The interchange amendment within the regulatory reform bill could create a conflict of interest for the Federal Reserve Board.
According to Stuart E. Weiner, a former director of payments at the Federal Reserve Bank of Kansas City, authorizing the Fed to set fees for debit transactions could pose a conflict with its role operating one of the nation's two automated clearing house networks.
The end result, he said, could lead the Fed to spin off its FedWire Services ACH operation.
Many types of ACH transactions, including online bill payment and decoupled debit, compete with the traditional debit card networks and issuers, said Weiner, who now works as an independent consultant and is a faculty member in Kansas State University's finance department.
"The Fed will be setting prices for a competing industry," he said. "It's difficult to believe the Fed will remain an ACH operator once it begins setting debit card interchange rates. … That's a byproduct that really hasn't been thought through."
Officials at the Fed declined to comment on the legislation and how it might affect their activities. Under the financial reform bill, the Fed would be responsible for establishing "reasonable and proportional" debit interchange rates.
The language is open-ended, so the Fed likely will not make major changes to the existing rate structures but instead will make incremental moves, he predicted.
"But the open-endedness will force the Fed to confront some very difficult issues and will force it to take a position on what costs should be considered," he said.
As the Fed weighs the costs issuers incur to handle debit transactions, fraud will be one of the factors. But fraud statistics are "severely lacking" in the U.S., and there is no independent source on fraud costs for the payments industry, Weiner said.
Moreover, the bigger expense involves processing debit card transactions, and it will be "very difficult to delineate the processing costs with all the other costs across the payment chain," he said.
"Conceptually, this is going to create some very difficult questions — what in fact is a cost to the issuer?" Weiner said. "That's where the open-endedness will be problematic."
The definition of "proportional" also is absent from the bill. Some observers have said that means the rates would be equal to the cost of processing a payment. But the Fed also might provide for some markup, and that could be where the "reasonable" aspect of the rate-setting comes in, Weiner said.
Despite the likely reduction in interchange revenue resulting from the Fed's rate review, Weiner believes debit card issuers will still have viable businesses. "Issuers will just need to figure out new ways to run their programs," he said, including introducing annual fees or restructured rewards programs. "I would bet that every major issuer today is already thinking about different scenarios."
Not everyone agrees interchange will even remain once the Fed completes its review. Jeff Shinder, a managing partner at Constantine Cannon, a New York law firm, suggests fraud should not be included as a cost in setting interchange rates but instead should be rolled into issuers' overall cost of doing business. He believes that signature-debit rates will drop, and PIN debit, which is more secure, will emerge as the preferred form of debit payment as the business case for signature debit weakens.
And if that occurs, the Fed should take advantage of the situation and use its authority to help push the U.S. market to adopt the EMV Integrated Circuit Card Specifications, just as most other parts of the industrialized world are doing, Shinder said. "The Fed may need to get involved to bring the process together," he said.
Shinder also believes an underlying goal of the debit-interchange portion of the financial reform legislation is to eliminate the "perverse competition" inherent in the setting of interchange rates. Both Visa Inc. and MasterCard Inc. compete by raising rates to attract issuers, which receive interchange fees each time their cards are used to initiate payments.
A fairer system would have issuers, merchants or both charging customers to have and use cards. That way, cash users would not incur the higher prices merchants charge for goods and services to offset their interchange costs, Shinder said.