A Long-Term View of the Fed’s Debit Interchange Gambit

The Dodd-Frank bill required the Federal Reserve to set debit interchange fees. Now, all interested eyes are poring through the Federal Reserve's proposed new Regulation II, Debit Card Interchange Fees and Routing regulations trying to figure out how to respond and what the future will be like when it is implemented. Of course, many interested parties will be lobbying for changes in favor of their particular objectives. This column is not intended to analyze the ins and outs of the proposed regulations -- there are already plenty of alternatives for readers. Rather, this is a good time for strategic-thinking readers to step away from the debit interchange fee trenches and contemplate the long-term effects of government price regulation on an important component of the banking industry's business model.

Whenever a government agency is chartered to regulate financial services pricing, the debate usually centers on a number of factors: cost vs. value; producers and distributors vs. consumers; innovation; and alternatives are among the factors that a long-term perspective should consider. Clearly, the Federal Reserve has staked out "cost" as a basis setting debit interchange fee in its proposal. Thinking about the future for producers (card issuers) and distributors (networks, merchant acquirers) that enable the debit interchange is one way of contemplating the effect of regulated debit fee pricing on innovation and alternatives.

Debit interchange is something that has evolved into a strong POS payment alternative over the past 25 years. The conversion of ATM cards and ATM networks into widely adopted debit card processing occurred in a fairly seamless manner, leveraging established POS and network processing infrastructure. Now, placing price controls on this type of POS alternative will reshape POS payment processing. Innovation may be driven to adapt to future changes banks make to both the debit card account (usually a checking account) and related debit card processing fees for consumers and merchants (e.g., no more free checking if the customer uses his/her debit card X times/month). Attention will be devoted to replacing today's debit interchange with new services-based alternatives that are not controlled by debit interchange fee-pricing regulations. One possibility is to rethink the features/functions that make up a debit card. Innovation may be able to incorporate new features/functions that add value to the card/account and allow the producer/distributor to charge, one way or the other, for the new incremental value. This is the type of long-term strategy analysis that the leading producers/distributors will execute to create new offerings for the marketplace.

Alternatives to debit POS are already emerging as options. One alternative that has been constrained in the U.S. is the EMV-standard smart card. While a lot of resistance from card issuers and retail merchants has helped sustain the mag stripe card transaction-processing environment, changing card-based POS processing technology to EMV standards may be to the producer's advantage for both debit and credit cards. Implementing this change now would highlight the "costs" that merchants would have to absorb as well as the producers and distributors. Enabling all cards with EMV standards is one clear way to facilitate and introduce new card-based capabilities that transcend the handling of debit POS transactions. For example, incentive-based programs can leverage a card with chip-based capabilities. Contactless and mobile payments are also manageable via EMV standards. EMV cards also provide a higher level of security and reduce card-based fraud. I wonder if Senators Dodd and Durbin or Congressman Frank ever contemplated if this part of the Dodd-Frank bill would be the tipping point that drove the mag stripe card out of business in the U.S. Probably not, but time will tell if there was a connection.

Bill Bradway, founder and managing director of Bradway Research LLC, analyzes the business strategies and IT investments of US banks and credit unions.