Fed’s Final Durbin Rule Chops Interchange by More Than 40%, Extends Compliance Deadline

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The Federal Reserve on Wednesday issued a long-awaited, final debit card regulation that caps interchange at 21 cents plus 0.05% of the transaction. The final rule, which culminates months of heated comment from merchants, banks, and the card networks, raises the interchange debit card issuers may receive from the 12 cents the Fed proposed in December.

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The 5 basis points added by the Fed to the 21-cent cap is intended to capture some of the fraud losses issuers sustain, the central bank said in a staff memo released on Wednesday summarizing the final rule. The final rule also allows, on an interim basis, a so-called fraud-prevention adjustment of 1 cent so long as the issuer uses what the staff memo calls “effective fraud-prevention policies and procedures.” The Fed set a Sept. 30 deadline for comments on the interim fraud adjustment. As in December’s proposed rule, the Fed’s final rule draws no distinction between signature and PIN debit.

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With the new cap and interim fraud allowance, covered issuers will sustain a 40%-plus cut in debit card interchange income, according to Fed estimates. While substantial, that is considerably less than the 70% cut the Fed’s original proposal would have levied.

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On the issue of network-routing arrangements, the Fed ruled that issuers must use at least two unaffiliated networks, effectively adopting what it called Alternative A in its December proposal. The rule also adopts the proposal’s requirement that issuers and networks not interfere in merchants’ freedom to use any network of their choice.

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The interchange cap, interim one-penny fraud adjustment, and routing-restriction ban take effect Oct. 1. The two-network minimum requirement for issuers goes into effect April 1, 2012, though it would not take effect for non-reloadable and reloadable general-purpose prepaid cards until a year later. These dates give networks, issuers, and processors more breathing room than was contemplated in the Durbin Amendment to the 2010 Dodd Frank Act, which set a July 21 deadline for the new debit card pricing and routing restrictions.

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The amendment, which earlier this month survived a close U.S. Senate vote to delay its effective date for six months, charged the Fed with setting rules to implement its restrictions. The amendment exempts banks with less than $10 billion in assets, as well as reloadable prepaid cards and government cards, from the interchange restrictions but not from the rules on network exclusivity and routing. The law and related rules have been avidly supported by merchants and just as hotly contested by banks and the card networks in what has turned out to be one of the most expensive, and dramatic, lobbying wars in the annals of electronic payments.

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The staff memo says the Fed’s rationale for the 21-cent cap is that it reflects the average allowable cost, per transaction, for the issuer at the 80th percentile, according to research the agency conducted last year. That research, released in December along with the proposed rule, found the average debit card interchange fee was 44 cents. Under the final rule, issuers will collect 24 cents on a $40 debit card transaction, taking into account the one-penny interim fee for fraud losses. Similarly, the new 5-basis-point ad valorem component is based on the average fraud loss sustained by the median issuer in that survey.

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Issuer costs allowed by the Fed under the rule include network connectivity; hardware, software, and labor involved in processing transactions; network processing fees; and the cost of risk-scoring and other transaction-monitoring methods. This is a broader range of costs than the Fed allowed in its proposed rule, and accounts for the higher cap in the final rule, according to the memo. Costs not allowed include corporate overhead; the cost of establishing the account; card production and delivery, marketing, and research and development; network membership fees; rewards-program costs; and customer inquiries.

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The Fed’s rule immediately drew fire from merchant and banking groups alike. The National Retail Federation, a leading Durbin Amendment supporter, issued a statement expressing “deep disappointment” with the Fed for “watering down swipe-fee reform.”

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“American consumers suffered a major loss today,” Matthew Shay, president and chief executive of the Washington, D.C.-based NRF, said in the statement. “We are extremely disappointed that the Federal Reserve chose to be influenced by special interests and ignored the will of Congress and American consumers. While the rate will provide modest relief, it does not go far enough.”

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The new rule did not alleviate the opposition of small banks, which opposed the Durbin Amendment even though it exempts them. Community banks and credit unions fear the possibility that market forces in an industry dominated by big banks subject to new price controls will drive their debit revenues down. Federal Reserve governors even noted that the bank card networks, which set interchange rates, are not regulated by the rule.

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“While the fee set forth in the Fed’s final rule is better than the originally proposed 12-cent cap, this is still government price fixing at a rate far below the current market-driven and risk-based fee merchants pay for debit card transactions, which frequently includes a merchant payment guarantee,” the Independent Community Bankers of Association said in a statement. “This harsh, below-cost price cap will be incredibly detrimental to community banks and their customers over time.”

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The Electronic Payments Coalition, an anti-Durbin lobbying group of big banks and card networks, was less strident, but a spokesperson said via e-mail that, “We continue to be concerned about the impact on consumers and small financial institutions from this price-fixing policy. We hope Congress will exercise vigorous oversight of this new policy and monitor its implementation in order to assess and minimize its negative consequences to consumers, small financial institutions, and the American economy.”

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Members of the Federal Reserve Board itself expressed reservations about the effects of their wide-ranging rule, but they said they did their best with the hand the Durbin Amendment gave them. “I want to underscore my colleagues’ unease with this kind of regulatory intervention,” said governor Sarah Bloom Raskin, Maryland’s former commissioner of financial regulation. Raskin said she was worried about how the rule might affect small banks and prepaid cards, but she noted that consumers have become increasingly concerned about the rise of debit card interchange fees over the past decade. “These fees have a disproportionately harmful effect on the 25% of the population that is unbanked and other consumers that pay by cash and checks since those consumers never receive the benefits of any card reward programs that are funded by interchange fees,” she said.

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In related news, a three-judge panel of the federal appellate court in St. Louis on Wednesday upheld a lower court’s denial of a motion by Minneapolis-based TCF National Bank for an injunction to delay the Fed’s regulations from taking effect while the bank, a big debit card issuer, challenges the Durbin Amendment’s constitutionality.