The Federal Reserve's forthcoming regulations on debit interchange may settle a long-running debate over whether fraud costs and risks are high enough to justify banks' current fees.
Right now it's not widely known exactly how high those costs are, since banks don't break them out. The murkiness has given rise to speculation that the industry exaggerates the role fraud plays in setting interchange rates. The Fed is taking a close look at how banks arrive at their numbers, so the caps that the regulator sets, and the rationale it gives, should shed light on the true cost of fraud.
"We will have more transparency once rates come out and banks ask for an exemption based on fraud," said Aaron McPherson, a research manager for payments at IDC Financial Insights.
The Fed's rule implementing the Durbin amendment to the Dodd-Frank financial reform law is expected to come out by April.
Bankers have said three main factors determine interchange costs: the costs of building the payment system's infrastructure, of maintaining it and of protecting against or reimbursing for fraud and other risks.
No one disputes massive costs are involved in building and running payment networks. But some observers say interchange has funded rewards and other things not explicitly necessary for the handling of payments.
"If the Fed sets interchange rates lower, it is likely an acknowledgement that the fraud component of interchange has always been too high," said Avivah Litan, a vice president and distinguished analyst at Gartner Inc. in Stamford, Conn.
IDC estimates that fraud has been stable for the past six years, at about 0.7% of transactions where the cardholder is present (like store purchases), and 2% of transactions where the cardholder is not (such as purchases made by phone or Web).
McPherson says competition between Visa Inc. and MasterCard Inc. for issuers' business likely has been another impetus behind interchange pricing increases in recent years.
Interchange rates (including both debit and credit cards) currently average 1.93%, up from about 1.6% five years ago, according to Robert Hammer, president of R.K. Hammer, a consulting firm in Thousand Oaks, Calif. The cost of rewards programs has primarily driven the increase, Hammer said. (The Fed's rule will not affect credit card interchange.)
Some bankers, however, maintain that keeping up with fraud is indeed a significant cost that interchange rates should reflect.
Ed Kadletz, executive vice president and head of debit and prepaid cards for Wells Fargo & Co., said the incidence of fraud has increased in recent years at the bank, which "has been doing a lot of investing in detecting and preventing fraud on the signature and PIN debit side, which has really helped keep our loss rates in check."
Kadletz would not specify what types of fraud were increasing and he would not go into detail about what Wells was doing to fight fraud.
He and his colleagues from Wells met with representatives from the Fed on Sept. 1 to explain the bank's debit and prepaid card programs and its authorization, clearing and settlement processes. "A key piece of the legislation is the tallying of costs related to this, and we wanted them to understand how this worked for us," Kadletz said.
Ken Clayton, senior vice president of card policy for the American Bankers Association, said the goal of the talks with the Fed should be to maintain a strong payment system with enough revenue to fight fraud now and in future years.
"The Fed has to look at the role of interchange fees in supporting fraud prevention," Clayton said. "This is a very critical component to protect consumers and to facilitate greater confidence in the system, and we think it is very important that the Fed permit banks to include fraud cost and fraud prevention efforts as part of their interchange."
Smaller banks have another set of concerns. Since their card transaction volume is lower than that of larger banks, they say they might be disproportionately affected by lower rates. (On paper, banks with assets of less than $10 billion are exempt from the interchange rules, but they fear that in practice they will also have to cut their rates to stay competitive with the big banks.)
Sam Vallandingham, vice president and chief information officer for the $250 million-asset First State Bank in Barboursville, W.Va., said smaller banks bear a heavier burden for fraud.
"Smaller banks don't have the ability or the tools that larger ones do to manage [fraudulent] activity," he said. "When you limit [interchange], it reduces the cost-effectiveness of the [fraud prevention] program for the bank."
Vallandingham also said that fraud damages the reputations of smaller banks more than those of bigger banks, so they have to be more vigilant and take extra steps that cost them more. If merchants accepting his cards have data breaches, for example, Vallandingham said his bank immediately reissues cards to its customers without waiting for fraudulent transactions to occur.
For that reason, "there is a pre-emptive cost to preventing fraud," he said.
But James Van Dyke, the president and founder of Javelin Strategy and Research in Pleasanton, Calif., said the cost of fraud disproportionately harms the merchants, not the banks.
A study that Javelin conducted of more than 1,000 merchants and banks in September for the legal information provider LexisNexis found that for every $100 in fraud, merchants wind up paying three times that amount in associated costs. "Merchants overwhelming[ly] bear the cost of fraudulent transactions," Van Dyke said. "Issuers pass that cost on to the merchant."
If interchange rates decline, Van Dyke said, "that should be taken as acknowledgement that there are opportunities to lower the cost of commerce and strengthen the economy by extracting costs from criminals and moving it back to the honest sector."