What Issuers Need to Do Now to Prepare for Reg II Changes
DISCLAIMER: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of PULSE® or its affiliates.
Tony Hayes
Founder, Banking & Payments Group
The Federal Reserve is expected to release the Final Rule for its update to Regulation II soon, ushering in a new era of lower debit interchange for covered issuers1. The change to Reg II will impact all participants in the payment system.
This article details the Fed’s proposed changes and offers recommendations on what issuers should do now to prepare. This guidance applies to all issuers, as the ramifications of this change are likely to be felt industry-wide.
Reg II – An Overview
The Dodd-Frank Act, signed into law in July 2010, includes the Durbin Amendment. The statute has two primary components:
The Federal Reserve implemented the Durbin Amendment via Regulation II, which capped the interchange fee a covered issuer can receive per transaction at $0.21 plus 0.05% of the transaction value, plus an additional $0.01 for fraud prevention (if the issuer’s fraud-prevention efforts qualify).
The impact was immediate for covered issuers. Debit program revenue plummeted, prompting them to explore ways to offset the reduction, and rates on signature and PIN debit converged.
Proposed interchange rate cap
In its new role as debit regulator, the Federal Reserve began to collect data on issuer costs via a biennial survey.
Data from the first survey were used to inform the original interchange rate cap. In 2022, the Federal Reserve conducted its 7th survey, collecting data for calendar year 2021. Through these surveys, the Fed concluded, “Analysis of data collected by the Board shows clear changes in costs underlying each of the three components of the interchange fee cap since Regulation II was adopted.”2
The Federal Reserve found that average debit transaction-processing costs for covered issuers declined by nearly 50%, from 7.7¢/transaction in 2009 to 3.9¢ in 2021. Citing its directive that interchange should be “reasonable and proportional” to issuers’ costs, the Fed proposed lowering the cap by approximately 28%.3 For a $40 debit transaction, under the proposal, a covered issuer would receive 17.3¢, down from 24.0¢ today.
The deadline for comments on this proposal was originally set for February 12, 2024. Given the significance of the proposed change to the entire payments industry, the Fed later extended this deadline to May 12.
This is the first time the Federal Reserve will change the interchange cap since its introduction, and all sides – issuers, merchants, and the Fed itself – are keen to “get it right.” There is little doubt that the cap will change, and we currently anticipate a go-live date of October 1, 2024 (to coincide with the 13th anniversary of the effective date of the first interchange rate cap).
Future cap adjustments
While the drop in issuers’ interchange income has captured most of the headlines, there is another important detail embedded within the Fed’s proposal.
Since the 2011 survey, covered issuers have been required to respond to the Federal Reserve’s biennial survey and to provide detailed information on their allowable debit-program costs. As part of the current proposal, the Fed has committed to automatic revisions to the cap every two years, using cost data from this survey to inform the new cap.
The wheels are already turning for the first rate change that will follow introduction of the new cap.
Issuers are currently in the process of responding to the Fed’s 2023 survey.4 Based on issuers’ cost data, the Federal Reserve will announce the new interchange cap by March 31, 2025. For the base component, the rate will be 3.7 times higher than the average transaction cost among covered issuers. This new rate will take effect July 1, 2025 and will prevail for 24 months (until the next survey’s data are used to adjust the rate again). Unlike now, the cap will be set without a comment period.
In other words, the stability of the past 13 years will be replaced with rate resets every two years (provided this provision remains intact in the final rule).
How issuers can prepare
Without the exact details of the new Reg II interchange cap, it may be tempting for issuers to delay planning their response; this would be a mistake. We can be confident that the interchange rate for covered issuers will be reduced significantly. Based on this direction, what should covered issuers do now? And should exempt issuers also make any preparations?
Covered issuers
Two-thirds of U.S. debit transactions will soon be re-priced lower. Financial institutions directly impacted by this change have three broad strategic choices:
1. Adjust fees
Debit interchange is a critical component of checking-account economics. Following the introduction of Reg II, a U.S. Government Accountability Office report stated, “Studies found that debit card interchange fee regulations increased the cost of checking accounts.”5 It is reasonable to anticipate similar consequences from the pending change. Some issuers may find it necessary to increase fees, boost minimum balances, or take other actions to support account economics. However, given the highly competitive banking market, any re-pricing risks pushing cardholders out of your institution (to a different covered issuer or to an exempt issuer or non-bank provider).
2. Reduce costs
A decline in the cap demands even more rigorous cost control and operating efficiency. The industry may already be at – or near – the bottom of the cost curve. With the current cap, approximately 23% of the 160 issuers that receive capped interchange lose money on every debit transaction. With a lower cap, there will be more issuers operating debit programs with negative margins. Cost containment needs to be Job #1 for these institutions.
3. Invest in growth
The number of U.S. debit transactions has doubled in the decade tracked by the Fed surveys, from 46.7 billion in 2011 to 92.1 billion in 2021. Looking forward, can issuers use additional volume to help offset the rate decline? Debit has become the most commonly used payment method, gaining share year after year. Rather than cutting costs, for many issuers the better strategy will be to continue to invest in their debit programs to drive greater cardholder engagement across consumer and small-business portfolios.
Exempt Issuers
While Reg II only caps the interchange per transaction that covered issuers can receive, there are still clear ramifications for exempt issuers. Smaller issuers are advised to consider two distinct dynamics.
1. Greater opportunity
Starting in October 2011, smaller institutions enjoyed a significant debit revenue advantage over their larger peers. Later this year, that revenue differential will increase. Based on the proposed rate, exempt issuers will earn an estimated three times more revenue per transaction than larger financial institutions. For an active debit cardholder, exempt institutions will earn over $100 more than larger FIs per account each year.6 This revenue differential creates multiple opportunities for smaller banks and credit unions to compete for new consumer and small-business customers.
2. Lower revenue
Exempt issuers should also prepare to receive a lower yield on their debit spend. Despite not being subject to the cap, issuers are likely to experience revenue declines as card-brand and EFT networks compete to win routing. Immediately following the introduction of Reg II, exempt issuers received an average of $0.32 per single-message debit transaction. By 2021, this rate had dropped to 19% lower than before Reg II went into effect.
With the revised cap providing a new lower reference point, exempt issuers would be wise to prepare for a spillover drag on their income stream.
Putting it all in perspective
No issuer will welcome the lower debit interchange cap. But the key metric for financial institutions is debit program revenue (price per transaction multiplied by volume). While issuers have no control over the rate, they do have some control over their volume.
With the doubling of debit transactions between 2011 and 2021, issuers collectively earned almost twice as much gross interchange revenue by the end of that period compared with the early days of Reg II ($31.6 billion in 2021 versus $16.3 billion in 2013).
For covered issuers, the challenge is clear. Between 2011 and 2021, these issuers managed to end the period receiving the same level of gross interchange ($12.9 billion) as they did at the start. With a similar level of determination, agile institutions that adapt to continue to meet their account holders’ payment needs will also overcome this new challenge.
While smaller financial institutions are technically exempt from interchange-rate regulation, they are likely to also experience downward pressure on the yield on their cardholders’ debit card spend. Strategic issuers will look to leverage their economic advantage to gain share, working with third-party partners that deliver the strongest revenue and cost propositions.
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1The label “covered issuer” is now a defined term within Regulation II and refers to issuers with debit cards that are covered by the interchange rate cap. It includes financial institutions with at least $10 billion in assets, but excludes reloadable prepaid cards, government-administered payment programs, and three-party networks. Covered issuers represent approximately two-thirds of all non-prepaid debit transactions (this share has been stable over time).
2Staff memo to the Federal Reserve Board of Governors re: “Proposed Revisions to Regulation II’s Interchange Fee Cap,” October 18, 2023.
3The interchange cap is constructed from three components. Within the base component, the original calculation used a 2.7x multiplier (issuer costs of 7.7¢ x 2.7 = 21.0¢). For the proposed new cap, the base component uses a 3.7x multiplier (allowable issuer costs of 3.9¢ x 3.7 = 14.4¢).
4Given the more direct linkage between the cost data that an issuer submits and the rate cap that the Fed imposes on the industry, the Federal Reserve is also increasing its scrutiny over the accuracy of survey responses provided by financial institutions. Going forward, FIs will need to retain the debit and finance records used to complete the survey in case the issuer ever needs to substantiate their submission.
5GAO report on Banking Services, February 2022.
6Based on the average number of transactions per card, for active cards. Source: 2023 PULSE Debit Issuer Study.