The Dodd-Frank Interchange Haircut Could Exceed $10 Billion

Visa and MasterCard debit card issuers stand to lose up to $10.7 billion in interchange income a year in a worst-case scenario under new federal interchange controls that will take effect next year, according to a Digital Transactions News analysis. Smaller reductions are more likely as the Federal Reserve Board begins the arduous task of transforming Congress’s dictates into regulatory reality, but issuers easily could lose more than $1 billion. Merchant acquirers, however, might get an opportunity to boost profits.

Digital Transactions News arrived at its estimates by analyzing data from Visa Inc. and MasterCard Inc., bank earnings reports, research reports and press accounts in the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act that President Obama signed into law July 21. The sweeping law contains the so-called Durbin Amendment offered by Senate Majority Whip Richard Durbin of Illinois, which requires the Fed to assess debit card interchange rates that are “reasonable and proportional” to costs.

Congress gave some guidelines about what the Fed may and may not consider in crafting rules, but the payments industry can only wonder what the Fed will come up with. But Bank of America Corp., the nation’s largest debit card issuer, on July 16 said it could lose 62% to 79% of its annual debit card interchange revenues (Digital Transactions News, July 19). Other banks haven’t been so up-front, but they and payments-industry companies have given clues that about the amount of revenue at stake.

Visa and MasterCard handled $1.21 trillion in U.S. debit card purchase volumes in calendar year 2009, according to data from each network. Meanwhile, Minneapolis-based U.S. Bancorp, a major credit and debit card issuer, noted in its July 21 second-quarter earnings conference call that sales volume on its debit cards amounted to $37 billion in 2009, generating $500 million in interchange. That works out to a 1.35% interchange rate.

Using U.S. Bank as a proxy for the industry, Digital Transactions News applied that rate to the Visa/MasterCard purchase volumes to estimate that U.S. debit card issuers grossed $16.34 billion in interchange last year. (Visa charge volumes include the Interlink PIN-debit network while MasterCard’s figures do not include the Maestro PIN-debit brand.)

The Durbin Amendment contains several so-called “carve outs,” or exemptions. They include the interchange revenues of financial institutions with $10 billion or less in assets—a group Durbin says accounts for 99% of banks and credit unions. Digital Transactions News estimates these small issuers generated about 10% of debit purchases last year, or $121 billion.

Also exempt are the interchange streams generated by prepaid cards governments use to distribute benefits, and general-purpose reloadable (GPR) prepaid cards, including so-called incentive cards. To estimate the value of those carve-outs, Digital Transactions News drew on figures from Maynard, Mass.-based Mercator Advisory Service Inc., which follows the prepaid and debit markets. Mercator estimates that open-loop (major brand) prepaid cards had $124.6 billion in charge volume last year. The volume included $94 billion on GPR cards as well as benefits cards. While all four major U.S. card networks have prepaid programs, Digital Transactions News is estimating that 90%, or $84.6 billion of GPR volume, was on Visa or MasterCard cards.

Minus the carve-outs, the affected charge volume is just a hair over $1 trillion, which last year would have generated $13.56 billion in interchange at 1.35%. So how much of a haircut can the debit industry expect?

Based on the 2009 industry figures and BofA’s low prediction of a 62% cut, debit issuers would lose $8.41 billion, leaving an interchange pie of $5.15 billion. The high estimate of 79% zaps $10.7 billion, reducing total interchange to $2.85 billion.

But analysts cited in a July 19 New York Times article said BofA was too pessimistic in forecasting that it could lose $1.8 billion to $2.3 billion of its predicted $2.9 billion in debit revenues this year. Analysts almost universally believe issuers will impose new charges on demand-deposit accounts, and BofA itself said those grim figures were “before mitigation.” “It’s going to be made up by the consumer,” says Tim Sloane, director of Mercator’s Prepaid Advisory Service.

On the lower end, a 10% cut by the Fed would have siphoned $1.36 billion from 2009’s interchange stream, leaving issuers with $12.2 billion. A 25% cut would take $3.39 billion, leaving them with $10.2 billion.

Reductions could boost the profitability of merchant acquirers, which pay issuers interchange based on rates Visa and MasterCard set. Acquirers include interchange in the discount rates they charge merchants, and they’re under no obligation to reduce their discount rates in proportion to a Fed-mandated interchange cut, notes a recent Goldman Sachs & Co. report.

Sloane says that while things might not be as bad as BofA forecasts, the Fed still could come up with “draconian cuts.” But even in a draconian situation, some companies will fare better than others. Frank M. Mastrangelo, president and chief executive of The Bancorp. Inc, which owns The Bancorp Bank, a major prepaid card issuer, said last week that 70% of the bank’s non-interest income comes from prepaid card interchange, and 78% of that interchange is exempt from regulation.