With Congress expected to approve the regulatory reform bill this week, including the much debated interchange amendment, banks are bracing for a significant hit to their debit card revenue.
Although the ink is barely dry on what is now known as the Dodd-Frank Act, and it's far from clear exactly how the Federal Reserve will adjust debit interchange fees, bankers and analysts agree that the fees are all but certain to come down — and probably by a lot.
By some estimates, the interchange regulations will vaporize more than $5 billion of banks' annual transaction fee revenue from issuing Visa Inc. and MasterCard Inc. debit cards.
"Revenue is going to drop like a brick," said Gary Jewell, an executive vice president of Carrollton Bank.
The $400 million-asset Baltimore financial company is already expecting a sharp decline in debit overdraft fee income from new regulations that take effect in August. Losing another chunk of revenue from debit interchange will be "extremely harmful" to the bottom line, Jewell said. "That's a double hit to the bank."
Carrollton issues Visa debit cards.
Mike Moebs, the chairman of the Lake Bluff, Ill., banking consultancy Moebs Services Inc., estimates that debit interchange represents 10% to 30% of revenue from checking accounts for credit unions and community banks.
Debit has picked up sharply in recent years; consumers shifted to payment cards instead of checks, and have repeatedly shown a preference for debit over credit for day-to-day spending. Debit transaction volume surpassed credit in 2008 and has not looked back, and financial companies have become increasingly dependent on the revenue generated by each transaction.
"Mainstream institutions will be terribly hurt" by debit interchange regulation, he said.
The Dodd-Frank Act authorizes the Fed to set debit transaction fees that are "reasonable and proportional" to the cost of processing the transactions, a phrase that has yet to be converted into an actual number.
But according to data compiled by PaymentsSource, a unit of SourceMedia, which also publishes American Banker, that could likely translate into a $4.16 billion decline in annual interchange revenue for banks that issue Visa debit cards.
MasterCard cards, which make up a far smaller share of the debit market, could see revenue fall by $1.47 billion per year.
These figures are based on the total volume of both PIN and signature payments reported by the two payments companies. Visa said it handled a total of $925 billion in debit purchases in the 12-month period that ended March 31. MasterCard reported $327 billion in debit transactions in 2009.
Other companies also offer debit cards, so this equation is certainly not comprehensive, but Visa and MasterCard make up a major slice of the market.
According to the National Retail Federation, which lobbied hard for interchange regulations, merchants pay about $20 billion annually in fees for accepting debit cards.
Interchange rates vary significantly; PIN is cheaper than signature, different types of merchants pay different rates and even the type of card can affect the fee charged for each purchase.
For this calculation, PaymentsSource assumed an average, blended interchange rate of 0.09%, meaning Visa debit cards are generating $8.3 billion in annual interchange revenue, at current levels, and MasterCard cards are bringing in another $2.9 billion.
(And these are both lowball figures, since debit is growing; Visa's volume increased 11% in the year that ended March 31, and MasterCard's 2009 total was up 5.8% over the previous year.)
Observers speculate that sometime next year the Fed will announce debit interchange rates that are 25% to 75% lower than current levels. The bill requires the Fed to draft regulations within nine months after being signed into law, and the new rates would become effective 12 months after the bill is signed. The debit interchange rules specify that the Fed will not directly regulate the network transaction fees Visa and MasterCard charge banks.
Sanjay Sakhrani, an equity analyst at Keefe, Bruyette & Woods of New York, said that range is broad because the Fed must consider a host of factors, including processing expenses, fraud and other incremental costs.
"It is not clear yet how much the Fed will cut debit interchange rates, which makes it difficult to estimate the effect" on issuers, Sakhrani said. There's "a lot of wiggle room."
For this estimate, PaymentsSource assumed that debit fees would be cut by 50%, eliminating $4.15 billion in interchange fees for Visa issuers and $1.45 billion for MasterCard issuers.
Visa declined to comment for this story. MasterCard said last Tuesday that it was "disappointed" with the legislation; on Friday it said it had no further comments.
Customers may suffer along with issuers.
"Interchange is a big enough component on consumer debit accounts that it finances a lot of other bank operations," said Adil Moussa, an analyst with Aite Group. A cut of 50% or more would likely force banks to add fees for more services, possibly including charging customers for maintaining checking accounts with debit cards.
Despite the loss of revenue, it is unlikely that lower interchange rates will deter banks from promoting debit, Moussa said. "Banks are going to keep pushing debit because it's a core product. And even if they make less revenue on it, they still want that revenue stream."
William Shaw, a group vice president of First Citizens Bank, said PIN transactions accounted for about 30% of its debit mix in 2008, and about half today. First Citizens, of Raleigh, operates more than 370 branches in seven states.
Because it's cheaper, Shaw said the company breaks even on PIN debit.
Signature debit rates are as high as 1.35%, he said, and the combined costs of marketing and supporting debit rewards programs consume about 60% of signature debit revenue. Losing a substantial portion of interchange revenue is going to force the bank to rethink its debit strategy, especially for rewards.
"We're going to see a big drop-off in signature debit programs when debit interchange regulation comes through," Shaw said.