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How Much Will Judge Leon's Decision Whack DDA Revenues?

It has been mighty quiet in payments land after the seismic shock hit from Judge Leon’s court. So, I thought I would break the silence and share my thoughts on just what damage it could cause.

Until a few weeks ago most everyone in the business thought the Durbin debate was behind us. The Fed had spoken. The result was a mixed bag: for debit card issuers it was better than the Fed’s initial cut, but still a significant drop and for merchants it wasn’t all they hoped for. Then Judge Leon blasted the Fed for ignoring the letter and perhaps even the spirit of Durbin.

How bad could Judge Leon’s ruling be for debit card issuers? The answer is pretty bad.

To understand this it is worth refreshing our memories on where the Fed had initially come out. The Fed staff proposed two alternatives to debit interchange fee regulation. Both would set a maximum of 12 cents per transaction for debit cards with no distinction between signature and PIN.

Under the first proposal, there would be a safe harbor of 7 cents per transaction. If issuers collected less than that they would not be hassled by the Fed. What’s the magic of 7 cents? It is the median average variable cost of authorization, clearing and settlement costs of the issuers who gave the Fed data. Issuers could make a case for more - up to 12 cents based on their actual average variable cost of authorization, clearing and settlement. Under the second proposal, issuers would have a cap of 12 cents per transaction. The Fed staff said that 80 percent of the issuers had average variable costs below 12 cents per transaction.

The Federal Reserve Board decided to go with higher numbers in its final rule making. It beefed up what could be included in the cost and stuck with the 80-percent quartile based cap so that 80 percent of the banks had lower costs than what they allowed. That’s the decision the retailers persuaded Judge Leon was wrong.

If Judge Leon’s decision is affirmed the Fed could go back to their initial approach. So, let’s see where that puts the non-exempt banks. In 2012 debit card interchange fees for non-exempt issuers were $8 billion. With the 12-cent cap non-exempt issues would have gotten half as much, $4 billion. With the 7-cent safe harbor with a 12-cent cap it is a bit harder to figure. The lower bound would be $2.33 billion if no bank sought the additional amount on the basis of having costs in excess of 7 cents (and probably close to $2.33 billion even if the higher cost banks did ask).

Unfortunately, this isn’t really the end of the story. The problem with setting any interchange fee cap based on debit card issuer costs, is that based on the survey the Federal Reserve Board did the costs are all over the map. The mean average variable cost was 4 cents and the median average variable cost was 7 cents. The big spread between the mean and the median suggests that large issuers had low average variable costs that brought down the average. Then 20 percent of the non-exempt issuers had average variable costs of more than 12 cents. There is likely to be an order of magnitude difference between the issuers with the lowest average variable costs (likely large issuers) and the issuers with the highest average variable costs (likely small issuers).

In the final rule making the Federal Reserve Board decided to go with a more expansive definition of costs. And it decided to go with the 80-percent rule for determining the cap. That’s what Judge Leon whacked down. If Judge Leon prevails, the Fed is likely to reopen the rulemaking procedure, probably collect new cost data and reconsider these issues in light of the court’s guidance on sticking close to the letter of Durbin. I would expect the retailers, fresh off of a court victory, would argue for lower fees. I’m not endorsing it, but one could imagine an argument for the mean of 4 cents on the grounds that that is the average variable cost for interchange fees. If the Fed went with that then interchange fee revenues for non-exempt issuers would fall to $1.33 billion based on their 2012 interchange fee revenues, about 17 percent of where it is today (and 9 percent of where it would have been but for Durbin).

I know it is the last thing banks want to hear at the moment, but Judge Leon’s ruling could, if upheld, wipe out somewhere between 50 percent of debit card interchange fee revenue if the Fed went with the most favorable version of their initial proposal, about 71 percent of the debit card interchange fee revenues if they went with the less favorable version of their initial proposal, and 83 percent of their debit card interchange fee revenues if they, under pressure from the decision, went with the even more stringent 4 cent standard.

The only ray of sunshine here for non-exempt debit card issuers is that between an appeal, maybe the Supremes, and a new rule making it could be a while before any of these reductions hit DDA and consumer banking P&Ls. And of course the Fed could prevail and life could go back to what we had thought was the new normal. But, if I were responsible for retail banking P&Ls at non-exempt depository institution - and thankfully I’m not! - I would be losing a bit of sleep these days.

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