more tailored to what the risks are," Mr. Cheskis said. "Obviously we hope whatever [the regulators] put in place is rational, but we think from the standpoint of MasterCard and our membership, that we've got an approach that works."
