David Stewart Feb 28, 2011

Keeping Debit in Focus Post-Durbin

The Federal Reserve’s proposed debit interchange regulation – the implementation of the Durbin Amendment – will eliminate several billion dollars in bank profits. That you know. But what do you do about it? Specifically, what do you do about debit?

One answer for bankers has been to fight like hell. Lobbying success may well delay a final ruling, but it’s no guarantee of a more favorable result for card issuers. Bankers can hope for the best, but they must plan for the worst. In their planning for debit card’s future, the winning banks will be rational and strategic, not emotional or knee-jerk in their response.

So, what will happen to debit? Interchange regulation will set in motion new forces that will either promote or discourage debit growth. On net, we believe regulation will intensify the slowdown in debit growth already underway due to its maturity.

One myth circulating about interchange regulation is that merchants will have a dramatic impact on debit by encouraging customers to use it. Merchants clearly face an incentive to try: on average, debit will provide a 125 basis-point cost advantage over credit. It could climb to over 150 basis points over time if small issuer interchange falls, but the mix of large and small issuer debit cards will lower debit’s marginal advantage for now.

Regardless, merchants will struggle to engineer a significant shift in tender mix. Why?

For starters, credit users don’t want to use debit. They will want to even less in a future with interchange inadequate to fund debit rewards. More important, however, is that discounts are the primary pricing lever available to merchants and it’s not in their best interest to use them aggressively.

In spite of all the good news for merchants over the past few months, network rules still prohibit surcharging for use of credit. The Durbin Amendment won’t change that; it provides merchants the ability to discount for use of one tender type over another. Sure, some mom & pop merchants will surcharge – they already do – but national retailers will continue to play by the rules, as always.

Merchant Discounts

So how would discount-based payment tender steering work? The typical amount would probably be 1%. It’s hard to imagine consumers’ valuing any lesser discount. Likewise, it’s impractical for merchants to offer more in any sustained way. What would happen if a merchant broadly advertised a 1% discount? He would cut his profit margin a full percentage point on all of his existing debit card sales. What would he gain? Some fraction of his credit card customers would probably take the bait.

Would it be worth it? Probably not. Only a merchant with low debit penetration and high credit penetration has any chance to cost-justify blanket discounts, and even then it’s hard. For example, a merchant with 10% debit sales today and 50% credit sales would need to displace three-quarters of his credit sales in order to justify a blanket discount on debit use. What type of merchants have credit-heavy and debit-light tender mix? Furniture stores? Home electronics stores? Airlines? The fact is, few Americans feel comfortable using their demand deposit account (DDA) to buy a new sofa, flat screen TV or family vacation. Blanket discounting for debit use just won’t work.

Merchant steering will happen – don’t get me wrong – but it must be targeted and, therefore, will be hard to execute. On net, merchant discounting will have modest effect on tender mix. The Durbin Amendment’s allowance of a $10 minimum on credit card purchases will probably have a greater, but also modest, impact.

Another myth circulating about interchange regulation relates to issuers’ ability to shift debit users to products, such as credit, charge or prepaid, that are exempt from price regulation. There will be some migration. The minority of debit users who particularly value its rewards are likely candidates to shift. Generally, however, debit users don’t like credit. They believe it fails on what they value most about debit – helping them to feel in control of their finances.

Could prepaid be the answer? It may be for a minority of debit users who can’t sustain balance levels high enough to avoid new, higher checking fees. But to most households, prepaid’s cost-benefit will fall short. So debit’s here to stay.

Not only will winning banks realize this but – brace yourself – they will also realize that debit’s not all that bad. Clearly, the proposed 70% to 85% reduction in debit interchange rates will hurt. New debit economics will look dreadful compared to old debit economics. But how will they compare to economics of other instruments? How many retail banks earn between $0.07 and $0.12 when a customer uses online bill pay (typically cleared via ACH) or writes a check? Admittedly, with check and ACH, banks can earn nonsufficient funds (NSF) fees. But we have seen what happens when bank profits depend on penalty fees.

What would happen if a bank used fees to steer accountholders away from debit? For starters, we would expect increased use of cash, because debit users prefer cash to credit. Is cash preferable to $0.07–$0.12 in debit interchange per-transaction? Perhaps, if it involved ATM fees, but those only apply to foreign ATM transactions. Should banks charge for on-us ATM withdrawals? Not unless they want to drive consumers into the branch. And so it goes.

I don’t advocate that banks take their lumps and continue with business as usual. Fees for debit, ACH, online banking or other channel activity may be part of the answer. Each bank must make important strategic decisions about how to serve each market segment. Winning banks are innovating their product offerings now. Our clients are marrying marketing science with dynamic financial models to anticipate the impact of the new incentives they may introduce. They’re going to optimize their future profitability.

Whatever the outcome of the Fed’s ruling on debit interchange, bankers must not lose sight of the big picture which includes, for their institution and their customer mix, how debit cards fit in. Interest rates will inevitably rise. DDA balances will become more valuable. DDA will continue to be the anchor product for broader deposit relationships. So take a deep breath and consider: what will your DDA strategy be – and how will debit fit in?

Mr. Stewart is a Chicago-based senior expert with McKinsey & Co. and can be reached at David_Stewart@mckinsey.com. He will deliver a longer presentation of this and related topics at the BAI Payments Connect Conference & Expo in Phoenix, Ariz. on March 7.


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