Cover Story: Don’t Fence Me in

Though aimed mainly at debit cards, the Durbin Amendment corrals prepaid cards in a number of ways, as well. Will the restrictions choke off growth in this thriving business?

By Linda Punch

When the Durbin Amend­ment passed, major financial institutions issuing prepaid cards thought they had dodged the proverbial bullet. While the amendment to 2010’s sweeping Dodd-Frank financial-reform law capped interchange rates on big banks’ debit cards, it appeared that prepaid cards would emerge pretty much unscathed.

But issuers’ relief was short-lived. When the Federal Reserve last June issued final rules interpreting the amendment, it effectively hobbled the largest banks issuing prepaid cards. The law exempts from regulation debit card interchange income of financial institutions with $10 billion or less in assets.

Some major prepaid card issuers, including MetaBank and The Bancorp Inc., fall below this threshold, but most of the nation’s largest banks as well as some large regional financial institutions have some presence in the prepaid space.

Under the final rule, however, reloadable cards issued by financial institutions above the $10 billion threshold are exempt only if they refrain from charging overdraft fees, allow the first ATM transaction each month to be free, and do not allow underlying funds to be accessed by any means other than the card itself. (The amendment does exempt governmental prepaid cards.)

Many major prepaid card issuers have offered cardholders the ability to make electronic bill payments, write checks, and access their accounts via the automated clearing house. Consumers, particularly the unbanked and underbanked, find such features attractive because they offer the versatility of a checking account.

But under the final rule, offering those features triggers the stringent interchange cap, set at 21 cents, plus 0.05% of the transaction value and another cent pending for fraud control. That’s a cut of more than 40% from the 40 cents the Fed said the average prepaid card transaction generated in 2009.

For larger issuers, the final Durbin rules cast the prepaid market in a new light. They could continue to offer their current lineup of access features and live with the reduced income or find ways to offset the lost revenue with fees for other services, which could ultimately drive up costs for cardholders.

The answer for some of the larger issuers is to pull out of the market, observers say. But others are continuing to move forward, albeit with different strategies. Some are even willing to live with lower interchange as a means to capture a piece of a largely untapped market—the unbanked and underbanked.

“We’ve got some split responses with major issuers,” says Madeline K. Aufseeser, senior analyst at Boston-based Aite Group LLC.

Frills vs. No Frills

The Fed’s intent in exempting only cards that don’t allow for outgoing ACH transactions, such as bill pay and savings accounts, was to prevent big banks from “shifting their debit card business to the prepaid business, simply gaming the system,” says Jennifer Tescher, president and chief executive at the Center for Financial Services Innovation (CFSI), a Chicago-based non-profit focused on lower income and underbanked consumers and a proponent of prepaid cards.

“But by doing so, unfortunately, they made it far less appealing for banks to want to use prepaid as a new tool to reach underserved consumers,” Tescher says. “It meant they could offer a prepaid card in the lobby but they couldn’t make it a very fully functional product and still qualify for the exemption.”

While some of the larger financial institutions may exit the prepaid market, others are finding ways to offer prepaid programs, Aufseeser says. (Nearly all the financial institutions contacted for this story declined to be interviewed or didn’t return calls for comment).

“Banks that are committed to it will stay in business and the banks that weren’t in the business or don’t feel as strongly about it will pull back,” she says. “But the banks that are still staying in it are finding ways to offer products that will either preserve their interchange by cutting features or coming out with a two-tiered, structured-type product.”

Adds Tescher: “You see some banks, bigger banks, starting to move into prepaid that are well above the $10 billion exemption and you don’t really see them pulling back. My sense is they’ve just said to themselves, ‘We’re not offering prepaid purely as a way to skirt the law and get more interchange. We’re offering prepaid as part of a larger strategy to reach underserved consumers and we’re going to take the revenue hit.’”

Those banks view prepaid cards as part of a broader strategy to build relationships with new customers and sell them a variety of products and services, and they’re not going to sacrifice that strategy for the sake of 20 cents more of interchange per transaction, she says.

“How Durbin affects you depends on who you are in the marketplace,” Tescher adds. “If you’re a really big bank, you’re probably less likely to come up with a prepaid offering. If you’re a big bank but not in the top 5, you’re going to offer prepaid because you see it as a broader customer-acquisition strategy and Durbin probably isn’t going to deter you.”

Some banks may offer a product only with features that will qualify for the higher interchange rates under the Durbin Amendment, but also offer a prepaid product that has features such as bill payment that the consumer will pay extra for to help offset the lower interchange, Aufseeser says.

“U.S. Bank has gone out in a big way reinforcing their programs for prepaid cards but they’re offering multilevel types of products—no frills versus a frill-type product,” charging higher fees for the product with additional features, she says.

High Costs, Thin Margins

Major financial institutions are looking at the opportunity in prepaid as a way to expand into a new market, and the Durbin Amendment may have little effect, says Patricia Hewitt, director of the debit advisory service for Maynard, Mass.-based Mercator Advisory Group Inc.

“Certainly, the requirement to not allow access other than through the card may require some changes in the way they integrate these into their current financial services,” she says. “But the major issuers are looking at prepaid products relative to the market and I’m not certain that the Durbin Amendment is really going to have a material impact on that.”

For many major banks, prepaid cards represent an opportunity in a number of different areas to expand their franchises, both from a retail and commercial perspective, Hewitt says.

“They’re looking at prepaid cards as a strategic product and how it fits into their product mix,” she says.

For some banks, that may mean issuing a no-frills prepaid card but finding another way to offer other financial services that won’t violate the Durbin Amendment. Birmingham, Ala.-based Regions Bank took such an approach to issuing general-purpose reloadable (GPR) prepaid cards by providing services such as bill pay and remittance.

Regions issues a basic GPR prepaid Visa card, but offers services such as check cashing and bill pay through Western Union, a spokesperson says. Customers can have payroll or government benefits loaded onto the card through direct deposit.

Although the bill pay and remittance and check-cashing services aren’t tied to the prepaid card, the products are marketed as a single suite of services under the Regions Now Banking name, the spokesperson says. The service is designed for customers who don’t have a regular relationship with the bank but can be used by any consumer. Regions Now services are available at Regions branches and online.

Nevertheless, while some large financial institutions aren’t ready to leave the prepaid arena, others are reconsidering whether or not to stay in a market where costs can be high and margins thin, says Terrence Maher, attorney for the Montvale, N.J.-based Network Branded Prepaid Card Association (NBPCA).

Some large banks were evaluating prepaid as a less expensive way to provide services similar to transaction accounts to underserved markets, such as small-balance customers, Maher says. “Durbin has definitely impacted that,” he says.

Mercator’s Hewitt agrees there might be some pullback from financial institutions that were developing a strategy to drive some consumers to accept a prepaid card in lieu of a checking account. “But as far as the major issuers really looking at prepaid as part of how does it fit in to their overall product strategy? How can it be used to expand their retail and commercial franchises? What’s the flexibility and utilization around those products? I don’t think Durbin’s going to materially put up big road blocks in the way of that,” she says.

So just how big banks will change their approaches to the prepaid market remains to be seen, Hewitt says. “We’re just now beginning to see the larger retail financial institutions begin to put prepaid card products out into the market,” she says. “And they’re taking very different approaches.”

But already, some changes are apparent. “We have seen a slowdown, for instance, on the bill-pay side where there may have been plans to introduce bill pay,” Hewitt says. “Maybe they’re looking at that now a little differently and how they can maybe manage that a little differently. But it’s really too early to tell what the impact is because that whole market is just beginning to emerge.”

‘Significant Disadvantage’

What direction major financial institutions will take in prepaid will depend largely on other regulatory efforts, the NBPCA’s Maher says. Their options may be limited because of existing and pending legislation that affects prepaid cards, including the Credit Card Accountability, Responsibility and Disclosure Act of 2009, or CARD Act.

That law mandates changes in disclosures, fee structures, expiration dates, and related areas. Under the rules, more-restrictive state laws take precedence over federal rules.

The Federal Reserve issued 104 pages of rules for complying with the CARD Act. They cover store gift cards, gift certificates, and GPR prepaid cards. Provisions include:

– Dormancy, inactivity, or service fees may be assessed only for a card or gift certificate that has had at least one year of inactivity. There can be no more than one such fee charged per month. The consumers must be given clear and conspicuous disclosures about fees.

– Fees subject to restrictions include monthly maintenance or service fees, balance-inquiry fees, and transaction-based charges such as reload fees, ATM fees, and point-of-sale fees.

– Expiration dates must be a minimum of five years after the date a certificate or card is issued or the date funds are last loaded. The expiration restrictions apply to a consumer’s funds, not to the certificate or card itself.

– Fees are prohibited for replacing an expired certificate or card, or for refunding the remaining balance, if the underlying funds remain valid.

“If you had a card that was subject to both the CARD Act restrictions as well as the Durbin restriction—the biggest one being the network-branded gift card—the big banks are really at a significant disadvantage,” Maher says. “Some larger banks are no longer in the markets that are subject to both the CARD Act and the Durbin restrictions.”

U.S. Sen. Robert Menendez, D-N.J., in 2010 introduced another bill that could further limit the options for prepaid card issuers. His bill, which would require full disclosure of fees and restrict the types of fees that could be charged, is pending in Congress.

The PrePaid Card Consumer Protection Act of 2010—cosponsored by Sens. Richard Durbin, an Illinois Democrat and author of the now-famous amendment to Dodd-Frank, and Jeff Merkley, D-Ore.—would provide for full fee disclosure before the consumer buys the card, including a wallet-sized summary of all fees and a toll-free number for customer service.

It also would limit the types of fees that could be charged, banning overdraft fees, balance-inquiry fees, customer-service fees, inactivity fees, account-closure fees, and other types of fees.

The bill also would provide for consumer protections for prepaid cards, such as Regulation E safeguards against loss or theft and Federal Deposit Insurance Corp. coverage to protect consumers’ money if the card sponsor goes bankrupt.

Prior to the Menendez bill, the Fed proposed extending Reg E protections to prepaid cards onto which federal payments are loaded, a position that CFSI and Consumers Union support. Reg E is the Fed’s body of rules for enforcing the Electronic Fund Transfer Act.

Legislation similar to the Menendez bill already is being introduced in several states, including Illinois and New Jersey. Under the Illinois bill, vendors of GPR prepaid cards can’t charge an activation fee greater than $1 or 1% of the value of the card. Issuers also can’t charge a reloading fee, balance-check fee, overdraft-protection fee, dormancy fee, inactivity charge, or service fee.

Under the New Jersey legislation, a financial institution would have to provide consumers with a prepaid debit account with a monthly account statement setting forth each electronic fund transfer during the month, including the amount and date, type of transfer, the identity of the consumer’s account with the financial institution from which or to which the funds are transferred, the identity of any third party to whom or from whom the funds are transferred; and the location of the transaction or ATM involved.

The bill also would prohibit a host of fees. A financial institution could be charged up to $1,000 a day for violating the law.

New Partners

For many players in the prepaid space, more regulation translates into higher costs and lower revenues in a business with slim profit margins. Large banks facing restrictions on fees, costly disclosure requirements and the restrictions of the Durbin Amendment may give up on prepaid cards, Maher says.

“That’s worrisome to the industry because first you have the interchange fee cut and then you have fee limitations and fee caps,” he says. “It really questions whether or not the products are going to be offered to businesses and consumers.”

Adds CFSI’s Tescher: “There are important things that can be done to make sure prepaid is a safe and affordable option for consumers but capping the price, particularly in the way a lot of legislation suggests, would simply kill the product altogether and foreclose an important access opportunity for consumers who really need it.”

What’s more, there is still some concern there will be some interchange compression on the exempt banks and exempt products because of a requirement under the Durbin Amendment that two independent payment networks be enabled on each card, Maher says. That rule takes effect for GPR prepaid cards on April 1, 2013.

Durbin’s anti-network-exclusivity requirement will make it easier for larger merchants to negotiate an even lower interchange fee because they can offer priority routing to the network offering the lowest rate, Maher says. “It basically sets up a market where large merchants, and maybe large acquirers, could put out RFPs and ask for networks to bid on business,” he says.

Meanwhile, while large banks are grappling with the Durbin Amendment restrictions, prepaid card issuers under the $10 billion cutoff and prepaid card management networks that do much of the heavy lifting in the industry are finding the competitive landscape much easier to navigate.

“There’s a trend among program managers trying to establish issuing relationships with banks under the $10 billion threshold, especially for prepaid cards that aren’t exempt from the interchange fee cap,” Maher says. “I’ve seen several program managers look to establish relationships with financial institutions that are under the $10 billion threshold so they can preserve the interchange fee differential for their non-exempt cards.”

Indeed, smaller issuers and prepaid card managers continue to pick up new partners and expand their networks. Monrovia, Calif.-based program manager Green Dot Corp. in November received regulatory approval to buy Utah-based Bonneville Bancorp. Green Dot currently issues cards through bank partners but is expected to take over issuance through Bonneville (box).

And prepaid card program manager NetSpend Holdings Inc. in January beefed up its retail distribution channels through an agreement with leading convenience-store chain 7-Eleven Inc.

NetSpend in February also announced it will be launching a prepaid MasterCard for PayPal Inc. that will be linked to the cardholder’s PayPal account. The card, issued by The Bancorp Bank, will be marketed online and through direct mail to the U.S. segment of PayPal’s total of 106 million active users.

Green Dot also continues to roll out new prepaid card programs, announcing in January the AARP Foundation Prepaid MasterCard. The card is tailored for older Americans and will allow for the direct deposit of paychecks and federal benefit payments. The card, scheduled to be launched online and at Walgreens stores in mid-February, also is issued by The Bancorp Bank.

‘Smaller Issuers’

The prepaid market also is attracting new players. Zynga Inc., the social-networking game developer, in March 2010 began selling prepaid game cards at retail locations and now sells cards at more than 45,000 stores, including 7-Eleven, Best Buy, Gamestop and Target.

Players use Zynga game cards to buy virtual goods in its games, such as batteries in CityVille and food in FrontierVille. Zynga makes Zynga Poker, FarmVille, CityVille and other popular games available through Facebook and elsewhere online.

With the emergence of new players and products, the prepaid market is going to continue to expand. And despite the disruption caused by the Durbin Amendment restrictions, GPR cards with features such as bill pay and remittance will be a major part of the market.

“The opportunity to provide services for the underserved and underbanked is going to continue to expand in the United States,” Mercator’s Hewitt says. “It’s one of the few net new markets that financial institutions can get into, they’re very interested in it. Whether it’s through a prepaid [card], whether it’s through checkless checking accounts or other types of entry-level products, the financial-institution industry is very interested.”

But increasing regulatory pressures on the market, particularly the Durbin Amendment, will “change the face of the prepaid issuing business,” Tescher says. “Particularly for general-purpose reloadable providers, it will push them to smaller issuers.”

 

Green Dot Powers up Its ‘Innovation Machine’

While financial institutions are reassessing their place in an increasingly regulated prepaid marketplace, prepaid program manager Green Dot Corp. is moving boldly forward. Over the past few months, the Monrovia, Calif.-based company acquired a bank and a processing operation and is preparing to expand into the issuing and processing side of prepaid cards.

Chairman and chief executive Steven W. Streit outlined the company’s plans for the recently acquired Provo, Utah-based Bonneville Bank during Green Dot’s fourth-quarter earnings conference call in January. The Federal Reserve Board of Governors also approved Green Dot’s request to become a bank holding company, a “huge milestone,” Streit said.

With the new acquisitions, Green Dot will have greater creative freedom to launch new products and services, Streit said. “Our goal is always to be an innovation machine at Green Dot and we believe that the bank will provide increased flexibility and speed to market as we roll out a wider range of products to meet the needs of new and existing Green Dot customers,” he said.

By becoming a bank holding company, Green Dot also strengthened its competitive position in the market, particularly in bidding for government-benefit programs, Streit said.

“Our experience has been that many public-sector entities and other institutions are only allowed to contract directly with the bank for financial services,” including the U.S. Treasury, he said. “We believe that having the bank deal directly with our clients will mitigate many risks inherent in the non-bank contracting structures that can help open new doors for us with government accounts and other organizations.”

Green Dot already is moving accounts from Synovus Bank, a major issuing partner, to the former Bonneville Bank, now renamed Green Dot Bank, and Streit said the majority of the Green Dot-branded card portfolio would be issued out of Green Dot Bank by the end of this year.

Current plans call for General Electric Co.’s GE Capital Retail Bank to continue issuing Green Dot’s biggest card, the Walmart MoneyCard for customers of Wal-Mart Stores Inc.

Green Dot also will be taking processing in-house after acquiring assets of eCommLink, a prepaid card processor in Nevada. “Going forward, we’ll issue the cards from our own bank, process those cards on our own processing platform, and create, design, and distribute these products for a distribution footprint of 59,000 retailers,” Streit said.