Tick Tock Goes the Durbin Clock- Eight Months to go on Debit Card Regulation

The Durbin clock is ticking. A week from today the Fed will only have 8 of its 9 months left for some of the most sweeping price regulation the economy has seen for a long time–caps on debit card interchange fees that will affect most depository customers in the US and all card-accepting merchants in the US. 

What will the Fed do? What’s the number or numbers going to be? Or is that going to be left to the banks to decide based on a framework? How are the associations going to work with the banks to implement these fees while of course being pursued by the merchants for price fixing in a massive yet-to-be-certified class action in federal court?  Will the associations adopt a two-tier schedule so that the thousands of small issuers in the country can get the exemption Congress threw their way? And, of course, what will the merchants do–put the savings in the bank, pass it along, or a bit of both? Will merchants really tell customers they have to pay extra for different payment types or refuse to carry some networks. 

Pymnts.com is the place to come to hear from experts and the payments community on what’s next with the debit card regs. Today we provide time-challenged readers, and those who hate my voice, to read a transcript of my discussion with Jason Kratovil, from the Independent Community Bankers Association. Jason answers some of these questions. We’re looking forward, though, to hearing from the PYMNTS crowd.

(Click here to listen to the interview.)

Interview with Jason Kratovil | Vice President, Congressional Relations for the Independent Community Bankers of America

David S. Evans: Hi, this is David Evans. PYMNTS.com asked me to talk to Jason Kratovil, who is Vice President for Congressional Relations at the Independent Community Bankers Association. I’m really pleased to be able to talk to Jason today. Jason, thanks a lot for joining me.

Jason Kratovil: My pleasure, David.

Evans: Jason, so what we want to talk about today is something that’s on everyone’s mind, which is the Swipe Fee Reform portion of the Dodd-Frank bill. I don’t remember the section number. You probably have it on the top of your head, at this point, but other people –

Kratovil: 920.

Evans: What is that?

Kratovil: Section 920.

Evans: Section 920. And Section 920 is what people, up until the point in time that the Dodd-Frank bill got passed, were referring to as the Durbin Amendment, and just to remind everyone what Section 920 does is it provides a system of regulation for interchange fees for debit cards and what we’d like to talk to Jason about is what the effect of that, in his view, is going to be on community banks and how that’s all going to play out. So to begin with Jason, help me understand what the next steps are. So the Federal Reserve Board has been mandated to go off and do something. What is that something and how do you think that’s going to play out?

Kratovil: Well, they have already made some initial and very informal outreach to the industry to begin what I imagine will end up being very significant data collection and information collection process that they are going to undertake in order to effectuate this rule making that they’ve been tasked with. Right now, again, there’s not been any notice or anything official in the federal register. It’s just been some informal outreach, asking industry and those that would be impacted by this new regulation to begin to gather information that can help them in formulating the rights that they’ve been tasked with setting. And that went out to everyone, not just us. It went to credit unions, the large issuers, all the trades around DC, etc. to try to help them in that process.

Interestingly, what they’ve asked for thus far are things that wouldn’t be “self evident” to the Fed. So it’s asking, you know, unique to your business model, what do we as the Fed need to know that may not be particularly obvious to us, that can help guide us as we begin this rule writing process? So that’s where we are right now. It’s still pretty early. Technically, I don’t think – it’s 11:05. I think the bill signing takes place sometime this hour. So I can’t even say the ink’s not even dry on the bill yet. So there’s still a little bit to go here, time wise, before the rulemaking actually starts.

Evans: But then they’re going to be off and running and they’re going to have their nine month clock ticking to get –

Kratovil: Correct.

Evans: – the rules in place.

Kratovil: Yes.

Evans: Now I can imagine this playing out in a variety of ways, and you and I talked about this actually a little while ago. One way I suppose is the Fed could actually just come up with rules and tell the individual bank issuers what the guidelines are for setting interchange fees and that seems to be the way the legislation is actually written. The other possibility is that the Fed realizing that that’s an awfully onerous task, especially given the way the industry operates, is going to be more inclined to try to come up with some guidance for Visa, MasterCard, and the EFT networks to set overall fee schedules. How do you think it’s actually going to work?

Kratovil: Well, as you and I discussed, I think in my mind, it seems more realistic that they choose the latter path, which is taking this new mandate in Section 920, the Durbin Amendment, and using that to direct the networks, to really focus on the networks pricing models rather than going out and saying, OK, in the world of let’s say the 200 or so institutions that are above that $10 million threshold, here are 200 new debit interchange fees that you may collect in any given interchange or debit transaction. I would think instead of doing that, that they would probably just go to the networks and say, these are the rates that you may establish for your member institutions.

Evans: And I suppose if your calculations suggest that the incremental cost of a debit card transaction plus the fraud cost is pretty similar across financial institutions, it doesn’t really much matter. On the other hand, as they find out that there’s quite a bit of variation across institutions, then that leaves us some questions, doesn’t it?

Kratovil: I think so. You know, I’ve always thought as this whole process was unfolding, that this is not going to be an easy task, and when word started getting out that there was talk of incorporating fraud costs, on the one hand, there’s a school of thought that well, that’s great. That can help get us closer to a market based interchange system. On the other hand, as you just noted, and I have to imagine even with the larger institutions, there was a tremendous amount of variability in terms of the fraud losses that those institutions realized. So I mean the language isn’t particularly specific in what the Fed is supposed to do with that. Are they supposed to average it? Are they supposed to take a median? How do they decide?

Again, it’s picking winners and losers. That institution that has tremendous fraud costs may feel a little bit better with whatever the Fed sets, whereas that institution that really did a good job protecting data and didn’t really suffer any compromised information may feel a little bit more of a squeeze.

Evans: Jason, let’s talk about your members and both the risks and the opportunities that the Durbin Amendment, in effect, poses for your group. I know that, or at least I recall that, by and large, you folks opposed the Durbin Amendment, but let’s put that to one side, and let’s just talk about the future now. What are the risks, in your mind, to community banks? Then after we talk about that, I want to talk a little bit about what the possible opportunities are, but first of all, let’s focus on what the risks are.

Kratovil: Sure, and for the benefit of your audience, let me just kind of describe who my membership is. ICBA represents 5,000 community banks. In the world of insured depositories, there are about 8,000 banks, 5,000 are our members. Our average asset size is about $250 million. We have a handful of bank members that are over that $10 billion threshold that was included in the amendment, but the preponderance of our members fall well below the $10 billion limit in the amendment. To answer your question, I have not been able to identify any opportunities. All I have seen is a great deal of risk and it can come from a variety of different angles, and I think that is going to be one of the biggest challenges for our banks going forward.

And there’s a lot of what ifs that you have to walk through to identify these. First of all, as you and I had discussed previously, there’s nothing in the Durbin Amendment that say, for example, mandates that community banks and credit unions have to receive market based interchange fees. The assumption is and was that the card networks would voluntarily choose to maintain two distinct interchange systems based on issuer asset size. Now as you certainly know, that is not how the interchange system was designed. In fact, the networks independently designed interchange systems that were completely blind to asset size because it is in their best interest historically to attract as many issuers from a $10 million rural community bank to one of the Wall Street mega banks to issue their cards.

And they have done so by, in large part, leveling the playing field and saying that any economies of scale advantage that a Bank of America may have over that small bank effectively don’t apply in the economics of electronic payments and the offering of a Visa or MasterCard branded card. That has obviously been a tremendous benefit to my members because otherwise, as is often the case, the economics rarely work in our favor and would allow us to directly compete on an unlevel playing field with one of the largest institutions. In this case, we’re able to. So when you think about it from the perspective of the networks who have built incredibly successful global brands based on the efficiencies in large part derived from being blind and not really caring about the size of the issuer, and now you take that away and you force them to either say, OK, now you’ve got this really efficient system, you’re going to have to put some forks in the road.

And that is going to impact everybody throughout the entire payments chain, from the individual mom and pop retailer where the consumer is swiping his or her card. That retailer’s acquirer, every processor, the network, and all the way through to the community bank issuer at the other end. All of that system is going to have to be reprogrammed in order to maintain these two separate and distinct systems based on asset size. Now you can do all of that, frustrate everyone, add cost throughout the system, or does it make more sense perhaps to simply continue the system that you’ve built so successfully, but simply apply whatever the Fed gives you to all issuers and run the risk that you’re going to upset the smaller issuers by reducing the value proposition that they receive in a debit transaction.

Now from a purely business perspective, I hate to say it, but if I were the networks, that would be very appealing to me because, let’s face it, even though we have strength in numbers – and by numbers, I mean there’s 5,000 of us, and there are another 7,000 credit unions that are impacted just as we are – combined, we make up maybe 20-25% of all card volume.

Evans: Jason, that’s not an insignificant amount. So let me run a scenario by you and just get your thoughts on whether this is possible.

Kratovil: Sure.

Evans: So we have a number of networks. So we have Visa, we have MasterCard, and then of course we have the handful – there aren’t that many left anymore, but we have the handful of electronic funds transfer networks as well. So we have STAR and PULSE and NYCE and so forth. Isn’t there potentially a competition that gets set up between them for the community banks, by offering the community banks a higher interchange fee?

Kratovil: Well, if that’s realistic, I think then the next logical step is – you’ve got to remember that there’s nothing right now stopping say Bank of America from setting up its own competing network. I mean a lot of the large issuers already do that. They operate AmEx style, closed loop networks to offer house branded cards. I have one in my wallet from Best Buy that doesn’t have a Visa or MasterCard bug on it, but on the back, there’s HSBC in the fine print. There’s nothing to stop any of these large issuers from saying, you know what? Enough. I mean the value proposition has been so eroded for me, I don’t feel like subsidizing the small issuers. I’m just going to go out and put together my own network and begin competing with Visa and MasterCard for large retailer business because again, it’s all about volume and I want to maximize my volume.

So I think you’re right in the sense that there is a possibility for many of the smaller, not as high profile debit networks to garner some business, and as you know, there’s another provision in the Durbin Amendment that actually goes at the exclusivity arrangements that the networks have with some of the larger issuers and some of the routing restrictions that they maintain in their rules. So there’s no question that that dynamic is going to change. I would love to have the sort of optimism that would suggest that these networks are going to get in a bidding war for the business of a local community bank. I hope that’s the case. It seems that to me, and I hate to be just such a pessimist, but that this is going to end up with being of very little benefit for a small, independent bank who doesn’t have a whole lot of leverage at the negotiating table to work out a deal that is particularly favorable for it.

Evans: Bank of America just announced a couple of days ago that the Durbin Amendment, the debit interchange fee restrictions and so forth were going to – I don’t have the number handy, but I believe they were estimating that it was going to cost several billion dollars to the bottom line.

Kratovil: Yes.

Evans: In the case of the community banks, do you think that’s the case – well, not talking about the number, but there’s going to be a significant hit to revenue, or do you think the community banks by – and other banks – by way of adjusting DDATs and other things will make a good portion of the interchange fee revenue back?

Kratovil: As I talk to our members, we’ve asked that question. Assuming you face a very significant hit to your debit interchange revenue, what are you going to do? And there are the obvious answers involving the elimination of free checking incentive programs and the reimposition of minimum balances, minimum transaction volume each month before fees start to be tacked on. I know my credit union colleagues have even done an analysis and survey of their members and the response has been, well, we’re just going to start charging people $10, $15 per month just to have a checking account. The problem for our members, and I hate to get all clichéd and mom, baseball, apple pie here, but really the uniqueness of a community bank is that it really is all about the relationship.

Now it’s one thing for a money center bank to begin to tack on a fee. It’s another thing when that banker has to face those people at church on Sunday and at the Little League games on Saturday. Why are you doing this to me, Mr. Community Banker? It really does come down to the reputation and if you’re a small bank and you are facing this sort of a squeeze to a significant portion of your revenue, to sustain your debit program, you’re going to have to somehow make it up. I mean you don’t have the luxury that a larger bank would have of making that up someplace else that isn’t quite in the face of the consumer as sort of the things that you described. We don’t have that luxury. What we do is we attract deposits and we make loans in the community. It’s pretty simple banking.

And as a result of that, those options that you just described are sort of what we’re going to have to look at and that is a losing proposition, no matter how you dice it. Do you start tacking on these direct-to-the-consumer fees and then risk having that customer shop with his or her feet and walk across to the larger bank that doesn’t have those fees, or do you get rid of your debit program? I mean you’re never going to attract a young person to your bank if you don’t have a debit card to offer. Come here and get your glossy new checkbook? That’s not realistic if you are a bank that wants to survive. And it’s going to – I don’t know what our guys are going to do. I mean some of them got back to us and said, we’re actually going to have to fire people, and that was amazing to us.

We kind of instinctively went to tacking on fees here and there to try to make up for that lost revenue, but then we saw, we’re going to have to cut personnel in order to absorb this loss because we simply can’t afford to now go out and start nickel-and-diming our customers.

Evans: So economists would expect that – I mean that’s more or less what’s going to happen, that there’s going to be an effort to cut expenses. There’s going to be an effort to make the revenue back somewhere else, but it might be difficult to get 100% back.

Kratovil: It’s going to be very difficult.

Evans: Jason, you had your pulse on what’s going on in DC and let me just ask you one final question, which I think is the thing that has puzzled so many people, and obviously what’s done is done and the bill is going to be signed and so forth and we’re going to live with the consequences over the next few years. Why debit cards? How on earth did the nice debit card, which didn’t have anything whatsoever to do with the financial crisis, get caught up in the Dodd-Frank bill?

Kratovil: I think it came down to what turned out to be a very successful strategy for the merchants, and you have to give them credit for this, which is sort of late in the game – obviously over the last X number of years that the interchange issue has been percolating in Congress, you’re right, it’s been all about credit, and they had an opportunity, in the CARD Act, to adopt some credit card interchange measures and those weren’t successful. And for whatever reason, we as an industry were able to make more of a case on the value proposition side for credit that made it more difficult for the merchants to go after credit in this context. So what did they do? Well, they said, but look at my checks that I accept. My checks clear at par, and since a debit transaction, just like a check, comes right out of a consumer’s checking account, why shouldn’t my debit transactions clear at par, just like a check? Because a debit card is just an electronic check.

And for a lawmaker who is not intimately versed in the economics of electronic payments, that’s a pretty reasonable argument. And you combine that sort of easily digestible argument with the very unfortunate political situation surrounding this issue and you sort of just have just the exact right environment to do this and –

Evans: I suspect your members don’t care so much about credit cards because I don’t think they’re big credit card issuers. I know you have an affiliate who does that, but do you think credit cards are eventually going to be next?

Kratovil: Well, I think you have to imagine there are – if not all, a significant portion, particularly amongst the larger big box retailers that are not simply going to go home and go fight the Card Check bill or something like that. They’re going to want to come back and say, all right, next bite of the apple. I think certainly that’s going to be the return fight in the next Congress, but I have to believe, and I like to think I’m not being optimistic here, that it’s going to be a tough sell. I don’t think many members enjoyed – of the Senate – having to vote on this, even though the vote was a strong vote for the merchants. I think every member understands that they have very good friends on both sides of this issue and this is just one of those very dicey ones that nobody ever wants to vote on.

And now that the Senate is on record, I have a hard time seeing the Senate coming back around again for another bite at interchange, at least any time in the near future. Now the House, of course the House has not actually formally voted on an issue like this, so it’s entirely conceivable that you could see some sort of a credit interchange measure advance, probably not this year, but perhaps at least resurface in the next Congress, depending on the political environment and the result of the elections.

Evans: Jason, this has been extremely informative for me, and I’m sure for all the listeners at PYMNTS.com. So we really appreciate your taking time out this morning and chatting with me.

Kratovil: My pleasure. Thanks for having me, David.


Executive Bios:

Jason Kratovil is Vice President, Congressional Relations for the Independent Community Bankers of America. In that capacity he is responsible for federal legislative advocacy on a variety of issues including interchange fees, credit and debit card policy, the payments system, privacy and data security.

Before joining ICBA in March of 2007, Mr. Kratovil served as Legislative Director for U.S. Representative Steven C. LaTourette (OH-14), and was actively involved in the creation of identity theft and data security legislation. Prior to coming to the Hill he worked in public affairs at Hill & Knowlton in Washington, and in marketing with Dell Computers in Round Rock, Texas.

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