Community bankers have a nagging question about their exemption from forthcoming caps on debit interchange under Dodd-Frank's Durbin amendment: Why did Congress even bother?

Months after the legislation set in motion plans for the Federal Reserve to cap interchange fees for banks over $10 billion in assets, bankers and payments experts have growing doubts about whether the major bank card networks are willing, or able, to provide the remaining 16,000 banks and credit unions a way to keep their current rates.

"There will be some type of separation, but in my belief from everything I'm hearing, I don't see there is a way they can keep the two rates separate over time," says John Burhmaster, president of $350 million-asset First National Bank of Scotia (N.Y.).

"Most likely," says Aaron McPherson, payments analyst with IDC Financial Insights, "Visa and MasterCard will voluntarily set the small-bank rates at whatever the Fed does for the big ones."

Such misgivings are fueled by Visa and MasterCard refusing to air specifics on how they would handle small-bank transactions apart from the debit traffic of the mega-issuers-a task more technically difficult than lawmakers understood, many believe. There's also the Durbin amendment language that doesn't actually require bankcard networks to establish dual-track pricing to include higher rates for small-bank debit interchange.

Even if Visa, MasterCard, Discover, et al, work out a second rail for exempt institutions, critics point out merchants have new allowances for purchase minimums and surcharges they could use to steer small-bank cardholders away from signature debit anyway. "Small banks should not take much comfort by the fact they were exempted from parts of the Durbin amendment," says Jaret Sieberg, a senior vice president with MFGlobal's Washington Research Group, a policy analyst firm.

The controversial amendment U.S. Sen. Dick Durbin (D-Ill.) added to the financial reform package signed into law this summer calls for the Fed to determine interchange fees "reasonable and proportional" to issuers' costs by April 2011. The Fed surveyed institutions this summer and fall, and banks are expecting new rates to drop dramatically and impair their fee income. Bank of America alone estimates it will lose $1.8 billion to $2.3 billion a year.

While observers say Visa and MasterCard have offered private assurances they'll manage small-bank debit transactions separately, neither network has spelled out how they'd pull off what some see as infeasible for both technical and business reasons.

Visa chairman and CEO Joseph Saunders said in the company's third-quarter earnings conference call that the network is doing its "darnedest" to adhere to the exemption, but "we have said consistently and we said prior to the law being passed, that's a very, very difficult thing to," and requires the cooperation of other payments entities "in order to achieve that end."

A major problem is most small issuers use a card processor or agent bank to handle debit transactions. The cards they issue carry the six-digit bank identification number of the small bank's partner, and this "shared BIN" is what most acquirers and networks use to match with complex interchange rate schedules.

Bank networks and acquirers would need to reconfigure transaction data and systems (perhaps merchant terminals, too) to siphon out small-bank transactions, says Linda Perry, a private consultant and former Visa senior vice president. "It's a very complex scheme that I don't think people want to entertain," she says.

From the time the rate caps were first proposed, community bankers complained they could not compete for merchant acceptance against large banks with artificially low interchange rates, on top of additional low-cost network routing options that may drive prices down further.

When interchange fees evaporate for small banks, despite the amendment's intentions, a community institution lacks the scale to offset revenue losses, says Jason Kratovil, vice president of Congressional relations for the Independent Community Bankers of America.

Jim Schlegel, a senior product manager for payments processor ACI Worldwide, says some banks may look to shut down many of their loyalty spending and customer retention programs. Some may go even further. "We've heard some banks starting to consider shutting down [branded] signature debit and exclusively issue PIN debit."

The exemption issue may not matter if 2010 financial regulatory reforms are revisited, or if the caps are successfully challenged in a federal lawsuit filed in October by TCF Financial Corp. against the new interchange rules.

But most consider those remote possibilities. That's why payments industry executives feel it's time Visa and MasterCard explain how, or if, a dual-rate program can work, regardless of where the Fed sets its rates. "The thing Visa and MasterCard need to do," says Schlegel, "is step up, take some leadership, and understand how their member banks will be impacted."

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