In late June, the Federal Reserve Board published a surprisingly favorable final rule on debit card interchange rates, compared with the draconian cap in its December proposal. But while this more moderate interpretation of the Durbin Amendment was gladly received in the banking industry, it would be a serious error for institutions to simply relax and attempt a return to business as usual.
Although the Fed’s final “Regulation II” shaved an anticipated debit interchange revenue shortfall from more than $10 billion to less than $5 billion, the financial impact still is substantial. And when it is combined with other regulatory changes affecting credit card charges and checking overdraft coverage, banks are still looking at more than a $30 billion annual revenue loss in their payments business, exclusive of other factors such as tight margins. That figure could grow even higher with likely future regulation from the newly-formed Bureau of Consumer Financial Protection.
Facing a towering revenue shortfall, banks need to step back and take a sober look at retail payments, a pivotal line of business that includes both credit and debit cards and the demand deposit account. Challenges include boosting the volume and sifting the mix of consumer electronic payments; redefining products and business models; taking out infrastructure cost; and expanding core customer relationships.
Signature Loses its Luster
As banks look to the future of debit, they must prepare for a world where their former flagship product, signature debit, no longer generates a superlative revenue stream. And while PIN debit probably will come into wider usage, that won’t restore sagging debit economics, exerting even more pressure on banks to recast retail payments.
PIN Dominates Signature. Based on an average $40 purchase, Signature debit previously generated about 60 cents of interchange revenue per transaction for issuing banks, or about 150 basis points. Now with the Durbin cap, it will generate no more than 24 cents per transaction, or about 60 basis points, on a par with PIN debit.
Bereft of a higher interchange rate, signature debit has lost its luster for issuing banks, which have already backpedaled in promoting this product. We expect to see signature debit usage fade over the long term, ultimately limited to special uses such as online, small ticket and overseas transactions.
Meanwhile PIN debit is poised to grow. The trend that saw all forms of debit transactions growing at roughly 10% annually will shift, with PIN growth accelerating to the low teens at the expense of signature’s drop to mid-to-high single digits. One advantage of this shift is improved security. Banks have a lower fraud risk with this form of debit; merchants have reduced fraud/chargeback exposure; and consumers gain a stronger sense of protection.
Out in local markets, PIN pads will proliferate well beyond the counters of larger merchants. Online secure PIN solutions will take hold as well. The shift toward PIN debit also sets the stage for the U.S. introduction of EMV, the global standard for authenticating credit and debit card transactions. This arrangement combines integrated circuit cards, or “chip cards,” with PIN, for common use at the merchant point of sale and at automated teller machines.
Higher Debit Growth. Compared with other options, the debit card becomes an even more attractive and viable solution across a wider spectrum of retail payments as a result of the Fed’s ruling. Interchange-conscious merchants now will see all debit cards (PIN or signature) as being more than two-thirds less expensive than credit cards. And banks will still want to emphasize debit over other methods of accessing the consumer demand deposit account, given that checking and Automated Clearing House (ACH) payments offer no direct transaction revenue.
In terms of consumer usage at the point of sale, we see debit cards taking additional share from credit cards, ACH, checks and even cash, raising the overall debit growth rate by two to three percentage points for several years.
Overall debit growth will include usage for low-value payments (where current interchange doesn’t get anywhere near the 24-cents cap); online payments (expect to see accelerated innovation around secure online PIN pads) and specialty areas such as health care, where debit can now compete on price with checks and ACH. Prepaid applications will continue to grow, but mostly as a niche business, and likely will not emerge as a broadly superior alternative to debit payments from a demand deposit account.
Debit Cost Reduction. Debit rewards programs were the first casualties even before the final Fed ruling, given that they add to bank costs and are not a major driver of customer preference for debit. Banks generally will continue to drop debit rewards. In other cases, rewards programs will be broadened to include deposits, DDA activity and overall bank relationships. Fraud cost reduction will push banks toward PIN debit. Banks will apply heavy pressure on payments networks to reduce their fees, and they will look for opportunities to streamline their own internal infrastructure costs.
The retail banking challenge extends well beyond the particulars of the post-Durbin debit card business. Instead of isolated plans for various individual payment and deposit products, banks will need integrated strategies to reposition for a very different future. Deliberations about debit will need to be folded into a larger context that includes:
Revenue Model. Previously, the main sources of bank retail payments revenue have been deposit spreads, penalty fees and interchange. With regulation drastically reducing penalties and transaction fees, banks must move to bifurcated retail DDA offers that are either deposit-based (higher balance minimums with higher yields) or payments-based (requiring high debit card usage and/or modest monthly fees).
Infrastructure Rationalization. $30 billion in regulatory hits makes the current retail banking cost structure unsupportable, especially if current low interest rates continue. Banks must aggressively adopt new branch network configurations and accelerate customer migration to low-cost digital channels.
Relationship Banking. Unfocused customer acquisition strategies and single-product silos are also much less sustainable. Banks must redouble their focus on core customers and develop much deeper retail bank relationships based on expected lifetime customer values. Product silos that have traditionally been scattered across alternative payment types must learn to collaborate to provide more integrated “cash management” solutions that provide customers with liquidity from both sides of the balance sheet.
For example, many consumers who have used their debit cards to overdraw their retail DDA accounts have larger household cash management needs, such as standby financing arrangements for contingency expenses. Attractive financing is also an important need for more affluent customers. They often turn elsewhere for their periodic liquidity needs, but banks can offer sweep accounts that tap idle deposit balances or lines of credit, possibly secured by home equity. Cash management is the foundation of “relationship banking” for both mass market and mass affluent customer segments.
Merchant-Friendly Innovation. Even in the face of revenue pressures, banks will need to keep up with proliferating innovation, much of it from nonbanks, in order to maintain their core payments franchise.
Merchant-funded rewards programs will get a closer look, for example. Although early ventures haven’t achieved market breakthroughs, new approaches are being actively explored. Some will take advantage of new mobile commerce platforms linked to payments, where banks will forge partnerships with the likes of Google or ISIS (the mobile payment network joint venture formed by AT&T, T-Mobile and Verizon), or with other entrants that have yet to show their hand.
Another innovation is PayPal’s use of person-to-person (P2P) payments as part of an “electronic wallet,” creating a superior value proposition for the merchants who account for the majority of PayPal’s revenue. Now that PayPal has evolved beyond its early niche in online auctions and is poised to move to the physical point of sale, it is time for banks to respond – they can do far better.
Banks will need to elevate P2P payments into a priority and make it a success. They also need to recognize that their merchant relationships are a strategic asset in this war, and extend those same payments to the point of sale, finding innovative new ways to work with merchants for mutual benefit.
Collaborative Action. To succeed with payments innovations that transcend traditional boundaries, banks will need to strengthen the coordination of their internal organizational silos; collaborate among themselves to create meaningful network effects; and partner with unfamiliar non-bank players having different agendas and cultures.
Along with their individual competitive agendas, banks need to address the collective industry challenges posed by new nonbank players and networks. Against some of these powerful new entrants, even the largest banks will need to compete in tandem in specific areas of payments innovation. And they will need to operate more holistically across traditional lines of business. The situation will also require banks to be more proactive and unified in advocacy and education, to protect and promote industry interests.
During the last year since the passage of Dodd-Frank, the threat to debit interchange caught the attention of bankers everywhere. But the Fed’s implementation of the Durbin Amendment does not bring this chapter to a close. The world of debit cards and consumer payments has been thrust into a period of rapid change that will continue for some time to come.
Mr. Kyriacou and Mr. Bramlett are partners in the New York office of Novantas LLC, a management consultancy. Kyriacou can be reached firstname.lastname@example.org, and Bramlett at email@example.com.