Rethinking Debit Cards

By Lauri Giesen

Changing profit dynamics will require a much more selective approach in managing debit cards.

The debit card long enjoyed a special status in the payments business, commanding merchant fee percentages equaling those of its cousin, the credit card, even though debit transactions are less expensive to process. That advantage obviously had an impact on the way that banks ran their debit card operations.

But now that at least some of the financial benefit is going away, banks will have to rethink their approach to what essentially is becoming a different business.

In a new era when the profitability of debit card operations will be far less assured, providers will have to become much more selective about the products they emphasize, the type of usage incentives offered and the customer segments they target. Efficiency and market share will become more urgent considerations as well, given the importance of offsetting lowered revenues per transaction with cost-saves and higher transaction volume.

The upshot is that the debit card business likely will require far more managerial attention than it did in the past, especially given that retreating isn't really an option. The debit card has become one of the "official" extensions of the checking account. In 2002 alone, customers used it to make $308 billion of retail purchases, according to TowerGroup Inc. of Needham, Mass.

That level of usage brings into focus the financial consequences of a proposed settlement, reached last spring between the credit card associations and a group of retailers, which reduces the interchange revenue banks receive from debit card usage by about 30%, at least until January. Most issuers are assuming it will remain lower.

One immediate priority is to recalibrate incentive programs. To promote the cards, bank issuers had been offering a wide variety of enticements, including frequent flyer miles and cash rewards. "Everyone is reviewing their program right now, particularly those that offer reward benefits," says Earl Stratton, executive vice president in charge of debit cards for Wayzata, Minn.-based TCF Bank, a unit of TCF Financial Corp.

Complicating the analysis is the fact that incentive programs, though costly, do help to encourage transaction volume. And volume grows in importance as per-transaction revenues fall. It's probably a safe bet that banks won't retreat from rewards programs entirely, but resources will have to be used far more selectively.

Another issue that needs to be scrutinized is fees. Currently, most institutions issue debit cards for free, except for those tied to the more expensive reward programs, such as frequent flyer mileage. Over time, consumers might see more card and transaction fees creep in to compensate for the lower interchange revenue. And these fees are most likely to be imposed upon customers whose usage patterns generate the least profits for the provider.

There also could be sea changes in the types of debit card products emphasized as signature-based debit cards lose their price-protected advantage over PIN-based cards.

Taken together, these issues underscore the need for an elevated approach to debit cards. In many cases, providers will need to go back to the drawing board and formulate fresh strategies for this business.

Interchange Shortfall

Motivated by interchange revenue for each transaction, financial institutions have strongly encouraged customers to use debit cards. Before last May that revenue amounted to about 1.25% of the transaction price.

While that sounds modest, the revenues added up and were comparable to fee percentages on credit card transactions. In some ways, debit cards were an even better deal for issuers than credit cards because there's no credit risk and usually less transaction risk. It made sense, then, to launch activation and promotion campaigns.

The honeymoon ended last spring when Visa USA and MasterCard International settled some long-standing litigation with a group of retailers led by Wal-Mart Stores Inc. The retailers contended that debit card interchange fees were too high and said they should not be forced to accept debit cards if they wanted to accept credit cards.

The settlement changed the dynamics of debit card issuance by reducing the interchange rate by about 30% — at least through January, and possibly even longer depending on the final rate established by Visa and MasterCard. Retailers also are no longer required to accept debit if they take credit, although few experts believe they will risk alienating customers by rejecting any type of card.

A survey of 12 large debit card issuers conducted by Boston-based Dove Consulting Group Inc. shows that 70% expect debit interchange will either remain at the reduced rate beyond January or go even lower.

The impact on individual institutions is murky, however. The settlement's benchmark of a 30% reduction in interchange income doesn't affect all issuers equally because cost structures and customer purchase volumes vary by institution. Some providers are better positioned than others to cope with the reduced revenue.

TCF, for example, expects its debit card-related revenues to remain stable during the first year after the settlement. Stratton explains that while revenue per transaction will decrease by about 30%, the total transaction volume has been growing by roughly 25% annually. With some additional promotions to increase card activation rates, TCF thinks it can make up that 5% difference. "We think we have the ability to stimulate growth even further," Stratton says. "There is still a lot of room left for this product to grow."

Similar dynamics appear to be at work at Bank of America Corp. Immediately after the settlement was announced in May, the Charlotte-based company said it expected its debit card-related revenue to be reduced by $200 million in 2003. By mid-August, however, that shortfall had been narrowed to $130 million. While a BofA spokesperson declined to explain the reason for the revision, industry observers have speculated that increased transaction volume compensated for some of the interchange shortfall.

Account Acquisition Tool

Whether banks can make up the interchange shortfall or not, they have good reasons to stick with debit cards. The principal factor is the link between debit cards and the checking account. Since the funds to pay debit card transactions are drawn from a checking account, any success an institution has in attracting customers via a debit card will ipso facto boost the number of checking accounts.

"Debit cards aren't really a product," says John Gould, director of consumer credit for TowerGroup. "They are extensions of the core product, which is the demand deposit account, and they need to be viewed as such."

Cleveland-based KeyCorp, for example, issues debit cards to all of its checking account customers. Additionally, since May, it has marketed a rewards-based card, called "KeyMiles," that offers mileage from Continental Airlines. "This card gives us a way to show established clients that we value them, and it also serves as an acquisition tool for new accounts," says senior vice president Carl Stauffner, who notes that nearly half of the 15,000 KeyMiles cards issued in the first three months went to new customers.

KeyCorp has promoted the card through branch office counter ads and mailings to established customers, as well as touting it as part of its overall mass media marketing, i.e., television, radio, newspapers and billboards. Because the card is targeted at travelers, the bank has also promoted it in select airports nationally, particularly at those that serve as Continental hubs.

Possibly most important from the standpoint of marketing effectiveness, the bank is engaging in joint promotions with Continental. Experts say such airline tie-ins help to build loyal customers. "The retention rate of customers who are participating in rewards programs such as airline miles is very high," says Dove managing director Tony Hayes.

U.S. Bancorp, meanwhile, is pursuing a broader rewards-based strategy. The Minneapolis-based bank had previously offered cash rewards — rebates in essence. Then in September, it announced an expansion of choices under its "Checking That Pays" program. Cardholders can now choose between four rewards options: cash rebates, airline miles with Northwest Airlines, points for merchandise and gift certificates or entries to win a Harley Davidson motorcycle. The bank expects to spend $30 million on the program by the end of 2004.

Pat Wesner, executive vice president of retail banking for U.S. Bank, says the option expansion is part of an ongoing effort to customize and personalize the company's DDA offerings "to fit the needs of different customers." Wesner says even more choices may be forthcoming in the next year as the bank forms additional partnerships with companies that supply rewards.

Like KeyCorp, U.S. Bancorp is hoping to attract new customers to its DDA base by marketing the debit cards to customers of its partners, in this case, Harley Davidson and Northwest Airlines.

Rethinking Rewards

While rewards programs make sense from a marketing point of view, the recent reduction of interchange income on transactions does raise some questions about the cost/benefit tradeoff. Consultant Gould says banks especially may want to re-think rewards programs that involve pricey giveaways.

"Free" airline miles, for example, cost a bank an average of two cents per mile. Applying that expense to a program where $2 in purchases earns one free mile, a bank would have received, under the pre-settlement formula, about 2.5 cents in interchange revenue for every mile awarded. Even after paying two cents for the rewards, the financial institution was left with a 0.5-cent profit.

Under the new interchange formula, however, the bank would receive about 1.75 cents on every $2 purchase and still have to pay two cents for the rewards. Therefore, any benefits the bank receives from the debit card program would have to come from sources other than transaction revenue.

"Rewards are important in getting customers to use their cards, but the economics of such programs need to be re-evaluated," says Rick Lyons, senior vice president of the deposit access group for MasterCard North America and a former debit card executive with Comerica Inc. "While there's still a lot of potential with this product, banks have to find less costly ways to increase adoption."

Both Visa and MasterCard offer rewards programs for their members that allow issuers, particularly smaller institutions, to take advantage of the associations' economies of scale, which lowers the cost of the rewards. MasterCard, for example, has a sweepstakes that offers hundreds of prizes to winning debit card users.

An institution's decision on which rewards program to offer needs to be governed by more than cost considerations, however. Gould says it's important to keep in mind the customer segments being targeted. If the goal is to attract and retain high-end customers for demand deposit accounts, for example, the more expensive rewards programs might be justified. "Airline miles tend to be most attractive to people who travel a lot — and they tend to be the high-income customers who are most profitable to banks," he says.

One approach might be to give the rewards card free to customers who keep large checking account balances while charging other customers. The ability to attract and retain high-end customers could justify the rewards. Under this scenario, the cost of the rewards for the less profitable customers would be covered by fee income.

KeyCorp charges $30 per year for its reward card but does not waive the fee for any customers. U.S. Bancorp is charging $20 per year for its airline mileage reward card but is not charging for the other rewards cards. Dove's survey of top issuers found that all of the banks that offered a mileage rewards program charge an annual card fee — ranging from $19 to $65 — but none of them routinely waive the fee for customers with large balances.

Consumer Revenue

Financial institutions know that customers resist fees. But at some point, the squeeze on interchange revenue may force them to impose fees on all their debit cards, not just the ones that offer rewards. "As the revenue received from retailers diminishes, banks will look at increasing the revenue from consumers," Gould says.

There are two main types of debit cards, those that use the customer's signature to secure the transaction and those that rely on a personal identification number. Most banks currently do not charge customers for using signature-based debit cards. But Dove's study indicates that 42% of banks do charge at least some customers a fee for using PIN-based cards. Those fees are typically per-transaction charges that range from between 25 cents and 50 cents and are often waived for high-balance customers. Those banks in the Dove study that did charge fees indicated that only between 21% and 50% of customers actually had to pay.

One reason that banks have charged for PIN-based debit but not signature-based debit is that they collected more revenue on the latter. Under the old interchange formula, for example, a $50 signature-based purchase would provide the bank with 63 cents of revenue, compared with between 12 cents and 50 cents on a PIN-based transaction, depending upon the regional electronic funds transfer network that processed the transaction.

Under the new rules, by contrast, the signature-based transaction would generate only about 41 cents. Because signature-based debit is based on a percentage of the transaction while PIN-based debit is typically a flat fee, the differential between the two is greater for large transactions. PIN-based debit could actually generate more revenue for card issuers on very small transactions.

Since the proposed settlement reduces the overall revenue differential between the two types of debit transactions, Gould believes many banks will no longer make a distinction when charging the consumer. The exception is that most banks will waive fees for their top customers. Gould also predicts card fees will be more common than transaction fees because they are easier to administer and don't discourage use of the card.

But not everyone likes the idea of charging consumers for debit, noting that such fees could potentially send customers back to their checkbooks. That would ultimately defeat the original purpose of the debit card — to reduce the costs and hassles to both banks and merchants of processing and handling paper checks.

" It would be tricky to charge consumers for debit usage when credit cards and checks are perceived as being free," says Ariana-Michele Moore, a researcher for Boston-based Celent Communications. She notes that consumers may also resent sudden charges for debit cards after being prodded for years to use these cards for free.

TCF's Stratton agrees with this line of thought. "A card fee is always an option," he says, "but a better alternative is to concentrate on growing the product." Indeed, Dove's survey of the top issuers indicates that few plan to change their fee policy "We haven't seen any indications of fee changes in light of the proposed settlement," Hayes says.

The situation should become clearer in 2004 when MasterCard and Visa announce a permanent interchange rate and the regional EFT networks reveal possible pricing changes for PIN-based debit. Hayes notes that the general trend in recent years has been a gradual increase of PIN-based debit interchange fees.

If Visa and MasterCard adhere to the settlement rate — or lower it even more — and some of the major EFT networks increase their PIN debit interchange rates, the differential could be even less and could cause banks to either drop the PIN debit fee or apply it to signature-based debit as well.

Regardless of whether banks charge new fees, slash costly reward programs or work to push transaction volumes even higher, it's clear they will need to take a hard look at how they manage and promote their debit cards.

Ms. Giesen is a freelance writer based in Libertyville, Ill.

Copyright © 2003 by Banking Strategies, published by BAI.

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