CO-OP Financial Services Blog: Insight Vault

Editor’s Note: The statement below represents an update to CO-OP Financial Services’ assessment of the Federal Reserve’s published draft rules relating to interchange. If you would like to learn more, join us on Fri., Jan. 28 at 11:30 a.m. Pacific time for an informational webinar. You can register to attend here.

CO-OP Financial Services has been following the interchange issue for many years and has taken an active role on behalf of credit unions through our support of CUNA, the Electronic Payments Coalition (EPC), and the Electronic Funds Transfer Association (EFTA). Despite our best efforts, the Merchant Payments Coalition and Senator Richard Durbin were successful in adding an interchange amendment to the Wall Street Reform Act.  

On Dec. 16, the Federal Reserve Board approved release of draft rules for comment pertaining to the Durbin Interchange Amendment. Comments are due by Feb. 22, with final rules to be published by April 21 and taking effect July 21, 2011. As with most draft rules, they create as many questions as they provide answers.

The first question is: What does this mean to credit unions?

• The current national average interchange for signature debit and PIN debit transactions is $0.44. The new rules propose a cap of $0.12 interchange per transaction and a “safe harbor” floor of $0.07. Many analysts believe even the $0.12 cap is below cost for most financial institutions. The statute was extremely restrictive on what costs could be considered.

• The $0.12 interchange cap represents a 73% decline in current interchange revenues. Using data from the 2009 Callahan and Associates survey, credit union debit interchange income is estimated at $2.2 billion. A 73% decline represents a potential $1.6 billion in revenue and income for credit unions at risk. To put this in perspective, Callahan reports total credit union net income after assessments in 2009 as $1.54 billion and estimates 2010 at $4 billion.

• The Durbin Amendment does exempt all financial institutions below $10 billion in assets as well as government card payment programs and reloadable prepaid cards. The Federal Reserve in comments during the Dec. 16 meeting indicated the networks (Visa, MasterCard, Star, NYCE, Pulse, etc.) will need to determine if they will offer interchange pricing tiered by asset size or card purpose. The lawmakers clearly intended that “exempt” mean current interchange income be sustained for exempted parties, but unfortunately that was not clearly defined in the law. Visa recently announced they will implement a two tier interchange structure with the exempt tier at least initially being very close to existing interchange rates.

• Fraud costs are not part of the $0.07 to $0.12 proposal. The Fed was dissatisfied with the fraud cost information gathered and was going to do additional surveys. Another consideration is whether the Fed will mandate new fraud technologies and how costs for those technologies will be recovered. Fraud costs are not likely to be part of the rule published April 21.

• The Fed proposed two routing rule alternatives. The first, that each issuer have one signature debit network and a second non-affiliated PIN network. The second alternative was that each issuer has two signature debit networks and two PIN networks. This second alternative would impact all credit unions and we believe would be unworkable from both a technical and market perspective. The first alternative will impact some credit unions, but would be the most practical and least disruptive. 

The headline in all of this is that $1.6 billion in annual interchange income is potentially at risk for credit unions. This brings us to the second question: What can credit unions do?

• First and foremost, all credit unions need to support our movement’s trade associations in their activities.

• Write a comment letter to the Fed. CUNA and your league are drafting samples, but if you want your letter to have full impact, personalize it from your credit union:
  • The lawmakers intended that credit unions under $10 billion in assets be exempted.  Encourage the Fed to enforce this exemption and see that current interchange levels are maintained for credit unions under $10 billion in assets.
  • If the exemption is not enforced, what will the impact be to your credit union? How much net income will your credit union lose? The calculation is simple, 73% of current debit interchange revenue. What would you need to do with pricing and how would that impact your members?
  • Even though credit unions should be exempted, we think it is important you comment on interchange rates. Two alternatives were proposed, a $0.07 to $0.12 range dependent upon individual institution costs or a $0.12 cap. We believe the only operationally workable solution is their second alternative, a cap.
  • The Fed also asked for comments on routing. We think the only practical solution is their first alternative: one signature debit network and one unaffiliated PIN network per card issuer.
  • Fraud remains a huge concern. Please comment on the cost of fraud prevention and the cost of fraud to your credit union. 

• Talk with your network representatives and encourage them to comply with the intent of the law and maintain current interchange levels for credit unions under $10 billion in assets.  Visa has announced their intent to implement a two tier structure, but even they left the door open for change in response to market conditions. We expect MasterCard and other networks to follow suit. CO-OP asks all credit unions to encourage the two tier structure and sustaining current interchange levels.       

The House Banking Committee is likely to hold hearings to review the interchange provisions. We need to support this process even though the likelihood of any new legislation is low. Interchange is a critical issue to credit unions and the payments industry. We encourage all credit unions to make their voices heard on this issue.  

(Editor’s Note: The statement below represents CO-OP Financial Services’ assessment of the Federal Reserve’s published draft rules relating to network interchange and exclusivity).

The Federal Reserve has published draft rules relating to network interchange and exclusivity. The Fed has asked for comment in all areas and posed specific questions relating to costs and routing.

WHAT WE KNOW

Interchange – The Fed has proposed a $0.12 cap per transaction on interchange with a $0.07 “safe harbor” floor. This translates to a 73 to 84 percent reduction in debit interchange. This is a far deeper reduction than the financial industry expected. It is prudent that you reflect this reduction in your budgets beginning July 2011.

How specific rates will be established will be up to the networks and the financial institutions. Fraud avoidance costs continue to be studied and will be incorporated, but possibly after implementation in July 2011.

Routing Exclusivity – The Fed suggested two models. The first calls for each card to have a signature brand and a nonaffiliated PIN brand; the second stipulates that each card have two nonaffiliated signature and two nonaffiliated PIN brands. The Fed asked for comments on these alternatives. We believe the latter – the second model – is impractical and detrimental to interchange income.

Timing – Final rules will be published in April for July implementation, with the caveat that some issues may not be fully defined.

WHAT WE DON’T KNOW

A member of the Fed’s Board of Governors specifically asked about exemptions of which all but three credit unions would be exempt. Fed staff responded that exemption pricing would be up to the respective networks. The staff member also noted the possibility of merchant discrimination against exempted cards despite both the law and network rules.

As expected, the draft rules have created as many questions as they have provided answers. The key issue for most credit unions remains the exemption. The Federal Reserve left it up to payments networks to implement the exemption. At this time we do not anticipate that the exemption will result in the exclusion of institutions below $10 billion in assets.

As we wrote in our white paper, “2010 Debit Payment Challenges: An Update on Regulatory Reform,” CO-OP Financial Services suggests the following course of action:

• Debit Strategies. The growth rates for both signature and PIN debit have remained strong. The impact of the Durbin Amendment should drive credit unions to re-think strategies about debit products and their positioning and pricing to members.
• Pricing Strategies. Various pricing strategies can be used to modify member behavior to increase volume and drive members to the revenue generating access vehicles. Continue to help members make the transition to card-based and electronic payment.
• Reduce Expenses. In addition to new pricing strategies, credit unions can mitigate the impact from lower revenues by paying close attention to the expense side of the business. Areas to look at in particular are fraud, card activation and card issuance.
• Scenario Planning. Plan, but don’t overreact until we know if the exemptions will work. We recommend using revenue and cost data to plan through various best and worst case scenarios, including debit impact, debit strategies, and account and relationship strategies.

You can read the complete white paper, downloading it for free, by completing the brief registration form here.

CO-OP Financial Services will continue to provide information and we suggest you comment directly to the Fed and through your trade associations, and please be prepared to assist in any lobbying efforts they may pursue.

Thank you.

(Editor’s Note: The article below is excerpted from the white paper “2010 Debit Payments Challenges,” provided by CO-OP Financial Services. If you would like to read all the insights provided in the complete paper, you can order it for free by clicking here.)

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was signed into law by President Obama with great fanfare on July 21, 2010. The event marked the start of the nine-month timetable placed before the Federal Reserve Bank for the writing of new rules governing pricing of debit transactions. This daunting task has been placed at the Fed’s doorstep by the Durbin Amendment to Dodd-Frank. Among other things, the Durbin Amendment:

• Challenges the Fed to create rules that address debit pricing at the marginal and transaction-specific level in an effort aimed at creating a “reasonable and proportional” pricing model.
• Bans practices that actually or virtually create exclusive relationships between debit card issuers and payments networks.
• Enables merchants to set minimum and maximum transaction amounts on credit card purchases.
• Prohibits merchants from discriminating against specific issuers or networks in card acceptance.
• Exempts most government benefit transfer and branded reloadable prepaid card programs.
• Exempts issuers with assets fewer than $10 billion.

At first glance, it would appear that the letter of the law relating to Durbin grants the vast majority of U.S. credit unions an exemption and the amendment will not impinge on their ability to earn debit interchange at historical levels. However, industry practices may contort Durbin’s spirit and cause major harm.

Due to its recent enactment, it is easy to overly focus on the Durbin Amendment to the Dodd-Frank Act as being the only wolf at the door. Yet, the Fed’s final rules on overdraft opt-in and the CARD Act play considerable roles in the overall non-interest income fracas.

To better prepare for the consequences of these three sets of regulations, we suggest the following:

First, it is essential that all credit unions gain awareness of what the market place is doing in response to financial reform. That is, how are payments networks, small and large commercial banks, processors and retailers posturing to either take advantage of change or to stem it? Frequent contact with industry trade associations, network partners and trusted advisors should keep awareness high.

Second, internal assessments of the combined revenue and net income impacts stemming from overdraft, CARD and Durbin ought to be updated frequently to measure the short and long term implications of these regulations. In conjunction with internal modeling on the revenue side, credit union executives should be watching for opportunities to strip non-essential processing and delivery costs from account and debit card programs – card re-issue cycles, paper statements and postage are areas worthy of review.

Third, plan for the full range of potential outcomes connected with the Fed’s rule-making activities and/or adverse actions taken by marketplace players. For instance, should the $10 billion carve-out stand up, most credit unions will foresee at least a temporary market advantage enabling them to offer better deposit account programs and debit rewards schemes. In short, prepare and launch an aggressive membership growth plan. There should also be a plan on the shelf for if/when networks capitulate to pressure and unify debit pricing into a single system. We have estimated that a 25 percent decrease might be possible, suggesting that credit unions will need to develop modest repricing strategies and encourage members to increase deposit balances to make up the shortfall.

Finally, credit union executives are reminded that debit transactions are a key part of an overarching relationship with members and that relationship has several moving parts. The endgame strategy for awaiting the outcome of overdraft opt-in, CARD and Durbin needs to encompass all components of that relationship – account pricing, customer service, all deposit account access channels and the value of affiliation.

Editor’s Note: On Sept. 28, CO-OP issued a news release on the Sept. 24 actions of the National Credit Union Administration regarding corporate credit unions, which included finalizing new rules governing the corporates. The CO-OP position statement below is from that news release. We invite you to join the discussion of this important issue by leaving us a comment.

“After many years of partnering with the corporates, we reaffirm our confidence in the corporate system and believe it is still valid and valuable to the movement,” said Stan Hollen, President/CEO, CO-OP Financial Services. “CO-OP will continue to pursue an active role in the future of credit union payments, and we will seek partnerships to fulfill that goal with corporate credit unions and the natural-person credit unions that comprise their owner-members.
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