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Two weeks before bitterly contested regulations regarding its debit cards went into effect in the fall, MasterCard threw a party in New York City. The company wanted to trumpet its commitment to the newest technology in payments, including a role in the about-to-launch Google Wallet, which lets a handful of eligible people buy chewing gum or bottled water by waving their smartphones around. Executives at the event were determinedly festive.

One of MasterCard's guests of honor was Tony Zazula, a thin, fastidious man whose jeans and rock-band T-shirt set him apart from the sober suits. Zazula became an unlikely spokesman for the banking industry when he stopped taking cash at his West Village restaurant, Commerce, a few years ago. As other merchants marshaled their decades of resentment at the card system into a successful legislative attack, Zazula helped with the defense-not of the fees, but of the value that cards provide over cash for small businesses like his. He appeared in publicity materials for MasterCard and Visa, and extolled the virtues of cards in stories that ran in The New York Times and The Wall Street Journal.

His praise only goes so far, though. Presiding over the canapes table at the MasterCard event, Zazula said that while he was still happy with Commerce's cards-only policy, he welcomed the coming regulations on debit. Like every other business that accepts plastic, Zazula's restaurant pays a fee when its customers pay by card. With a cap on what banks could charge for debit interchange, each swipe of a debit card would, on average, cost Zazula about half the amount it used to.

"It needs to go down," Zazula says. "These fees are exorbitant."

Merchants and payments companies have long had a symbiotic existence. Zazula appreciates this more than most. He gave up on cash in 2009, seeing as how the vast majority of his upscale clientele already paid with cards anyway. "I weighed it against the cost of handling all that cash-or that little bit of cash." He initially worried that people having a drink before sitting down to a plate of Commerce's roasted sweet potato tortelloni or pork schnitzel with fingerling potatoes might miss the ritual of throwing a $20 bill on the bar. But he says "no one is really that upset about it." Certainly Zazula isn't. He says eliminating the need for daily trips to the bank to make deposits and saving "all that time spent at the end of the night reconciling the $20 difference no one can find" made it well worth the extra expense to steer the cash portion of his business onto the card networks.

So when a cards evangelist like Zazula complains about excessive fees, it's a good indication of the fissures in the relationship between banks and merchants. Both sides say tension is at an all-time high, after a months-long fight in Washington over swipe fee regulation drew blood-and an estimated $5 billion in annual revenue-from banks and their card network partners.

"It's going to take a long time before that relationship can be repaired," says Richard Hunt, the head of the Consumer Bankers Association, who calls the retail industry's support of debit-card fee regulation "so disingenuous. ... They owe everybody an apology."

Retailers are far from apologetic, though. Preserving the debit card swipe fee reforms included in the Dodd-Frank Act was No. 1 on the Retail Industry Leaders Association's list of its top legislative accomplishments of 2011, when Republicans in Congress were threatening to repeal parts of the 2010 bill. Among RILA's top legislative priorities for this year? Extending swipe fee reform to credit cards.

"Merchants are so fed up with a lot of the attributes of the current payments system, they're looking for any alternatives. And that's what led to a lot of the activities on the Hill last year," says Mark Horwedel, a former Wal-Mart executive who now runs the Merchant Advisory Group, which represents large retailers in their negotiations with payments companies.

"I've been in the payments business 37 years," he says, "and I've never seen the degree of animosity that exists today."

Now, people on both sides worry whether the warring industries can reconcile and work together effectively. That mandate is more important than ever in these early days of mobile payments, with traditional banks and networks having to fend off the outsiders encroaching on their business. Some of the interlopers-they range from startups like Square to more well-known brands like Google-are working hard to court merchants' favor. If they succeed, it is the established payments industry players that have the most to lose.

On Oct. 1, banks started watching debit interchange revenue drain from their already-depleted coffers, as a result of the Durbin amendment to Dodd-Frank. Another part of the law goes into effect this month, eliminating the lucrative, exclusive processing contracts that some banks have with Visa and MasterCard.

Proposed late in the debate over Dodd-Frank, the Durbin amendment came as a shock to financial services firms, which struggled to find the connection between interchange rules and the call for regulatory reform that the financial crisis had prompted. In a May 2010 speech from the Senate floor, the amendment's main champion explained why he introduced the measure: "I had the CEO of Walgreens contact me last week," said Sen. Richard Durbin, a Democrat from the drugstore chain's home state of Illinois, "and he told me that ... the fees that Walgreens pays to credit card companies is the fourth-largest item of cost for their business," with only wages, real estate, and healthcare benefits costing more.

And with that, a high-stakes battle between powerful industries began playing out on a new stage. The two sides "got into a legislative process instead of a negotiated process-and once that starts happening, relationships tend to deteriorate because the parties are talking to legislators and not each other," says banking lawyer Oliver Ireland, a partner with Morrison & Foerster in Washington.

"Some subset of the merchant community proposed that legislation, put it together. Congress passed it, and that took billions of dollars out of banks' pockets. ... I think some people are really going to react negatively to that, probably for some time to come."

Banks including JPMorgan Chase and Bank of America already have reported sizeable drops in debit card revenue, and it's tough to see how they might recover the lost income. Chase killed its debit-card rewards program last year; even so, executives said in February that most customers with less than $100,000 in deposits and investments remain unprofitable to the bank. BofA attempted to impose a $5 monthly fee on debit customers, but its approach made for one of the biggest customer relations blunders in recent memory, and the idea was withdrawn.

Visa and MasterCard appear to have been more successful so far in deflecting the regulatory impact. The two largest card networks spent much of 2010 watching their share prices plummet as regulation around the Durbin amendment took shape. Investors worried the new rules would block growth. But both stocks have more than recovered, and the companies have found ways to offset the effects of new federal restrictions by rejiggering how they charge merchants' banks and technology vendors for accepting debit cards.

"It's a complicated balance," says Craig Vosburg, MasterCard's head of U.S. market development. "Our objective is to manage [pricing] in a way that allows the network to grow."

Credit card executives say they understand that merchants don't like interchange prices, but Vosburg argues that they would complain no matter what they were charged.

"The important thing is to deliver the value in exchange for that pricing," he says. "Some of that value has become a little taken for granted, as cards have become such an everyday part of our lives."

Still, executives from Wal-Mart, Home Depot, McDonald's and other retailers large and small continue to decry the way they are charged for using electronic payments, arguing that the Durbin amendment did little to change the fundamental power imbalance between the financial companies that run the card networks and the merchants that have to abide by their rules.

"I find the whole thing excessive. We're all forced into it. We don't have a choice as merchants," says Zazula, who estimates that his restaurant pays about $150,000 a year to accept credit and debit cards.

"For every transaction that's authorized and funded by a financial institution, there's a merchant on the other end, and why is it that only one side makes all the decisions about the rules?" says Horwedel, of the Merchant Advisory Group. "I think as long as that is the case, there are going to be issues."

Indeed, long-pending merchant lawsuits over the interchange system for credit cards have banks and card networks bracing for a potentially expensive resolution. The cases are widely expected to get settled, at amounts reaching into the billions, before going to trial this fall.

The friction between the retail and financial sectors, if not resolved, could gum up the payment industry establishment's bigger plans for growth, as well as its efforts to protect itself from other powerful companies looking to muscle in on its profitable turf.

Debit cards are popular among consumers but no longer very lucrative for banks, thanks to Durbin and other regulations, including restrictions on overdraft fees. Credit cards are more profitable but have less room to grow; after the recession, banks and consumers alike are wary about increasing personal debt, and the big banks that specialize in credit card lending mostly seem to be trying to poach from the limited pools of one another's least-risky customers.

Now, some of the biggest financial companies are pinning their hopes on mobile payments.

Americans love their smartphones, the reasoning goes, and people in other countries already use phones to pay for transit or goods. So how long can it be before U.S. consumers get used to pulling out their phones in places where today they would pull out a wallet?

But migrating to a mobile world won't necessarily make it any easier for players on either side of the interchange debate to agree on fair prices for payments processing.

"There's a new vision of how [merchants and banks] can operate together. But a lot of these same old problems still exist," says Matthew Friend, who runs the North American payments practice of consulting firm Accenture.

While the term "mobile payments" can describe many different uses for technology, Google Wallet has become one of the most mainstream examples. Google unveiled it with great fanfare a year ago, along with partners including MasterCard, Citigroup and Sprint Nextel. Visa has tested a similar product, while a coalition of the biggest mobile telephone companies is trying to get a similar venture, called Isis, off the ground. Bankers and credit card executives often talk of these projects as opportunities. But as Google, Apple, Facebook and other technology companies-not to mention the wireless phone companies-wade into the world of electronic payments, some entrenched players see a threat in sheep's clothing.

"I think you're going to have people like Verizon, Sprint, and T-Mobile who will play a role in processing mobile transactions," says Joseph Rosenbaum, a partner at the law firm Reed Smith and a former in-house senior counsel at American Express. "Why do we think they will not want to have a piece of that pie?"

Accenture's Friend says that compared with networks, consumers and merchants, banks are less enthusiastic about mobile payments.

"There's the potential to do more transactions, but there is also still the real concern for further reduced fee income and the threat of disintermediation," he says.

Just last month, the American Bankers Association formed a payment systems task force led by Jeff Plagge, vice chairman of the ABA and president of Northwest Financial in Arnolds Park, Iowa. Plagge says that with so many digital and mobile payments innovations emerging, it is "important to ensure competitive access and participation for banks of all sizes and charters." All of the task force members represent community banks, and five of the eight are bank CEOs, including Howard Boyle of Home Savings Bank in Kent, Ohio, and Guy Williams of Gulf Coast Bank and Trust Co. in New Orleans.

Not everyone is full buying into the promise of mobile payments just yet. Steve Kietz, an executive with digital advertising technology firm EDO Interactive, says he has seen some big card issuers cut back on their investments in emerging payment technologies. (He would not name names.) But banks cannot afford to ignore mobile payments entirely-and the best way to make sure they maintain a hand in them may be to keep merchants on their side.

The fear is that consumer adoption of mobile payments, while sluggish thus far, could explode if an innovation from the outside turns the industry on its head-much in the way that Apple's iTunes revolutionized the music business, and gutted traditional record companies in the process. If a similarly powerful threat emerges in payments, hastening the proliferation of near-field communications or any of the other mobile payments technologies currently competing for acceptance, banks and networks want to be prepared.

"They absolutely know it has to happen, because when consumers start doing it-when the iPhone 5 hits and it comes with NFC-at that point in time it's going to be a very fast slope that everybody slides down," Friend says.

Some bankers are skeptical that such a day is near. "Mobile is definitely going to be a significant presence. But three years from now it will look very different than it does today," says Stephen Eulie, who runs the credit card division at First National Bank of Omaha.

Much of what it will look like will depend on merchants. If Google Wallet and similar products make inroads with enough customers to become the mobile payments system of choice, retailers-or somebody-will have to shoulder the costly, time-consuming task of upgrading card readers at the register and training front-line staff on the technology. "Someone's going to have to pay for that equipment, and nobody's stepping up. The banks don't want to, the networks-it's not their business, and the merchants aren't getting an incentive," says James Tierney, chief investment officer of asset manager W.P. Stewart, which invests in both financial and retail companies.

Merchants are far from enthusiastic about the potential expense. "Have you ever seen a merchant pushing mobile right now? It's all hardware guys and networks," says David True, a former MasterCard executive who now consults.

Zazula says he would consider accepting smartphone-wallet-type payments at his restaurant "if it's not an additional cost and it's not a hassle for the guest." But Horwedel and others representing the retail industry say they have seen no signs that the banks or the networks would be willing to subsidize merchants' costs for upgrading terminals or training staff.

Visa did not respond to a request for comment; MasterCard's Vosburg declined to discuss specifics of his company's discussions with merchants, but says that when it comes to the adoption of mobile payments, "the merchant ultimately will make the decision as to whether that value will warrant investment." Meanwhile, the CBA's Hunt says his banks are "doing everything we can to satisfy the needs of the customer. That's where merchants are going to have to change their systems as well."

If merchants cannot be persuaded to align themselves closely with banks in the early days of mobile, the banking industry risks losing ground to new competitors. Some merchants already view mobile payments as a chance to cut out the traditional payments infrastructure. Most of the people interviewed for this article made at least one reference to PayPal, the payments unit of eBay, which is trying to leap from the online world to the brick-and-mortar one, with an initiative to steal traditional card transactions at every Home Depot store. Other big merchants, including Wal-Mart and Target, are reportedly trying to build their own mobile payment systems.

"The shift into mobile has opened up opportunities for other players to consider more cost-effective, and therefore more widely desirable, alternatives," says Mallory Duncan, senior vice president of the National Retail Federation. "We now have the potential of using new and emerging networks ... as mechanisms for payment delivery that may or may not run through the traditional channels."

Don Kingsborough, PayPal's vice president of retail and prepaid products, suggested in a recent interview with Reuters that the rift between banks and merchants makes Paypal's work easier. "The existing competition has adversarial relationships with retailers. We have love fests." If so, it might have something to do with the subsidies that PayPal is handing out. Kingsborough told Reuters that PayPal would continue to offer merchant discounts on its service as the payments upstart tries to gain scale.

PayPal and the merchant-controlled alternatives have their skeptics. Bank investors and analysts note that PayPal still controls a relatively tiny portion of the transaction-processing market, compared with Visa and MasterCard. Even older, more established competitors like Discover Financial Services have yet to make much of a dent in the business of the industry's two biggest players. As card industry veteran Andrew Kahr observes, "The duopoly does not need to become cheaper or more efficient in order to compete."

Kahr, who founded credit card company First Deposit, later known as Providian Financial, says there have "always been outsiders who suck off volume. Now it's PayPal and promoters of decoupled debits and virtual wallets," in addition to traditional card companies such as Discover and American Express. (Kahr is a regular contributor to American Banker's BankThink blog.)

New opportunities in mobile payments could either help or hurt any chances of reconciliation by banks and merchants. For now, at least some observers are optimistic that the two sectors will find a way to stay aligned with one another. "The devil you know is better than the devil you don't," says EDO's Kietz. "Cash is expensive to handle and leads to shrinkage," or internal theft, while "new payments systems take a long time to build. The merchants and the banks-they're going to have to find out a way to work together."

In other words, unless and until PayPal or another alternative payments network succeeds beyond its wildest dreams, the payments establishment and the retail industry are stuck with one another-for better or for worse.

"They're wedded, period," says Eric Grover, of the payments consulting firm Intrepid Ventures. "But like many marriages, each partner is trying to get a better deal."


Maria Aspan is the consumer finance editor for American Banker.

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