McGovern Smith Advisors has analyzed the proposed cap on the base component of debit card interchange and by all appearances the Federal Reserve staff responsible for analyzing the data and recommending interchange do not appear to be honest brokers in the matter. The following is our view on potential dramatic changes to the largest component of interchange.
What is the proposal?
Since 2011, maximum allowable debit card interchange for covered issuers (those over $10 billion in assets) has been $0.210 (base component) + $0.010 (fraud prevention adjustment) + 5 bps on the transaction value (ad valorem component). Last October, the Federal Reserve proposed a base component of $0.144, a fraud prevention adjustment of $0.013, and an ad valorem component of 4 bps on the transaction value. The Federal Reserve also proposed an automatic formula to calculate the interchange fee standard every two years.
So why is the Federal Reserve doing this now?
This is a key question to ask. It is hard to believe the Federal Reserve overlooked its requirement every two years to ensure that debit card interchange is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. In its 2011 and 2013 study release, the Federal Reserve explicitly said it did not plan to propose revisions to interchange. By not stating anything to the contrary or stating unequivocally the original construct was no longer valid, the Federal Reserve by default confirmed interchange has been reasonable and proportional to allowable costs over the years. Otherwise, we must believe staff were asleep at the wheel for 10 years and suddenly woke up in 2021 to find interchange no longer reasonable and proportional.
Federal Reserve staff understands most of the decline occurred in 2011 and that transaction weighted average ACS costs (as an industry) declined by only $0.0032 since 2015. Again, why is the Federal Reserve doing this now?
The Federal Reserve also knows the 2009 data set is unreliable, softly disclosing the issue in its proposal. Yet, that did not stop the Federal Reserve from stating the “costs on which the Board based the base component have nearly halved;” thus, requiring a dramatically lower interchange. One only gets there by including the results of 2009.
The 2009 survey was voluntary and the data used to establish interchange was from 43 financial institutions that provided relevant cost and transaction data – composition of the issuers, amount of transactions, and mix of dual and single message transactions is unknown. The industry has no way of validating how the data in 2009 effectively compares to 2011 and all other studies.
Furthermore, the types of costs categorized as ACS were changed in 2011 to better match the categorization of costs used to determine the interchange fee standard. Again, the industry has no way of knowing how this change impacted the results. What we do know is that the 2009 data is driving 34% of the decline in transaction weighted ACS cost over time, cannot be verified, and certainly cannot be relied upon to set policy.
Are other factors influencing the results?
For some unknown reason, the Federal Reserve has never disclosed in any study dual message, single message, and pre-paid debit transactions at the issuer (high, mid, low) segment level. This seems to be rather pertinent information to ascertain what is going on in the industry study to study and over time. Table 2 has study data that highlights several correlations. Key areas of growth are in green, key areas of decline are in red, and neutral years in yellow.
Industry transaction weighted average ACS costs strongly correlate with high-volume issuer share. ACS costs declined 2013 to 2017 as high-volume issuers accounted for a larger share of covered issuer transactions and costs increased in 2019 when high-volume issuer share fell. A similar dynamic can be observed with single message debit (which has lower ACS costs relative to dual message debit). Please refer to Appendix C.
Obviously, there are multiple interdependent factors influencing results, including the rapid rise of card not present transactions. By not having transparency in the data necessary to determine granular trending, it is impossible to determine if other factors are contributing to the results and, if so, by how much. While cardholders will continue to make purchases using the debit payment product of their choosing, merchants can influence underlying volumes and industry ACS costs (whether by dynamic routing, prompting for PIN, negotiating acceptance agreements with networks, or other actions). It is important to understand what is mathematics driven (i.e. mix related) and what portion is driven from
true decline in ACS costs.
The complexity of the market and the various interdependencies at play are key reasons why the automatic calculation approach proposed by the Federal Reserve (using a factor multiplied by average industry ACS costs) is fundamentally flawed.
Why is the 80th percentile no longer valid?
This issue will likely be ground zero in any battle regarding the appropriate level of debit interchange. The Federal Reserve’s current position is that “the Board did not indicate that the Board was adopting any particular cost-recovery target across covered issuers (i.e., that 80 percent of covered issuers should fully recover their base component costs) or across covered issuer transactions.”
We find this statement to be incongruous at best. This position is counter to what the Federal Reserve said in December 2010: “The Board proposes a cap of 12 cents per transaction because…it allows for the recovery of per-transaction variable costs for a large majority of covered issuers (approximately 80 percent).” There was no apparent qualifier in that notice to the industry.
We do recognize that the Federal Reserve attempted to provide clarity about the 80th percentile and the data set in July 2011. However, its final word on the matter stated: “Based on a review of the survey data and public comments, and for the reasons explained above, the final rule establishes a standard that caps the base component of any interchange fee at 21 cents per transaction, which corresponds to the 80th percentile issuer’s average per-transaction included costs.”
And the Federal Reserve said the following in March 2013 regarding the 2011 study: “Sixty-seven percent of covered issuers had average ACS costs below 21 cents (the base component of the interchange fee standard) in 2011. This proportion is lower than the 80 percent of covered issuers with average ACS costs below 21 cents in 2009 due to the addition of first-time survey respondents, most of whom are foreign banking organizations or other covered issuers with very small debit card programs and high ACS costs per transaction.” The Federal Reserve made no commentary that the 80th percentile was no longer valid or that a new methodology was used to arrive at keeping interchange at $0.21.
We believe the Federal Reserve’s position that the 80th percentile is no longer valid is because they could not justify materially lowering interchange otherwise. In Table 3, the 75th percentile of ACS costs were $0.180 in 2009 and $0.176 in 2021. That certainly would not support a dramatic lowering of interchange and most likely the 80th percentile, if published, would not as well.
The data also begs the question as to why no action was taken when the 75th percentile ACS costs increased dramatically in 2011, 2013, and 2015. There was a rational argument to be made to increase interchange. However, we suspect political or other headwinds constrained any ability or desire to revisit interchange rather than the Federal Reserve tacitly using a different standard to determine whether interchange was reasonable and proportional.
Community financial institutions will be harmed
The Federal Reserve’s proposal to reduce interchange by $0.066 will be detrimental to covered community financial institutions and, if history is any guide, will also trickle down to exempt / small financial institutions. In 2013, only 62% of mid-volume issuers had ACS costs that were below the level permitted by the interchange fee standard. For low-volume issuers, the number was 7.1%.
In 2021, 77.4% of all covered issuers had costs below $0.21. This 77% ratio was also relatively stable over the prior six years. In 2021, 78.3% of mid-volume issuers and 21.1% of low-volume issuers had costs below $0.21.
The Federal Reserve expects its proposal will lower the share of issuer costs covered by the interchange standard to 66%. Much lower than the 77.4% that occurred in 2021. Appendix A data shows that the $0.144 rate would cover ACS costs for the 50th percentile of mid-volume issuers and maybe a 60th percentile but likely no low-volume issuers. More mid-volume and low-volume issuers would not be able to cover their ACS costs. And when one factors in other debit program costs (e.g., card production, cardholder inquiry support, overhead, etc.), but not allowed in setting interchange, many of these financial institutions will be greatly harmed.
Community financial institutions do not have the ability to raise banking fees or charge debit program fees to offset the shortfall. And they certainly do not have the ability to rationalize ACS costs by $0.066 as most of authorization, clearing, and settlement are performed by third party providers. The Federal Reserve study data shows that transaction weighted average ACS costs only fell by $0.0037 for midvolume issuers from 2011 to 2021.
Debit is an integral part of a cardholder’s deposit relationship with its financial institution. The Federal Reserve’s proposal has the chance to be quite devastating to mid-volume and smaller financial institutions. There is a real-risk that this proposal will accelerate consolidation among these institutions and force many to consider exiting the market prior to exceeding the $10 billion asset threshold to be a covered issuer.
In our view, the Federal Reserve’s proposal is based on flawed data, lacks the transparency in terms of relevant data to determine what is truly happening with respect to ACS costs, and is otherwise bad policy.
Scott Reaser (Partner), with over 25 years of industry experience, manages the Strategic Sourcing practice at McGovern Smith Advisors. He can be reached at [email protected]
