Nonbank acquirers have emerged as powerful players in merchant credit card processing. Of the top 20 acquirers ranked by sales volume last year, 70% were nonbanks. (This includes the acquiring alliances some banks have with First Data Merchant Services.)
But as their volume has increased, so has their dependence on the credit card association member banks to provide clearing and settlement functions.
In so-called rent-a-BIN arrangements, "sponsored acquirers" use a bank's own bank identification number to funnel merchant volume through.
This is a potentially profitable service for banks, but its availability is limited. Most banks are reluctant to enter rent-a-BIN agreements, in part because they are unfamiliar with them and the risks involved.
Recent regulatory and association actions may make such arrangements even more unpopular. Visa and MasterCard guidelines may cap the volume that banks can process for nonbank acquirers. There are six major risks for banks in rent-a-BIN arrangements.
Sponsored-acquirer credit risks. These include the nonbank's being unable to cover chargebacks or a settlement position or just failing. Nonbank acquirers should be thoroughly scrutinized for such risks at the start and then periodically.
The bank may also want to assess its exposure in the event of a "doomsday scenario" - for example, if the acquirer went bankrupt or defrauded it and could not settle its interchange and/or its merchant position. A back-of-the-envelope calculation can be useful to determine the bank's exposure: Given annual sales of $10 billion, it could be as high as $75 million, assuming one-day exposure to cover the merchant's settlement, chargebacks, and returns.
Regulatory risks. The Office of the Comptroller of the Currency is preparing to release the first update since 1992 of its acquiring examination manual for merchant acquirers.
The OCC may make the leap from guidelines to regulatory requirements in such areas as risk-based capital, Internet access for merchants, merchant chargeback insurance, and maintaining sufficient liquidity to meet settlement obligations.
What the OCC does may affect even state banks, which it does not regulate, because the FDIC and the state bank examiners may follow suit .
Association-related risks. Visa and MasterCard regulate their members and try to ensure the transaction flow (authorization through settlement) is safe and efficient. Visa currently uses a rule of thumb in determining the amount of capital a bank should have on hand for its merchant acquiring business. This calculation takes into account the sales volume processed through the bank, including any rent-a-BIN arrangements.
Furthermore, there has been much debate over Visa's recently enhanced risk management policy, which requires members operating high-risk acquiring programs to establish a compliance plan defining milestones toward satisfactory performance. Members that fail to meet these guidelines may be subject to the imposition of certain conditions affecting their Visa program operation or membership status.
The guidelines include the following elements:
- Capital support for merchant sales. The average weekly merchant sales for the most recent quarter must be less than 20% of the member's tangible equity capital.
- Concentration of high-risk merchants. The proportion of merchant volume from Visa's high-risk merchant category code must be less than 20%.
- Capital support for chargebacks. The aggregate chargebacks for the previous six months must be less than 5% of the member's tangible equity capital.
Visa says the aim is to protect members from a few acquirers with high concentrations of high-risk merchants. Smaller acquirers and independent sales organizations say the program is a grab by the larger issuers/acquirers for more market share and margin.In any case, the program is bound to have a ripple effect for banks that provide outclearing arrangements for nonbank acquirers.
Though MasterCard has waited on the sidelines in this fight, its own regulations also present risks, though relatively minor ones.
For example, any MasterCard nonmember that acts as a "member service provider" for multiple members needs separate MasterCard approval for each. Acquirers with multiple-sponsor banks must register and stay in compliance with MasterCard's regulations, much as they must with Visa's independent sales organization regulations.
And though most rent-a-BIN agreements assign all liability related to MasterCard rule violations to the sponsored acquirer, MasterCard will still look to the member.
Portfolio risk characteristics. If a sponsored acquirer cannot meet its obligations, the bank's risk will be driven in part by the underlying riskiness of the portfolio for which it clears. The bank should review the portfolio periodically to help mitigate this risk. Portfolio characteristics to focus on include:
- Chargeback rate. The industry average is approximately 5 basis points (number of chargebacks divided by transaction volume).
- Concentration of merchant category codes. The bank should have a periodic review of the portfolio to ensure there is not an unusually high concentration of high-risk merchants (or to simply be aware of the concentration).
- Merchant volume concentration: The concentration of merchants in a portfolio determines a part of its riskiness, specifically credit risk. For example, if 75% of the volume in a portfolio is made up of two merchants, there is a high degree of risk associated with this portfolio, since the credit risk from one or two events is high relative to the volume.
- Underwriting guidelines: Obviously, the bank will need to have the final word on underwriting - a requirement of both Visa and MasterCard. But you may also want to prenegotiate certain limits. The bank may want to exclude certain industries (Internet, airlines, health clubs, adult entertainment) or may want volume caps.
Reputation risks.Anytime a bank outsources its merchant processing services, it exposes itself to reputation risk. The sponsored acquirer decisions may affect the bank's ability to establish new relationships or continue existing relationships.And if the sponsored acquirer cannot settle with the merchants, and the bank decides not to intervene and provide funds, the bank could be open to lawsuits from the merchants associated with the portfolio.
Internal expenses.The bank will want to ensure that its internal expenses - settlement float, management/personnel, and automated clearing house expenses, among others - are at the minimum covered by the compensation it receives from the sponsored acquirer.
Banks entering into or renegotiating a relationship should be aware of the risks and cognizant of the mitigating remedies. These remedies often include contractual provisions and pricing measures.
Furthermore, given the relatively limited market for these relationships, banks generally have stronger negotiating leverage than they realize.
Despite the many inherent risks, rent-a-BIN arrangements can be quite profitable, given the minimal investment and time required.
Mr. Abbey is a principal and Mr. Calliham is a senior consultant at First Annapolis Consulting, a financial services consulting firm in Linthicum, Md. Both focus on the merchant acquiring industry.