Debit 2.0: Surprisingly Good News…for Exempt Issuers

 Author: Lee Wetherington, AAP lwetherington@profitstars.com

Remember the run up to Dodd-Frank? When community banks joined hands with mega banks in a united front against the inchoate incursions of a heavy-handed regulatory response to the recession?

I do. I was in West Virginia awaiting my turn on stage at a bank conference. The chairman of a national banking association had just whipped the crowd of bank CEOs into a frenzy, i.e., they were nodding their heads a lot. The chairman told them the Durbin amendment—despite its exemption of smaller debit-card issuers from its rate cap—would ultimately devastate all banks’ debit card fee income, regardless of size.

I disagreed. And I made the potentially career-limiting decision to express my disagreement during my keynote presentation. I explained that, at a minimum, Durbin would create a 2-to-3 year competitive advantage for smaller issuers, one they should leverage to the hilt.

As soon as I descended from the stage, the chairman intercepted me and, as we say in South Georgia, “took me to the woodshed.” He told me in no uncertain terms that my speech threatened to divide the ranks at a time when unity was essential. I politely apologized for being honest.

Good News

We are now officially one year into Debit 2.0, the post-Durbin era brought to us by way of the Federal Reserve’s Reg II. So, have all debit card issuers had their interchange income equally decimated? No. Far from it.

According to Oliver Wyman’s 2012 Debit Issuer Study, commissioned by PULSE, debit card growth remains robust. The average consumer debit cardholder spent $8,326 on his debit card in 2011, up from $7,781 in 2010. Active debit users averaged 18.3 debit purchases per month, up from 16.3 the year prior. This year, exempt debit issuers (under $10 billion in assets) expect 14% growth in PIN debit transactions, 13% for signature.

Early studies by both the Federal Reserve and Oliver Wyman indicate that exempt issuers have experienced little if any compression in their signature debit interchange rates and virtually no compression in their PIN rates.

Recently, however, there have been anecdotal reports of some exempt issuers experiencing debit interchange rate declines of 6% to 8%. The good news is that even if exempt issuers experience a 10% decline in their debit interchange rates, this compression is more than offset by current and projected growth in total transaction and dollar volumes per debit card.

Better News: Business Debit Lucrative for Smaller Issuers

An often overlooked aspect of the rate cap in Reg II is its structure. Unlike smaller exempt issuers who still enjoy interchange as a percentage of the transaction amount, regulated issuers (above $10B in assets) labor under what is essentially a fixed cap, one that does not float with the amount of the transaction. The result is that big issuers suffer most on high-dollar transactions, such as those common to business debit cards.

Before Reg II, business debit card transactions commanded a much higher interchange rate than consumer debit card transactions. According to Oliver Wyman, “the revenue per business debit transaction was notably higher… averaging $2.10 (versus $0.52 for consumer signature debit).”

Under Reg II’s interchange cap, however, business debit’s profit margin has dropped drastically for large issuers. “Business signature interchange has declined by 87% for regulated issuers to $0.26 per transaction,” according to Oliver Wyman.

The hit has been so severe for many regulated issuers that business debit is now unprofitable. For these issuers, the average cost of a business debit transaction now exceeds the average revenue. The result is tactical retrenchment from business debit portfolios by large issuers.

For smaller exempt issuers, higher-dollar business debit transactions represent the most attractive interchange revenue because for these issuers interchange remains a percentage of the transaction amount. The higher the dollar amount, the higher the revenue. The bottom line is that exempt issuers have an opportunity to capitalize on the most profitable segment of debit card volume at precisely the time Reg II has made it untenable for regulated issuers.

The Best News: Rewards, Mobile Payments & the Merchant-Funded Gravy

Exempt issuers’ gross margin per debit transaction is now more than double that of regulated institutions. Moreover, PIN debit fraud loss rates are down.

To leverage these advantages fully, exempt issuers should continue to incent penetration, activation, and usage of their debit cards by way of issuer-sponsored and merchant-funded rewards, both of which are now being turbo-charged by the convenience of geo-located, real-time offers on mobile devices. Many merchant-funded mobile reward apps offer revenue-share arrangements with the financial institutions that provision them to their mutual clientele.  

Speaking of mobile, exempt issuers should also be looking to further leverage their debit franchises by enabling or supporting mobile wallet models that ride debit rails. Debit-card centric mobile wallets offer another way for smaller community bank and credit union issuers to make the most of their Durbin exemption while it lasts.

Some are concerned that Visa’s PIN-authenticated Visa Debit (PAVD) gateway and Fixed Acquirer Network Fee (FANF) may fuel interchange compression for exempt issuers. Maybe, but only if these new services and fees survive the white-hot scrutiny of the Department of Justice, the Federal Trade Commission, and the Federal Reserve, all of whom are watching Visa closely.

The strategic roadmap for exempt issuers and regulated institutions could not be more different. When it comes to debit, smaller issuers must avoid assuming their fortunes mirror the big boys. For now, the good news is that they don’t.