March 31, 2012

The Durbin Derby: Are There Any Winners?

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) impacted to some degree almost every aspect of the financial services industry, from securities transactions to mortgage origination and servicing to deposit accounts. For many Americans, the changes brought about by the Act have seemed distant and theoretical until now. But the recent implementation of one of the Act's provisions has resulted in changes in banking relationships that have made that Act more of a reality for many individuals. Among its many provisions, the Act included an amendment to the Electronic Fund Transfer Act (EFTA). That amendment added EFTA section 920, which limits the fees that banks can charge retailers for their customers' use of debit cards and establishes other restrictions for debit card transactions. This provision, which was a last-minute addition to the Act, has been dubbed "the Durbin Amendment" (or Amendment), named after its author, Senator Richard Durbin.

The Durbin Amendment

EFTA section 920(a)(2) limits the amount of the interchange transaction fee that a debit card issuer may receive or charge with respect to an electronic debit transaction to an amount that is "reasonable and proportional" to the issuer's cost with respect to the transaction. Section 920(a)(3) requires the board of governors of the Federal Reserve System (the Board) to establish a regulation to implement this requirement. The Board responded by adopting a final implementing rule, Regulation II, 12 C.F.R. § 235, which generally became effective on October 1, 2011.

An "interchange transaction fee," the focus of the Durbin Amendment and Regulation II, is any fee established, charged or received by a payment card network to compensate a debit card issuer for its involvement in an electronic debit transaction. The amount of this "swipe fee" must be reasonable and proportional to the cost incurred by the debit card issuer with respect to the transaction. The Board has established a maximum interchange fee of $0.21 per debit card transaction, plus five basis points of the transaction's value (as an ad valorem component), plus a fraud-prevention adjustment of up to $.01 per transaction for qualifying issuers. The $0.21 cap, as implemented by Regulation II, effectively creates a "safe harbor"; a debit card transaction interchange fee that complies with the cap is deemed to be conclusively reasonable and proportional. Regulation II also creates certain exemptions from these rules and prohibits specific actions, discussed below.

Overview of Debit Card Industry

The typical debit card transaction consists of the interaction of the cardholder, the bank that issued the debit card to the cardholder, the network operator, the merchant's bank, and the merchant itself, with the network operator in the center of the transaction. On one side of the network operator is the consumer utilizing his or her debit card and the bank that issued the debit card to the consumer (the issuer). The merchant and its bank (the acquirer) are on the other side of the network operator. The merchant traditionally contracts with its bank in order to gain access to the network operator and to compensate the bank for its services. In a pre-Durbin Amendment $100 debit card transaction, the funds might have been distributed as follows: the merchant received roughly $97.20; the issuing bank kept approximately $1.70 and remitted about $.50 to the merchant bank for the network operator.

Debit card transactions are typically processed over networks utilizing a personal identification number, or "PIN," or the cardholder's signature. A PIN debit network uses a single-message system that carries authorization and clearing information in one message. A signature-based network uses a dual-message system, carrying the transaction authorization and clearing information in separate messages. The vast majority of debit cards support both PIN- and signature-based transaction methods.

The Durbin Rule's interchange fee standards apply to the four-party system. The four-party system, the most commonly used processing system, involves the cardholder, the issuer, the merchant, and the acquirer. In a typical four-party system, the cardholder provides his or her card to a merchant to initiate a purchase, and, in a PIN debit, enters a PIN. The merchant sends an electronic authorization request for a specific dollar amount, along with the cardholder's account information, to the acquirer and to the network, which sends the request to the issuer. The issuer verifies that the cardholder's account balance is sufficient to cover the transaction amount and that the card is valid. A message approving or declining the transaction is returned to the merchant by the reverse path, usually within seconds of the authorization request. The network calculates and communicates to the issuer and acquirer its net debit or credit position for settlement.

Each debit card transaction involves various fees. Typically, the merchant pays an interchange fee to the issuer through the network operator, which sets the amount of the fee. The network also charges the acquirer and issuer a "switch fee" as compensation for its role in processing the transaction. In each transaction, the acquirer charges the merchant a merchant discount, which includes the interchange fee, the network switch fee, any other acquirer costs, and a markup applied by the acquirer. Over the past 10 years, the levels of nearly all components of the interchange fee assessed by PIN-based networks have risen, and caps on overall fees have been increased or eliminated entirely. Signature-based transaction fees followed the same pattern but have risen more slowly.

In addition to assessing fees, each card network establishes operating rules with which merchants and processors must comply in order to utilize the network. These rules govern conduct such as merchant card acceptance, technological specifications for cards and terminals, risk management and determination of how a transaction will be routed when multiple networks are available.

Regulation II (12 C.F.R. part 235)

Definitions

For purposes of the Durbin Amendment's implementing Regulation II, "debit card" is defined broadly as a card, payment card, or device issued through a payment card network to debit an "account," which is a transaction, savings or asset account established for any purpose and located in the United States. "Debit cards" do not include checks, drafts, or similar paper instruments or electronic representations of those instruments or the use of an account number to initiate ACH transactions.

An "electronic debit transaction" is the use of a debit card as a form of payment to initiate a debit to an account. It includes the use of a debit card to purchase goods or services, to satisfy an obligation (e.g., taxes) or for other purposes. It also includes a transaction in which a cardholder uses a debit card to make a purchase and to withdraw cash at the point of sale (a "cash-back transaction"). Transactions conducted at ATMs, including cash withdrawals and balance transfers, are not "electronic debit transactions."

Fee Restrictions

The October 1, 2011, deadline has passed and, for the most part, the requirements established by the Durbin Amendment, implemented by the Board's adoption of Regulation II, have become effective. An issuer is prohibited from receiving or charging a debit card interchange transaction fee in excess of a base component of $0.21, which does not vary with a transaction's value, plus an ad valorem component equal to five basis points of the transaction's value. The interchange fee amount does not differ between PIN and signature transactions. The base component includes certain allowable costs related to authorization, clearance, and settlement of a debit transaction, consisting of network connectivity; software, hardware, equipment, and associated labor; network processing fees; and transaction monitoring. The ad valorem component is based on the median per-transaction fraud losses that issuers reported to the Board. A fraud-prevention adjustment of $0.01 per transaction is also available if the issuer meets certain standards established by the Board.

The fee restrictions and the other limitations of Regulation II apply to both business and consumer accounts, as well as general-use prepaid cards, unless they are subject to the prepaid exemption to the interchange fee limitation, discussed below. Decoupled debit cards (where the issuer does not hold the debit account), deferred debit cards (where the issuer agrees not to post transactions until a later date), and payment codes or devices (even if not issued in card form, like a mobile phone or sticker containing a contactless chip) are all subject to the regulation's restrictions.

Interchange Fee Exemptions

A small issuer that, with its affiliates, has assets of less than $10 billion is exempt from the interchange fee restrictions. The Board will publish an annual list of all institutions, identifying those with assets below the $10 billion exemption amount. Exempt issuers are permitted to receive a higher interchange rate than the Regulation otherwise permits for non-exempt issuers. The Board's staff has been instructed to monitor how well the exemption works for small issuers and to report to the Board over time regarding the exemption's impact on small issuers.

Debit cards issued pursuant to government-administered programs and certain reloadable general-use prepaid cards are also exempt from the fee restrictions. However, these exemptions will expire on July 21, 2012, if the issuer charges an overdraft fee in connection with the card or a fee for the first withdrawal each month from an ATM that is part of the issuer's designated ATM network.

Network Exclusivity and Routing Restrictions

The Durbin Amendment also required the Board to prescribe regulations that prohibit an issuer or network from restricting the number of networks over which a merchant may process an electronic debit transaction to fewer than two unaffiliated networks (the "network exclusivity restrictions"). In addition, the Board was required to issue regulations prohibiting an issuer or network from preventing a merchant that accepts debit cards from routing a debit transaction through any network that will process the transaction (the "merchant routing restrictions"). These exclusivity restrictions are implemented by section 235.7(a)(1) of Regulation II. An issuer complies with these requirements if it allows an electronic debit transaction to be processed on at least two unaffiliated payment card networks, each of which does not restrict network operation to a limited geographic area, specific merchant, or transaction and each of which has taken steps to enable the network to process the debit transaction that it reasonably expects to be routed to it, based on transaction volume. For example, it would be sufficient for an issuer to issue a debit card that operates on one signature-based card network and one PIN-based card network, as long as the two networks are not affiliated. Alternatively, an issuer could issue a debit card that operates on two unaffiliated signature-based card networks, but is not enabled for PIN debit transactions, or vice versa.

In order to avoid a prohibited exclusivity arrangement, a network may not restrict or limit an issuer's ability to contract with any other payment card network that may process debit card transactions involving the issuer's debit cards. Similarly, a network may not set rules or guidelines that allow only that network's brand, mark, or logo to be displayed on a particular debit card or that prohibit the appearance of logos of other networks on a debit card. However, there is no requirement for a debit card to display the brand, mark, or logo of each network over which a debit card transaction may be processed.

There is no exemption from the routing and exclusivity restrictions for small issuers, cards issued pursuant to government-administered payment programs and certain reloadable prepaid cards.

A network cannot prohibit a merchant from offering a discount to customers who pay by a particular method, including cash, check, debit or credit cards. In addition, a network cannot prevent a merchant from setting a minimum dollar value for accepting credit cards, provided that the minimum amount does not vary amount issuers or payment card networks and the established minimum value does not exceed $10. No such minimum value has been established for debit cards; it could be set at any amount.

The exclusivity rules as they apply to payment card networks were effective on October 1, 2011. Otherwise, the rules are generally effective on April 1, 2012. However, April 1, 2013, is the effective date for these rules as they apply to (1) debit cards that use point-of-sale transaction qualification or substantiation systems to verify the eligibility of purchased goods or services and for general-use prepaid cards. The routing rule was effective on October 1, 2011.

Enforcement

Compliance with Regulation II will be administratively enforced by an entity's functional regulator under the EFTA. The Consumer Financial Protection Bureau is not authorized to enforce this provision. Furthermore, the criminal and civil liability provisions of the EFTA are not applicable to violations of this provision.

Response to the Durbin Amendment

Debit Card Industry Response

Since the Board's publication of its rule implementing the Durbin Amendment (or the "Durbin Tax" as it has been referred to lately), many banks have responded by implementing reactionary programs and policy changes.

1. Additional Fees? Maybe Not. As one of the primary early responses to the Board's $0.21 cap on debit card interchange fees, a number of banks either adopted monthly checking account charges or fees for debit card charges for checking accounts that had previously been free of such charges. Comparison site Bankrate reported that not even half of all checking accounts were free in 2011, whereas the majority were free in 2010. In a heavily publicized move, Bank of America was the first to announce that it would impose a $5 monthly debit card fee for checking accounts, beginning in October 2011, in an effort to recoup at least a part of the large sums that the bank expected to lose as a result of the reduction in interchange fees. Most of the other large banks followed suit and announced plans to increase checking account fees and/or begin imposing debt credit fees. The public's reaction to these new or increased fees was swift and extremely negative. As a result of this reaction, the vast majority of these fees have been canceled or modified to substantially reduce their effect.

2. Rewards Programs. Many banks have announced that debit card rewards programs will be limited, if not eliminated entirely, since these rewards programs were largely funded by debit card interchange fee income. At least one bank cited the Durbin Amendment as the basis for its decision to close a significant number of branches, while some analysts asserted that the Amendment should be more properly considered as a factor contributing to, rather than a root cause of, bank closures. However, industry observers roundly admit that the implementation of the Durbin Amendment has triggered cost-cutting decisions by a number of banks.

3. Where Will the Savings Go? The reduction in the interchange fees that they have to pay could result in a major boost to merchants' bottom lines. However, the net savings that merchants will realize is uncertain because the Amendment and Regulation do not restrict how much debit card networks can charge merchants.

Consumer interest groups have announced that they will closely watch merchants to ensure that they pass on interchange fee savings to consumers. Richard Hunt, president of the Consumer Bankers Association, stated that "[r]etailers, their trade associations and Senator Durbin repeatedly stated they would pass along the ten billion dollars in savings to consumers immediately." Mallory Duncan, chairman of the Merchants Payments Coalition, noted that multiple approaches will be used, and that consumers will likely see a mixed result among retailers; some retailers will not raise prices while others will cut prices as a result of the reduction in interchange fees.

In the wake of the large banks' reaction to the changes implemented by the Durbin Amendment, smaller banks that qualify for the $10 billion exemption have attempted to attract new customers by publicizing their lack of debit card fees and checking account fees.

Public reaction to the fees proposed by major banks encouraged, if not created, a strong consumer backlash against major banks, manifested by "Bank Transfer Day." Depositors at major banks were urged to close their accounts with those major banks on Bank Transfer Day, November 5, 2011, and move those accounts into credit unions and smaller community banks.

While Bank Transfer Day was a grassroots initiative designed to highlight customer dissatisfaction at major banks, it created some lasting momentum. It demonstrates a current trend of depositors moving away from major banks and into banks they view as local and more consumer friendly. Although consumer sentiment regarding big bank fee initiatives is decidedly negative now, analysts expect the long-term impact on banks nationwide to be modest.

Credit Card Industry Response

In the wake of the implementation of the Durbin Amendment, retailers have already begun efforts to obtain similar restrictions on credit card interchange fees. The Retail Industry Leaders Association is already initiating plans to lobby on the same scale for credit card interchange fees as it lobbied for debit card interchange fees. However, financial services industry representatives indicate that, because of lingering political fatigue from the contentious fight over debit card transaction fees, this is not an optimal time for such a debate.

Conclusion

It is still too early in the process to accurately predict whether or how the Durbin Amendment and Regulation II will affect the various parties involved in a debit card transaction. While the small issuer exemption could prove to be valuable, too many unknowns still exist to be able to accurately predict how smaller banks will be ultimately impacted. Consumers may see some savings as a result of the new fee restrictions, but this depends on merchants' willingness to pass along part of the interchange fee reduction. The real winner of the Durbin Derby will only be identified with the passage of time, when the full impact of the Amendment's restrictions and exemptions is more apparent.