Where's Banks' Incentive to Cut Card Fraud?

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The Federal Reserve Board is preparing to release yet another important rule required by Dodd-Frank: how and why fraud occurs in debit card transactions and who should have to pay for it.

Tackling these questions would address one of the big problems with the current system, which is a lack of incentive to dramatically reduce the causes of fraud.

For more than a decade, banks have encouraged all retailers, not just the grocers who are members of our trade association, to have their customers sign for their debit card purchases instead of entering a personal identification number, or PIN. This signature system relies on antiquated technology and is far more prone to fraud.

In a recent study, the Food Marketing Institute found that about 85 percent of the $1.4 billion in debit-card fraud losses occurred as a result of transactions associated with signature transactions (as opposed to PIN transactions.) Yet, thanks to the banks' efforts to bolster and financially reward the signature system, nearly two-thirds of debit card transactions are completed with only a signature.  There is currently little incentive for banks to change the system, and potentially even less if the fraud adjustment rule fails to also recognize the $1.4 billion in fraud from a substandard system that rewards the banks and punishes the retailer.

Under the Federal Reserve's final rule on debit card swipe fees, the cap on debit fees remains the same whether the transaction is completed with a PIN or only with a signature. With PIN transactions priced virtually the same, there is no longer a financial incentive for many merchants who have been the only countervailing force encouraging customers to enter their PIN (in order to receive cash back and avoid ATM fees).

The more secure PIN transactions can now be artificially inflated to the higher price now that banks are able to charge the maximum swipe transaction fee, regardless of the technology, because the Fed in its final rule also let banks charge the maximum 23 cents even on small purchases like a cup of coffee for which they once charged only a few cents.

The fees collected by the banks are not small change. Last year, more than one-third of all retail transactions in America were made with debit cards – a tidy $1.4 trillion. Consider these figures from our research: every bank that issues a debit card faces an estimated $1.50 in fraud prevention costs and direct fraud losses of $1.48 per card. Compare that to the $118 in fees and other charges that each card generates, and you reach an average estimate of $115 in net profit per card. Now take a look at the retailer statistics: Retailers pay hefty fraud-prevention costs that amount to an average of $15.42 per debit card in the U.S., in addition to the $87 in swipe fees that the merchant must bear.

If banks would encourage safer PIN transactions and pass along the savings to merchants and consumers, the reduced fraud would save money for everybody — food retailers who account for 13 percent of retail sales; the other merchants; and, of course, consumers who would not only benefit from lower costs, but also from more secure transactions and improved identity protection.

Regulators must look at this question not as a means of rewarding the banks to cover-up the symptoms, but as a means of treating the root illness by putting a better fraud-resistant system in place.

We can look at other countries' models as we move forward in addressing fraud in our payments system. The U.S. is far behind technologically on card security. Other countries use cards with embedded microchips rather than the unencrypted magnetic strips on American cards, which can be duplicated by thieves and wear out. Banks in other countries must issue cards with PIN numbers and have for years. When French banks adopted this system back in 1992, debit fraud dropped by half in the first year, according to our research.

Merchants are not alone in feeling the burden of fraud. As payment fraud increases, it imposes unnecessary costs on the grocery industry (operating with a .98 percent profit margin), translating to higher prices and fewer jobs — at a time when consumers can least afford such a hit.  The Federal Reserve has the opportunity to look at fraud reduction, not just a fraud adjustment and can adopt more effective incentives and technologies, like chip and PIN, to reduce fraud in our payments system.

Leslie Sarasin is the president and chief executive officer of the Food Marketing Institute.

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