Acquiring: Debit’s Cloudy Future

 

By Lauri Giesen

 

Now that the Durbin rates are in place for debit cards, questions are swirling about debit’s growth prospects, the fate of PIN debit and of the small-ticket market, and the implications for prepaid cards.

 

 

 

Imagine a world where banks try to get customers not to use debit cards. Where fast-food restaurants encourage customers to use credit cards instead of debit cards. Where debit card transactions secured with a PIN are promoted because of their security features, with no reference to their relative cost to the merchant. And where some banks actually make it easier for customers to use prepaid cards rather than open a checking account.

 

All of this would have been unimaginable two years ago. Banks have spent decades trying to get customers to use debit cards at the point of sale. Merchants have tried to steer customers who wanted to pay with plastic toward PIN debit, because it was the least costly card for them to accept.

 

Bankers and retailers alike talked about debit card fraud but didn’t take active steps to reduce it. And prepaid cards were promoted by banks as a niche product, not an alternative to a bank account for mainstream customers.

 

But then came the Durbin Amendment to the 2010 Dodd-Frank Act, which was passed by Congress last year, and all conventional wisdom about payment cards went out the window.

 

Effective Oct. 1, the Federal Re-serve, in implementing the amendment, capped debit card interchange for financial institutions with more than $10 billion in assets at a rate that is about 45% below what it had been. And because these big banks are receiving drastically reduced revenue from the cards, many have stopped promoting them.

 

More Regs to Come?

 

Indeed, for a while this fall some big banks toyed with the idea of charging consumers for debit card usage. Bank of America Corp., for example, drew up plans to impose a $5 monthly fee on some checking-account holders when they use their debit cards for purchases. The bank backed off after its plans ignited a firestorm of controversy both in the press and in Washington, D.C. Such direct fees are now such political dynamite that few banks are willing to contemplate them.

 

Meanwhile, the interchange differential between PIN and signature debit card transactions, which historically made PIN less costly to retailers, has been eliminated. That makes it harder to convince merchants to purchase the PIN pads necessary to route debit transactions through the PIN networks.

 

So, instead of pricing, fraud control has become the biggest benefit of PIN, particularly at a time when issuers can no longer rely on hefty interchange revenue to cover their fraud losses. Some PIN backers have even turned their attention away from brick-and-mortar stores to promote PIN to the online retail world, where card fraud is the highest.

 

Finally, new interchange tables from Visa Inc. and MasterCard Inc. have made debit cards very pricey for small-ticket retailers. That’s because they applied the Fed’s cap to all transactions from big issuers, so, somewhere around $11 and under, transactions are actually more expensive than they were under the old rates.

 

Some industry experts believe certain retailers—for example, fast-food restaurants, coffee shops, vending-machine operators—could even drop debit cards or at least promote credit card use.

 

With the rules of the game changing, many payment experts are having a hard time predicting what will happen with debit card use. Will it continue to grow? Will retailers stop putting in PIN pads now that there is no pricing incentive? Will customers angered by bank fees—or even attempted fees— turn to prepaid cards?

 

Complicating the situation is the fear that yet more regulation could be coming. Buoyed by their success in getting caps placed on debit cards, some retailer groups are expected to lobby for credit card regulation as well, making it harder than ever to predict the future of debit cards.

 

“There are more shoes ready to drop with regard to card payments than Imelda Marcos had in her closet,” says Paul Tomasofsky, president of Montvale, N.J.-based Two Sparrows Consulting LLC. “There is so much experimentation with regard to pricing and card acceptance, it is hard to see how this will all shake out.”

 

‘We Are Divided’

 

Still, some believe debit card use will continue to grow despite these changes. Brian Riley, senior research director in the retail banking and cards practice with Boston-based TowerGroup, is predicting 6% to 8% annual growth in debit card transactions over the next few years, adding that a higher rate might have been possible had it not been for the weakened economy.

 

Riley believes that consumers have gotten to like debit cards and aren’t going to give them up. While many banks have eliminated debit card rewards programs, Riley points out these rewards programs were always skimpy relative to rewards from credit cards.

 

And, particularly in a time of austerity, Riley expects consumers will not want to risk running up big credit card bills when debit cards give them the same convenience of credit cards with closer controls on spending.

 

Others aren’t sure what will happen to debit. “We are divided here,” says George Albright, vice chairman of Alpharetta, Ga.-based Speer & Associates Inc. “About half our staff think there will be a drop in debit card use as customers shift to credit card use to avoid fees and gain rewards points and half say it will be business as usual.”

 

Despite disincentives for debit card use, Albright says some of his associates believe that banks, customers, and retailers alike don’t want to see debit cards go away. “It took a long time to get terminals in point-of-sale locations and no one wants to watch debit card use deteriorate,” he says.

 

Indeed, some retailers are confident that debit card use will continue to grow in a post-Durbin world. “Debit is convenient for customers and a huge cost savings for financial institutions,” says Mallory Duncan, senior vice president and general counsel of the Washington D.C.-based National Retail Federation, a major proponent of the Durbin price controls. “We expect debit to continue to be popular.”

 

But if observers are uncertain about debit’s overall growth prospects, they are also wondering about the future of such key debit markets as PIN debit, small tickets, and prepaid cards.

 

PIN Debit’s New Focus

 

Take PIN debit. Since debit cards were first introduced, PIN transactions have been less costly for retailers to accept than signature transactions. Although the prices vary widely depending upon the PIN network and while PIN interchange rates have crept up in the past decade, there still remained a significant gap in the cost to merchants of the two types of debit cards.

 

As a result, many of the large retail chains have not only installed PIN pads in all their checkout lanes, but they have also actively encouraged customers to enter their PINs after they swipe their debit cards.

 

All of that has changed now. The Durbin Amendment sets the interchange cap at the same level for both PIN and signature on big-bank cards. On the surface, that would seem to indicate that PIN debit now has less appeal to retailers and could cause those merchants that have not yet installed PIN pads to hold off.

 

But payment experts aren’t ready to write off PIN debit. Instead, many believe the focus will move from cost to security. After all, the fraud rates on signature debit cards are six times higher than on PIN debit, Tomasofsky points out.

 

That puts pressure on banks, which had been pushing signature over PIN, to take another look at PIN. “For the first time ever, I think we will see banks encourage PIN. Suddenly the fraud losses associated with debit cards become more meaningful,” says Eric Grover, principal at Intrepid Ventures, a Minden, Nev., payments consultancy.

 

“PIN is by far the better authentication method,” adds Duncan. Retailers can not only reduce their own fraud rates using PIN but also cut back on chargebacks as PIN transactions are harder to dispute.

 

And Dan Kramer, senior vice president at Shazam, an Iowa-based PIN debit network, notes that retailers also like PIN because of the ability to offer cash back. “PIN allows retailers to reduce expenses by securely getting cash out of their drawers and into the hands of their customers,” he says.

 

All this could also bode well for PIN debit in one market where it has struggled: e-commerce. While credit cards remain the dominant payment method on the Internet, there has been some use of signature debit for online purchases as well. But PIN has been almost non-existent here due to the lack of a secure, widely used means to enter PINs on home computers.

 

Now, some experts expect that to change. “Online purchases is where we see the biggest fraud rates and I think more online retailers are going to want to take another look at PIN debit to lower their fraud and chargeback rates,” says Tomasofsky.

 

Online merchants are keenly concerned about fraud because, unlike their physical-world cousins, they are generally speaking on the hook for fraud losses.

 

Kramer notes that online sales are an area where Shazam has been actively promoting PIN acceptance. “We support three different types of technology to allow for Internet PIN. We have made a big commitment to supporting PIN on the Internet. Consumers have shown that they want innovative options that allow them to pay over the Internet with confidence,” he says.

 

The Prepaid Alternative

 

Another trend to watch is associated with small tickets. Visa and MasterCard, which have created dual debit interchange tables—one for Durbin-regulated issuers, one for non-regulated issuers—recently eliminated incentive debit card interchange rates for small-ticket purchases in their regulated tables. USA Technologies Inc., operator of a wireless payment network for vending-machine owners, recently struck a deal with Visa to keep total small-ticket acceptance costs at pre-Durbin levels for a year.

 

So while the Durbin rate is considerably lower for most retailers, it actually has become more costly for retailers to accept debit cards than credit cards on small-ticket purchases.

 

Grover believes that could cause some retailers, particularly vending-machine operators or fast-food outlets, to drop debit cards while continuing to accept credit cards.

 

But now that customers are used to using debit cards at these locations, it will be difficult for retailers to suddenly stop accepting them, says Albright. “Most retailers want to accommodate their customers, and while they may not encourage use of debit cards, most are not going to want to risk turning away customers,” he says.

 

Albright also points out that debit cards have proven to have additional benefits for retailers, such as reducing the amount of time it takes for customers to pay for goods compared to cash and increasing ticket sizes over cash payments.

 

But Duncan is not sure those benefits are enough. If the cost to accept debit becomes too onerous, many retailers will stop accepting the cards, he says. “For years, retailers with small tickets did not take the cards because the cost was so high. The only reason they started to accept them is that the other benefits were combined with a special low rate. If you take away the low rate, the other benefits might not be enough,” Duncan says.

 

One other implication of Durbin’s impact on debit could be renewed interest by banks in prepaid cards. Banks may have been stymied in their efforts to charge direct consumer fees for debit usage, but they could impose less-direct account fees. Some already have.

 

That might lead some lower-balance customers to either close up bank accounts altogether and switch to prepaid cards or at least transfer sums from a traditional checking account to a prepaid card.

 

“Banks will experiment with different alternatives to debit cards, and prepaid cards are one alternative,” says Grover.

 

Visa’s new interchange schedule en-courages prepaid card issuance by boosting rates for prepaid card transactions.

 

While general purpose prepaid cards have been previously promoted to low-income individuals without bank accounts or niche markets, such as teenagers, some believe the market of “unbanked” or “underbanked” served by prepaid cards could now grow.

 

But TowerGroup’s Riley doesn’t believe a lot of consumers are going to be comfortable with prepaid cards. “General-purpose prepaid cards do not offer the same protection under Regulation E and people are sensitive to the risk associated with these cards,” he says.

 

And Shazam’s Kramer argues that rather than switch to prepaid cards, many consumers will simply switch banks. For the most part, banks that are charging account fees are those with over $10 billion in assets. Mid-size and community banks that are exempt from the cap on debit interchange fees are unlikely to charge.

 

As a result, Kramer believes these banks could gain market share at the expense of the big bank competitors that charge fees, Kramer says. “I think consumers would switch financial institutions before they would switch to prepaid cards,” he adds.