The $13 Billion Dollar Question: How Will the Proposed Interchange Fee Rules Work?

When the Federal Reserve released its proposed rule (Regulation II) implementing Section 1075 of the Dodd-Frank Act (DFA) on Debit-Card Interchange Fees and Routing, it unleashed a firestorm of comments from the banking industry opposing the rule.  Some have estimated that the new regulations would reduce banks’ income from fees by $13 billion.  Last week, the House Financial Services Committee held a hearing on the issue.

What Regulation II does, broadly speaking, is that it seeks reduce the amount of fees that debit-card bank issuers can charge merchants with the intent that such reductions would result in lower retail prices for consumers.  It does so in two ways: (1) by enacting a prohibition on network exclusivity arrangements and routing restrictions, and (2) establishing an interchange fee standard.

Seen more as a market-based approach, the prohibition on Network Exclusivity Arrangements and Routing Restrictions prohibit issuers and payment card networks from restricting the number of networks on which a debit card transaction may be processed to fewer than two unaffiliated networks. In Federal Reserve Governor Sarah Raskin’s recent testimony on the proposed rule, there are two possible interpretations of the prohibition: 
1.     Transactions must be routed through at least two unaffiliated payment card networks (such as one pin-based network, and one signature-based network); or
2.     Transactions must be routed through at least two unaffiliated payment card networks for each method of authorization available.

Under the second interpretation, Raskin argues that there are more routing choice for merchants, but concedes that there are more operational changes required of debit card networks, issuers, merchant acquirers, merchants, and their processors.  Notably, however, her testimony mentions that 6 of 8 million merchants currently have no PIN-based capacity. Further, the new regulations prohibit issuers and networks from inhibiting the ability of merchants to route debit card transactions over any network that may process such transactions.  Although the Fed has been accepting comments on these two possible interpretations of the prohibition, Governor Raskin’s testimony does seem to suggest that the Fed favors the second interpretation.

Regulation II’s second and much more contentious regulatory change deals with the establishment of an interchange fee standard.  Under Regulation II, interchange fees that an issuer may receive for a debit-card transaction is limited to an amount that is “reasonable and proportional” to issuer’s cost with respect to the transaction. In particular, § 1075 requires that the Fed, in establishing these standards, to consider how the standards will make debit-card transactions functionally similar to check transactions, which have no fees.  That essentially means setting standards such that it minimizes costs to consumers.  § 1075  also requires that the Fed distinguish between the issuer’s incremental costs to authorize, clear and settle transactions and its fixed cost.  The Fed has chosen to interpret incremental costs in § 1075 to equate to “average variable costs” and have proposed a cap of 12 cents for interchange fees, which is 70 percent lower than last year’s 44 cent per transaction average, based on its survey and analysis of industry costs.  It’s worth noting that the new interchange fee caps exempt small issuers (with assets below $10 billion), government benefit programs and pre-paid cards. However, there are no exemptions for the network exclusivity and routing requirements.

Even as the commenting period comes to close on Tuesday, February 22, 2011, advocates and industry interest groups alike will continue to wage a public battle against these new proposed rules.

James Nguyen, The $13 Billion Dollar Question: How Will the Proposed Interchange Fee Rules Work?, Berkeley Bus. L.J. Network (March 23, 2011),