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On December 16, 2010, the Federal Reserve Board (“Board”) released its proposed rule to implement the Durbin Amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted on July 21, 2010.  The Durbin Amendment amends the Electronic Fund Transfer Act by adding a new section 920 regarding interchange transaction fees and rules for payment card transactions.  Comments on the proposed rule were due by February 22, 2011, and the rule goes into effect July 21, 2011.  The new regulation will be located within Part 235 of Title 12 of the Code of Federal Regulations.

The proposed new Regulation II, Debit-Card Interchange Fees and Routing, establishes standards for determining whether a debit card interchange fee received by a card issuer is reasonable and proportional to the cost incurred by the issuer for the transaction.  These standards ostensibly do not apply to issuers that, together with their affiliates, have assets of less than $10B.  There are two alternative fee standards that would apply to all covered issuers:

• Based on each issuer’s costs, with a safer harbor (initially set at 7 cents per transaction) with a cap (initially set at 12 cents per transaction); and
• A stand-alone cap (initially set at 12 cents per transaction).

Under the first alternative, issuers that wish to assess an interchange fee in excess of 7 cents per transaction would need to demonstrate that their costs exceed the safe harbor amount by dividing the costs incurred by the issuer with respect to electronic debit transactions during the calendar year preceding the start of the implementation period, divided by the number of electronic debit transactions on which the issuer charged or received an interchange transaction fee during that calendar year, not to exceed 12 cents per transaction.  Costs are defined as only those that vary with the number of transactions sent to the issuer and that are attributable to:

• Receiving and processing requests for authorization of electronic debit transactions;
• Receiving and processing presentments and re-presentments of electronic debit transactions;
• Initiating, receiving, and processing charge-backs, adjustments, and similar transactions with respect to electronic debit transactions; and
• Transmitting or receiving funds for interbank settlement of electronic debit transactions; and posting electronic debit transactions to cardholder accounts, exclusive of fees charged by a payment card network with respect to an electronic debit transaction.

The proposed rule also prohibits ALL issuers and networks from restricting the number of networks over which debit card transactions may be processed.  Again, there are two alternative approaches:

• One alternative would require at least two unaffiliated networks per debit card
• The other would require at least two unaffiliated networks per debit card for each type of cardholder authorization method (such as signature or PIN).

Regardless of which alternative is decided upon, the issuers and networks would be prohibited from inhibiting a merchant’s ability to direct the routing of debit card transactions over any network that the issuer enabled to process them.

Not surprisingly, this proposed rule has encountered great resistance from credit unions and community banks.  In practice, the small institution (under $10B in assets) exemption is illusory.  It is unclear how merchants and card networks would distinguish between small and large institutions.  Would merchants deny debit cards issued by small institutions in favor of debit cards issued by large institutions with the knowledge that the large institutions are limited in their ability to charge higher interchange fees?  In a letter to the Federal Reserve Board, endorsed by the National Association of Federal Credit Unions and the Independent Community Bankers of America, the Financial Services Roundtable stated, “With virtually unprecedented unanimity, every major bank and credit union trade association is writing to express opposition to the rule proposed by the Board of Governors of the Federal Reserve System.”

In congressional testimony, Federal Reserve Chairman, Ben S. Bernanke, Federal Reserve Board of Governor, Sarah Bloom Baskin, and Federal Deposit Insurance Corporation Chairman, Sheila Bair, voiced concerns that could slow implementation of the rule.  Bernanke told the Senate Banking Committee that, “It is possible that because some merchants will reject more expensive cards from smaller institutions or because networks will not be willing to differentiate the interchange fee for issuers of different sizes, it is possible….that the interchange fees available to smaller institutions will be reduced to the same extent we would see for larger banks.”  Bair testified that debit transaction fees would likely force smaller banks and credit unions to make up for lost revenue with higher account fees for their customers and members.

In a letter to the Board, the American Bankers Association (“ABA”) joined every major bank and credit union trade association urging the Board to rewrite the proposed rule on debit card interchange fees.  The executive director of the ABA Card Policy Council, Kenneth J. Clayton, wrote, “…setting price caps is un-American and this is even worse.  Banks won’t even be able to cover their expenses and will lose money on every transaction.  If the rule isn’t changed, the result will be increased fees for bank customers to make up for lost interchange fees charged to retailers.”  This letter also pointed out that free and low-cost checking accounts supported by interchange fees—and that are considered very important to low and moderate income customers—will no longer be available, forcing many Americans out of the banking system.  Card networks have estimated that these interchange fee restrictions will reduce revenue by as much as 75%.

It is not clear what effect the opposition will have on the proposed rule change.  Will the cap be increased to some value more reasonable than 12 cents per transaction?  Possibly.  However, regardless of the outcome of the Board’s rulemaking, it is imperative for all financial institutions to contemplate how they will compensate for lost revenue through debit interchange fees.

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