Contrary to expectations, the Federal Reserve Board’s draft report on debit interchange did not resolve the debate on the cost of fraud in card payments.
Many in the industry thought the report would say how much of the cost of interchange banks could justify as necessary in the fight against fraud. Though the Fed proposed an interchange rate, it made clear that fraud was not fully addressed in its proposal.
In the report, released Dec. 16, the Fed set two categories that would give bankers room to make an adjustment in the interchange they charge for fraud (
Buried in the draft report is a fairly in-depth account of what the Fed says it believes are the true costs of fraud. For example, it says that issuers “reported that total signature- and PIN-debit card fraud losses to all parties averaged 13.1 and 3.5 basis points respectively.” The report goes on to say issuers and merchants bore 55% and 45% of signature-debit fraud losses respectively.
However, during a Dec. 16 Board of Governors meeting, the governors acknowledged they would not have a final ruling on fraud costs until after the comment period, and most likely they would have to rule separately on fraud after it issues the final rule on debit interchange in April.
The Fed set a safe harbor floor on interchange of 7 cents per transaction, which could rise to high as 12 cents for various costs related to running the payments network.
Tien-tsin Huang, JPMorgan Chase & Co.’s senior analyst covering the Computer Services & IT Consulting industry, suggested in a Dec. 17 research note that an allowance could be made for fraud. In an e-mail, Huang said that allowance could be 1.8 cents per transaction.
Banks were hesitant to weigh in just yet.
“We realize, and [the Fed] realize(s), how important debit cards are to our customers and to the nation as a whole,” says Alanson Van Fleet, a spokesperson for Wells Fargo & Co. of San Francisco. “We are reviewing the draft comment carefully, and we will be responding to the Fed in the 60-day period they mentioned. But we feel it is premature for us to speculate beyond that point.”
Industry observers say they thought the draft report indicated the cost for merchants would go up because they would have to install new point-of-sale terminals and add technology such as that specified in the Fed report: end-to-end encryption, tokenization, chip-and-PIN acceptance and dynamic data.
“The regulations would put a significant burden on merchants, either to make the terminal upgrades required under the first alternative or in the form of additional interchange fees,” says Aaron McPherson, a research manager for payments at the Framingham, Mass.-based research firm IDC Financial Insights. The boon most certainly would go to security-technology vendors, he adds.
What the Fed has done is attempt to identify some of the most important fraud-prevention technologies, McPherson says, noting that while he thought that was important to try to do, the effort fell short. “There are some holes in this that need filling like, what are the technologies,” and how much of the cost could be put into interchange? he says.
It might be problematic for the Fed to specify a list of approved technologies, but it could be a way to jump start more-secure fraud-prevention technologies, such as EMV chip-and-PIN, in the U.S.
But that “puts the Fed in the position of kingmaker, which it prefers to avoid,” McPherson says.
Julie Conroy McNelley, senior risk and fraud analyst for Aite Group in Boston, disagrees about who would bear the cost of putting in new security systems. “The only ones who win will be merchants, and this will shift the entire burden of operating the infrastructure to the banks,” McNelley says. “Banks will pass this on to the consumers, and they will be the biggest losers.”
The Fed is “bringing transparency to the issue, and that is really needed,” says Avivah Litan, vice president and a distinguished analyst at the Stamford, Conn.-based research company Gartner Inc. Interchange “has long been a monopoly, but it was never recognized as such,” she says.
The fraud cost for merchants always has been a mystery, though many believe that retailers bear most of the cost today, Litan says.
The American Banker’s Association said it is concerned the impact of a cap on interchange could limit the ability of banks to combat fraud.
“It is very important the Fed get this right,” says Ken Clayton, the association’s senior vice president of card policy. “It is important to the banks and to consumers and for confidence in the overall system.”
Small community banks, though exempted by a $10 billion asset rule from the cap on interchange pricing, would be even more adversely affected because they have less technology at their disposal than bigger banks do to fight fraud, and their reputational risk is greater, Clayton adds.
Some analysts say they saw issues in the lack of standardization around technology used to fight debit card fraud, and that ultimately could affect earnings.
“There’s a great difference between one issuer and another within the areas of ‘fraud prevention,’” says James Van Dyke, founder and principal researcher of Javelin Strategy and Research in Pleasanton, Calif. If interchange were reset today based on the vague yardstick for fraud proposed, “the profits of one issuer versus another would vary widely,” he adds.
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